National Culture and Internal Control Disclosures: A Cross‐country Analysis

• Date: 01 July 2015
• Author: Reggy Hooghiemstra,Jim Emanuels,Niels Hermes
• DOI: http://doi.org/10.1111/corg.12099
• Published date: 01 July 2015

National Culture and Internal Control

Disclosures: A Cross-country Analysis

Reggy Hooghiemstra*, Niels Hermes, and Jim Emanuels

ABSTRACT

Manuscript Type: Empirical

Research Question/Issue: This study examines the association between national culture and the amount of information on

internal controls listed companies disclose in their annual reports. In particular, we argue that culture affects managers’

perceptions of the costs and benef‌its of disclosing information and, consequently, drive managers’ disclosure choices. In

addition, we investigate whether culture indirectly, via investor protection, determines disclosure decisions.

Research Findings/Insights: Using unique hand-collected datafrom a sample of 4,370 f‌irm-year observations for 1,559 f‌irms

from 29 countries for the period 2005 to 2007, we f‌ind that national culture directly affects such disclosures. Moreover, we

show that national culture also indirectly affects disclosures via the level of investor protection in a country.

Theoretical/Academic Implications: This article is the f‌irst to examine cultural determinants of internal control disclosures

using a framework in which managers’ disclosing decisions are determined by the trade-off between the costs and benef‌its

of disclosing such information. Moreover, we are the f‌irst to demonstrate that culture not only directly but also indirectly,

via investor protection, inf‌luences disclosure choices.

Practitioner/Policy Implications: This study contributes to the debate on the development and design of corporate

governance practices. Accounting scandals and corporate failures in recent years have raised calls for improved internal

controls, as well as enhanced reporting about these internal controls. Many of these calls are characterized by the view that

there is an optimal way of developing such systems. We show that differences in internal control disclosures are inf‌luenced

by cultural differences. Therefore, introducing a uniform approach to demanding disclosure of information on internal

controls may not necessarily translate into uniform reporting practices.

Keywords: Corporate Governance, Financial Disclosure, Internal Control Disclosure, National Culture, Investor

Protection

INTRODUCTION

The importance of disclosing information on internal

controls (also referred to as internal control disclosures)

has been debated since the late 1970s (McMullen,

Raghunandan, & Rama, 1996). The attention for this type of

disclosure increased substantially after the accounting scan-

dals at the beginning of the twenty-f‌irst century. These scan-

dals triggered public concerns about the lack of internal

control quality and raised awareness of the key role of effec-

tive internal controls in the governance of the f‌irm (e.g., Lin,

Wang, Chiou, & Huang, 2014). Internal controls are estab-

lished to protect the interests of investors by promoting

reliable f‌inancial reporting and by providing timely infor-

mation about risks that may endanger the achievement

of the f‌irm’s goals. Disclosure in the annual report of

information on the design and functioning of these internal

controls is therefore important, as investors may use the

information to scrutinize managers (Hammersley, Myers, &

Shakespeare, 2008; Hermanson, 2000; Van de Poel &

Vanstraelen, 2011). Research has shown that investors per-

ceive these disclosures as value-relevant. Indeed, a number

of US-based studies f‌ind evidence that internal control dis-

closures affect the cost of capital. Except for an early study

by Ogneva, Subramanyam, and Raghunandan (2007), evi-

dence supports the view that internal control risk matters to

investors. For instance, studies by Ashbaugh-Skaife, Collins,

Kinney, and LaFond (2009) and Beneish, Billings, and

Hodder (2008) demonstrate that f‌irms reporting internal

control problems face higher cost of equity, while Costello

and Wittenberg-Moerman (2011) and Dhaliwal, Hogan,

*Address for correspondence: Reggy Hooghiemstra, Department of Accounting,

Faculty of Economics and Business, University of Groningen, Duisenberg Building,

Room 811, PO Box 800, 9700AV Groningen, TheNetherlands. Tel: +31 50 363 3772; Fax:

+31 50 363 7174; E-mail: r.b.h.hooghiemstra@rug.nl

Corporate Governance: An International Review,

© 2014 John Wiley & Sons Ltd

doi:10.1111/corg.12099

2015, 23(4): 357–377

357

Trezevant, and Wilkins (2011) report a similar effect on the

cost of debt. In a similar vein, Campbell, Chen, Dhaliwal, Lu,

and Steel (2014) demonstrate that investors incorporate risk

factor disclosures into market values.

Given the value-relevance of disclosing information on

internal controls, it is surprising that only the United States

mandates the disclosure of this type of information. In the

United States, the response to the accounting scandals was

the introduction of the Sarbanes-Oxley Act of 2002 (SOX).

SOX requires managers of large publiclylisted companies to

report on the effectiveness of internal controls over f‌inancial

reporting. Outside the United States, law does not prescribe

reporting on internal controls. Instead, national corporate

governance codes have been established in which the impor-

tance of internal control disclosures is discussed, but the

nature of these codes makes reporting on internal controls

largely voluntary. That is, outside the United States, manag-

ers have discretion with respect to the amount of informa-

tion they disclose on the f‌irm’s internal controls. This means

that outside the United States internal control disclosures

can be considered to ref‌lect managers’ economic and agency

incentives. Consequently, this may lead to considerable

variation in reporting, not only between f‌irms within a

country but also cross-nationally. Understanding the incen-

tives underlying managers’ decisions to voluntarily disclose

information on internal controls therefore seems pertinent.

Notwithstanding the importance of internal control dis-

closures, our understanding of why managers decide to vol-

untarily disclose this information is limited. The few

available studies focus on aspects such as the size of f‌irms,

capital structure, and specif‌ic corporate governance arrange-

ments, such as the presence or absence of active audit com-

mittees, ownership concentration, and type of ownership

(Bronson, Carcello, & Raghunandan, 2006; Deumes &

Knechel, 2008). These studies suggest that managers’ deci-

sions with respect to voluntary internal control disclosures

are based on a tradeoff between the costs and benef‌its of

disclosing information. Although these studies provide

useful insights about the determinants of internal control

disclosures, they do not address possible cross-national dif-

ferences in this tradeoff as they are based on a single

country. In our study, we extend prior work by using a

larger sample of f‌irms, that spans many different countries,

large and medium-sized f‌irms, and a recent time period,

allowing us to investigate whether the perceptions of the

costs and benef‌its of voluntarily disclosing information on

internal controls are culturally determined. We argue that

the social normative nature of culture determines the char-

acteristics of agency relations (Fidrmuc & Jacob, 2010;

Wiseman, Cuevas-Rodríguez, & Gomez-Mejia, 2012). In par-

ticular, we posit that national culture determines the accep-

tance and legitimacy of different approaches of managers

towards the voluntary disclosure of information on internal

controls. Specif‌ically, we develop hypotheses on the deter-

minants of voluntary disclosure of information on internal

controls and explain how culturally determined social

norms affect the cost-benef‌it trade-off managers make in

their disclosure choices.

While we are not the f‌irst to investigate the link between

culture and voluntary disclosures of f‌irms, we make a

number of theoretical and empirical contributions to the

literature. First, prior studies mainly rely on Gray’s (1988)

theory to explain how differences in national culture lead to

variations in accounting systems (e.g., Chanchani &

MacGregor, 1999; Doupnik, 2008; Doupnik & Tsakumis,

2004). Gray’s theory is suitable primarily for explaining the

effects of national culture, through accounting values, on

broad systemic or structural differences across countries

(Doupnik & Tsakumis, 2004; Han, Kang, Salter, & Yoo, 2010).

In contrast, our cost-benef‌it framework is more suitable for

explaining how preferences and behaviors of economic

agents are culturally determined. As such our framework

constitutes the f‌irst attempt to bridge the gap that separates

the f‌irm-level voluntary disclosure literature from the

country-level, systemic approachembodied by Gray’s (1988)

theory.

Second, we contribute to the literature on the relationship

between culture and voluntary disclosure by specif‌ically

focusing on the voluntary disclosure of information on inter-

nal controls. Previous studies in this f‌ield (e.g., Doupnik,

2008; Doupnik & Tsakumis, 2004; Zarzeski, 1996) focus on

f‌inancial disclosures only, i.e. the disclosure of information

regarding f‌inancial statement numbers. These studies rely

on proxies that measure to what extent specif‌ic items on the

balance sheet, the income statement, and the cash f‌low state-

ment are present in a f‌irm’s annual report.In contrast, in this

study we consider the relatively new internal control disclo-

sures that are of a completely different nature. Internal

control disclosures convey contextual information about the

mechanisms managers have designed to promote reliable

f‌inancial reporting and about the risks that may endanger

the company’s goals. Moreover, in our study we consider

information on the control environment, risk assessment,

control activities, and monitoring (COSO, 1992). As such, we

adopt a broader view than currently used in US-based

studies, which focus on internal controls over f‌inancial

reporting (e.g., Lin et al., 2014; Schneider, Gramling,

Hermanson, & Ye, 2009).

Our regression analyses, which rely on unique, hand-

collected panel data from a sample of 4,370 f‌irm-year

observations for 1,559 f‌irms from 29 countries during the

period 2005 to 2007, provide robust evidence that differ-

ences in the amount of internal control disclosures are cul-

turally determined. Moreover, we provide evidence that

the association between culture and internal control disclo-

sures has a direct and indirect component. We show that

part of the impact of culture on voluntary disclosures runs

through the impact culture has on molding formal institu-

tions (i.e., investor protection). While prior studies show

that differences in culture are correlated with differences in

investor protection (Licht, Goldschmidt, & Schwartz, 2005,

2007; Stulz & Williamson, 2003), and while prior studies

establish that culture directly inf‌luences managers’ f‌inancial

reporting decisions (e.g., Doupnik & Tsakumis, 2004; Han

et al., 2010; Shao, Kwok, & Guedhami, 2010), to the best of

our knowledge, we are the f‌irst to demonstrate that

national culture not only directly but also indirectly, via

investor protection, inf‌luences managers’ choices such as

the level of voluntary disclosure in annual reports.1That is,

we show that the impact of national culture on the level of

voluntary disclosure in annual reports is mediated by

investor protection.

CORPORATE GOVERNANCE

© 2014 John Wiley & Sons Ltd

Volume 23 Number 4 July 2015

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