The Impact of Internal Control Quality on the Capital Market’s Perception of Earnings Quality: Evidence from a Comprehensive Internal Control Index in China

Abstract

    The internal control disclosure becomes a requirement for large publicly traded U.S. firms after the Sarbanes-Oxley Act. However, the information delivered to investors by such mandatory disclosure is parsimonious in that firms are only required to report whether their internal controls over financial reporting are effective or not. We study whether it is beneficial for firms to disclose more detailed information on internal controls by using a unique comprehensive Internal Control Index (ICI) in China. Based on the COSO’s integrated framework on internal controls, ICI considers five integral elements in internal controls: control environment, risk assessment, control activities, information and communication, and monitoring. We find that ICI is negatively associated with earnings management, suggesting that better internal controls improve firms’ financial reporting. This finding validatesICI by documenting a known relation between internal control quality and earnings quality. Moreover, we find that ICI has a positive impact on the earnings response coefficient, suggesting that better internal controls make financial reporting more credible to investors. This finding with market-based measures of earnings quality demonstrates that disclosing detailed in-depth information on internal controls can be beneficial to the capital market.

Keywords:Internal Control Index; Earnings Quality; Earnings Response Coefficient

JEL Classification:M41