The effect of the internal control regulation on reporting quality in China

Abstract

This paper aims to investigate whether Chinese internal control regulation improves reporting quality. After the enactment of US Sarbanes–Oxley Act (SOX), China introduced a quasi-SOX practice (C-SOX). C-SOX stipulates that firms should disclose both management and audit reports on internal control and aims to help firms ensure reporting reliability. Previous studies provide solid evidence of the effectiveness of SOX, but the conclusion cannot simply be generalized to emerging markets. We employ a modified difference-in-difference approach regarding the special batched implementation schedule of C-SOX and observe earnings management during the reform, finding that accrual-based earnings quality is enhanced significantly after compliance with C-SOX without causing more real activity manipulation. Our results thus show that C-SOX has a positive effect on reporting quality and triggers no side-effects harming firms’ long-term value. Our findings suggest that the mandatory disclosure regime of C-SOX contributes to better corporate disclosure even with weak enforcement.