Voluntary Disclosure of Internal Control Weakness and Earnings Quality: Evidence From China
Introduction
Establishing a high-quality internal control system has long been viewed as an important mechanism to ensure high-quality financial reporting. Prior studies show that weak internal control can increase the probability of material errors and false financial disclosures (Bell and Carcello, 2000, Kinney and McDaniel, 1989); it can also increase the probability of a firm restating its earnings (Bizarro, Boudreaux, & Garcia, 2011), as weak internal control creates more opportunities for intentional earnings management and unintentional accounting estimation errors (Ashbaugh-Skaife et al., 2009, Doyle et al., 2007). In July 2002, the U.S. Congress passed the Sarbanes–Oxley Act (SOX) in response to numerous corporate failures and accounting scandals (Altamuro & Beatty, 2010). The most important aspect of SOX is its requirement of the management and the auditor to evaluate internal control on financial reporting (Public Company Accounting Oversight Board [PCAOB], 2004; Securities and Exchange Commission [SEC], 2003). While the effectiveness of such regulation on internal control is still debated and remains controversial (Bedard, 2011, Costello and Wittenberg-Moerman, 2011, Doyle et al., 2007, Rice and Weber, 2012), some countries have followed the U.S. lead, introducing internal control reporting (ICR) with a softer approach (Cox, 2006). For example, Japan has implemented an internal reporting system with less strict requirements for all listed firms from 2008 (Nishizaki, Takano, & Takeda, 2014). Other countries, such as the UK and other European Union member states, have adopted a broad approach (Deumes & Knechel, 2008) that encompasses a wider scope of internal control systems in relation to the whole management process, rather than focusing only on financial reporting. In May 2008, the Basic Standard of Enterprise Internal Control (Basic Standard hereafter) was jointly issued by five regulatory authorities in China, including the Ministry of Finance (MOF, 2008), the China Securities and Regulatory Commission (CSRC), the National Auditing Office (NAO), the China Banking Regulatory Commission (CBRC), and the China Insurance Regulatory Commission (CIRC). Three supporting guidelines for implementing the Basic Standard were further issued in 2010. The Basic Standard and guidelines require Chinese listed firms to provide a management evaluation report on the effectiveness of their internal control as well as an auditor's assessment of the effectiveness of clients' internal control. In an ICR, the Chinese listed firm needs to disclose whether an internal control weakness (ICW) is minor, major, or serious; the ICR also includes a remedial plan for its ICWs. However, these regulations became mandatory only from January 1, 2012. Prior to this date, firms could choose to voluntarily comply with internal control regulations (Ministry of Finance (MOF), 2010a, Ministry of Finance (MOF), 2010b, Ministry of Finance (MOF), 2010c).
Prior studies suggest a consistent and negative relationship between disclosure of ICWs and earnings quality in Western countries (Ashbaugh-Skaife et al., 2008, Chan et al., 2008, Doyle et al., 2007, Lu et al., 2011). Our study differs from prior studies in several aspects. First, China has a different financial reporting environment in comparison with Western countries. Chinese listed firms exhibit a strong presence of state ownership, heavy political influence, and weak corporate governance mechanisms (Chen and Yuan, 2004, Liu and Lu, 2007, Liu and Sun, 2005). Therefore, research findings for Western markets may not necessarily be applicable to the implementation of the Basic Standard in China. Second, in the United States, SOX focuses particularly on the internal control system related to financial reporting; China's Basic Standard is, however, more comprehensive and extends the scope of the internal control system to a much broader scope of business management. The Internal Control Application Guidelines identify 18 internal control areas that listed firms in China must strengthen, from organizational structure, human resource management, budget, and corporate social responsibility to procurement and sales activities, outsourcing, and contract management. Internal control directly related to the preparation of financial reporting is only one of the components of the overall internal control system articulated in the Basic Standard. It is therefore important to investigate the association between earnings quality and ICWs in relation to the broader internal control system in China, in contrast to the narrow disclosure scope of ICWs in the U.S. In our study, we partition all ICWs into two categories: accounting-related ICWs versus non-accounting-related ICWs. We then examine the association between earnings quality and voluntary disclosure of each category of ICW. Third, U.S. SOX–focused studies are conducted in a mandatory disclosure regime, while the institutional setting of this study is voluntary. Fourth, we investigate not only the impact of the existence of ICWs on earnings quality but also the impact of the severity of ICWs on earnings quality. Our research is a significant extension of earlier studies. Doyle et al. (2007) and Ashbaugh-Skaife et al. (2008) use a dummy variable to measure whether a firm has ICWs and then compare the earnings quality between firms with and without ICWs, whereas, Lu et al. (2011) examine the relationship between accrual quality and the number of ICWs disclosed. We use both a dummy variable and a continuous variable to measure the existence and the severity of ICWs. Then, we investigate whether earnings quality is significantly different between firms with and without ICWs, and whether the severity of ICWs affects earnings quality.
This study has two goals. First, to investigate the relationship between voluntary disclosure of ICWs and earnings quality in Chinese listed firms in the period 2010–2011, the period in which listed firms could voluntarily release ICRs.1 Second, this study investigates whether a much broader internal control standard, which extends from accounting-related to non-accounting-related internal control, has any impact on earnings quality. We hand-collected the ICW data from 1059 Chinese listed firms that voluntarily provided ICRs in 2010 and 2011. Following prior studies (Ashbaugh-Skaife et al., 2008, Chan et al., 2008, Doyle et al., 2007), we use absolute discretionary accruals (ABSDA) as a measure of earnings quality.
Our results show that earnings quality is significantly associated with ICWs disclosed by Chinese listed firms. ABSDA is positively related to disclosure of ICWs, meaning that firms with ICWs are more likely to be engaged in earnings management through use of discretionary accruals. With respect to different types of weaknesses, our results demonstrate that earnings quality is significantly associated with disclosure of both accounting-related and non-accounting-related ICWs.
In summary, we find that voluntary disclosure of ICWs by Chinese listed firms provides additional and useful information to users, enabling them to reassess their economic decisions. Our study makes significant contributions to the existing literature on internal control as well as earnings quality and holds practical implications for policy-making in China and around the world. First, prior studies show a negative association between disclosure of ICWs and earnings quality in the SOX 302 and 404 regimes (Ashbaugh-Skaife et al., 2008, Chan et al., 2008, Doyle et al., 2007). These results, however, are limited only to the context of the internal control system with particular emphasis on financial reporting. It is not clear whether ICWs other than those in financial reporting have any impact on earnings quality. Given that financial reporting is an integrated component of business operations and that the quality of financial disclosure is affected by all aspects of business management, our results suggest that a wider scope of disclosure of ICWs, including both accounting-related and non-accounting-related ICWs, does affect earnings quality. This is consistent with the view that different elements of internal control need to function together in order to minimize enterprise risks. This finding has profound policy implications for regulators worldwide who are considering whether the SOX requirement should be expanded to non-accounting-related areas. Second, our study is the first in the internal control literature to investigate the relationship between the severity of ICWs disclosed and earnings quality in an emerging stock market, which has different institutional attributes from those in developed markets. Our results enrich the internal control literature by showing that earnings quality is affected not only by the existence of ICWs but also by their severity. Finally, our findings may assist regulators and professional bodies in China and worldwide to predict and comprehend the likely effects of implementing internal control regulations such as the Basic Standard in their own environment.
The remainder of this paper proceeds as follows. Development of the internal control regulatory framework in China is discussed in Section 2. Section 3 presents a literature review and hypothesis development, followed by an outline of the research design in Section 4. Section 5 discusses sample selection and descriptive statistics. Empirical results are presented and discussed in Section 6. Finally, conclusions are drawn in Section 7, which also addresses research limitations and considerations for future research.
Section snippets
Development of the internal control regulatory framework in China
Well aware of listed firms' deficiencies in internal control, regulators in China have determined to establish a comprehensive internal control regulatory framework. In June 2005, the MOF and CSRC jointly presented their report, Improving Internal Control System in China by Referring to the U.S. SOX, to the State Council, aiming to obtain approval and support from the state to develop a set of internal control standards and guidelines for Chinese listed firms. Four months later, CSRC issued
Literature review and hypothesis development
Business entities all face uncertainties that present both risks and opportunities, with the potential to affect stakeholder value (COSO, 2004). The uncertainties confronted by firms come in a wide array of forms, from the threat of acquisitions by predators sweeping many industries as firms strive to build scale, to regulatory intervention that can adversely impact companies across industries or take a toll on a specific industry (Pellet, 2007).4
Research design
Lennox, Francis, and Wang (2012) address the issue of sample selection bias. These authors point out that many accounting articles in leading journals fail to control for selection bias (Heckman, 1979). Selection bias occurs when samples are not selected randomly. The selection indicator, for example, whether a firm chooses to disclose ICWs, is an endogenous variable. To control for selection bias, we apply a two-stage model to test our hypotheses. In the first stage, we run the probit model
Sample selection
Our sample consists of publicly listed firms on the Shanghai Stock Exchange and Shenzhen Stock Exchange that issued ICRs voluntarily in 2010 and/or 2011. According to Table 1, Panel A, 60.8% of listed firms provided ICRs in 2010, and 62.1% of listed firms provided ICRs in 2011. After deducting missing data, our final sample includes 1059 observations (497 observations in 2010 and 562 observations in 2011). We manually collected all ICW data from ICRs released by these 1059 firms on the two
Earnings quality and disclosure of ICWs
Table 4 provides results addressing whether disclosure of ICW influences earnings quality in terms of ABSDA. Model 2 tests the association between ICW disclosure and ABSDA, while Model 5 examines the relationship between different types of ICW and ABSDA. As discussed above, discretionary accruals are calculated via the modified Jones model (Dechow et al., 1995, Jones, 1991) with added lagged ROA as a controlling variable (Kothari et al., 2005).
According to Table 4, the coefficient of DISWEAK in
Conclusion
This paper investigates the relationship between voluntary disclosure of ICWs and earnings quality in the unique environment of China. We find that internal control is an effective tool for controlling enterprise risks, and earnings quality, measured as the ABSDA, is positively related to the disclosures of ICWs. The more ICWs disclosed, the higher the value of ABSDA. In terms of different types of weakness (accounting-related versus non-accounting-related ICWs), our results demonstrate that
Acknowledgements
We thank participants at the 2013 AAA Annual Conference in Anaheim, US, the 2013 European Accounting Association Annual Congress in Paris, France, and the 2014 Accounting and Finance Association of Australian and New Zealand Annual Conference in Auckland, New Zealand for their helpful comments and suggestions.
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