Internal Control Deficiency Disclosures Among Chinese Reverse Merger Firms

Abstract

In recent years, financial reporting problems among Chinese reverse merger firms (CRMs), listed on U.S. exchanges, have attracted unfavorable attention from regulators, investors, and the business press. Under the SOX Act of 2002, managers’ Section 302 assessments of internal control over financial reporting are intended to provide investors with early warning about the likelihood of current and future non-GAAP financial reporting problems. We investigate managers’ propensity to issue unfavorable SOX 302 reports when internal control problems exist. We find that managers of CRMs have equal or greater propensity to issue adverse SOX 302 reports when serious internal control problems exist in the current quarter than those of control firms listed on U.S. exchanges, including reverse merger and IPO firms from the U.S. and other countries as well as Chinese IPO firms. Furthermore, managers of CRMs also have an equal or greater propensity to issue adverse SOX 302 reports when internal control problems are not known to exist. One reasonable conclusion is that CRM firms tend to have weaker internal controls than comparison groups, and CRM firms are forthcoming in disclosing such weakness. Finally we analyze the specific nature of internal control deficiencies disclosed by each category of our sample firms.