Mandatory internal control and earnings management

ABSTRACT

This paper examines whether the mandatory implementation of an internal control system influences listed firms’ earnings management in China. We use firms that are mandated for implementing internal control as the treatment group, and firms that do not implement internal control as the control group. We find that the mandatory implementation of an internal control system results in an increase in both real and accrual-based earnings management. We also find that the extra institutional compliance cost induced by implementing a mandatory internal control system was the main cause of the increase in earnings management. Our conclusions thus provide empirical evidence that differs from that on the developed market regarding the research about mandatory internal control and earnings management.

KEYWORDS:

• Mandatory internal control system
• accrual-based earnings management
• real earnings management

JEL:

• G38
• D82
• M41

Disclosure statement

No potential conflict of interest was reported by the author(s).

Notes

1. The “Announcement” stipulates that both the central and the local state-owned companies listed on the Main Board should fully implement an internal control system beginning in 2012; the non-state-owned companies listed on the Main Board with a total market capitalization of more than RMB 5 billion before December 31, 2011, and with an average net profit of more than RMB 30 million between 2009 and 2011 should fully implement an internal control system beginning in 2013; Other companies listed on the Main Board should fully implement an internal control system beginning in 2014.

2. Date source: FEI Survey: Sarbanes-Oxley Compliance Costs Are Dropping[R]. Financial Executives Research Foundation, 2006, http://www.fei.mediaroom.com/index.php?s=43&item=74.

3. Date source: SEC. Final Rule: Management’s Reports on Internal Control over Financial Reporting and Certification of Disclosure in Exchange Act Periodic Reports (Release No. 33–8238) [S]. Washington, D. C.: SEC Government Printing Office, 2003, http://www. Sec.gov/rules/final/32-8238.htm.

4. This is formulated in the “Standards.”

5. They are a dummy of whether there is a material weakness in the internal control ($MW$), and the natural logarithm of the sum of the inventory turnover length and the accounts receivable turnover length ($OP\mathrm{\_}CYCLE$).

6. For the calculation of classification shifting please refer to McVay (2006).

Additional information

Funding

Jiaxin Wang acknowledges the financial support from National Natural Science Foundation of China [Project No. 72102229], Ministry of Education in China [Project No. 20YJC630143] and Zhongnan University of Economics and Law [Project No. 2722021BZ030]. Zilong Song acknowledges the financial support from Ministry of Education in China [Project No. 19YJC790113], National Natural Science Foundation of China [Project No. 71802105].