1. Introduction
Firms’ sustainability differs when the outside degree of economic policy uncertainty is different. As far as firms are concerned, given the high risk and more principal–agent costs conveyed by economic policy uncertainty, higher uncertainty around the economic policy indicates that it is harder for the firm to survive and grow sustainably. In particular, economic or political shocks can elicit significant reactions from the real economy, such as investment curtailment [
1], deferring investments [
2], increasing the cost of external financing [
3], or making it easier to fall into financial distress [
4], which have increased the difficulty of sustainable development for firms. However, there is little empirical research on the efforts firms make to deal with this uncertainty, especially from the perspective of firm system construction. Our study proposes a link between economic policy uncertainty and internal control to explore how firms handle the challenges of developing sustainably from the perspective of firm system construction.
Specifically, we address this question by using a Chinese dataset of public firms listed on the Shanghai and Shenzhen stock exchanges. In our view, this task is particularly attractive and difficult in China. On the one hand, China is a unique market in which test the impact of policy uncertainty because it is still regarded as in transition, shifting from a planned economy to a market-based economy. During this period, firms in China have had to face unprecedented economic policy challenges. On the other hand, sustainable development may be particularly difficult in emerging markets like China, where firms’ growth is known to hampered by principal–agent problems and poor management [
5].
Sustainable development requires the economy to transform from high-speed to high-quality growth. For firms, the intrinsic demand for sustainable development is closely related to the objectives of internal control, specifically: ensuring achievement of an organization’s objectives in terms of operational effectiveness and efficiency, reliable financial reporting, compliance with applicable laws and regulations, and safeguarding of assets [
6], which serve as the foundation for ensuring the sustainable and steady development of firms. Better internal control promises to effectively guard against operation risks [
7] and solve agency problems [
8] caused by information asymmetry, thereby promoting a more effective allocation of resources.
A large body of literature has examined the influence factors of internal control, most of them focusing on the influence of the firm-level factors upon internal control [
9,
10,
11], with few directly examining the influence of factors outside firms upon internal control. However, it is necessary to consider the influence of macro factors upon internal control, since the internal control serves as the medium bridging macro-economic policy and micro governance behavior. To this end, this paper attempts to examine the influence of economic policy uncertainty upon internal control.
Increasing economic policy uncertainty means that the economic policy, such as monetary, fiscal, regulatory, and trade affairs, might change, thereby indicating increasing risk in the external environment [
12]. On one hand, the change in risk may increase losses and the difficulty of developing sustainably, forcing managers to put more efforts into improving operational efficiency, avoiding penalties like salary cuts or dismissal for poor performance, and ultimately improving the willingness of management to carry out internal control. On the other hand, the impact of uncertainty increases the difficulties of firm operation risk evaluation and problem solving, hence making internal control more difficult. Moreover, it may also influence internal control because of the principal–agent cost between controlling shareholders and minority shareholders, shareholders, and managers. In addition, in environments with weak investor protection, it is possible that the internal control is captured by management and controlling shareholders, and is therefore ineffective. Hence, it remains an empirical issue to be verified how economic policy uncertainty influences internal control.
We begin our empirical analysis by measuring the two main variables. To measure economic policy uncertainty, we resort to Baker et al. [
13], in which they develop a new index of economic policy uncertainty (EPU) for the USA. Their EPU index has been shown to be a good proxy of real economic policy uncertainty. Following similar logic and methodologies, they then constructed EPU indexes for Europe, Canada, China, and India. For our study, we adopt their China index to proxy the economic policy uncertainty. To measure internal control in China, we use the “Internal Control Index of Chinese Listed Companies” constructed and released by Chen et al. [
14], which comprehensively evaluates and quantitatively measures a firm’s internal control, based on the Internal Control Integrated Framework of the Committee of Sponsoring Organizations of the Treadway Commission (COSO). The COSO framework was identified by the Securities and Exchange Commission (SEC) Release No. 33-8810 as being suitable for management to assess the effectiveness of the company’s ICFR [
15]. (In the same release, SEC also cited the Guidance on Assessing Control published by the Canadian Institute of Chartered Accountants (“CoCo”) and the report published by the Institute of Chartered Accountants in England & Wales Internal Control: Guidance for Directors on the Combined Code (known as the Turnbull Report) as examples of other suitable frameworks that issuers could choose in evaluating internal control effectiveness. SEC encourages companies to examine and select a framework that may be useful in their own circumstances; the SEC also encourages the further development of existing and alternative frameworks.)
The COSO framework defined internal control as a process, effected by an entity’s board of directors, management and other personnel, designed to provide reasonable assurance regarding the achievement of objectives in four categories: (1) effectiveness and efficiency of operations, (2) reliability of financial reporting, (3) compliance with applicable laws and regulations, and (4) safeguarding of assets. (The first three categories are contained in the 1992 original COSO report and the fourth category, “safe guarding of assets,” is added in the 1994 COSO addendum to the Reporting to External Parties volume of the COSO report.) The internal control index that we use encompasses the full set of internal controls pertaining to the aforementioned four categories in the COSO report. Because we are assessing firms’ sustainability, we treat the internal control as the micro foundation for ensuring sustainable and steady development of firms; adapting it to accommodate unique Chinese conditions, we use this internal control index, which is based on the COSO framework, to measure internal control quality. In other words, the method can better measure internal control quality and suit our situation. This index has been validated and used widely in internal control research [
16,
17,
18,
19].
Using a panel of publicly listed Chinese firms from 2007 to 2015, we conducted empirical tests on the association between economic policy uncertainty and internal control. Results reveal that internal control of firms are significantly enhanced when outside economic policies are more uncertain, suggesting that, in order to deal with the impact of economic policy uncertainty for firms developing sustainably, managers are more motivated to improve the internal control. It also indicates that, due to the impact of economic policy uncertainty, the benefit of improving internal control outweighs the cost. After considering the marketization degree, nature of property rights and analyst following, it is discovered that the influence of economic policy uncertainty upon internal control is more obvious in state-owned firms and regions with more analysts following and relatively low marketization. Further verification shows that the managers indeed enhance internal control when the uncertainty is relatively high, so the corresponding internal control auditing cost lowers accordingly. Hence, we have empirically verified the association between economic uncertainty and internal control cost to prove the main hypothesis, and the result of empirical verification also verifies our expectation, i.e., the internal control cost is relatively high in the context of economic policy uncertainty.
This paper makes the following contributions. Firstly, most of the existing literature starts with the angle of company traits or governance and discusses the influence of factors inside firms upon internal control. Although this area of research is abundant, there are two problems with it, including little consideration of the influence of macro factors upon internal control, and regarding internal control as more of a restraint upon financial reporting rather than as a risk prevention decision influencing a firm’s operational strategy and sustainable development. The external macro environment is the foundation and precondition for developmental decision-making by firms, so it has a serious influence upon internal control decision-making. It is by utilizing the exogenous variable of economic policy uncertainty that this paper explores the influence of external environmental uncertainty upon internal control of firms, analyzing the association between the two from the angle of information supply and demand changes caused by external risk and information asymmetry, and thereby enriching the research on internal control and partially making up for internal control research’s lack of macro vision.
Moreover, the existing literature has also studied the influence of economic policy uncertainty upon macro-economic development [
20], tax avoidance [
21], investment [
2], corporate financing [
22], financial risk [
23], etc. These studies mainly focus on the influence of discontinuous external turmoil caused by economic policy uncertainty upon a firm’s financial decision-making or the financial market. However, our study shows that firms tend to increase internal control when economic policy uncertainty is high. In terms of firm behavior, this raises a more fundamental issue for firms’ sustainable development, i.e., whether economic policy uncertainty influences firm system construction, or, in other words, will firms try to seek system dividends to ensure the sustainability of development when external uncertainty increases? This study also pushes forward the research on economic policy uncertainty, providing more complete evidence on economic policy uncertainty and firm behavior.
The rest of this paper is arranged as follows: the second part is the theoretical background, the third part gives the hypothesis, the fourth part explains the research design, the fifth part reports the empirical results, and the sixth part gives our research conclusions.
6. Conclusions
Sustainability is a perpetual topic. First of all, sustainability requires us to consider both the needs of current development and the needs of future development; we cannot pursue temporary development and interests at the expense of the interests of the next generation. Furthermore, sustainability means maintaining development trends even when facing unpredictable environmental shocks. Because the sustainability concept is quite wide, the research on sustainability is diverse and challenging, but mainly includes sustainable urban and rural development [
78], sustainable use of the environment and resources [
79], energy sustainability, the economy [
80], business and management aspects of sustainability [
81], etc. This study is included in a branch of research that considers business and management aspects of sustainability, focusing on firms’ sustainability.
Because sustainable development requires the economy to transform from high-speed to high-quality growth, we explore how firms seek sustainable development in a turbulent external environment by conducting the first study analyzing the association between economic policy uncertainty and internal control. We provide evidence that internal control is enhanced as firms seek to handle uncertainty and develop sustainably. Specifically, when economic policy uncertainty is higher, firms will improve internal control. Especially for those firms in the provinces with a low marketization degree, state-owned ones, and ones with a smaller number of analysts following, the effect is even greater. A more obvious promotion effect of uncertainty upon internal control on those firms mentioned above indicates that they are more sensitive to economic policy uncertainty and have more difficulty developing sustainability. Furthermore, we conducted an analysis of side demonstration, finding out that economic policy uncertainty lowers internal control auditing fees, demonstrating the association between uncertainty and internal control from the side. Collectively, these findings enrich the studies of economic policy uncertainty and internal control, giving empirical evidence for linking macro uncertainty factors and the micro foundation of sustainable development for firms.
Different from existing studies that care more about the outcomes of corporate sustainable development, such as profit and sales income [
28,
82], this study focuses on the micro-foundation of firms’ sustainable development, i.e., internal control. We believe that internal control is the micro-foundation of corporate sustainable development, so we directly test the relationship between economic policy uncertainty and internal control, and explore whether enterprise managers will perceive economic policy uncertainties when constructing internal control and how to deal with the risks brought about by such uncertainties. There are two reasons to support us. First, based on the important internal control framework, the COSO framework recommended by the SEC, the four main objectives of internal control are: (1) effectiveness and efficiency of operations, (2) reliability of financial reporting, (3) compliance with applicable laws and regulations, and (4) safeguarding of assets provide guarantees. We have a view to improving efficiency, reducing risk, helping ensure the credibility of financial statements, complying with laws and regulations, and protecting asset safety. The COSO framework believes that an internal control system consists of five elements: controlled environment, risk assessment, internal control activities, information and communication, and supervision, which run all through enterprise management and business activities. At the same time, an overwhelming number of existing studies show that good internal control is closely related to corporate sustainable development, such as improving corporate investment efficiency [
39], reducing the likelihood of bankruptcy and financial distress [
83], and lowering the risk of stock price collapse [
16,
84,
85]. No matter the objectives, elements, or existing experience, they all indicate that internal control can effectively improve the sustainable development of enterprises, serving as the micro-institutional foundation for corporate sustainable development.
Moreover, our research results show that, when economic policy uncertainty is higher, enterprises will improve the quality of internal control; it is further found that the internal control audit fees of enterprises will be reduced. As mentioned previously, different from previous studies that focus more on the influence of economic policy uncertainty on financial decisions such as investment and financing, we have studied the micro-institutional foundation of enterprises for sustainable development, i.e., internal control, which is a more fundamental issue, exploring the influence of economic policy uncertainty on the micro-institutional foundation of corporate sustainable development. Furthermore, our research has successfully captured how, when constructing and investing in internal control, managers can truly perceive external economic uncertainties and make corresponding responses, so as to effectively protect against the risks brought about by the uncertainties and ensure the sustainable development of enterprises. That economic policy uncertainty reduces internal control audit fees also proves that enterprises have indeed improved the efficiency of resource allocation, backing up the relationship between economic policy uncertainty and internal control. The existing literature mainly discusses the influence of internal factors on internal control from the perspective of corporate traits or governance, with few considering the influence of external factors on internal control.
By drawing on the external variable of economic policy uncertainty, this paper studies the influence of external environmental uncertainty on the internal control, thus expanding the macroscopic view of internal control research. Therefore, this paper examines a more fundamental question: whether economic policy uncertainty will affect the system construction of corporate sustainable development, i.e., internal control; in other words, will a company seek institutional dividends by raising internal controls when external uncertainty increases? This paper also further advances the research on external environment and corporate sustainable development, and provides more complete evidence for the study of economic policy uncertainty and corporate sustainable development.
The current study has several important implications. First of all, the influence of economic policy uncertainty upon firms comes from implicit economic policy guidance and intensity, so policymakers can ease the pressure upon information demand by raising the information disclosure level and improving information consistency and comparability before and after the introduction of economic policies; they should also ensure that introduced policies are put into practice, so as to decrease possible losses that might be incurred by firms. Moreover, given that internal control serves as a means for firms to enhance their own ability to cope with risk, for the purpose of sustainability, policymakers need to emphasize the design and arrangement of an internal control system, elements and execution procedures, and ensure effective implementation of risk management and control procedures. There are several limitations to this work: first of all, because the Chinese economic policy uncertainty index is based on article indexes in the English version of the South China Morning Post, there may be a certain contextual discrepancy between it and the Chinese version. The development of emerging industries and firms has brought about new opportunities and challenges for sustainability. Future research may center on the sustainability of emerging firms, such as entrepreneurial firms.