The effect of different levels of internal control over financial reporting regulation on the quality of accounting information: evidence from Korea

Abstract

This study investigates the effect of different levels of internal control over financial reporting (ICFR) regulations on accounting information quality. Stricter ICFR regulation restricts the opportunistic behavior of managers, leading to better accounting information quality. Strictly regulated firms tend to report lesser discretionary accruals. The results of this study indicate that the accounting information quality of less strictly regulated firms deteriorated, while there was no significant change in the accounting information quality of strictly regulated firms. This implies that the effect of ICFR regulation depends more on the enforcement rather than the adoption of the regulations.

Keywords:

• ICFR
• accounting information quality
• discretionary accruals
• SOX 404

JEL classification:

• M40
• M42
• M48

Notes

1. Only firms which are cross-listed in the US and the Korean stock markets are familiar with the COSO internal control framework. These firms are fewer than 10.

2. The best practice guidelines comprise five chapters except the supplementary provisions. The first four out of five chapters apply to large listed firms, while only chapter five applies to small public firms and large private firms. Small private companies subject to the External Audit Act were initially required to comply with the new ICFR provisions in 2003, but the application of this rule was delayed and eventually exempted from the provisions later. Thus, the best practice guidelines allow only two different levels of ICFR regulation: the one followed by the large public companies, and the one followed by the small public firms or large private companies. Small public companies and large private companies are subject to the same level of ICFR regulation (review by management). In our main analyses, we consider only public firms, because private firms’ data regarding ICFR are difficult to collect.

3. Our approach differs from Altamuro and Beatty (2010) in that their approach compares an experimental group of firms that are affected by the regulation with a control group of firms that are not affected by the regulation in their analysis. In Korea, all listed companies are subject to the ICFR regulation. Thus, we do not have a control group of listed firms that are not affected by the ICFR regulation.

4. PCAOB defines internal control as ‘a process designed by […], management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP …’ in Auditing Standard No. 2, paragraph 7.

5. Even though we posit that stricter ICFR is more likely to restrict the discretionary behavior of managers by enhancing controls, managers are still able to exercise discretion, which may lead to improved financial reporting in some cases. But this is only when managers have superior knowledge about the business and exercise their discretion to select reporting methods, estimates, and disclosures that accurately reflect the firm’s business economics (Healy and Wahlen 1999). However, managements’ use of judgment also creates opportunities for earnings management in which managers choose reporting methods and estimates that do not accurately reflect their firms’ underlying economics. If firms establish and operate effective internal controls, managers’ opportunistic behavior is more likely to be curbed by these controls. In this regard, the findings of this study would be the results on average after offsetting the effect of the alternative explanation.

6. KIS-VALUE II (Korea Information Services) is comparable to COMPUSTAT in the US.

7. DART is the electronic disclosure information system rendered by the Financial Supervisory Service (FSS). It is comparable to EDGAR in the US.

8. We use several different samples in the robustness tests. A consistent sample of 1960 firm-year observations comprises firms that existed both in the pre- and post-ICFR regulation periods and includes 52 firms that reported material weaknesses in their internal controls. In additional tests, we also use a sample of large firms, which includes both large public and private firms (1047 firm-year observations).

9. These values are similar to those reported in Hribar and Nichols (2007) which use US data. They report mean values of absolute discretionary accruals 10.1 and 13% when discretionary accruals are estimated by modified Jones model and performance-matched model, respectively.