Chen 2020

Journal of Corporate Finance 64 (2020) 101695
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Journal of Corporate Finance

journal homepage: www.elsevier.com/locate/jcorpfin
Internal controls, risk management, and cash holdings

T
Hanwen Chena, Daoguang Yanga, Joseph H. Zhangb, , Haiyan Zhouc
⁎
a
University of International Business and Economics, China
b
The University of Memphis, USA
c
University of Texas Rio Grande Valley, USA
ARTICLE INFO ABSTRACT
Keywords: Exploiting a unique setting in China where internal controls are intended to manage risks, we
Internal controls investigate how internal controls shape the cash holding policies. Results show that firms with
Risk management higher internal control quality (ICQ) are less likely to have abnormal cash holdings, either excess
Cash holdings or deficit cash, and this effect is not driven by corporate governance quality. We also find that
Corporate spending
firms with higher ICQ are more likely to increase dividend payments and are less likely to in-
crease M&A investments, especially when the firms have had a negative experience with prior M
JEL classifications:
&A investments. Furthermore, our tests on the market valuation of cash holdings show that in-
G30 G38 M48
vestors place a higher value on cash holdings of firms with higher ICQ. Collectively, our findings
suggest that internal controls help companies shape reasonable cash policies that lead to value
creation.
1. Introduction
“Cash is king” as it directly determines financing, investments, operations, payouts, and consequently firm value. Given either
deficit cash or excess cash would incur risk and uncertainty concerns for business, an optimal level of cash holdings is the centerpiece
at the heart of the finance, risk, and governance challenges. It requires firms to equip a sound risk control system, which treats risk as
neutral and manages it within a reasonable capacity to maximize firm value (COSO, 2004; COSO, 2017). The Sarbanes-Oxley Act
(SOX) of 2002, issued after a series of financial frauds, requires internal controls over financial reporting, which distract firms from
business operation to compliance (Engel et al., 2007), reduce risk-taking (Bargeron et al., 2010; Kang et al., 2010), and hinder
operational performance (Ahmed et al., 2010). Different from U.S. SOX, China reformed internal controls in 2008 in order to tackle
the problem of operational inefficiency.1 It requires firms to establish an effective internal control system to manage and control risks,
to achieve important business objectives, and to sustain and improve firm performance. In this paper, we investigate how internal
controls shape the cash holding policies using China's setting in which its internal controls are intended to manage risks.
In addition to the scope and objectives of the internal controls, China's setting provides an impetus to evaluate how effective
internal controls improve cash management. First, as the world's largest emerging and transitioning economy, China's financial
Corresponding author.
⁎
E-mail addresses: hwchen@uibe.edu.cn (H. Chen), dgyang@uibe.edu.cn (D. Yang), jzhang5@memphis.edu (J.H. Zhang),
haiyan.zhou@utrgv.edu (H. Zhou).
1
In August 2008, the Chinese regulatory bodies, including the Ministry of Finance, the Security Regulatory Commission, the National Audit Office,
the Banking Regulatory Commission, and the Insurance Regulatory Commission, jointly issued the Basic Standard for Enterprise Internal Control
(hereafter, the Standard). In April 2010, the five government agencies mentioned above published three supplemental guidelines for implementing
the Standard: Guidelines for Application of Enterprise Internal Control (Application Guidelines), Guidelines for Assessment of Enterprise Internal
Control (Assessment Guidelines), and Guidelines for Audit of Enterprise Internal Control (Audit Guidelines).
https://doi.org/10.1016/j.jcorpfin.2020.101695
Received 1 February 2019; Received in revised form 16 May 2020; Accepted 6 July 2020
Available online 12 July 2020
0929-1199/ © 2020 Elsevier B.V. All rights reserved.
H. Chen, et al. Journal of Corporate Finance 64 (2020) 101695
system is dominated by a gigantic yet creaky, clumsy banking sector, with a rapidly growing but still inefficient and inequitable
capital market (Allen et al., 2005; Megginson et al., 2014; Li et al., 2017). These under-developed systems make external financing
costly. For many Chinese firms, managing liquidity is among the most important tasks, particularly in the face of potential economic
downturns. This institutional background offers a unique avenue through which we can examine the impact of effective internal
controls on cash management.
Second, by using Chinese firms, this study gains the advantage of data availability. Chen et al. (2017b) develop a comprehensive
dataset of internal control quality (ICQ) index for Chinese firms that allow us to measure the effectiveness of internal controls, which
covers operations, compliance, safeguarding of assets, and financial reporting. The index is built on COSO (1992, 2004), the Standard,
and the rules from exchanges (i.e., Shanghai and Shenzhen stock exchanges), and other applicable laws (e.g., Code of Corporate
Governance for Listed Companies in China). Unlike the U.S. data that involve binary ratings (i.e., “effective” versus “ineffective”) to
indicate internal control quality, this dataset provides a continuous, graded measurement of ICQ, which can assess the large variance
in ICQ within firms having effective or ineffective internal controls (e.g., Chen et al., 2017b; Ge et al., 2019). It is also less likely to
suffer from the nondisclosure problem documented in Rice and Weber (2012).
Based on a large sample of Chinese firms listed on the Shanghai and Shenzhen stock exchanges from 2007 to 2015, we find that
ICQ is significantly and negatively associated with abnormal cash holdings, suggesting that effective internal controls contribute to
targeting at the optimal level of cash holdings. After partitioning the full sample into subsamples of extra cash and deficit cash, we
find that the negative association between ICQ on abnormal cash holdings remains, indicating that internal controls help manage
both upside and downside risk related to cash holdings.
An alternative explanation for our main results may be that a set of corporate governance mechanisms, such as independent
directors, institutional investors, and well-structured ownership, drive the inhibiting effect of abnormal cash holdings. While cor-
porate governance and internal controls partially overlap in one of the five components of internal controls, i.e., Control Environment,
they are different channels for value creation, as the former focuses on incentive alignment between owners and managers and the
latter on risk management involving all the workforce within a firm (Chen et al., 2020). We exclude corporate governance elements
from the ICQ index to generate a new index with no corporate governance and find that the above association is not mitigated,
suggesting that the effect of internal controls on cash policies is not led by corporate governance quality.
The effective internal control system consists of five integrated components (COSO, 1992): Control Environment, Risk Assessment,
Control Activities, Information and Communication, and Monitoring. These components work to establish the foundation for adequate
internal control within the company. To check their specific role in cash holdings, we examine each component and find that the
quality of Control Environment, Control Activities, Information and Communication, and Monitoring are negatively associated with ab-
normal cash holdings. Caution should be taken in interpreting the insignificant effect of Risk Assessment on abnormal cash holdings.
As internal control functions are desegregated, it is plausible that its effect may be absorbed by that of the other four components.
To deepen our understanding of the role of internal controls, we conduct some additional tests. Considering policies of cash
spending, we examine how internal controls affect the way that firms disgorge extra cash. We find that firms with higher ICQ are
more likely to increase dividend payments and are less likely to increase M&A investments, especially when the firms have had a
negative experience with prior M&A investments. We also consider how ICQ affects the market valuation of cash holdings. Our results
suggest that investors place a higher value on the cash held by firms with higher ICQ. Collectively, these findings indicate that
internal controls help firms shape reasonable cash policies that lead to value creation.
This study contributes to the literature in the following ways. First, by exploiting a unique setting in China whose internal controls
have different orientations from the U.S., we contribute to the understanding of the economic consequences of country-specific
internal control regulations. After 2002, many countries passed internal control regulations intended to mimic the reform embedded
in SOX. However, both Leuz (2007) and Coates and Srinivasan (2014) solicit more evidence to extrapolate the findings from market
and country-specific trends. We fill this gap by providing evidence in China where internal controls regulation covers both internal
controls over financial reporting (ICFR) and non-financial reporting and targets risk management.
Second, unlike Gao and Jia (2016), who examine the effect of internal control deficiencies in the U.S. on the valuation of cash
holdings from the perspective of agency motives, our study attempts to investigate how internal controls can influence cash policy.
We investigate several relevant aspects, including whether cash holdings are optimal, the means and motives for disgorging extra
cash, and the market value of cash holdings. Besides, while other U.S. studies depict how ICFR spillovers from financial information
to operation (e.g., Cheng et al., 2013; Bauer, 2016; Cheng et al., 2018; Harp and Barnes, 2018), our research directly assesses the role
of internal controls in corporate finance by examining control systems that go above and beyond the financial reporting objective.
Third, our findings help to mitigate debates on the potentially negative effects that internal controls and related regulatory
reforms (e.g., SOX and other contemporary corporate governance reforms) have on operational decisions. Critics claim that SOX
imposes certain constraints on corporate operations, such as leading managers to behave too cautiously (Engel et al., 2007; Kang
et al., 2010), shifting their work focus toward rule compliance (Ahmed et al., 2010), avoiding risk-taking (Bargeron et al., 2010), and
discouraging innovation (Gao and Zhang, 2019). All of the constraints would impair the long-term firm growth. Our findings,
however, suggest that in China, internal controls serve to manage risk at a reasonable level (Chen et al., 2020) that benefits the firm's
value-creation.
The remainder of this paper proceeds as follows: Section 2 reviews the literature and presents our research hypothesis, Section 3
presents the research sample, Section 4 discusses the main empirical results, Section 5 reports the results of additional tests and
robustness check, and Section 6 concludes the paper.
2
2. Literature review and hypothesis development
2.1. Existing studies
The challenges of establishing and maintaining effective internal controls rest with the strictness of risk control. This type of
internal control is accompanied by flexible constraints that cannot be too strict or too loosened. Instead, managers are expected to
align their strategy with the firm's risk appetite to deliver firm value, as COSO's (2004) risk management framework suggests. The
SOX Act mandates strict internal controls. Hence, criticisms of SOX have continued since its enactment in 2002 (Coates and
Srinivasan, 2014), though some benefits of SOX compliance are documented in the extant literature, such as improving internal and
external information environments of firms (e.g., Ashbaugh-Skaife et al., 2008; Arping and Sautner, 2013), enhancing corporate
governance (Chhaochharia and Grinstein, 2007; Hochberg et al., 2009) and their economic consequences such as increasing in-
vestment and operational efficiency (Cheng et al., 2013; Feng et al., 2015; Bauer, 2016; Cheng et al., 2018), and reducing financing
costs (Ashbaugh-Skaife et al., 2009; Kim et al., 2011).
However, these benefits may come with high implementation costs. Hart (2009) contends that SOX is not based on sound
principles, but rather on a practical solution to an emergency. Alexander et al. (2013) show that although most investors generally
express positive attitudes toward the benefits of internal controls, they admit that these benefits are insufficient to make up for the
costs. Among those potential costs, the most important one arises from the increased liabilities for managers, who are required to
implement rigorous control. This burden may discourage a firm's managers from risk-taking and change the firm's focus from op-
eration to compliance.
Such a focus switch could bear the consequences of firm performance. For example, Ahmed et al. (2010) find that except the costs
of implementing SOX, operational performance can decline when managers spend more time and energy complying with new
regulations and becoming more risk averse. Several other studies confirm this concern. For instance, Kang et al. (2010) find that the
discount rates managers apply to investment projects increase significantly post-SOX, indicating that managers are becoming more
cautious. Bargeron et al. (2010) provide evidence of reductions in R&D and investment expenditures, less volatile stock returns, and
more cash, suggesting that SOX discourages corporate risk-taking. Gao and Zhang (2019) find that on average, firms that have to
comply with the SOX 404 rule (i.e., requiring external auditors to attest the manager's assessment on the effectiveness of ICFR)
experience a decrease in the number of patents by 18% and a reduction of the number of patent citations by 21%, relative to firms
that are exempted from this rule.
Unlike in the U.S., internal control functions in China are unanimously considered as having positive impacts on firms. Most
Chinese studies on internal controls examine their direct effects on financial reporting in terms of earnings management, earnings
attributes (e.g., earnings persistence or conservatism), and informativeness (Chen et al., 2017a). In considering the spillover from
financial reporting to corporate governance, Ge et al. (2019) find that strong internal controls can curb resource extraction by
insiders. Nevertheless, to the best of our knowledge, no study investigates how internal controls directly affect a firm's operational
decisions in terms of risk management, with the exception of Chen et al. (2020) who show that high-quality internal controls increase
tax avoidance for under-sheltering firms, and decrease tax avoidance for over-sheltering firms. This suggests a two-side moderating
effect of internal controls on risk-taking; whereas, high-quality accounting controls tend to decrease tax avoidance for all firms,
indicating a unilateral reduction in risk-taking.
2.2. Hypothesis development
The amount of cash held by a firm (regardless of whether it is higher or lower than that held by other peer firms) is optimal for
itself if the level of cash meets the firm's demands (both current and future). In firms with keen risk awareness and sound controls,
managers make a tradeoff between risks and returns in determining the amount of cash holdings (e.g., Opler et al., 1999; Harford
et al., 2008; Chen et al., 2012; Gao et al., 2013). Holding more cash can serve to meet cash demands arising from future investment
opportunities or other cautionary purposes (e.g., Han and Qiu, 2007; Bates et al., 2009; Chen et al., 2014; Chen et al., 2015a; Xu et al.,
2016). Besides, cash holdings can provide low-cost financing (Harford et al., 2014), thus reducing the risk of future financial distress
(Myers and Majluf, 1984; Cui et al., 2018), which is commonplace for Chinese firms given their difficulties in seeking external capital
(Guariglia and Yang, 2016).
However, the disadvantages of high cash holdings are also salient. Holding cash assets may involve high opportunity costs, as cash
could grow if it is channeled into promising investment projects. Furthermore, excessive cash holdings may be at higher risk of being
dissipated by insiders. For example, the controlling shareholders may tunnel the cash to other companies they own (e.g., Jiang et al.,
2010; Chen et al., 2012), profligate managers may build their own empires or/and increase their perks (e.g., Jensen, 1986; Dittmar
et al., 2003), and the firm's staff may steal cash in collusion (e.g., Dittmar and Mahrt-Smith, 2007). Even worse, these self-dealing
behaviors are less likely to be detected when firms hold extra cash, as external monitoring from capital providers decreases when
firms do not need external financing (e.g., Harford et al., 2008). Yet, there are also risks and costs of holding too little cash. The risks
and returns of holding less cash are just as present as the risks and returns of holding more cash. In other words, neither too much nor
too little cash is good for firms; instead, the amount of cash holdings should match the firm's demand and risk appetite.
As China has adopted a broad internal control policy based on the COSO's (1992, 2004)) framework, the Standard provides
principles and generic guidelines on risk management. Firms with higher ICQ have a set of complete risk management procedures
that involve techniques and tools for risk identification, risk assessment, risk response, and scientific risk management (Chen et al.,
2020). A sound control environment includes a well-structured governance infrastructure with competent staff to ensure that the firm
3
makes a correct risk assessment and fully implements the required control procedures (Guo et al., 2016; Ge et al., 2019). A timely
monitoring system with a smooth communication process is implemented to check, respond to, and rectify any weaknesses in the
design or implementation of risk management activities (e.g., Arping and Sautner, 2013; COSO (2013, 2017). Such firms with higher
ICQ are less likely to have abnormal cash reserves or cash deficits, as they adequately assess the benefits and costs of holding more or
less cash and implement cash policies appropriately. Hence, we state our first hypothesis as follows:
H1: Ceteris paribus, internal control quality is negatively related to abnormal cash holdings, either surplus or deficit.
3. Research sample
3.1. Data and sample selection
Our initial sample consists of all firms that issued A-shares to the public in the Shanghai Stock Exchange and the Shenzhen Stock
Exchange during the 2007–2015 period. The primary data source is the China Securities Markets and Accounting Research Database
(CSMAR), from which we retrieve financial information data. We acquire internal control data by following Chen et al. (2017b) for
publicly listed companies in China starting in 2007 and construct internal control index.2 The CSMAR records 19,792 firm-years over
our sample period. We exclude 441 firm-years in financial industries (Category “I” in CSRC Industry Classification) from our sample,3
due to these firms' uniqueness of operations, the structure of their financial reporting, and their specific regulations. We also drop
1043 ST (i.e., special treatment) and PT (i.e., particular transfer) firm-year observations, and 55 observations on firms with negative
equity, because these firms are in financial distress and face strict supervision. After further excluding 1775 observations with missing
data on the variables required for our baseline model (see Eq. (2) in the next subsection), we obtain a final sample of 16,468 firm-year
observations for our main tests, as described in Panel A of Table 1.
To eliminate the effect of the outliers, we winsorize all continuous variables at 1% and 99%. The industry breakdown is shown in
Panel B of Table 1, and it is generally consistent with the distribution of the CSMAR population. The following five industry sectors
have relatively more observations: Machinery, Equipment, and Instruments (19.13%), Petroleum, Chemical, Rubber, and Plastic
(9.61%), Metal and Nonmetal (8.41%), Information Technology (8.06%), and Wholesale and Retail Trades (6.75%).
3.2. Descriptive statistics
We provide descriptive statistics for the sample in Table 2. The mean and median values of abnormal cash holdings (AbCASH) are
0.438 and 0.346, respectively, and the range from the first to the third quartile is 0.452. The mean and median values of ICQ are
higher than the corresponding numbers during the 2007–2010 period, as reported in Chen et al. (2017b),4 which indicates that ICQ
usually improves after several transformative years of guidance and implementation.
Regarding the five components of internal controls, Control Activities (ICQ3) and Information and Communication (ICQ4) have the
largest mean values, of 0.626 and 0.515, respectively, which are nearly double the mean of Risk Assessment (ICQ2). The three largest
variances are found in Risk Assessment (ICQ2), Control Activities (ICQ3), and Monitoring (ICQ5). These results together imply that most
firms have done satisfactory work on the most direct and detailed aspects of their internal controls, e.g., Control Activities (ICQ3) and
Information and Communication (ICQ4). Still, they need further improvement in aspects related to the fundamental institutional
environment, e.g., Control Environment (ICQ1). Furthermore, the mean value of SOE shows that state-owned enterprises (SOEs)
comprise nearly half (48.6%) of our sample. On average, our sample firms have a debt-to-assets ratio (LEV) of 0.453, two business
segments (SEG), 8.17 years of age (FIRMAGE), and a dividend payout ratio (DIV) of 24.7%.
4. Empirical results
4.1. Internal control quality and abnormal cash holdings
To quantify abnormal cash holdings at the firm level (AbCASH), we refer to the existing literature on the determinants of cash
holdings and construct the following model specified as:
2
Chen et al. (2017b) use the analytic hierarchy process to analyze over 100 measures along with five COSO components and developed the
weighted average scores constituting the ICQ Index. Please refer to Chen et al. (2017b, p. 357-362) for the detailed methodology. The original Index
scores range from 0 to 100. We divide these scores by 100 for our measures of ICQ. The index scores are published annually in major financial
newspapers in China (i.e., China Securities Journal, Shanghai Securities Journal, and Securities Times). Also, the index is well recognized by the Chinese
business community and by corporate entities such as Deloitte (China) and the Public Company Monitoring Division of the Shanghai Stock Ex-
change.
3
Industry classification is based upon the guideline issued by the China Securities Regulatory Commission (CSRC) in 2001.
4
In this study, the Q1, median, and Q3 value of ICQ are 0.366, 0.432, and 0.492, respectively, and the corresponding values reported by Chen
et al. (2017b, in Table 2, p. 348) are 0.287, 0.358, and 0.427, respectively.
4
Table 1
Sample selection and industry distribution.
Panel A: Sample selection
Initial sample:
Firms listed as A stocks on the Shanghai and Shenzhen Stock Exchanges from 2007 to 2015 19,792
Drop:
Observations in financial industries 441
Observation with ST (special treatment) or PT (particular transfer) 1043
Observations with negative equity value 55
Observations with missing values of variables in the baseline model 1775
Final sample: 16,468
Panel B: Industry distribution
The CSRC Industry Classification Firm-year Obs. Percentage
1-A: Farming, Forestry, Animal Husbandry, and Fishery 274 1.66%

2-B: Mining and Quarrying 521 3.16%
3-C0: Food and Beverage 673 4.09%
4-C1: Textile, Clothing, and Fur 444 2.70%
6-C3: Papermaking and Printing 265 1.61%
7-C4: Petroleum, Chemical, Rubber, and Plastic 1583 9.61%
8-C5: Electronics 865 5.25%
9-C6: Metal and Nonmetal 1385 8.41%
10-C7: Machinery, Equipment, and Instruments 3151 19.13%
11-C8: Medicine and Biologic Products 1004 6.10%
13-D: Production and Supply of Power, Gas, and Water 715 4.34%
14-E: Construction 442 2.68%
15-F: Transportation and Storage 620 3.76%
16-G: Information Technology 1327 8.06%
17-H: Wholesale and Retail Trades 1112 6.75%
19-J: Real Estate 976 5.93%
20-K: Social Services 666 4.04%
21-L: Transmitting and Culture 262 1.59%
22-M: Integrated 183 1.11%
Total 16,468 100%
LnCASHi, t
= 0 + 1 SOEi, t + 2 SIZEi, t + 3 GROWi, t + 4 LEVi, t + 5 CFi, t + 6 CF _VOLi, t + 7 RET _
VOLi, t + 8 SEGi, t + 9 FIRMAGEi, t + 10 NWCi, t + 11 CAPEXi, t + 12 R&Di, t + 13 M
&Ai, t + 14 DIVi, t + 15 PBi, t + 16 ESi, t + i, t (1)
where LnCASH refers to cash holdings, measured as the ratio of cash and marketable securities to the book value of total assets.
Following prior studies such as those by Foley et al. (2007), Bates et al. (2009), Gao et al. (2013), Chen et al. (2014), Megginson et al.
(2014), and Xu et al. (2016), we use the natural logarithm of the dependent variable to reduce the outlier effect. The explanatory
variables included in the model can be categorized into two types: (1) common factors found to affect cash holdings, e.g., ultimate
owner (SOE), firm size (SIZE), growth (GROW), capital structure (LEV), cash flow (CF), cash flow volatility (CF_VOL), stock return
volatility (RET_VOL), the number of business segments (SEG), and firm age (FIRMAGE); (2) factors substituting for or simultaneously
determined by cash holdings, including net working capital (NWC), capital expenditures (CAPEX), research and development ex-
penses (R&D), M&A expenditures (M&A), cash dividends (DIV), bond issuance (PB), and equity issuance (ES). The variable definitions
are listed in Appendix I. AbCASH is the absolute value of abnormal cash holdings as estimated from regressing Eq. (1) based on
industry-year observations. We require that each industry-year group should have at least 20 observations.
To examine whether ICQ is related to abnormal cash holdings, we specify the model as follows:
AbCASHi, t = 0 + 1 ICQi, t + Controls + Industry &Year fixed effects + i, t (2)
ICQ, the internal control quality, is the score of the Internal Control Index of Chinese Listed Firms developed by Chen et al. (2017b).
Controls refers to the same vector of control variables of firm characteristics used in Eq. (1) in addition to CEO's risk preference
proxied by CEO's gender (GENDER), age (CEOAGE), cash compensations (SALARY), and share ownership (SHARES).5 We regress Eq.
5
We first use the widely used proxies of a CEO's risk aversion, such as delta and vega. However, public firms in China rarely grant CEOs stock
options, especially SOEs, where granting shares to CEOs is regarded as misappropriation of state assets. Due to the missing data, we follow existing
literature (e.g., Rego and Wilson, 2012; Dittmar and Duchin, 2016; Faccio et al., 2016) to use a CEO's gender, age, cash compensation, and share
5
Table 2
Descriptive statistics.
Variables Mean Std. Dev. P25 Median P75
AbCASH 0.438 0.375 0.162 0.346 0.614

ICQ 0.426 0.095 0.366 0.432 0.492
ICQ1 0.349 0.123 0.283 0.341 0.421
ICQ2 0.262 0.170 0.131 0.208 0.368
ICQ3 0.626 0.165 0.506 0.640 0.758
ICQ4 0.515 0.123 0.431 0.496 0.587
ICQ5 0.396 0.166 0.284 0.395 0.499
SOE 0.486 0.500 0.000 0.000 1.000
SIZE 8.116 1.244 7.211 7.945 8.824
GROW 0.185 0.451 −0.029 0.114 0.282
LEV 0.453 0.210 0.289 0.457 0.618
CF 0.043 0.075 0.002 0.043 0.087
CF_VOL 0.050 0.042 0.021 0.038 0.065
RET_VOL 0.025 0.007 0.020 0.024 0.029
SEG 0.757 0.661 0.000 0.693 1.386
FIRMAGE 2.100 0.752 1.609 2.303 2.708
NWC 0.005 0.204 −0.131 0.009 0.147
CAPEX 0.058 0.053 0.018 0.042 0.081
R&D 0.477 1.639 0.000 0.000 0.000
M&A 0.006 0.020 0.000 0.000 0.000
DIV 0.247 0.301 0.000 0.183 0.349
PB 0.083 0.276 0.000 0.000 0.000
ES 0.374 0.484 0.000 0.000 1.000
GENDER 0.944 0.230 1.000 1.000 1.000
CEOAGE 3.868 0.130 3.784 3.871 3.951
SALARY 12.667 2.158 12.479 13.003 13.470
SHARES 0.034 0.095 0.000 0.000 0.001
The sample consists of 16,468 firm-year observations. All continuous variables are winsorized at the 1% and 99% levels. Refer to Appendix I for
variable definitions.
(2) for the full sample and two subsamples of firms having positive (i.e., extra cash sample) or negative value of cash holdings (i.e.,
deficit cash sample).
In Table 3, the coefficient on ICQ in the full sample is negative at the significance level of 1% (coefficient = −0.236 with
t = −4.66), indicating that one standard deviation of ICQ leads to 5.12% decrease (= −0.236 × 0.095 ÷ 0.438) in AbCASH. This
result suggests that high-quality internal controls can curb unreasonable cash holdings. Abnormal cash holdings, either excess or
deficit cash, would represent firm risk. To further investigate those upside and downside risk of abnormal cash holdings, we sepa-
rately estimate Eq. (2) for the extra cash sample and deficit cash sample. As shown in Column (2) and (3), the coefficient on ICQ for
firms with extra cash is negative at the significance level of 5% (coefficient = −0.107 with t = −2.09). In the deficit cash sub-
sample, the coefficient is negative at the significance level of 1% (coefficient = −0.376 with t = −4.28), meaning that one standard
deviation of ICQ leads to 2.49% decrease (= −0.107 × 0.094 standard deviation ÷ 0.404 sample mean) in AbCASH for firms with
extra cash and 7.54% decrease (= −0.376 × 0.096 standard deviation ÷ 0.479 sample mean) in AbCASH for firms with deficit cash,
respectively.
This pattern indicates that firms with higher ICQ generally hold a reasonable level of cash, neither excess nor deficit. By such
balanced cash management, a firm reduces the risks of empire building or dissipation of cash by insider dealing and avoids the risks
of failing to cover business losses and incur higher financing costs. These findings, to a large extent, indicate that internal controls
function as risk management over cash holdings. Moreover, the magnitude of the coefficient on ICQ in the deficit cash subsample is
significantly larger than that in the extra cash subsample (i.e., χ2 = 12.09 with p-value < 1%). The results suggest that the risk of
cash shortage is perceived higher than that of cash surplus – a reflection of investors' asymmetric risk tolerance.
4.2. Internal controls or corporate governance
Another explanation for the above main findings is that corporate governance rather than internal controls impacts cash holdings.
To parse out that our findings are driven by corporate governance instead of internal control, we follow Chen et al. (2020, Appendix
B, p. 50) to identify the elements pertaining to corporate governance in the internal control index developed by Chen et al. (2017b).6
(footnote continued)
ownership to control for the CEO's risk preference.
6
Chen et al. (2017b) list a total of 27 elements that are related to corporate governance, most are board-specific and top management-specific – a
key difference as governance mechanisms are mostly exerted top-down or from outside, whereas control processes can be exercised bottom-up or
from inside and top-down or from outside (Acharya et al., 2011).
6
Table 3
The effect of internal controls on cash holdings.
Variables Full sample Extra cash sample Deficit cash sample
ICQ −0.236⁎⁎⁎ −0.107⁎⁎ −0.376⁎⁎⁎

(−4.66) (−2.09) (−4.28)
SOE −0.033⁎⁎⁎ −0.032⁎⁎⁎ −0.036⁎
(−2.96) (−2.79) (−1.81)
SIZE −0.002 −0.012⁎⁎ 0.007
(−0.36) (−2.13) (0.71)
GROW −0.021⁎⁎⁎ −0.019⁎⁎ −0.025⁎⁎
(−3.00) (−2.40) (−2.09)
LEV −0.201⁎⁎⁎ −0.114⁎⁎⁎ −0.320⁎⁎⁎
(−5.54) (−3.32) (−4.96)
CF −0.211⁎⁎⁎ −0.283⁎⁎⁎ −0.113
(−3.99) (−5.20) (−1.24)
CF_VOL −0.016 0.047 −0.133
(−0.17) (0.50) (−0.76)
RET_VOL 0.184 −0.004 0.447
(0.25) (−0.01) (0.36)
SEG −0.012⁎ −0.010 −0.017
(−1.95) (−1.57) (−1.50)
FIRMAGE 0.057⁎⁎⁎ 0.045⁎⁎⁎ 0.070⁎⁎⁎
(8.10) (6.50) (5.72)
NWC −0.220⁎⁎⁎ −0.239⁎⁎⁎ −0.197⁎⁎⁎
(−6.25) (−7.26) (−3.23)
CAPEX −0.239⁎⁎⁎ −0.275⁎⁎⁎ −0.224⁎
(−3.11) (−3.52) (−1.66)
R&D −0.012⁎⁎⁎ −0.009⁎⁎⁎ −0.016⁎⁎⁎
(−6.42) (−5.39) (−4.82)
M&A −0.700⁎⁎⁎ −0.449⁎⁎⁎ −1.062⁎⁎⁎
(−5.07) (−2.58) (−4.69)
DIV −0.042⁎⁎⁎ −0.048⁎⁎⁎ −0.036⁎
(−3.67) (−3.99) (−1.95)
PB −0.009 −0.002 −0.020
(−0.73) (−0.17) (−0.92)
ES −0.034⁎⁎⁎ −0.042⁎⁎⁎ −0.027⁎⁎
(−4.91) (−5.91) (−2.12)
GENDER −0.013 −0.007 −0.016
(−0.72) (−0.39) (−0.52)
CEOAGE −0.005 0.004 −0.009
(−0.14) (0.14) (−0.16)
SALARY −0.002 0.001 −0.006⁎
(−1.12) (0.63) (−1.65)
SHARES −0.058 −0.017 −0.084
(−1.57) (−0.47) (−1.19)
Intercept 0.635⁎⁎⁎ 0.580⁎⁎⁎ 0.688⁎⁎⁎
(4.82) (4.39) (2.99)
Industry & Year FE Yes Yes Yes
Obs. 16,468 9097 7371
Adj. R2 0.069 0.098 0.067
This table presents the results testing the effect of internal controls on abnormal cash holdings (AbCASH). The dependent variable is AbCASH
in all columns. The Extra (Deficit) cash sample consists of firm-year observations with positive (negative) abnormal cash holdings. See
Appendix I for the definitions of other variables. The t-values in parentheses are based on standard errors adjusted for heteroscedasticity and
clustering at the firm level. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively.
We then construct an internal control index with no corporate governance (ICQ_NCG) by removing the corporate governance ele-
ments and a composite governance index (CG) based on the removed corporate governance elements from the internal control index.
We replace ICQ with ICQ_NCG and include the governance index (CG) in Eq. (2). Table 4 shows that the coefficients on ICQ_NCG
are significantly positive (Coefficients = −0.200, −0.086, −0.333, respectively), across Column (1)–(3) for the full sample, extra
cash subsample, and deficit cash subsample, respectively. The coefficients on CG are not significant across all the three columns. It
suggests that our findings in Table 3 are driven by internal controls rather than by corporate governance.
4.3. The components of internal controls
The integral internal control system consists of five components, namely Control Environment, Risk Assessment, Control Activities,
Information and Communication, and Monitoring (COSO, 1992, 2013). The Control Environment is the cornerstone of the entire internal
control system. This component includes corporate strategy and culture, risk appetite, organization and governance structure, human
resources, and other functions. Risk Assessment involves the idea of a method for setting risk management targets, identifying risks,
7
Table 4
The effect of internal controls (excluding corporate governance elements) on cash holdings.
Variables Full sample Extra cash sample Deficit cash sample
ICQ_NCG −0.200⁎⁎⁎ −0.086⁎ −0.333⁎⁎⁎

(−3.89) (−1.67) (−3.67)
CG −0.079 −0.001 −0.120
(−1.16) (−0.02) (−0.98)
SOE −0.034⁎⁎⁎ −0.032⁎⁎⁎ −0.036⁎
(−3.00) (−2.80) (−1.84)
SIZE −0.003 −0.013⁎⁎ 0.006
(−0.51) (−2.29) (0.59)
GROW −0.021⁎⁎⁎ −0.019⁎⁎ −0.024⁎⁎
(−2.89) (−2.35) (−1.99)
LEV −0.201⁎⁎⁎ −0.113⁎⁎⁎ −0.317⁎⁎⁎
(−5.53) (−3.31) (−4.92)
CF −0.216⁎⁎⁎ −0.286⁎⁎⁎ −0.117
(−4.07) (−5.26) (−1.27)
CF_VOL −0.014 0.049 −0.132
(−0.14) (0.52) (−0.75)
RET_VOL 0.243 0.017 0.533
(0.33) (0.02) (0.43)
SEG −0.012⁎⁎ −0.010 −0.017
(−1.97) (−1.56) (−1.55)
FIRMAGE 0.055⁎⁎⁎ 0.044⁎⁎⁎ 0.067⁎⁎⁎
(7.67) (6.36) (5.31)
NWC −0.220⁎⁎⁎ −0.240⁎⁎⁎ −0.195⁎⁎⁎
(−6.23) (−7.29) (−3.19)
CAPEX −0.234⁎⁎⁎ −0.273⁎⁎⁎ −0.219
(−3.05) (−3.48) (−1.62)
R&D −0.012⁎⁎⁎ −0.009⁎⁎⁎ −0.016⁎⁎⁎
(−6.42) (−5.42) (−4.79)
M&A −0.685⁎⁎⁎ −0.443⁎⁎ −1.041⁎⁎⁎
(−4.97) (−2.55) (−4.58)
DIV −0.042⁎⁎⁎ −0.048⁎⁎⁎ −0.035⁎
(−3.65) (−4.00) (−1.90)
PB −0.009 −0.003 −0.020
(−0.74) (−0.18) (−0.96)
ES −0.034⁎⁎⁎ −0.042⁎⁎⁎ −0.026⁎⁎
(−4.84) (−5.92) (−2.02)
GENDER −0.013 −0.007 −0.017
(−0.75) (−0.39) (−0.54)
CEOAGE −0.006 0.004 −0.011
(−0.19) (0.13) (−0.20)
SALARY −0.002 0.001 −0.006⁎
(−1.17) (0.57) (−1.67)
SHARES −0.057 −0.016 −0.083
(−1.54) (−0.45) (−1.18)
Intercept 0.701⁎⁎⁎ 0.596⁎⁎⁎ 0.792⁎⁎⁎
(5.12) (4.38) (3.30)
Industry & Year FE Yes Yes Yes
Obs. 16,468 9097 7371
Adj. R2 0.069 0.097 0.067
This table presents the results testing the effect of internal controls (excluding corporate governance elements) on abnormal cash holdings
(AbCASH). The dependent variable is AbCASH in all columns. The Extra (Deficit) cash sample consists of firm-year observations with positive
(negative) abnormal cash holdings. See Appendix I for the definitions of other variables. The t-values in parentheses are based on standard
errors adjusted for heteroscedasticity and clustering at the firm level. ***, **, and * indicate statistical significance at the 1%, 5%, and 10%
levels, respectively.
evaluating the probability and severity of risk events, and making detailed risk response strategies and tactics. Control Activities
consist of particular control structures, mechanisms, and procedures, which form the basis of a checks and balances system. In-
formation and Communication occurs throughout the whole process of internal controls and includes information sharing and com-
munication among internal and external parties. Monitoring consists of ongoing monitoring and assessing whether internal controls
are comprehensively designed and effectively implemented to detect problems, give feedback, and to rectify internal control
weaknesses, all in a timely and consistent manner.
In Table 5, we present the results regarding the individual roles of each component of the internal control system in influencing
cash holdings. AbCASH is the dependent variable across all of the models. In Column (1)–(5), the results for the five components of
the model are given in sequence. These results show that all of these components, except Risk Assessment (ICQ2), are significantly
8
Table 5
The effect of five internal control components on cash holdings.
Variables (1) (2) (3) (4) (5) (6)
ICQ1 −0.109⁎⁎⁎ −0.067⁎⁎

(−3.33) (−1.99)
ICQ2 −0.019 0.011
(−0.72) (0.43)
ICQ3 −0.098⁎⁎⁎ −0.064⁎⁎⁎
(−4.00) (−2.59)
ICQ4 −0.105⁎⁎⁎ −0.073⁎⁎
(−3.46) (−2.38)
ICQ5 −0.073⁎⁎⁎ −0.040⁎
(−3.07) (−1.69)
SOE −0.037⁎⁎⁎ −0.037⁎⁎⁎ −0.035⁎⁎⁎ −0.037⁎⁎⁎ −0.034⁎⁎⁎ −0.034⁎⁎⁎
(−3.22) (−3.28) (−3.07) (−3.31) (−3.03) (−2.99)
SIZE −0.004 −0.007 −0.006 −0.005 −0.006 −0.002
(−0.62) (−1.16) (−0.95) (−0.88) (−1.11) (−0.41)
GROW −0.021⁎⁎⁎ −0.020⁎⁎⁎ −0.021⁎⁎⁎ −0.020⁎⁎⁎ −0.020⁎⁎⁎ −0.021⁎⁎⁎
(−2.91) (−2.82) (−2.91) (−2.86) (−2.85) (−2.99)
LEV −0.200⁎⁎⁎ −0.199⁎⁎⁎ −0.200⁎⁎⁎ −0.201⁎⁎⁎ −0.198⁎⁎⁎ −0.202⁎⁎⁎
(−5.48) (−5.46) (−5.51) (−5.54) (−5.45) (−5.57)
CF −0.210⁎⁎⁎ −0.221⁎⁎⁎ −0.217⁎⁎⁎ −0.218⁎⁎⁎ −0.222⁎⁎⁎ −0.210⁎⁎⁎
(−3.97) (−4.16) (−4.09) (−4.11) (−4.18) (−3.97)
CF_VOL −0.016 −0.008 −0.014 −0.014 −0.004 −0.019
(−0.16) (−0.08) (−0.14) (−0.14) (−0.04) (−0.20)
RET_VOL 0.284 0.403 0.255 0.368 0.315 0.157
(0.38) (0.55) (0.35) (0.50) (0.43) (0.21)
SEG −0.012⁎ −0.012⁎ −0.012⁎ −0.012⁎ −0.012⁎ −0.012⁎
(−1.94) (−1.93) (−1.93) (−1.95) (−1.90) (−1.94)
FIRMAGE 0.057⁎⁎⁎ 0.059⁎⁎⁎ 0.057⁎⁎⁎ 0.058⁎⁎⁎ 0.059⁎⁎⁎ 0.057⁎⁎⁎
(8.12) (8.30) (8.07) (8.26) (8.32) (7.99)
NWC −0.221⁎⁎⁎ −0.227⁎⁎⁎ −0.223⁎⁎⁎ −0.227⁎⁎⁎ −0.227⁎⁎⁎ −0.221⁎⁎⁎
(−6.26) (−6.43) (−6.34) (−6.45) (−6.43) (−6.25)
CAPEX −0.247⁎⁎⁎ −0.252⁎⁎⁎ −0.242⁎⁎⁎ −0.249⁎⁎⁎ −0.246⁎⁎⁎ −0.237⁎⁎⁎
(−3.23) (−3.28) (−3.16) (−3.24) (−3.20) (−3.09)
R&D −0.012⁎⁎⁎ −0.013⁎⁎⁎ −0.013⁎⁎⁎ −0.012⁎⁎⁎ −0.013⁎⁎⁎ −0.012⁎⁎⁎
(−6.55) (−6.69) (−6.58) (−6.53) (−6.62) (−6.37)
M&A −0.695⁎⁎⁎ −0.677⁎⁎⁎ −0.694⁎⁎⁎ −0.685⁎⁎⁎ −0.683⁎⁎⁎ −0.707⁎⁎⁎
(−5.03) (−4.90) (−5.03) (−4.97) (−4.95) (−5.12)
DIV −0.043⁎⁎⁎ −0.044⁎⁎⁎ −0.043⁎⁎⁎ −0.043⁎⁎⁎ −0.044⁎⁎⁎ −0.042⁎⁎⁎
(−3.74) (−3.84) (−3.73) (−3.75) (−3.81) (−3.63)
PB −0.010 −0.012 −0.011 −0.010 −0.011 −0.009
(−0.77) (−0.92) (−0.89) (−0.80) (−0.88) (−0.70)
ES −0.035⁎⁎⁎ −0.036⁎⁎⁎ −0.035⁎⁎⁎ −0.036⁎⁎⁎ −0.035⁎⁎⁎ −0.034⁎⁎⁎
(−5.04) (−5.14) (−4.96) (−5.08) (−5.04) (−4.87)
GENDER −0.013 −0.013 −0.012 −0.012 −0.013 −0.013
(−0.74) (−0.72) (−0.71) (−0.69) (−0.76) (−0.72)
CEOAGE −0.003 −0.002 −0.003 −0.003 −0.003 −0.004
(−0.08) (−0.07) (−0.10) (−0.11) (−0.09) (−0.14)
SALARY −0.002 −0.003 −0.003 −0.003 −0.003 −0.002
(−1.24) (−1.38) (−1.27) (−1.30) (−1.35) (−1.13)
SHARES −0.057 −0.059 −0.057 −0.058 −0.060 −0.057
(−1.54) (−1.57) (−1.54) (−1.56) (−1.61) (−1.55)
Intercept 0.600⁎⁎⁎ 0.595⁎⁎⁎ 0.634⁎⁎⁎ 0.627⁎⁎⁎ 0.606⁎⁎⁎ 0.652⁎⁎⁎
(4.56) (4.51) (4.79) (4.73) (4.61) (4.91)
Industry & Year FE Yes Yes Yes Yes Yes Yes
Obs. 16,468 16,468 16,468 16,468 16,468 16,468
Adj. R2 0.068 0.067 0.068 0.068 0.068 0.069
This table presents the results testing the effect of the five components of internal controls (i.e., ICQ1–5) on abnormal cash holdings (AbCASH). The
dependent variable is AbCASH in all columns. See Appendix I for the definitions of other variables. The t-values in parentheses are based on standard errors
adjusted for heteroscedasticity and clustering at the firm level. ***, **, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively.
associated with less abnormal cash holdings, which again confirms H1.7 Among these components, the effect of Control Environment is
the largest (coefficient = −0.109 with t = −3.33), which makes sense because this component provides the institutional infra-
structure that determines the integral internal controls. In Column (6), the five individual components are included in a single model.
7
When we use alternative measures to assess the quality of the five components in their respective decile ranks, the results, unreported for brevity,
are indeed similar.
9
The results for the four components (i.e., except ICQ2) remain significant. However, this set of results should be interpreted with
caution. Internal controls require the integration of all five components, rather than the individual effect of each separate and
independent component (COSO, 1992, 2004). Therefore, the incremental effect of any individual component can be subsumed by
other components when they are simultaneously considered (Chen et al., 2020). Especially for Risk Assessment, it functions as a
connection between Control Environment (ICQ1) that determines what risks and the relevant risk assessment policies are and Control
Activities (ICQ3) that are arranged following the results of risk assessment.
4.4. Cross-sectional tests
Prior research (e.g., Chen et al., 2014; Guariglia and Yang, 2016) has documented that institutional developments play important
roles that influence the cash holdings of Chinese firms. To further our analysis, we conduct several cross-sectional tests, and provide
results in Table 6. In Column (1), we consider the degree of marketization in each province where the firms are located. MKT is a
dummy variable, which proxies for the degree of marketization. The coefficient on ICQ is significantly negative, and that on ICQ
interacting with the MKT dummy is significantly positive, indicating that the effects of internal controls on abnormal cash holdings
are mitigated for firms in the highly marketized environment. In other words, effective internal controls, to a certain extent, offset the
less developed external environment.
In Column (2), we include an interaction term between ICQ and NOISY (a dummy of 1 if the sample year is during the transition
period of internal control regulations from 2009 to 2012 when a staggered implementation strategy was adopted before finalizing,8
and 0 otherwise) to examine whether the effects of internal controls are greater for firms during “noisy” years of internal control
reform. The results show that during the regulation transition period, the effect of ICQ on abnormal cash holdings is weakened. The
findings suggest that internal controls at these uncertain times are less likely to play a key role in cash policies. In Column (3), we test
the moderating effect of analyst following (FOLLOW) since financial analysts are perceived as important information intermediaries
and have monitoring function for investors (Chen et al., 2015b). We find that firms with more analyst coverage show a mitigating
effect on the relation between ICQ and abnormal cash holdings. The significantly positive coefficient on ICQ × FOLLOW suggests that
the marginal value of internal controls decreases when firms are followed by more financial analysts.
In Column (4), we include ownership concentration (CONC), because internal controls may be conducted as a mere formality
rather than essentially applied if the ownership is concentrated in several large shareholders who are on the board of directors or the
management team (Ge et al., 2019). The positive coefficient on ICQ × CONC suggests that internal controls tend to malfunction in
firms with more concentrated ownership, possibly because controls in such firms are merely a formality. In Column (5), we test the
moderating effect of financial constraint (FC), as such constraint is one of the main driving forces that determine the level of cash
holdings (Denis and Sibilkov, 2010; Lins et al., 2010; Harford et al., 2014). Our results show that the role of internal controls in cash
holdings tends to be marginalized when financial constraint becomes a more fundamental determinant, as the coefficient on ICQ ×
FC (coefficient = 0.370 with t = 3.59) is significantly positive. Moreover, the effect of ICQ on abnormal cash holdings may differ
between growth firms and other firms since the demands on internal controls vary in the different steps of the firm's development
(Doyle et al., 2007). In Column (6), we show that the benefit of internal controls becomes smaller in growth firms, evidenced by the
positive coefficient on ICQ × GROW_H (coefficient = 0.151 with t = 2.39).
5. Additional tests
5.1. Internal control quality and the disgorgement of extra cash
It is unclear whether firms with higher ICQ are inclined to hold back spending. On the one hand, firms with higher ICQ are more
likely to hoard money and do nothing for enjoying the “quiet life” (Bertrand and Mullainathan, 2003), which would impair firms'
growth opportunity (Almeida et al., 2004). On the other hand, cash is also possibly used for value-increasing activities. Such firms
would tend not to miss investment opportunities, and they typically seek to reduce the risk that surplus cash may be dissipated for the
insiders' private benefit (e.g., through empire building or high perks). Therefore, firms could hoard their extra cash or use them on
necessary capital expenditures or new projects that promise greater returns and are more likely to distribute cash dividends (e.g.,
Harford et al., 2008; Banerjee et al., 2015).
We thus examine how internal controls improve decisions related to corporate spending. Following Harford et al. (2008) and Gao
et al. (2013), we consider four cash spending variables: whether a firm will increase capital expenditures (△CAPEXt+1), R&D ex-
penditures (△R&Dt+1), M&A expenditures (△M&At+1), or cash dividends (△DIVt+1) in the following year. We run the following
regression:
CashSpendi, t + 1 = 0 + 1 EXTRAi, t + 2 ICQ _Hi, t + 3 EXTRAi, t × ICQ _Hi, t + Controls + Industry &Year fixed effects + µi, t (3)
where △CashSpendt+1 proxies for the change of cash spending during the subsequent year, EXTRA is an indicator variable for firm-
year observations with positive abnormal cash holdings, and the dummy form of ICQ (i.e., ICQ_H) is used, given that ICQ is a
moderating variable that indicates whether internal controls impact the relation between extra cash holdings and cash spending.
Among them, capital expenditures, R&D expenditures, and M&A expenditures have different implications of risk and impacts on
8
Appendix II presents the background information of the internal control regulations in China.
10
Table 6
Heterogeneous effects of internal controls on cash holdings.
Variables Dummy = Dummy = Dummy = FOLLOW Dummy = CONC Dummy = Dummy =
MKT NOISY FC GROW_H
ICQ −0.314⁎⁎⁎ −0.408⁎⁎⁎ −0.398⁎⁎⁎ −0.309⁎⁎⁎ −0.406⁎⁎⁎ −0.303⁎⁎⁎

(−4.69) (−4.09) (−4.08) (−4.59) (−5.77) (−4.86)
Dummy −0.052⁎ −0.103⁎⁎ −0.126⁎⁎⁎ −0.062 −0.149⁎⁎⁎ −0.084⁎⁎⁎
(−1.69) (−2.10) (−2.95) (−1.63) (−3.79) (−2.93)
ICQ × Dummy 0.159⁎⁎ 0.225⁎⁎ 0.219⁎⁎ 0.145⁎ 0.307⁎⁎⁎ 0.151⁎⁎
(2.10) (2.08) (2.23) (1.72) (3.59) (2.39)
SOE −0.033⁎⁎⁎ −0.033⁎⁎⁎ −0.032⁎⁎⁎ −0.033⁎⁎⁎ −0.034⁎⁎⁎ −0.033⁎⁎⁎
(−2.93) (−2.97) (−2.88) (−2.92) (−3.03) (−2.92)
SIZE −0.002 −0.002 0.002 −0.002 0.004 −0.002
(−0.35) (−0.41) (0.31) (−0.39) (0.50) (−0.38)
GROW −0.021⁎⁎⁎ −0.021⁎⁎⁎ −0.020⁎⁎⁎ −0.021⁎⁎⁎ −0.023⁎⁎⁎
(−3.00) (−2.98) (−2.80) (−2.94) (−3.20)
LEV −0.202⁎⁎⁎ −0.202⁎⁎⁎ −0.206⁎⁎⁎ −0.201⁎⁎⁎ −0.209⁎⁎⁎ −0.201⁎⁎⁎
(−5.55) (−5.58) (−5.65) (−5.52) (−5.70) (−5.51)
CF −0.211⁎⁎⁎ −0.212⁎⁎⁎ −0.197⁎⁎⁎ −0.211⁎⁎⁎ −0.220⁎⁎⁎ −0.208⁎⁎⁎
(−3.98) (−3.99) (−3.74) (−3.98) (−4.11) (−3.94)
CF_VOL −0.022 −0.013 −0.020 −0.017 0.008 −0.023
(−0.22) (−0.13) (−0.20) (−0.17) (0.08) (−0.24)
RET_VOL 0.152 0.065 0.295 0.192 0.146 0.080
(0.21) (0.09) (0.40) (0.26) (0.19) (0.11)
SEG −0.012⁎ −0.012⁎ −0.012⁎ −0.012⁎ −0.014⁎⁎ −0.012⁎
(−1.90) (−1.91) (−1.94) (−1.95) (−2.15) (−1.91)
FIRMAGE 0.057⁎⁎⁎ 0.057⁎⁎⁎ 0.054⁎⁎⁎ 0.057⁎⁎⁎ 0.054⁎⁎⁎ 0.056⁎⁎⁎
(8.14) (8.01) (7.60) (7.92) (6.92) (7.89)
NWC −0.220⁎⁎⁎ −0.223⁎⁎⁎ −0.215⁎⁎⁎ −0.218⁎⁎⁎ −0.225⁎⁎⁎ −0.219⁎⁎⁎
(−6.24) (−6.32) (−6.09) (−6.19) (−6.31) (−6.23)
CAPEX −0.239⁎⁎⁎ −0.240⁎⁎⁎ −0.211⁎⁎⁎ −0.234⁎⁎⁎ −0.250⁎⁎⁎ −0.227⁎⁎⁎
(−3.12) (−3.12) (−2.75) (−3.06) (−3.21) (−2.97)
R&D −0.012⁎⁎⁎ −0.012⁎⁎⁎ −0.012⁎⁎⁎ −0.012⁎⁎⁎ −0.012⁎⁎⁎ −0.012⁎⁎⁎
(−6.40) (−6.46) (−6.38) (−6.37) (−6.43) (−6.40)
M&A −0.702⁎⁎⁎ −0.703⁎⁎⁎ −0.682⁎⁎⁎ −0.700⁎⁎⁎ −0.722⁎⁎⁎ −0.704⁎⁎⁎
(−5.08) (−5.10) (−4.95) (−5.07) (−5.20) (−5.11)
DIV −0.042⁎⁎⁎ −0.041⁎⁎⁎ −0.040⁎⁎⁎ −0.041⁎⁎⁎ −0.042⁎⁎⁎ −0.042⁎⁎⁎
(−3.65) (−3.60) (−3.48) (−3.62) (−3.63) (−3.62)
PB −0.009 −0.010 −0.010 −0.009 −0.011 −0.009
(−0.74) (−0.76) (−0.81) (−0.73) (−0.88) (−0.72)
ES −0.034⁎⁎⁎ −0.034⁎⁎⁎ −0.031⁎⁎⁎ −0.034⁎⁎⁎ −0.034⁎⁎⁎ −0.035⁎⁎⁎
(−4.90) (−4.90) (−4.50) (−4.84) (−4.85) (−5.04)
GENDER −0.013 −0.014 −0.014 −0.012 −0.013 −0.012
(−0.71) (−0.77) (−0.77) (−0.70) (−0.75) (−0.69)
CEOAGE −0.005 −0.005 −0.005 −0.006 −0.005 −0.005
(−0.15) (−0.14) (−0.17) (−0.18) (−0.14) (−0.16)
SALARY −0.002 −0.002 −0.002 −0.002 −0.002 −0.002
(−1.14) (−1.07) (−0.94) (−1.10) (−1.03) (−1.11)
SHARES −0.059 −0.055 −0.053 −0.058 −0.061 −0.056
(−1.58) (−1.49) (−1.43) (−1.56) (−1.59) (−1.52)
Intercept 0.660⁎⁎⁎ 0.713⁎⁎⁎ 0.689⁎⁎⁎ 0.669⁎⁎⁎ 0.679⁎⁎⁎ 0.675⁎⁎⁎
(4.97) (5.18) (5.10) (5.05) (4.94) (5.09)
Industry & Year FE Yes Yes Yes Yes Yes Yes
Obs. 16,468 16,468 16,468 16,468 16,193 16,468
Adj. R2 0.069 0.070 0.071 0.069 0.069 0.069
This table presents the results of several cross-sectional tests, such as the degree of marketization (MKT), the transition period of internal control
regulations (NOISY), the effect of analyst following (FOLLOW), ownership concentration (CONC), financial constraint (FC), and growth (GROW_H).
The dependent variable is abnormal cash holdings (AbCASH) in all columns. See Appendix I for the definitions of other variables. The t-values in
parentheses are based on standard errors adjusted for heteroscedasticity and clustering at the firm level. ***, **, and * indicate statistical sig-
nificance at the 1%, 5%, and 10% levels, respectively.
firm value. R&D expenditures are generally riskier than capital expenditures, and they often have negative effects on short-term firm
performance, but they could have longer-term positive effects on firm value (e.g., Eberhart et al., 2004). Therefore, R&D expenditures
are commonly used to examine managerial myopia, which is one form of agency conflict (e.g., Lev and Sougiannis, 1996; Coles et al.,
2006; Bargeron et al., 2010; Kraft et al., 2018). M&A activities are risky and often associated with another form of agency conflict,
namely “empire building” (e.g., Harford, 1999; Masulis et al., 2007; Harford et al., 2008; Harford et al., 2012). To a large extent,
payment of cash dividends reflects a commitment to avoid either dissipation or hoarding when cash is sufficient (e.g., Jensen, 1986;
La Porta et al., 2000; Harford et al., 2008; Gao et al., 2013). The term Controls refers to the main control variables in Eq. (2).
In Table 7, we show that the coefficient on EXTRA × ICQ_H in Column (1) where △CAPEXt+1 is the dependent variable is
11
Table 7
Internal control quality and disgorgement of excess cash.
D.V. = △CAPEXt+1 △R&Dt+1 △M&At+1 △DIVt+1
EXTRA 0.003⁎⁎⁎ 0.000 0.006⁎⁎⁎ −0.018⁎⁎⁎

(3.45) (1.20) (3.47) (−2.68)
ICQ_H −0.001 −0.000 0.004⁎⁎ −0.020⁎⁎⁎
(−1.12) (−0.79) (2.47) (−2.72)
EXTRA × ICQ_H 0.001 0.000 −0.005⁎⁎⁎ 0.018⁎
(0.53) (0.08) (−2.60) (1.76)
SOE 0.001⁎ 0.001⁎⁎⁎ −0.001 −0.005
(1.78) (2.68) (−0.92) (−1.37)
SIZE −0.000 −0.000 −0.001⁎⁎ 0.007⁎⁎⁎
(−0.67) (−0.35) (−2.14) (4.06)
GROW 0.000 0.000 −0.008⁎⁎⁎ −0.024⁎⁎⁎
(0.47) (0.46) (−3.94) (−3.50)
LEV −0.011⁎⁎⁎ −0.001 −0.015⁎⁎⁎ −0.035⁎⁎⁎
(−7.27) (−1.15) (−4.45) (−3.49)
CF 0.011⁎⁎⁎ −0.002 −0.003 0.009
(2.58) (−1.46) (−0.36) (0.30)
CF_VOL 0.010 0.005 0.027⁎⁎ 0.082⁎
(1.51) (1.59) (2.28) (1.73)
RET_VOL 0.220⁎⁎⁎ −0.089⁎⁎⁎ 0.167 −1.039⁎
(3.17) (−2.65) (1.26) (−1.74)
SEG 0.001⁎⁎ 0.000 −0.001 −0.004
(2.32) (0.38) (−1.12) (−1.02)
FIRMAGE 0.004⁎⁎⁎ −0.000 0.001 0.013⁎⁎⁎
(9.72) (−0.62) (1.58) (4.80)
GENDER 0.002 −0.000 0.003 0.001
(1.46) (−0.89) (1.44) (0.14)
CEOAGE 0.000 0.000 −0.004 −0.001
(0.26) (0.45) (−1.30) (−0.07)
SALARY −0.000 −0.000 −0.001⁎ 0.000
(−0.54) (−0.54) (−1.77) (0.02)
SHARES −0.005⁎ −0.000 0.019⁎⁎⁎ −0.004
(−1.73) (−0.22) (2.86) (−0.16)
Intercept −0.016⁎ 0.003 0.025⁎ −0.058
(−1.87) (0.70) (1.65) (−0.80)
Industry & Year FE Yes Yes Yes Yes
Obs. 16,451 16,452 16,452 16,468
Adj. R2 0.013 0.025 0.012 0.008
This table presents results testing the effect of internal controls on cash spending during the subsequent year. The dependent variable is the change
of capital expenditures (△CAPEXt+1), R&D (△R&Dt+1), merger and acquisition transactions (△M&At+1), and dividends (△DIVt+1), respectively. See
Appendix I for the definitions of other variables. The t-values in parentheses are based on standard errors adjusted for heteroscedasticity and
insignificant, indicating that firms with high ICQ do not spend their extra cash on capital expenditures. Although capital expenditures
are regarded as less risky (compared to M&A), more capital expenditures by firms with extra cash may also indicate dissipation by
management (Harford et al., 2008). Therefore, our results from Column (1) do not necessarily mean that internal controls discourage
managers' risk-taking. In Column (2), where △R&Dt+1 is the dependent variable, the coefficients on EXTRA and EXTRA × ICQ_H are
small and insignificant, suggesting that disclosures or/and accounting of R&D expenditures by Chinese firms are commonly in-
sufficient.9
In Column (3), where △M&At+1 is the dependent variable, the coefficient on EXTRA (EXTRA × ICQ_H) is significantly positive
(negative), which suggests that firms with lower ICQ tend to spend more on M&A activities when they have extra cash, and this
tendency is less likely to happen in firms with higher ICQ. Given that M&A activities are found to benefit the insiders, though M&A
can be potential strategic means of creating value for firms by re-structuring and re-deploying resources (Devos et al., 2009; Harp and
Barnes, 2018; Kravet et al., 2018), these findings, to some extent, show that effective internal controls help reduce the risks involved
in dissipating extra cash.
We further investigate whether the findings from Column (3) is conditional on their past M&A experience. As the impairment in
the value of goodwill indicates that the expected benefits of a prior acquisition have been overestimated on the balance sheet (Li
et al., 2011), it is appropriate to use goodwill impairment to indicate a firm's prior M&A inefficiency. We partition our sample into
9
As Koh and Reeb (2015) show, firms have the incentive (e.g., to avoid proprietary costs) and the opportunity (e.g., of using discretions in
financial reporting and in restructuring corporate activities) to avoid reporting R&D in the U.S. This situation is more severe in China, for example,
in our sample, 78.8% of the firm-year reports show zero expenditure for R&D, whereas, in the U.S., Kob and Reeb (2015) find that 42.2% of firm-
year reports show zero R&D spending.
12
two subsamples based on whether goodwill impairment occurs. The results (untabulated and available upon request) show that the
coefficient on EXTRA × ICQ_H is significantly negative in the subsample where goodwill impairment occurs (coefficient = −0.016
with t = −2.35) and that the difference between these two subsamples is significant. In other words, internal controls can restrain M
&A expenditures when the firm's prior M&A experience is negative, but such controls do not inhibit M&A expenditures when prior M
&A experience is positive. Therefore, internal controls purport to deter unsuccessful or inefficient M&A expenditures.
In Column (4), the coefficient on EXTRA × ICQ_H is positive (coefficient = 0.018 with t = 1.76), indicating that firms with high
ICQ are more likely to pay back their extra cash to investors. The results from Column (4) rule out the possibility that high-quality
internal controls reinforce the tendency for firms to hoard extra cash, rather than expending cash for purposes such as paybacks to
shareholders. In summary, our findings infer that high-quality internal controls help firms hold or expend their cash reasonably,
prevent risky investments, and encourage the payoff of shareholders when holding extra cash.
5.2. Internal control quality and the value of cash holdings
From an ex post perspective, investors would place a higher value on cash held by firms that make decisions consistent with their
own welfare, rather than managers' private benefits (Faulkender and Wang, 2006; Dittmar and Mahrt-Smith, 2007; Frésard and Salva,
2010; Louis et al., 2012; Megginson et al., 2014). If internal controls help firms shape reasonable cash policies that lead to value
creation, we could find that the cash held by firms with strong internal controls is valued higher by investors. To examine the
relationship between ICQ and the value of cash holdings from the market perspective, we follow the model of Pinkowitz et al. (2006,
p.2739), specified as:
Vi, t = 0 + 1 LnCASHi, t + 2 ICQ _Hi, t + 3 LnCASHi, t × ICQ _Hi, t + 4 NAi, t + 5 NAi, t + 1 + 6 Ei, t + 7 Ei, t + 8
Ei, t + 1 + 9 R &Di, t + 10 R&Di, t + 11 R&Di, t + 1 + 12 Ii, t + 13 Ii, t + 14 Ii, t + 1 + 15 Di, t + 16 Di, t + 17
Di, t + 1 + 18 Di, t + 19 Ii, t + 20 Vi, t + 1 + Industry &Year fixed effects + i, t (4)

where Vi,t refers to firm value, defined as the firm's market value of equity plus the short- and long-term debt, scaled by total
assets. Given that we rely on the results of the interaction between cash holdings and ICQ, we use a binary variable of ICQ (i.e.,
ICQ_H), with a value of 1 where the ICQ of a firm is greater than the median value of all ICQ scores, and 0 otherwise. △ stands for the
annual change in certain variables. NA, E, D, I, and R&D refer to the total assets excluding cash and marketable securities, net
earnings, cash dividends, interest expenditures, and expenditures on research and development, respectively. All of these variables
are scaled by total assets.
Table 8 reports the results on how ICQ affects the market valuation of cash holdings. In Column (1), the coefficient on the
interaction LnCASH × ICQ_H is significantly positive (coefficient = 0.183 with t = 4.08), suggesting that the market places a higher
value on cash held by firms with higher ICQ. This finding is further substantiated by the results that the value-relevance coefficient
for the firms with lower ICQ is 0.070, much smaller than that for firms with higher ICQ where the sum of coefficients on LnCASH and
LnCASH × ICQ_H is 0.253 (= 0.070 + 0.183). Whereas, it could be inappropriate to estimate their model across all firms if there are
large systematic differences in the costs of equity across subsamples, e.g., large firms and small firms (Fama and French, 1998). We
drop the small firms whose market values of equity are less than the lowest tenth of the sample in Column (2). The coefficient on
LnCASH × ICQ_H remains significantly positive (coefficient = 0.140 with t = 2.89). Overall, our findings show that investors deem it
commendable when firms with effective internal controls maintain higher cash holdings.
5.3. The difference-in-differences analysis
As China adopt a trial-and-error approach to regulate public firms' internal controls (see details in Appendix II), we design the
difference-in-differences (DiD) tests in five sub-periods in Table 9. For the sub-period of 2007–2009, the Treatment group is for firms
listed on the Main Board, and the control group is for firms listed on SME Board. The cutoff year is 2009 (i.e., Year 2009 is defined as
post-regulation period and Year 2007–2008 is pre-regulation period). The coefficient on POST × TREAT in Column (1) of Table 9 is
significantly negative (coefficient = −0.023 with t = 1.87).
For the sub-period of 2009–2011, in order to avoid the systematic differences among different boards, we focus on firms on the
Main Board in the following DiD tests. In this period, the shock is that cross-listed and pilot firms are mandated to have an attestation
report starting in 2011. Hence, we define cross-listed firms and pilot firms (the rest of firms in Main Board) as treatment (control)
sample, 2009–2010 (2011) is defined as pre (post)-period. The coefficient on POST × TREAT in Column (2) is insignificant (coef-
ficient = −0.019 with t = −0.72), which may result from the trial-and-error approach, in which all firms are required to issue self-
assessment report starting in 2009 under the regulation of 2008. However, only cross-listed and pilot firms are mandated to do so
starting in 2011 under the regulations of 2010 and 2011, which might contaminate the DiD tests.
For the sub-period of 2011–2012, SOEs are required to have both self-assessment and auditors' attestation starting in 2012, so we
use SOEs (after excluding cross-listed and pilot firms that implement starting in 2011) as the treatment group and non-SOEs (ex-
cluding cross-listed and pilot firms) as the control group. Year 2011 (2012) is defined as pre (post)-period. The coefficient on POST ×
TREAT in Column (3) is again insignificant (coefficient = −0.045 with t = −1.53). It makes sense in that all the firms except cross-
listed and pilot firms should have both self-assessment and attestation starting in 2012 under the regulation of 2010, but only SOEs
are mandated starting in 2012 under the regulation of 2012. To a certain extent, such a trial-and-error approach makes our DiD
unclean.
13
Table 8
Internal control quality and the market valuation of cash holdings.
Variables (1) (2)
LnCASHt 0.070⁎ 0.118⁎⁎⁎

(1.77) (2.70)
ICQ_Ht −0.036 −0.130
(−0.38) (−1.26)
LnCASHt × ICQ_Ht 0.183⁎⁎⁎ 0.140⁎⁎⁎
(4.08) (2.89)
△NAt −0.398⁎⁎⁎ −0.345⁎⁎⁎
(−3.41) (−2.78)
△NAt+1 0.673⁎⁎⁎ 0.753⁎⁎⁎
(8.14) (8.51)
Et 6.789⁎⁎⁎ 7.146⁎⁎⁎
(7.93) (7.83)
△Et −0.580 −0.060
(−1.04) (−0.10)
△Et+1 3.683⁎⁎⁎ 4.193⁎⁎⁎
(8.73) (9.05)
R&Dt 0.055⁎⁎⁎ 0.060⁎⁎⁎
(3.08) (3.11)
△R&Dt −0.052⁎⁎⁎ −0.062⁎⁎⁎
(−2.74) (−2.99)
△R&Dt+1 0.027⁎⁎ 0.027⁎
(2.06) (1.87)
It −1.209 −1.186
(−1.35) (−1.32)
△It 0.963 0.930
(1.15) (1.12)
△It+1 −0.085⁎⁎⁎ −0.085⁎⁎⁎
(−5.36) (−4.97)
Dt 7.752⁎⁎⁎ 7.748⁎⁎⁎
(3.73) (3.57)
△Dt −2.155 −3.355⁎⁎
(−1.50) (−2.13)
△Dt+1 3.017⁎⁎ 2.360
(2.20) (1.64)
△Vt+1 −0.030 −0.055⁎⁎⁎
(−1.54) (−2.74)
Intercept 3.514⁎⁎⁎ 3.585⁎⁎⁎
(21.01) (21.20)
Industry & Year FE Yes Yes
Obs. 15,638 14,082
Adj. R2 0.353 0.359
This table presents the results testing the effect of internal controls on the market valuation of
cash holdings. The dependent variable in both columns is firm value (Vt). In the second
column, we exclude firms whose market values of equity are less than the lowest tenth of the
sample. See Appendix I for the definitions of other variables. The t-values in parentheses are
based on standard errors adjusted for heteroscedasticity and clustering at the firm level. ***,
**, and * indicate statistical significance at the 1%, 5%, and 10% levels, respectively.
For the sub-period of 2012–2013, large non-SOEs (excluding cross-listed and pilot firms) as the treatment, and the rest of non-
SOEs (excluding cross-listed and pilot firms) as the control, Year 2012 (2013) is defined as pre (post)-period. The coefficient on POST
× TREAT in Column (4) is insignificant, too. It may ascribe to the uncertainty in 2012 when the regulations of 2010 and 2012 have
different requirements.
For the sub-period of 2013–2015, the regulation in this period is finalized. We define the large non-SOEs excluding cross-listed
and pilot firms (the rest of non-SOEs excluding cross-listed and pilot firms) as the control (the treatment) group, and Year 2013 (Year
2014–2015) is defined as pre (post)-period. We do not include SOEs in the control group because SOEs have implemented the rule
before large non-SOEs. The coefficient on POST × TREAT in Column (5) is significant (coefficient = −0.012 with t = −1.79),
consistent with our main findings.
5.4. Robustness checks
We conduct a battery of robustness tests. First, to control for the time-invariant confounding factors, we include the firm-level
fixed effects in Eq. (2). Second, we re-estimate abnormal cash holdings by including variables on managerial characteristics such as
CEO's gender, age, salary, and share ownership in Eq. (1). Third, we re-estimate abnormal cash holdings by replacing LnCASH in Eq.
(1) with the cash ratio without logarithm transformation. Fourth, we re-estimate abnormal cash holdings by re-defining LnCASH in
14
Table 9
Difference-in-differences settings with staggered compliance.
Variables 2007–2009 2009–2011 2011–2012 2012–2013 2013–2015
POST 0.011 −0.042⁎⁎⁎ 0.056⁎⁎ 0.032 0.013

(0.74) (−2.84) (2.24) (0.99) (0.55)
TREAT 0.019 −0.036 0.011 0.035 0.003
(0.073) (−1.52) (0.44) (0.63) (0.05)
POST × TREAT −0.023⁎ −0.019 −0.045 −0.050 −0.012⁎
(−1.87) (−0.72) (−1.53) (−1.02) (−1.79)
SOE −0.039⁎⁎ −0.016
(−2.28) (−0.84)
SIZE −0.006 −0.005 −0.013 −0.047 −0.049⁎⁎
(−0.52) (−0.46) (−1.09) (−1.61) (−2.36)
GROW −0.019 −0.021 −0.031⁎ −0.012 −0.024
(−1.22) (−1.62) (−1.95) (−0.37) (−1.05)
LEV −0.223⁎⁎⁎ −0.193⁎⁎⁎ −0.103 −0.169 −0.147
(−3.54) (−2.97) (−1.32) (−1.22) (−1.11)
CF −0.286⁎⁎⁎ −0.252⁎⁎⁎ −0.009 −0.541⁎⁎ −0.432⁎⁎
(−3.19) (−2.63) (−0.08) (−2.29) (−2.42)
CF_VOL 0.128 0.089 −0.332 −0.701⁎ −0.267
(0.87) (0.51) (−1.57) (−1.80) (−0.89)
RET_VOL −0.364 −1.734 3.347 4.586 0.213
(−0.41) (−1.04) (1.42) (1.37) (0.43)
SEG −0.011 −0.013 0.004 −0.032 −0.033
(−1.11) (−1.06) (0.23) (−1.05) (−1.25)
FIRMAGE 0.051⁎⁎⁎ 0.053⁎⁎⁎ 0.077⁎⁎⁎ 0.050⁎ 0.023
(2.91) (2.79) (4.09) (1.67) (0.79)
NWC −0.279⁎⁎⁎ −0.254⁎⁎⁎ −0.257⁎⁎⁎ −0.140 0.072
(−4.54) (−4.06) (−3.30) (−1.24) (0.77)
CAPEX −0.155 −0.200 −0.513⁎⁎⁎ −0.516 −0.432
(−1.21) (−1.24) (−2.73) (−1.53) (−1.55)
R&D −0.018⁎⁎ −0.019⁎⁎⁎ −0.013⁎⁎⁎ −0.020⁎⁎ −0.030⁎⁎⁎
(−2.19) (−4.55) (−2.95) (−2.45) (−4.43)
M&A −1.244⁎⁎⁎ −1.530⁎⁎⁎ −1.584⁎⁎⁎ −1.545⁎⁎ −0.832⁎
(−3.51) (−4.53) (−3.81) (−2.38) (−1.82)
DIV −0.042⁎ −0.044⁎ −0.033 −0.039 −0.073
(−1.85) (−1.71) (−1.05) (−0.86) (−1.41)
PB −0.014 0.011 0.011 0.012 −0.005
(−0.58) (0.42) (0.43) (0.28) (−0.25)
ES −0.036⁎⁎ −0.041⁎⁎⁎ 0.004 −0.012 −0.047⁎
(−2.32) (−2.59) (0.20) (−0.39) (−1.71)
GENDER 0.058⁎⁎ 0.030 −0.018 −0.032 0.029
(1.98) (0.86) (−0.44) (−0.46) (0.43)
CEOAGE −0.045 −0.025 0.028 0.073 0.066
(−0.77) (−0.40) (0.36) (0.60) (0.72)
SALARY −0.000 −0.002 −0.002 −0.011 −0.004
(−0.00) (−0.47) (−0.51) (−1.03) (−0.99)
SHARES −0.226⁎ −0.251 −0.119 −0.249 −0.398⁎⁎
(−1.89) (−1.14) (−0.79) (−1.62) (−2.23)
Intercept 0.667⁎⁎⁎ 0.716⁎⁎⁎ 0.322 0.555 0.671
(2.85) (2.68) (1.00) (0.93) (1.21)
Industry FE Yes Yes Yes Yes Yes
Obs. 3826 3364 1877 735 1184
Adj. R2 0.067 0.069 0.099 0.161 0.135
This table presents the results of the difference in differences tests. The dependent variables in all columns are abnormal cash holdings (AbCASH).
TREAT is an indicator, 1 if the firm is within the scope of internal control regulation, and 0 otherwise. POST is an indicator, 1 if the year is after the
regulation becomes effective, and 0 otherwise. See Appendix I for the definitions of other variables. The t-values in parentheses are based on
standard errors adjusted for heteroscedasticity and clustering at the firm level. ***, **, and * indicate statistical significance at the 1%, 5%, and 10%
levels, respectively.
Eq. (1) as the natural logarithm of the sum of cash and marketable securities scaled by the total assets net of cash and marketable
securities. Fifth, to mitigate the potential endogeneity concern of ICQ, we re-estimate Eq. (2), where the ICQ and all other explanatory
variables are one-year lagged. The inferences in the respective column of Table 10 are indeed unaltered as compared to those shown
in Table 3.
6. Conclusions
Corporate managers often confront the challenges in managing risks within an acceptable range. Too strict internal controls will
15
Table 10
Robustness tests.
Variables (1) (2) (3) (4) (5)
ICQ −0.139⁎⁎ −0.246⁎⁎⁎ −0.015⁎ −0.257⁎⁎⁎ −0.193⁎⁎⁎

(−2.46) (−4.47) (−1.92) (−4.35) (−3.76)
SOE −0.004 −0.029⁎⁎ −0.002 −0.035⁎⁎⁎ −0.036⁎⁎⁎
(−0.10) (−2.39) (−1.43) (−2.67) (−3.07)
SIZE −0.022⁎ −0.016⁎⁎⁎ 0.001 0.000 −0.003
(−1.89) (−2.71) (0.79) (0.04) (−0.53)
GROW −0.017⁎⁎ −0.011 0.000 −0.020⁎⁎ −0.019⁎⁎
(−2.15) (−1.43) (0.49) (−2.44) (−2.58)
LEV −0.190⁎⁎⁎ −0.082⁎⁎ −0.104⁎⁎⁎ −0.376⁎⁎⁎ −0.201⁎⁎⁎
(−3.40) (−2.48) (−17.75) (−8.88) (−5.34)
CF −0.151⁎⁎⁎ −0.090⁎ −0.003 −0.208⁎⁎⁎ −0.254⁎⁎⁎
(−2.64) (−1.73) (−0.31) (−3.32) (−4.60)
CF_VOL −0.241⁎⁎ 0.055 0.059⁎⁎⁎ 0.084 0.028
(−2.06) (0.52) (4.18) (0.74) (0.27)
RET_VOL 0.942⁎ 0.151 0.361⁎⁎⁎ 0.903 −0.076
(1.74) (0.18) (3.02) (1.03) (−0.10)
SEG 0.002 −0.017⁎⁎ −0.002⁎⁎ −0.015⁎⁎ −0.012⁎
(0.35) (−2.36) (−2.28) (−2.06) (−1.81)
FIRMAGE 0.104⁎⁎⁎ 0.057⁎⁎⁎ 0.000 0.054⁎⁎⁎ 0.057⁎⁎⁎
(7.42) (7.18) (0.04) (6.53) (7.26)
NWC −0.208⁎⁎⁎ −0.000⁎⁎⁎ −0.092⁎⁎⁎ −0.372⁎⁎⁎ −0.228⁎⁎⁎
(−4.40) (−4.69) (−16.70) (−9.03) (−6.29)
CAPEX −0.299⁎⁎⁎ −0.031 −0.104⁎⁎⁎ −0.419⁎⁎⁎ −0.228⁎⁎⁎
(−3.30) (−0.36) (−8.84) (−4.69) (−2.82)
R&D −0.008⁎⁎⁎ −0.011⁎⁎⁎ −0.002⁎⁎⁎ −0.015⁎⁎⁎ −0.012⁎⁎⁎
(−3.12) (−5.16) (−6.37) (−6.49) (−6.32)
M&A −0.509⁎⁎⁎ −0.331⁎ −0.193⁎⁎⁎ −0.989⁎⁎⁎ −0.672⁎⁎⁎
(−3.23) (−1.79) (−8.87) (−6.10) (−4.78)
DIV −0.042⁎⁎⁎ −0.013 −0.002 −0.042⁎⁎⁎ −0.040⁎⁎⁎
(−3.43) (−1.00) (−0.87) (−3.08) (−3.41)
PB −0.009 0.016 0.000 −0.007 −0.009
(−0.73) (1.09) (0.17) (−0.45) (−0.70)
ES −0.022⁎⁎⁎ −0.023⁎⁎⁎ 0.000 −0.033⁎⁎⁎ −0.037⁎⁎⁎
(−3.08) (−3.07) (0.01) (−3.99) (−5.18)
GENDER 0.007 −0.009 −0.002 −0.018 −0.018
(0.28) (−0.46) (−0.76) (−0.85) (−0.98)
CEOAGE 0.002 −0.026 0.002 −0.000 −0.006
(0.05) (−0.74) (0.48) (−0.01) (−0.18)
SALARY 0.001 −0.002 0.000 −0.002 −0.002
(0.43) (−1.14) (0.58) (−0.82) (−1.07)
SHARES −0.173⁎ −0.089⁎⁎ −0.002 −0.055 −0.056
(−1.95) (−2.11) (−0.31) (−1.21) (−1.45)
Intercept 0.568⁎⁎⁎ 0.735⁎⁎⁎ 0.084⁎⁎⁎ 0.734⁎⁎⁎ 0.638⁎⁎⁎
(3.27) (5.07) (4.38) (4.80) (4.66)
Firm FE Yes No No No No
Industry & Year FE No Yes Yes Yes Yes
Obs. 16,468 13,964 16,468 16,468 15,006
Adj. R2 0.416 0.055 0.127 0.063 0.069
This table presents the results of robustness tests. In Column (1), the firm-level fixed effect is included; in Column (2), CEO characteristics such as
gender, age, salary, and share ownership are included when estimating abnormal cash holdings in Eq. (1); in Column (3), abnormal cash holdings is
estimated in Eq. (1) where LnCASH is replaced by the cash ratio without logarithm transformation (i.e., the ratio of cash and marketable securities to
the book value of total assets); in Column (4), abnormal cash holdings is estimated in Eq. (1) where LnCASH is replaced by LnCASH2, calculated as
the sum of cash and marketable securities scaled by the total assets net of cash and marketable securities, measured as the natural logarithm; in
Column (5), the ICQ and all other explanatory variables are one-year lagged. The dependent variables in all columns are abnormal cash holdings.
See Appendix I for the definitions of other variables. The t-values in parentheses are based on standard errors adjusted for heteroscedasticity and
make firms more risk-averse and thus avert opportunities, while too loose internal controls will induce firms to be more risk-taking.
The SOX Act enacted in the U.S. mandates strict internal controls. Significant figures such as William Donaldson, Milton Friedman,
and Alan Greenspan have expressed concern that SOX would douse firms' passion on risk-taking, and confirmed by empirical evi-
dence (e.g., Ahmed et al., 2010; Bargeron et al., 2010; Kang et al., 2010; Gao and Zhang, 2019). In this study, we use a sample of firms
from China, a different setting where internal controls are designed to manage risks and improve operational efficiency, to examine
whether internal controls improve cash management.
We show that Chinese firms with higher ICQ have less abnormal cash holdings (either extra cash or deficit cash), indicating that
effective internal controls help firms target at the optimal level of cash holdings and manage both upside and downside risk related to
16
cash holdings. Further analyses show that this effect is not driven by corporate governance and is more pronounced in the four of five
internal control components, Control Environment, Control Activities, Information and Communication, and Monitoring. We also find
firms with higher ICQ are more likely to increase dividend payments but are less likely to increase M&A investments, especially when
these firms have had a negative experience in the past. Furthermore, our tests on the market valuation of cash holdings show that
investors are prone to place a higher value on cash holdings of firms with higher ICQ. Overall, our findings suggest that internal
controls in China help firms shape reasonable cash policies that lead to value creation.
We take advantage of the setting in China, where the regulations go beyond controls over financial reporting and emphasize risk
management. Our findings have the following practical implications. First, regulators could encourage firms to establish and
maintain effective internal controls that go beyond controls over financial reporting. The advantages of emphasizing internal controls
over financial reporting requirements arise from the fact that it is often easy to structure and implement, due to its narrow scope and
the immediate possibility of meeting the demands of investors and regulators for financial reporting purposes. The disadvantages of
this approach include a potential shift of focus from operation to compliance, which may encourage managers to be more risk averse.
Second, internal controls should not be eased to rote compliance, nor should they hinder the decision-making powers of managers.
Instead, internal controls can be used to maximize the utility function of the firm's objectives if managers can integrate and im-
plement firms' objectives and risk preferences into an effective internal control system. Finally, more considerable attention should be
given to managers' attitudes toward internal controls to ensure that the insiders' interests will not override the control systems, as
even well-designed internal controls cannot function effectively if they are viewed as mere formalities.
Acknowledgments
We thank Bill Megginson (the Editor) and two anonymous reviewers for their exceptional guidance and constructive suggestions.
We extend our thanks to Mei Feng, Jarrad Harford, Siyi Liu, Chuancai Zhang, Guochang Zhang, and workshop participants at Xiamen
University, University of International Business and Economics, and the 2015 Annual Conference of European Accounting
Association, for providing helpful comments. Hanwen Chen acknowledges the research grant from the National Natural Sciences
Foundation of China (No. 71932003, 71332008, 71790604). Daoguang Yang acknowledges the research fund from the National
Natural Science Foundation of China (No. 71702030).
Appendix I: Definitions of variables
Variables in Eqs. (1) and (2)
AbCASH = An absolute value of abnormal cash holdings, measured by estimating Eq. (1) by each industry-years with at least 20 observations. See
details in Section 4.1.
LnCASH = The ratio of cash and marketable securities to the book value of total assets, measured as the natural logarithm.
ICQ = Internal control quality, following Chen et al. (2017b), to measure the internal control quality of a firm through the five components of
internal controls (i.e., Control Environment, Risk Assessment, Control Activities, Information and Communication, and Monitoring).
ICQ1 = The quality of the first component of internal controls, calculated as the scores of the Control Environment component in the Internal Control
Index constructed by Chen et al. (2017b).
ICQ2 = The quality of the second component of internal controls, calculated as the scores of the Risk Assessment component in the Internal Control
ICQ3 = The quality of the third component of internal controls, calculated as the scores of the Control Activities component in the Internal Control
ICQ4 = The quality of the fourth component of internal controls, calculated as the scores of the Information and Communication component in the
Internal Control Index constructed by Chen et al. (2017b).
ICQ5 = The quality of the fifth component of internal controls, calculated as the scores of the Monitoring component in the Internal Control Index
constructed by Chen et al. (2017b).
ICQ_NCG = The internal control quality that excludes corporate governance, which is obtained by removing the corporate governance elements from
the Internal Control Index following Chen et al. (2020).
CG = The composite governance index, which is obtained from the corporate governance elements in Internal Control Index following Chen et al.
(2020, p. 50).
SOE = The nature of ultimate shareholders of the firm, 1 for a state-owned enterprise, 0 otherwise.
SIZE = Size, calculated as the natural logarithm of total assets (in million RMB).
ROA = Return on assets, calculated as net income divided by total assets.
GROW = Growth, calculated as the sales growth rate relative to the last year.
GROW_H = An indicator variable, 1 if the firm's growth rate (GROW) is larger than its industry-year median, 0 otherwise.
LEV = Leverage, calculated as total liabilities, scaled by total assets.
CF = Cash flow, calculated as the operating cash flow divided by total assets.
CF_VOL = Industry cash flow risk, calculated as the median value of standard deviations of CF over the past three years within the same industry-
year group.
RET_VOL = The volatility of market adjusted stock return, calculated as the standard deviation of daily adjusted stock returns over the year.
SEG = Segments, calculated as the natural logarithm of the number of business segments the firm has.
FIRMAGE = Firm age, calculated as the natural logarithm of one plus the number of years the firm has been publicly traded.
NWC = Net working capital, calculated as (current assets minus current liabilities minus the sum of cash and marketable securities), scaled by
total assets.
CAPEX = Capital expenditure, calculated as cash paid to purchase fixed assets, intangible assets, and other long-term assets, scaled by total assets.
R&D = R&D intensity, calculated as 100 multiplying R&D expenditures divided by total assets. We set R&D expenditures equal to zero if missing.
M&A = Merger and acquisition expenditures, calculated as cash paid for merger and acquisition, scaled by total assets.
17
DIV = Dividend, calculated as the cash dividend paid, scaled by net earnings.
PB = Public debt issuance, an indicator variable, 1 if the firm issues public debt, 0 otherwise.
ES = Equity issuance, an indicator variable, 1 if the firm issues new equity, 0 otherwise.
GENDER = The gender of CEO, 1 if the CEO is male, 0 for female.
CEOAGE = The age of CEO, calculated as the natural logarithm of the CEO's age.
SALARY = The salary of CEO, calculated as the natural logarithm of the CEO's cash compensation.
SHARES = The number of shares CEO owned divided by the total number of the firm's shares.
MKT = The degree of marketization following Wang et al. (2016), a higher value indicates more developed marketization. We use it as a dummy,
1 if the province where the firm is located ranks the top 10 among the 31 provinces in China, 0 otherwise.
NOISY = A time dummy, 1 if the sample period is during 2009–2012, 0 otherwise.
FOLLOW = A dummy, 1 if the number of financial analysts following the firm is more than its industry-year median, 0 otherwise.
CONC = A dummy of ownership concentration, 1 if a firm's sum of the square of top five largest shareholder's share percentages is larger than its
industry-year median, 0 otherwise.
FC = A dummy of financial constraint, 1 if the value of a firm's financial constraint (as measured by Hadlock and Pierce (2010), calculated as
−0.737 × SIZE + 0.043 × SIZE2 – 0.040 × FIRMAGE) is larger than its industry-year median, 0 otherwise.
Variables in Eq. (3)
△CAPEXt+1 = Annual change in capital expenditures, calculated as industry-year adjusted capital expenditures, scaled by total assets in year t + 1 minus
that total in year t.
△R&Dt+1 = Annual change in R&D, calculated as industry-year adjusted expenditures on R&D, scaled by sales revenue in year t + 1 minus sales
revenue in year t.
△M&At+1 = Annual change in M&A expenditures, calculated as industry-year adjusted expenditures on M&A, scaled by sales revenue in year t + 1
minus sales revenue in year t.
△DIVt+1 = Annual change in dividends, calculated as industry-year adjusted cash dividends, scaled by net earnings in year t + 1 minus net earnings
in year t.
EXTRA = An indicator variable of extra cash holdings, 1 if the model residual value of cash holdings estimating Eq. (1) is positive, 0 otherwise.
ICQ_H = An indicator for high-quality internal controls, 1 if the ICQ of the firm is greater than the median value of ICQs each year, 0 otherwise.
Variables in Eq. (4)
V = Firm value, calculated as the market value of equity plus the short- and long-term debt, scaled by total assets.
NA = Non-cash assets, calculated as non-cash assets, scaled by total assets.
E = Earnings, calculated as the net earnings, scaled by total assets.
I = Interest expenses, calculated as the interest expenses, scaled by total assets.
D = Dividends, calculated as the amount of cash dividends paid, scaled by total assets.
Appendix II: China's stock markets and internal control regulations
China has a multi-tiered capital market system, which consists of Main Board in Shenzhen Stock Exchange (hereafter, SZSE) and
Shanghai Stock Exchange (hereafter, SSE) established in 1990, SME Board (small and medium enterprise) founded in 2004 in SZSE,
and ChiNext Board (China's Next for innovative and entrepreneurial young firms) founded in October 2009 in SZSE. The internal
control regulations vary in the three boards.
Main Board:
• The Standard issued in June 2008 required all of the listed firms to issue a self-assessment of their internal controls. These firms
were suggested (aka voluntarily) to provide internal control attestations by external auditors as of July 1, 2009.
• The Supplemental Guidelines for the Standard issued in April 2010 changed the compliance schedule. It required firms cross-listed
on oversea stock exchanges, including Hong Kong, to issue a self-assessment of their internal controls and disclose an auditor's
report on internal controls, as of January 1, 2011, and the rest of public firms listed on either the SSE or the Main Board of SZSE to
comply as of January 1, 2012.
• In February 2011, the Chinese Securities Regulatory Commission (CSRC) launched a pilot program (including 68 cross-listed firms
and 216 piloted firms), in which firms were required to issue a self-assessment of their internal controls and to have their auditors
attest on internal controls starting in 2011.
• In August 2012, the CSRC and the Ministry of Finance (MF) SOEs revised the compliance schedule on self-assessment and the
auditor's attestation of internal controls in order to give firms sufficient time to establish and implement internal controls. The
compliance deadline was extended to 2013 for the “large” non-SOEs whose total market value was greater than RMB 5 billion as
of December 31, 2011, and whose average net income from 2009 to 2011 was greater than RMB 30 million. It was extended to
2014 for the rest of the non-SOEs.
SME Board:
On Dec. 31, 2010, SZSE required firms listed on SME Board to disclose their self-assessment report on internal control effec-
tiveness for 2010 and subsequent fiscal years' annual reports and disclose their attestation reports on internal control effectiveness
issued by the external auditors at least once every two years. Note that for Chinese public firms, the fiscal year is always the same as
the calendar year ending December 31.
18
ChiNext Board:
On Oct. 16, 2009, when the ChiNext Board was founded, SZSE required firms listed on ChiNext Board should annually disclose
their self-assessment reports on internal control effectiveness and disclose their attestation reports on internal control effectiveness
issued by the external auditors at least once every two years. The first batch of firms were listed on ChiNext starting 2010. Therefore,
the internal control regulation was enforced for their 2010 fiscal year reports.
According to the above regulations, the mandatory compliance schedule is tabulated as follows:
Main Board SME Board ChiNext Board
Self-Assessment Annually Attestation Annually Self-Assessment Annually Attestation Biannually Self-Assessment Annually Attestation Biannually
2007 None None None None

2008 None None None None
2009 All None None None
2010 All None All All All All
2011 Cross-listed and Pilot Firms All All All All
SOEs
SOEs
Large non-SOEs
SOEs
Large non-SOEs
Other non-SOEs
SOEs
Large non-SOEs
Other non-SOEs
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Journal of Corporate Finance 64 (2020) 101695

Contents lists available at ScienceDirect

Journal of Corporate Finance

Internal controls, risk management, and cash holdings

ARTICLE INFO ABSTRACT

2. Literature review and hypothesis development

2.1. Existing studies

2.2. Hypothesis development

3.1. Data and sample selection

3.2. Descriptive statistics

4.1. Internal control quality and abnormal cash holdings

Panel B: Industry distribution

The CSRC Industry Classification Firm-year Obs. Percentage

1-A: Farming, Forestry, Animal Husbandry, and Fishery 274 1.66%

VOLi, t + 8 SEGi, t + 9 FIRMAGEi, t + 10 NWCi, t + 11 CAPEXi, t + 12 R&Di, t + 13 M

&Ai, t + 14 DIVi, t + 15 PBi, t + 16 ESi, t + i, t (1)

AbCASHi, t = 0 + 1 ICQi, t + Controls + Industry &Year fixed effects + i, t (2)

AbCASH 0.438 0.375 0.162 0.346 0.614

4.2. Internal controls or corporate governance

ICQ −0.236⁎⁎⁎ −0.107⁎⁎ −0.376⁎⁎⁎

4.3. The components of internal controls

ICQ_NCG −0.200⁎⁎⁎ −0.086⁎ −0.333⁎⁎⁎

ICQ1 −0.109⁎⁎⁎ −0.067⁎⁎

4.4. Cross-sectional tests

5.1. Internal control quality and the disgorgement of extra cash

ICQ −0.314⁎⁎⁎ −0.408⁎⁎⁎ −0.398⁎⁎⁎ −0.309⁎⁎⁎ −0.406⁎⁎⁎ −0.303⁎⁎⁎

EXTRA 0.003⁎⁎⁎ 0.000 0.006⁎⁎⁎ −0.018⁎⁎⁎

5.2. Internal control quality and the value of cash holdings

Ei, t + 1 + 9 R &Di, t + 10 R&Di, t + 11 R&Di, t + 1 + 12 Ii, t + 13 Ii, t + 14 Ii, t + 1 + 15 Di, t + 16 Di, t + 17

Di, t + 1 + 18 Di, t + 19 Ii, t + 20 Vi, t + 1 + Industry &Year fixed effects + i, t (4)

5.3. The difference-in-differences analysis

LnCASHt 0.070⁎ 0.118⁎⁎⁎

5.4. Robustness checks

POST 0.011 −0.042⁎⁎⁎ 0.056⁎⁎ 0.032 0.013

ICQ −0.139⁎⁎ −0.246⁎⁎⁎ −0.015⁎ −0.257⁎⁎⁎ −0.193⁎⁎⁎

Appendix I: Definitions of variables

Variables in Eqs. (1) and (2)

Appendix II: China's stock markets and internal control regulations

Main Board SME Board ChiNext Board

2007 None None None None

Available at. http://www.coso.org.

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