Internal control structures can help organizations prevent fraud, monitor risk, and improve the quality of their financial information. But can internal controls also help organizations increase their innovative output? A recent research study we conducted suggests that the improved information environment from higher-quality internal controls can help companies identify and patent their most innovative ideas. In fact, we found that when companies have higher-quality internal controls, they have more patents, and those patents relate to more valuable ideas for companies.
At first glance, it isn’t obvious that internal control quality would influence innovative output. On one hand, internal control systems could create an overly bureaucratic environment that hinders innovation and creativity. On the other hand, internal controls could allow for systematic documentation of projects and better information flows within organizations. Having this increased amount of information could help managers identify the most promising projects to patent.
OUR STUDY
We examined data on the internal control quality of U.S. public companies along with data on patent filings from the U.S. Patent and Trademark Office. We started our analysis by examining the relation between ineffective controls and innovation. (For the complete study, see “The Impact of Control Systems on Corporate Innovation,” Contemporary Accounting Research, Summer 2022.)
Because internal operational controls of public companies are largely unobservable to outsiders, we relied upon data about financial controls, which are publicly disclosed through various financial reporting filings with the U.S. Securities & Exchange Commission. The quality of financial controls can help us better understand operational controls because financial and operational controls are largely interdependent.
To measure the quality of internal controls, we used a three-pronged approach. First, we gathered data on financial control weaknesses, which are publicly disclosed on an annual basis as required by the Sarbanes-Oxley Act of 2002.
Second, we identified instances where public companies had to restate their financial statements. Companies restate financial statements to correct errors in their original filings, which suggests these companies likely had ineffective controls when they filed their original set of financial statements. Third, we inferred ineffective controls using a statistical prediction model from academic research.
We measured innovation as either the stock market’s value of patents or the number of patents. While the stock market’s value of patents provides an indication of patent value based on the market response to the patent, the number of patents provides a measure of the quantity of innovation over a given period. Regardless of which of these measures we examined, we consistently found that companies with worse internal control quality also had lower innovative output.
At the start of our research, we conjectured that higher-quality controls can help managers best identify patents that position the company well in terms of market and technology changes. In other words, managers can better survey their in-process research projects and convert them into valuable patents. To explore this possibility, we examined a mechanism for this effect—the ability of companies to convert research and development (R&D) dollars into patents.
POOR INTERNAL CONTROLS HINDER INNOVATION
Ineffective control systems are likely to reduce the quality of data, as well as the quality of project tracking and identification within organizations. If poor internal controls reduce managers’ ability to receive accurate and timely information, managers may be unable to identify the internal projects with the most valuable intellectual property within their organizations. In other words, managers may be unable to allocate appropriate levels of staffing and financial resources to projects that can maximize their company’s R&D investments.
Consistent with our conjecture, we found that poor control quality hinders companies’ ability to convert R&D dollars into patents. We interpret these results as suggesting that when the quality of internal controls is low, managers are less likely to get the most out of their investments in R&D.
The process of converting R&D into projects that can be patented can be a lengthy one. As such, it’s unclear whether the investment in internal control structures pays off immediately or in future periods. Yet our evidence suggests that internal control quality influences innovative patent output in both the same year of the patent filing as well as the subsequent year after the patent filing. This evidence suggests that investments in internal controls has benefits beyond the current year.
LIMITATIONS AND IMPLICATIONS FOR PRACTICE
Combined, our evidence suggests that managers who care about innovation should consider the benefits of stronger control systems. Our evidence also suggests that control systems can lead to an increase in the quantity and value of patents as measured by the stock market’s reaction to patent filings. On average for the companies in our sample, higher internal control quality is associated with increased innovative output. In particular, these control systems appear to help managers convert R&D into valuable patents.
We found these results when comparing companies with higher-quality controls to those that don’t have higher-quality controls as well as when looking within the same company, examining changes in innovative output as the company’s own internal control quality changes.
Our findings shouldn’t be seen as advice that improving control systems will result in immediate economic payoffs. There are certainly some companies for which innovation is less important, and these companies are likely to see less benefit on the innovation front from an investment in improved controls. Furthermore, it’s important to remember that while we found results on average, the results may not hold for all companies, even within those for which innovation is important.
Despite these limitations, we believe our study helps us better understand the innovative process within companies. We showed that ineffective control systems are associated with lower levels of innovative output. Overall, our evidence suggests that higher-quality control systems improve the quality of information within companies, enabling management to identify and patent projects with higher innovative potential. Broadly speaking, our study suggests effective control systems can benefit companies when it comes to innovation, which is an important strategic priority for corporate executives.
February 2023
