The association between human resource investment in IT controls over financial reporting and investment efficiency
Introduction
This study examines the relation between human resource investment in information technology (IT) internal control over financial reporting (IT controls hereafter) and firms’ investment efficiency by examining listed firms in Korea. The standard of a company’s internal control (IC) system, which determines its financial reporting quality and information environment, depends on the number of personnel who oversee its ICs. In the United States, the Public Company Accounting Oversight Board (PCAOB), through the Staff Audit Practice Alert, emphasizes the importance of IC-related employees by stating that “the loss of such employees increases the risk of deficiencies in ICs, which would result in a deterioration in IC strength” (PCAOB, 2008, p. 6). Empirical evidence also proves the benefits of having a sufficient number of IC-related personnel. Choi et al. (2013) provide evidence that having a sufficient number of IC-related staff helps firms maintain strong ICs. They also show that an increase in the number of IC-related personnel is positively associated with the possibility of remediating previously disclosed IC weaknesses. They thus contend that having a sufficient number of IC-related personnel helps firms ensure an “adequate segregation of duties, timely review, and monitoring of accounting functions” (Choi et al., 2013, p. 170).
Since the enactment of the Sarbanes–Oxley Act (SOX), Sections 302 and 404 in particular, a vast amount of research has focused on issues related to a firm’s IC. Studies provide empirical evidence that ICs in firms are important by investigating the effect of a firm’s ICs on the market, investors’ perceptions, and the firm’s operations (Ashbaugh-Skaife et al., 2007, Ashbaugh-Skaife et al., 2008, Feng et al., 2009, Bedard and Graham, 2011, Cheng et al., 2013). However, only a few researchers have focused on the effect of investment in ICs. To the best of our knowledge, there have been no studies on the effect of human resource investment, especially in IT controls, on the efficiency of investment, which is one of the most important internal decisions within a firm.
Among the several components of a firm’s ICs, we focus on IT controls and their effect on investment efficiency. Since the enactment of Sections 302 and 404 of the SOX, IT controls have grasped the attention of accounting practitioners and scholars. The PCAOB (2004) states that since the influence of IT on companies’ operations and financial reporting processes has become more extensive and pervasive, IT controls should be one of the most important factors for maintaining effective ICs. The 2013 framework on ICs by the Committee of Sponsoring Organizations of the Treadway Commission (2013) also emphasizes the importance of IT by listing, selecting and developing IT controls as a pivotal principle of ICs. In addition to practitioners and regulators, accounting scholars provide evidence that the effect of IT controls is much more pervasive than other components of ICs (Canada et al., 2009, Klamm et al., 2012, Li et al., 2012, Haislip et al., 2016, Holder et al., 2016, Masli et al., 2016, Heninger et al., 2018). They contend that IT controls are more important than any other components of ICs by analyzing the relation between IT-related IC weaknesses and audit fees (Canada et al., 2009), management turnover (Haislip et al., 2016, Masli et al., 2016), earnings management (Heninger et al., 2018), and firm performance (Stoel and Muhanna, 2011, Lunardi et al., 2014).
Most extant works related to IT controls focus on analyzing the importance of IT controls and its effect on external reporting by examining the effect of IT-related material weaknesses on external reporting, such as financial reporting quality (Klamm and Watson, 2009) and earnings management (Heninger et al., 2018). Other works investigate the effect of IT-related material weaknesses on firm performance (Stoel and Muhanna, 2011, Lunardi et al., 2014) and the internal information environment (Li et al., 2012). However, there have been no studies to explore the effect of human resource investment in IT controls, and limited research has examined the effect of IT controls on a firm's internal decisions. Also, most extant studies provide evidence of the importance of IT controls and its effect by examining the ex-post effect of IT controls through the effect of IT-related material weaknesses. Thus, analyzing the relationship between human resource investment in IT controls and a firm's investment efficiency is important, as it allows us to investigate the ex-ante effect of IT controls and their effect on a firm’s internal decisions.
In this study, we contend that the investment in IT control personnel enhances a firm’s investment efficiency by influencing its financial reporting quality and internal information environment. Prior research shows that investing human resources in ICs enhances a firm’s ICs (Choi et al., 2013, Shin et al., 2017). More specifically, human resource investment in ICs is negatively associated with the disclosure of IC weaknesses and audit reporting lag. Along the same lines, we expect human resource investment in IT controls to enhance a firm’s IT controls, which in turn increases its financial reporting quality and internal information environment. The integrity and reliability of the financial information disclosed by the firm are the key factors for its financial reporting quality as well as business operations and managers’ effective decision-making. In this respect, maintaining a high level of ICs is crucial to have the reliable and high-quality financial information and a sound internal information environment. IT-related IC weaknesses lower financial performance, raise the likelihood of restatement, increase the number of IC material weaknesses, lower the accuracy of management forecasts, and reduce operational efficiency (Canada et al., 2009, Stoel and Muhanna, 2011, Li et al., 2012, Holder et al., 2016, Cheng et al., 2018).
As McNichols and Stubben (2008) argued, investment decisions are based on future growth and product demand expectations. Expectations of the future growth of a firm depend on financial information that includes revenue and earnings. Thus, financial reporting quality is critical in investment decisions because low-quality financial reporting, such as a misstated financial report, can distort the underlying trends in revenue and earnings growth if a firm is unaware of such incidents. Similarly, a large body of research suggests that high-quality financial reporting supports firms in increasing investment efficiency by reducing information asymmetry, a cause of moral hazards and adverse selection, between managers and outside suppliers of capital (Verrecchia, 2001, Biddle et al., 2009, Bushman et al., 2011). In this respect, Cheng et al. (2013) show that strong ICs increase a firm’s investment efficiency by enhancing financial reporting quality. Researchers also show that strong IT controls and ICs assist management in managing operations effectively, creating forecasts, monitoring performance, and producing financial information for stakeholders by enhancing the internal information environment (Li et al., 2012, Cheng et al., 2013, Holder et al., 2016, Cheng et al., 2018, Heninger et al., 2018). Thus, given that human resource investment in ICs increases a firm’s IC effectiveness, which also enhances its financial reporting quality and internal information environment, we argue that human resource investment in IT controls improves a firm’s investment efficiency.
This study uses novel hand-collected data on human resource investment in ICs in Korea. To the best of our knowledge, Korea is the only country that provides detailed information on human resource investment in ICs, including the number of personnel, the number of certified accountants, and the average working experience of personnel responsible for ICs in each department. This disclosure of detailed information on firms’ ICs provides us with an opportunity to examine the association between human resource investment in IT controls and a firm’s investment efficiency.
To analyze this association, the study proxy for a firm’s human resource investment in IT controls as the ratio of (1) the number of employees responsible for IC in the IT department (IT control personnel), (2) the number of IT control personnel who are certified public accountants to the total number of employees in the firm, and (3) the natural logarithm of average working experience in months of IT control personnel. We subsequently examine the relationship between a firm’s absolute value of abnormal investment following McNichols and Stubben (2008) and human resource investment in IT controls. The analysis provides evidence that investment in IT control personnel is associated with the efficient investment. We find a negative association between human resource investment in IT controls and the absolute value of abnormal investment efficiency. Furthermore, we find that the number of IT control personnel who are certified public accountants and the average working experience in months is also positively associated with a firm’s investment efficiency.
To verify whether human resource investment in IT controls improves investment efficiency by influencing financial reporting quality, we examine the association between human resource investment in IT controls and financial reporting quality proxied by discretionary revenue and the likelihood of reporting IC material weaknesses. The result shows that human resource investment in IT controls improves a firm’s financial reporting quality as human resource investment in IT controls is negatively associated with discretionary revenue and the likelihood of reporting IC material weaknesses. This result suggests that human resource investment in IT controls influences a firm’s financial reporting quality, which in turn improves investment efficiency.
Several additional analyses support our main results. When we divide the sample into two subsamples based on a firm’s lagged discretionary revenue and analyst following, the results show that the negative association between an increase in human resource investment in IT controls and a firm’s absolute value of abnormal investment efficiency is more pronounced in firms with higher discretionary revenues and firms without analyst following. This suggests that human resource investment in IT controls plays a more important role and has a larger influence on firms with low levels of financial reporting quality and poor information environments. This result also indirectly supports our argument that investment in IT control personnel influences a firm’s financial reporting and information environment quality, which in turn improves investment efficiency. Furthermore, at the department level, when departments are divided into IT and non-IT, only human resource investment in IT controls has a significant positive relationship with a firm’s investment efficiency. We also find that human resource investment in IT controls enhances a firm’s investment efficiency by reducing overinvestment. Our main result is robust to a battery of sensitivity tests, including change analyses and Heckman two-stage analysis. However, the inverse Mills Ratios (IMR) in Heckman (1979) two-stage analysis are negative and significant, suggesting an issue with self-selection bias. Therefore, we conduct Heckman (1979) two-stage analysis not only for our main analysis but also for every analysis. The untabulated results continue to show qualitatively consistent results, which support our analyses. Moreover, to further address the potential endogeneity, we also conducted propensity-score matched sample analysis, and the results continue to support our main results.
This study contributes to the literature in several significant ways. First, using novel data sets, this study is the first to provide evidence on the relationship between human resource investment in IT controls and a firm’s investment efficiency. As noted above, most extant research analyzes the importance of IT controls and its effect on external reporting of financial information by examining the effect of IT-related material weaknesses, which shows the ex-post effect of IT controls (Canada et al., 2009, Klamm and Watson, 2009, Stoel and Muhanna, 2011, Haislip et al., 2015, Holder et al., 2016, Heninger et al., 2018). Our study enhances this stream of literature by providing the empirical evidence that IT controls also have a significant effect not only on external reporting but also on a firm’s internal decision-making by examining the ex-ante effect of a firm’s IT controls. Second, our study documents the significant economic benefits of human resource investment in IT controls. Over the past few decades, researchers have documented many failed IT-related investments (Standish Group, 2015). According to the Information Technology Governance Institute (ITGI), approximately 20 to 70 percent of larger-scale IT-related investments are wasted or fail to generate an intended benefit (ITGI, 2008). Our study provides a possible solution to this issue by contributing empirical evidence that human resource investment in IT controls produces economic benefits to firms by enhancing investment efficiency. Finally, this study enriches the literature related to investment efficiency by illustrating that human resource investment in IT controls is also a significant determinant of investment efficiency.
The rest of the paper is organized as follows. The next section provides the background, and the hypothesis is developed in 2 Institutional background, 3 Prior literature and hypothesis development. Our research model and design are presented in Section 4. Section 5 provides the results of the analysis, and Section 6 concludes with a discussion of the results and implications for future research.
Section snippets
Disclosure of the accounting IC system in Korea
In the United States, the SOX, which was enacted in 2002 because of large-scale accounting scandals such as Enron, Waste Management, and WorldCom, requires companies to disclose detailed information on ICs to ensure a firm’s accounting transparency. After the enactment of the SOX, the Financial Supervisory Service in Korea, which corresponds to the Securities and Exchange Commission in the United States, reformed Korean accounting systems. As a part of this reform, it required Korean listed,
Human resource investment in ICs
Human resources are one of the critical factors in maintaining a firm’s ICs. The Staff Audit Practice Alert issued by the PCAOB (2008) states that the loss of IC-related personnel increases the risk of deficiencies in ICs. Choi et al. (2013) examine the effect of human resource investment in ICs on the disclosure of IC weaknesses and find that such investment is negatively associated with the disclosure. They also find that a change in IC-related employees has a positive relationship with the
Research design
To test our hypothesis, this study uses the level of abnormal investment to capture a firm’s investment efficiency. To estimate the abnormal investment of a firm, following McNichols and Stubben (2008), the following model is employed:where the dependent variable captures a firm’s investment level in year t, while represents
Main results
Table 4 reports the empirical results for our hypothesis. Column (1) presents the results of regressing a firm’s investment efficiency on the number of IT control personnel. The coefficient of IC1ITt (-0.233) is negative and significant at the 1 percent level (t-value = -2.87). This result suggests that as a greater proportion of IC personnel is involved in IT controls, a firm’s investment efficiency improves. Column (2) provides the association between a firm’s investment efficiency and the
Conclusion
This study investigates the effect of human resource investment in IT controls on a firm’s investment efficiency. It is widely held that strong IT controls improve a firm’s information environment, financial reporting quality, effectiveness of overall ICs, and operating efficiency (Feng et al., 2009, Klamm and Watson, 2009, Stoel and Muhanna, 2011, Li et al., 2012, Cheng et al., 2018, Heninger et al., 2018). Thus, human resource investment in IT controls enhances a firm’s investment efficiency
Declaration of Competing Interest
The authors declare that they have no known competing financial interests or personal relationships that could have appeared to influence the work reported in this paper.
Acknowledgments
The authors would like to thank anonymous reviewers and participants at the 2020 Joint Midyear Meeting of the AIS, SET and International Sections for their helpful feedback on earlier versions of this study.
Data statement
Financial data are available in TS2000 and KIS-Value database (equivalent to Compustat in the United States). Data on IC personnel in Korean listed firms is manually collected from the “Report on the operation of the internal control system,” which forms part of the firm’s annual report. The annual report of each Korean listed firm can be retrieved from Data Analysis, Retrieval, and Transfer System (DART: equivalent to EDGAR in the United States).
Funding
This work was supported by the Korea Accounting Information Association.
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