Internal control quality, voluntary disclosure, and cost of equity capital: The case of an unregulated market

• Date: 01 March 2019
• Author: Mark Soliman,Khaled Samaha,Hichem Khlif
• DOI: http://doi.org/10.1111/ijau.12151
• Published date: 01 March 2019

ORIGINAL ARTICLE

Internal control quality, voluntary disclosure, and cost of equity

capital: The case of an unregulated market

Hichem Khlif

1

|Khaled Samaha

2

|Mark Soliman

3

1

Accounting, Faculty of Economics and

Management of Sfax, University of Sfax, Sfax,

Tunisia

2

Accounting, American University of Cairo,

Cairo, Egypt

3

Accounting, Marshall School of Business,

University of Southern California, Los Angeles,

California, USA

Correspondence

Hichem Khlif, Accounting, Faculty of

Economics and Management of Sfax,

University of Sfax, Sfax, Tunisia.

Email: hichemkhlif@gmail.com

This paper examines the direct effect of internal control quality (ICQ) on cost of

equity capital and whether ICQ has a moderating effect on the association between

voluntary disclosure and cost of equity capital in an emerging market (Egypt). ICQ is

measured using a survey of external auditors. A content analysis approach is used

to proxy for the level of voluntary disclosure in annual reports. Finally, the Capital

Asset Pricing Model framework is used to estimate cost of equity capital. Based on

a sample of 512 firm‐year observations over the period 2007–2014, we find that

ICQ is negatively and significantly associated with cost of equity capital, indicating

that better controls reduce cost of equity capital as predicted by theory. In addition,

ICQ moderates the association between voluntary disclosure and cost of equity cap-

ital since this association is only negative and significant for companies characterized

by high ICQ. These findings remain stable after controlling for endogeneity concerns

and political instability. Our study contributes to the internal control literature by

focusing on an emergent unregulated market with respect to internal control disclo-

sure and documents that ICQ plays an important role in reducing cost of equity capital

(either directly or indirectly) by increasing the value relevance of voluntary disclosure

among investors on the Egyptian stock exchange.

KEYWORDS

cost of equity capital, Egypt, ICQ, voluntary disclosure

1|INTRODUCTION

A long‐standing empirical literature (e.g., Ashbaugh‐Skaife, Collins,

Kinney, & LaFond, 2009; Gao & Jia, 2017; Ogneva, Subramanyam, &

Raghunandan, 2007) has been developed in order to examine whether

internal control quality (ICQ) affects cost of equity in developed econ-

omies; specifically in the US setting. Prior research (e.g., Donelson,

Ege, & McInnis, 2017; Doyle, Ge, & McVay, 2007) suggests that inter-

nal control deficiencies reduce financial reporting quality through both

intentional and unintentional misstatements implying lower earnings

quality and less reliable financial reporting. This may result in an

increased information risk faced by investors, which translates into a

higher cost of equity capital (Ashbaugh‐Skaife et al., 2009; Lopez,

Vandervelde, & Wu, 2009; Ogneva et al., 2007).

In their recent review concerning internal control in accounting

research, Chalmers, Hay, and Khlif (2018) noted that the effect of

ICQ on investors' reactions has been exclusively examined in the USA

(e.g., Ashbaugh‐Skaife et al., 2009; Ogneva et al., 2007), Japan

(Nishizaki, Takano, & Takeda, 2014), and China (Chen, Chan, Dong, &

Zhang, 2017). They suggested that future research should explore

the possible interaction that may exist between voluntary disclosure,

ICQ, and cost of equity capital (Chalmers et al., 2018, p. 20). Similarly,

Khlif and Samaha (2016, p. 284) pointed this out and suggested that

future research dealing with the economic consequences of ICQ may

focus on the impact of ICQ on the cost of equity capital in emerging

economies. We heed these callings and explore those relations in this

paper, and in response we examine these relations in an emerging

economy, since it provides a richer setting because of the larger

cross‐sectional variation found there in terms of disclosure level

(Ebaid, 2016) and ICQ (Khlif & Samaha, 2014). Operating under a

low mandatory disclosure regime, Egyptian listed firms have more

incentives than nonlisted companies to distinguish themselves from

Received: 6 November 2017 Revised: 4 December 2018 Accepted: 10 December 2018

DOI: 10.1111/ijau.12151

144 © 2019 John Wiley & Sons Ltd Int J Audit. 2019;23:144–160.wileyonlinelibrary.com/journal/ijau

their country's mean levels and increase their disclosure practices and

the quality of their internal control systems to improve the marketabil-

ity of their shares (Khlif & Samaha, 2014; Khlif, Samaha, & Azzam,

2015). Accordingly, we investigate whether ICQ affects cost of equity

capital in an emerging economy (Egypt), and we explore how ICQ may

interact with voluntary disclosure in shaping the cost of equity capital.

Since the level of investor protection and transparency in the USA

is relatively high, the minimum bar imposes a high threshold and thus

reduces any meaningful variation, since most firms simply choose the

minimum legal limit in that setting (Hail, 2002). However, in a setting

like Egypt, firms vary a great deal in their choice and abilities with

respect to ICQ (Khlif & Samaha, 2014; Samaha, Dahawy, Hussainey,

& Stapleton, 2012). Accordingly, the Egyptian setting provides for a

wider range of outcomes and allows us to explore lower levels of

disclosure and ICQ not seen in the USA or other highly regulated

and developed countries.

We choose Egypt as our setting of an emerging economy for

three reasons. First, Egypt, as an emerging market has been fertile

ground for new regulatory reforms due to the country's weak auditing

and accounting infrastructure (Khlif & Samaha, 2016). To address

these issues, new regulations include (a) the Egyptian Accounting

Standards (EASs) in 2006, (b) new corporate governance law in

2005, and (c) the Egyptian Standards on Auditing (ESA), which were

introduced in early 2009 (Khlif & Samaha, 2014). These new pro-

nouncements were made in attempts to shore up the information

environment but will surely take time to have real and lasting effects.

Second, Egypt represents a case of an unregulated market with

respect to internal control specific legislations. Finally, the Egyptian

Exchange (EGX) is more active than the stock markets of other emerg-

ing economies either in the Middle East or North African countries

and other emerging markets. To this point, Allini et al. (2018, p. 300)

suggested that, over the period from 2002 to 2014, “EGX annual per-

formance based on Morgan Stanley Capital International Index ranged

from 1.59% to 29.36%, compared with −6.00% to −1.82% for the

emerging markets index, and with −18.98% to 4.71% for all countries

world index, in 2002 and 2014, respectively (www.msci.com)”. These

unique characteristics of the Egyptian setting represent a useful test-

ing ground for the association between ICQ and cost of equity capital

that merits further investigations. For instance, the weak institutional

environment prevailing in the Egyptian setting provides a fertile

ground for large cross‐sectional variation in ICQ and voluntary disclo-

sure. This wide variation in disclosure practices and ICQ may influence

investors' decisions concerning their resource allocation, especially in

an active emergent market like the EGX. Furthermore, an active stock

exchange may increase firms' management incentives to ameliorate

firms' transparency through the improvement of ICQ.

Our analysis includes several key measures to capture underlying

constructs. The cost of equity capital is calculated using the Capital

Asset Pricing Model (CAPM) framework. To measure ICQ, we con-

ducted a survey among Egyptian's external auditors based on an inter-

nal control checklist. Finally, a content analysis of annual reports was

used to proxy for the level of voluntary disclosure. Based on a sample

of 512 firm‐year observations over the period of 2007–2014, these

unique empirical measures allowed us to test our hypotheses. First,

we find that, in an emerging market, ICQ is negatively and significantly

associated with the cost of equity capital, similar to developed

markets. In addition, our results show that voluntary disclosure is

negatively and significantly associated with cost of equity capital only

when ICQ is high.

1

This finding implies that ICQ is an important compo-

nent of corporate transparency, since it gives rise to the value rele-

vance of information disclosed among investors; thus, it reduces the

cost of equity capital and is only seen when examining developing

markets, not in highly regulated and developed economies. The results

hold in both the pre‑(2007–2010) and postrevolution (2011–2014)

periods and continue to hold after controlling for endogeneity.

This study contributes to the accounting literature in the follow-

ing ways. First, our study adds to the internal control literature by

focusing on an emerging unregulated market with respect to internal

control disclosure and documents that ICQ has a negative effect on

cost of equity capital. Second, it explores the interactions between

ICQ and voluntary disclosure in shaping the cost of equity capital

and shows that higher ICQ increases the value relevance of voluntary

disclosure among investors on the EGX. Our primary contribution

comes in the fact that voluntary disclosure only matters within a

certain band of ICQ, outside of which it no longer affects the cost of

equity capital. Thus, ICQ acts as a substitute for weak corporate gov-

ernance mechanisms and a low disclosure environment in the Egyptian

setting, and this may urge Egyptian regulators to enact new rules

obliging firms to communicate information about ICQ or charging

auditors to report information about a firm's ICQ in its reports.

The remainder of the paper is organized as follows. Section 2

presents the legal and institutional characteristics of the Egyptian

setting. Section 3 reviews the previous literature and elaborates

the hypotheses. Section 4 presents the data collection, Section 5 the

methodology, and Section 6 discusses the research findings. The

final section summarizes the paper and provides some questions for

further research.

2|EGYPTIAN LEGAL AND INSTITUTIONAL

CHARACTERISTICS

During the last decade, Egypt has passed several regulations dealing

with financial reporting and corporate governance in order to improve

transparency in the EGX. This makes it an ideal country to study how

information is processed by market participants in an emerging market.

With respect to financial reporting, EASs have been revised three

times since 1997. The first version of EASs was enacted by Ministerial

Decree 503/1997 and became effective in fiscal years starting Janu-

ary 1, 1998 (Elbannan, 2011). EASs were developed in conformity

with the International Accounting Standards (IASs) prevailing at the

time of their adoption, except for lease accounting (Elbannan, 2011).

In 2002, Ministerial Decree 345/20027 was issued to institute the

adoption of a current set of IASs, specifically 23 standards, replacing

the EASs previously adopted in 1997. The last revision of EASs took

place in 2006, whereby 17 of the previously issued IASs were revised,

1

This result emerges both when (a) using and interaction variable between ICQ

and voluntary disclosure or (b) when conducting a subgroup analysis based on

the level of ICQ.

KHLIF ET AL.145