Impacts of internal control quality on profitability of the listed construction companies in Vietnam

Profit is a central concern of listed companies and internal control is said to be an useful tool to

achieve such purpose. Construction companies face many types of risk so controls play an even

more important role. Using Internal control theory of COSO (Committee of Sponsoring

Organizations), this paper examines the relationship between Internal control quality and

profitability of the listed construction companies in Vietnam. In more details, the paper explores

the relationship between components of internal control and profitability of such listed companies.

The results show that internal control quality and each component of internal control (namely

Control Environment, Monitoring, Control Activities, Information and Communication, Risk

Assessment) are associated with profitability. These findings have practical implications for

executives and policy makers in designing internal control for profit purposes.

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584 International Conference on Finance, Accounting and Auditing (ICFAA 2018) November 23rd, 2018 Hanoi City, Vietnam Impacts of Internal Control Quality on Profitability of the Listed Construction Companies in Vietnam Nguyen Thi Phuong Hoaa, Dang Thuy Anhb, Phan Thi Thanh Loana aNational Economics University, bVinh University Submission day: 30/10/2018 Review day: 10/11/2018 Acceptance day: 15/11/2018 Abstract Profit is a central concern of listed companies and internal control is said to be an useful tool to achieve such purpose. Construction companies face many types of risk so controls play an even more important role. Using Internal control theory of COSO (Committee of Sponsoring Organizations), this paper examines the relationship between Internal control quality and profitability of the listed construction companies in Vietnam. In more details, the paper explores the relationship between components of internal control and profitability of such listed companies. The results show that internal control quality and each component of internal control (namely Control Environment, Monitoring, Control Activities, Information and Communication, Risk Assessment) are associated with profitability. These findings have practical implications for executives and policy makers in designing internal control for profit purposes. Keywords: Internal control, Listed construction companies, Profitability 1. Introduction Construction companies play an important role in the Vietnamese economy thanks to their GDP contribution, employment generation and infrastructure development. However, construction companies face many types of risks, ranging from weather risks, labour safety risks, liquidity risks to dispersed locations and complexity of construction projects. These pervasive risks make the profit target of construction companies vulnerable and may not be realized. Hence, internal control becomes very essential to help management of listed construction companies control risks and meet the profit and dividend expectations of 585 shareholders. This seemingly logical argument however has not been confirmed by any empirical study yet. To fill in this gap, the paper analyses theoretical framework of internal controls and profitability, explains the empirical model and discusses the empirical results for listed construction companies in Vietnam. Then, recommendations will be drawn 2. Theoretical Framework and Methods Internal controls aim at 3 purposes: (i) reliability of financial information, (ii) efficiency and effectiveness of operations, and (iii) compliance with rules and regulations. Hence, internal controls are expected to be very useful for listed companies because of management’ profit concern. Construction companies face with various kinds of risks, so internal controls are even more relevant in listed construction companies. Acknowledged the benefits of internal controls, the Sarbanes Oxley Act 2002 of US required listed companies’ management to establish and maintain effective internal controls. Empirical studies indicate impacts of internal controls on profitability of companies. Typically, Chih-Yang Tseng (2007) verified impacts of weaknesses in internal control components on the market value of companies, and found that companies with weak internal control associated with low market values. Ebarahim Mohammed Al – Matari et al. (2012) found that features of CEO, size of audit committee, and leverage had impacts on ROA. John Kang’Aru Kinyua (2016) indicated separate impacts of Control Environment, Internal Audit, Control Activities, Risk Management inter alia on profitability of listed companies in Nairobi stock exchange. Specifically, Control Environment, Internal Audit, Risk Management, and Control Activities explained 16.9%, 10.8%, 30.2%, and 20.2%, respectively, the change in profitability of such companies. For listed companies, the central concern of management is profitability in general and ROE in particular. ROE rather than ROA will be used in this study because shareholders and investors are concerned with dividends on their investment. Following the theoretical framework about positive impacts of internal controls and its components on profitability, the following hypotheses are used for listed construction companies in Vietnam: H1: Quality of Internal Control (ICQ) has positive impact on ROE H2: Control Environment (CE) has positive impact on ROE H3: Control Activities (CA) exerts positive impact on ROE H4: Information and Communication (IC) has positive impact on ROE H5: Risk Assessment (RA) exerts positive impact on ROE H6: Monitoring (M) has positive impact on ROE ROE is calculated from the financial statements of listed construction companies in Vietnamese stock exchange. 586 Each component of internal controls is measured by constituent elements suggested by COSO. Each element is measured using Likert measure 1-5 (1 means Totally disagree, 2: Disagree, 3: Neutral, 4: Agree, 5: Totally Agree). The measurement of elements is conducted following Karagiorgos, T., et al. (2011), Conor O’Leary (2004), COSO (1992), Faudziah Hanim Fadzil et al. (2005). Quality of internal control (ICQ) is measured by averaging components of internal controls, following Faudziah Hanim Fadzil et al. (2005), Karagiorgos, T., et al (2011): ICQ = (CE+CA+IC+M+CR)/5 Beside internal controls, other factors are argued to have impacts on company profitability, namely Size of company (Doyle, J. et al. 2006), Leverage (Al-Matari et al. 2012), Listing time. These variables are also included in our empirical model to ensure the explanatory power of the model. 3. Results and Discussion The study was conducted based on a survey of all 107 construction companies listed in the stock exchange of Vietnam. After cleaning data for missing observations, data on 54 listed construction companies are used in the empirical model. Eviews 9.0 is used to estimate the impacts of internal controls on ROE and the results are presented in Tables 1-6 below. 587 Table 1: Empirical impact of internal control quality (ICQ) on ROE Dependent Variable: ROE Method: Least Squares Sample: 1 54 Included observations: 54 Variable Coefficient Std. Error t-Statistic Prob. C -52.65457 13.65049 -3.857341 0.0003 ICQ 11.55978 1.811170 6.382493 0.0000 SIZE 1.199073 0.742937 1.613963 0.1131 LEV 0.053566 0.046931 1.141358 0.2594 T -0.783377 0.592103 -1.323042 0.1921 LD -0.000724 0.000360 -2.013271 0.0497 R-squared 0.503992 Mean dependent var 7.049778 Adjusted R-squared 0.452324 S.D. dependent var 8.470330 S.E. of regression 6.268479 Akaike info criterion 6.613384 Sum squared resid 1886.104 Schwarz criterion 6.834382 Log likelihood -172.5614 Hannan-Quinn criter. 6.698614 F-statistic 9.754509 Durbin-Watson stat 1.907895 Prob(F-statistic) 0.000002 588 Table 2: Empirical impact of Control environment (CE) on ROE Dependent Variable: ROE Method: Least Squares Sample: 1 54 Included observations: 54 Variable Coefficient Std. Error t-Statistic Prob. C -50.17696 15.05149 -3.333688 0.0017 CE 9.240950 1.820402 5.076325 0.0000 SIZE 1.591353 0.809413 1.966058 0.0551 LEV 0.077911 0.051488 1.513181 0.1368 T -1.191042 0.647532 -1.839356 0.0721 LD -0.000816 0.000400 -2.038855 0.0470 R-squared 0.403355 Mean dependent var 7.049778 Adjusted R-squared 0.341205 S.D. dependent var 8.470330 S.E. of regression 6.875044 Akaike info criterion 6.798112 Sum squared resid 2268.779 Schwarz criterion 7.019111 Log likelihood -177.5490 Hannan-Quinn criter. 6.883343 F-statistic 6.489982 Durbin-Watson stat 2.155792 Prob(F-statistic) 0.000110 589 Table 3: Empirical impact of Control activities (CA) on ROE Dependent Variable: ROE Method: Least Squares Sample: 1 54 Included observations: 54 Variable Coefficient Std. Error t-Statistic Prob. C -41.83564 16.07527 -2.602484 0.0123 CA 8.046432 2.119351 3.796650 0.0004 SIZE 1.230677 0.891218 1.380893 0.1737 LEV 0.087638 0.056214 1.558998 0.1256 T -1.039216 0.703784 -1.476611 0.1463 LD -0.000550 0.000426 -1.290483 0.2031 R-squared 0.294813 Mean dependent var 7.049778 Adjusted R-squared 0.221356 S.D. dependent var 8.470330 S.E. of regression 7.474286 Akaike info criterion 6.965253 Sum squared resid 2681.518 Schwarz criterion 7.186252 Log likelihood -182.0618 Hannan-Quinn criter. 7.050484 F-statistic 4.013414 Durbin-Watson stat 2.074055 Prob(F-statistic) 0.004018 590 Table 4: Empirical impact of Information and Communication (IC) on ROE Dependent Variable: ROE Method: Least Squares Sample: 1 54 Included observations: 54 Variable Coefficient Std. Error t-Statistic Prob. C -27.82940 15.98130 -1.741373 0.0880 IC 4.781683 1.510977 3.164629 0.0027 SIZE 1.264080 0.926708 1.364055 0.1789 LEV 0.005692 0.061008 0.093305 0.9260 T -0.966250 0.730916 -1.321971 0.1924 LD -0.000388 0.000438 -0.884840 0.3807 R-squared 0.241334 Mean dependent var 7.049778 Adjusted R-squared 0.162306 S.D. dependent var 8.470330 S.E. of regression 7.752521 Akaike info criterion 7.038352 Sum squared resid 2884.876 Schwarz criterion 7.259351 Log likelihood -184.0355 Hannan-Quinn criter. 7.123583 F-statistic 3.053789 Durbin-Watson stat 1.905424 Prob(F-statistic) 0.017940 591 Table 5: Empirical impact of Risk Assessment (RA) on ROE Dependent Variable: ROE Method: Least Squares Sample: 1 54 Included observations: 54 Variable Coefficient Std. Error t-Statistic Prob. C -41.01902 16.27598 -2.520219 0.0151 RA 5.543062 1.545531 3.586510 0.0008 SIZE 1.678924 0.890604 1.885151 0.0655 LEV 0.084783 0.056874 1.490726 0.1426 T -1.116167 0.712595 -1.566341 0.1238 LD -0.000495 0.000430 -1.150462 0.2557 R-squared 0.276837 Mean dependent var 7.049778 Adjusted R-squared 0.201507 S.D. dependent var 8.470330 S.E. of regression 7.568952 Akaike info criterion 6.990425 Sum squared resid 2749.874 Schwarz criterion 7.211424 Log likelihood -182.7415 Hannan-Quinn criter. 7.075656 F-statistic 3.675014 Durbin-Watson stat 2.155363 Prob(F-statistic) 0.006773 592 Table 6: Empirical impacts of Monitoring (M) on ROE Dependent Variable: ROE Method: Least Squares Sample: 1 54 Included observations: 54 Variable Coefficient Std. Error t-Statistic Prob. C -41.82267 15.14950 -2.760663 0.0081 M 5.231382 1.146481 4.562991 0.0000 SIZE 1.610552 0.837950 1.922014 0.0606 LEV 0.064532 0.053248 1.211900 0.2315 T -0.485754 0.683124 -0.711077 0.4805 LD -0.000579 0.000406 -1.426406 0.1602 R-squared 0.360457 Mean dependent var 7.049778 Adjusted R-squared 0.293838 S.D. dependent var 8.470330 S.E. of regression 7.117910 Akaike info criterion 6.867545 Sum squared resid 2431.903 Schwarz criterion 7.088543 Log likelihood -179.4237 Hannan-Quinn criter. 6.952775 F-statistic 5.410720 Durbin-Watson stat 1.988894 Prob(F-statistic) 0.000503 593 The empirical results show that quality of internal control and each component of internal control, namely control environment, risk assessment, control activities, information communication and monitoring, have positive and statistical impacts on ROE of the construction companies listed on the stock exchange of Vietnam. The impacts are all statistically significant at the 99%. The empirical results thus confirm the arguments for the benefits of internal controls for the case of listed construction companies in Vietnam. These results imply that implementing and enhancing internal controls do not only mean to fulfill requirements of authorities, but also to help construction companies to control their various risks and costs better, thereby increasing their profitability. It is thus worth to suggest construction companies in general to enhance their internal control quality and each component of their internal control system for the benefit of stakeholders of the companies, including owners, tax authorities, creditors, employees, etc. Though establishing and implementing internal control are seen to be costly from the viewpoint of the board of directors, the positive and significant impacts of internal control on profit justify their worthiness. The empirical results imply that each component of internal controls should be established and implemented continuously and effectively. As internal controls are complicated in nature and continuously evolve corresponding to the market, understanding about modern internal controls and its five components remain vague by companies’ directors and managers. Training will be thus very useful. The stock exchange authorities may organize training courses about internal controls to help directors of listed companies understand clearly about the benefits and contents of internal controls, and the way to establish and run an effective internal controls. Vietnam Association of construction companies may also provide training about internal controls in construction companies. Besides, with expertise about internal controls, auditing firms should provide more consulting services to help listed construction companies to establish and monitor effective internal controls. As Control environment is the most important and complicated factor of internal controls, training and consulting should focus and devise in details for Control environment. The positive impacts of internal control on profitability also imply that authorities may require the board of directors of construction companies to establish and implement their internal control adequately and effectively. This is for the benefit of company’s stakeholders as well as for the sustainable development of society. From US experience, Sarbanes Oxley Act 2002 requires the board of directors of listed companies to state about the effectiveness of their internal controls in their financial statements and auditors have to verify and confirm such kind of statement. Similarly is the case of Singaporean stock exchange. This requirement is thus strongly relevant for construction companies listed in the Vietnamese stock exchange due to the positive role of internal controls. Auditors should then have responsibility to evaluate and to conclude about the clients’ internal controls. 594 4. Conclusions Internal controls have been discussed a lot in developed countries for their benefits of helping company’ management to deal with risk and increase competitiveness. In Vietnam, internal controls remain rather new and not be awared well by company management. Listed construction companies play an important role in the Vietnamese economy, but face many kinds of risks, so the possibility to meet dividend expectation of shareholders is uncertain. The empirical results show that quality of internal controls and each component of internal controls have statistically positive impacts on profitability of listed construction companies in Vietnam. The results imply the necessity to establish and maintain effective internal controls in listed construction companies in Vietnam. 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