The top management in the firm is responsible for establishing strong internal control systems, which may include complying with internal auditing standards, international accounting standards, and Sarbanes-Oxley Act of 2002. In order to understand internal control systems, this research presents several definitions. For example, Romney and Steinbart (2003) define internal control as “a plan or method that will be used from the organisations to preserve their assets, provide accurate and reliable information, promote and improve operational efficiency, and encourage adherence to prescribed managerial policies”. In another definition, Amudo and Inanga (2009) describe internal control as “a system to monitor and control the manipulation, and accounting scandals in the financial statements in the developed and emerging markets”. Hayes, Dassen, Schilder and Wallage (2005) define internal control as “a procedure that guides the board of directors
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and management to monitor and achieve all the performance and profitability goals in the firms”.
Aforementioned definitions document that the main aim of internal control is to prevent any potential errors, mistakes or fraud that might occur during the preparation of financial statements, which means that the strong internal controls are more likely to increase the transparency and reliability in financial statements (Doyle, Ge and McVa, 2007). Internal control and management control act as a combined system and work together to control business affairs. In other words, it is not possible to separate internal control from management functions (i.e. planning, organizing, staffing, directing, leading, controlling and coordinating), where both of them are working to achieve firm objectives (Chambers and Rand, 1997).
The Committee of Sponsoring Organizations of the Treadway Commission, the Public Oversight Board and the Board of Directors of the AICPA document that the reports of internal control would lead to the improvement of internal control systems for two reasons: (1) good internal control will lead the firms to comply with the operating and financial objectives that have issued by accounting institutions, and (2) reporting the quality of internal control in financial reporting could lead to improvements in the quality of firm’s disclosures by providing financial reporting users, whether internal or external, with proper information (COSO, 2009). On the other hand, there are some writers who believe that internal control reporting does not affect internal control systems. This debate makes internal control reporting an important issue to the accounting profession, and generates significant controversy in the context of internal control (McMullen, Roghunandan and Rama, 1996).
Several studies in prior literature document that internal control is considered as one of the most important factors that prevent the errors and mistakes or manipulations that might occur during the preparation of financial statements. Altamuro and Beatty (2010) find a positive relationship between the application of internal control regulations and quality of financial reporting. In another research study, Karagiorgos, Drogalas, Gotzamanis and Tampakoudis (2010) investigate the roles of internal audit contribution to corporate governance from the theoretical side in which three variables were used to
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measure internal auditing quality (audit committee composition, external auditor, and internal audit process). This study finds that the audit committees contributed to corporate governance by providing information about internal controls, risk management processes, fraudulent activities or irregularities, managing and reviewing annual and periodic audits reporting. They also found that external audit and internal audit processes contributed to corporate governance by conducting and reviewing ethics policies and the organization’s code and communicating to employees. Finally, their empirical evidence indicates that external audit and internal audits are considered to be a cornerstone of corporate governance by detecting any error or mistake or manipulation that might arise during the preparation of financial statements.
Based on a sample of 13,395 firms from Germany, Australia, Switzerland, France and the UK over the period 1994-2002, Brown, Pottb and Wömpenerb (2014) argue that greater effectiveness and efficiency in internal control could lead to increased earnings quality in these firms. They used two models to examine their argument; (1) the returns-based model, and (2) the accruals-based model. Cross-sectional regressions were used to compare German firms with UK, Swiss, French and Australian firms. Thus, they made a comparison between legislation of SOX and KTG for German companies in order to reflect internal control variables. Their findings show that the effectiveness and efficiency of internal control leads to increased earnings quality in the financial statements in these countries.
Prior studies have also investigated the impact of internal control on different issues such as financial reporting, earnings quality and financial institutions taking lending decisions. For example, Altamuro and Beatty (2010) examine the impact of internal control regulations on financial reporting in the US. Their results show a positive relationship between the application of internal control regulations and financial reporting disclosure. Based on interviews with 111 loan officers, Schneider and Church (2008) investigate the relationship between internal control systems and lending officers’ assessments of company’s creditworthiness. Measures such as an adverse internal control opinion, unqualified internal control opinion and employing a "big four" firm as external auditor were used to assess the quality of the internal control system. Their results show the firms
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that receive unqualified internal control opinions by external auditors could easily get bank loans.