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1、Appendix:Disclosure on Internal Control SystemsAs a Substitute of Alternative Governance MechanismsAccording to agency theory, various governance mechanisms reduce the agency problem between investors and management (Jensen and Meckling, 1976; Gillan, 2006). Traditionally, governance mechanisms have
2、 been identified as internal or external. Internal mechanisms include the board of directors, its role, structure and composition (Fama, 1980; Fama and Jensen, 1983), managerial share ownership (Jensen and Meckling, 1976) and incentives, the supervisory role played by large shareholders (Demsetz and
3、 Lehn, 1985), the internal control system (Bushman and Smith, 2001), bylaw and charter provisions (anti-takeover measures) and the use of debt financing (Jensen, 1993). External control is exerted by the market for corporate control (Grossman and Hart, 1980), the managerial labor market (Fama, 1980)
4、 and the product market (Hart, 1983).After the various financial scandals that have shaken investors worldwide, corporate governance best practices have stressed in particular the key role played by the internal control system (ICS) in the governance of the firm. Internal control systems contribute
5、to the protection of investors interests both by promoting and giving assurance on the reliability of financial reporting, and by addressing the boards attention on the timely identification, evaluation and management of risks that may compromise the attainment of corporate goals. These functions ha
6、ve been widely recognized by the most diffused frameworks for the design of ICS that have stated the centrality of internal control systems in providing reasonable assurance to investors regarding the achievement of objectives concerning the effectiveness and efficiency of operations, the reliabilit
7、y of financial reporting and the compliance with laws and regulations (COSO, 1992; 2004).Notwithstanding their relevance, investors cannot directly observe ICSs and therefore cannot get information on their design and functioning because they are internal mechanisms, activities and processes put in
8、place within the organization (Deumes and Knechel, 2008).As investors take into account the costs they sustain to monitor management when pricing their claims (Jensen and Meckling 1976), management have incentives to communicate information on the characteristics of the ICS in order to inform invest
9、ors on the effectiveness of ICS when other monitoring mechanisms (the ownership structure of the firm and the board of directors) are weak, and thereby providing them with the convenient level of monitoring (Leftwich et al., 1981). The possible existence of substitution among different mechanisms ha
10、s been debated in corporate governance literature (Rediker and Seth, 1995; Fernandez and Arrondo, 2005) based on Williamsons (1983) substitute hypothesis, which argues that the marginal role of a particular control mechanism depends upon its relative importance in the governance system of the firm.I
11、n this paper, we contend that disclosure on the characteristics of ICS is a relevant alternative governance mechanism in the monitoring package selected by the management. According to Leftwich et al. (1981) “managers select a monitoring package, and the composition of the chosen package depends on
12、the costs and benefits of the various monitoring devices” (p. 59).In particular, we focus particular on the relationship between ICS disclosure and two other mechanisms of the monitoring package ( the ownership structure of the firm and the board of directors) that according to literature (Jensen an
13、d Meckling, 1976; Fernandez and Arrondo,2005; Gillan, 2006) play a relevant role in monitoring managements behavior. We posit that incentives for reporting on the characteristics of ICS depend on the supervisory role played by the firms ownership structure and board of directors.We therefore examine
14、 the contents and extent of ICS disclosure of 160 European firms listed in four different stock exchanges (London, Paris, Frankfurt and Milan) on a three-year period (2003 2005). By using this international sample, we are able to the depict some features of different institutional environments.We fi
15、nd evidence that disclosure on ICS is a substitute for the monitoring role played by other governance mechanisms as ownership concentration, institutional ownership, the proportion of independent directors sitting on the board and the proportion of accounting expert members on the audit committee.We
16、 add to previous literature on the governance role played by disclosure on ICS by adopting a complete disclosure framework that allows us to consider in detail the content and extent of information the management discretionarily communicates on the ICS of the firm. While corporate governance best pr
17、actices ask for the disclosure on the characteristics of the ICS, they do not provide instructions on what management should disclose and on the extent of such disclosure. Such lack of instructions leaves management with a discretionary choice on the narrative content of ICS disclosure.This paper of
18、fers empirical support for Williamsons (1983) substitute hypothesis among different governance mechanisms and it has relevant policy implications. While most corporate governance studies consider disclosure as a complementary mechanism management adopts to reinforce the governance system of the firm
19、 (Chen and Jaggi, 2000; Eng and Mak, 2003; Barako et al., 2006) and indeed provide contrasting results, in this study we show that disclosure on ICS substitutes for other governance mechanisms. This means that not necessarily better governance implies greater transparency and disclosure. Firms adher
20、e to corporate governance best practices by disclosing information on the ICS and such disclosure is more extensive when investors need more assurance about the protection of their interests, when other governance mechanisms are weak. On the other side, when the governance system is sound, managemen
21、t have less incentives to extensively disclose information on the ICS, as this is a costly activity and its benefits are overwhelmed by the other governance mechanisms.The evidence provided by the empirical research has important policy implications, because it offers insights to firms and practitio
22、ners on the relevance of disclosure on internal control systems as a monitoring mechanism for investors. The remainder of the paper is structured as follows. The next section reviews the theoretical background and develops the research hypotheses. The research method is described in section 3, follo
23、wed by results discussed in section 4. Concluding remarks are presented in the last section.Theoretical Background and Hypotheses DevelopmentAccording to corporate governance literature, the main internal monitoring mechanisms are the board of directors, the ownership structure of the firm, and the
24、internal control system (Gillan, 2006). In particular, ICSs play a central role in the protection of investors interests both assuring the reliability of financial reporting and promoting the timely identification, assessment and management of relevant risks that encumber upon the business. The cent
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