The implementation, assessment, and monitoring of effective internal control systems is a key determinant of financial reporting quality. Specifically, high-quality internal controls curtail the intentional manipulation of information reported to outsiders, reduce the risk of random procedural and estimation errors in reporting, and mitigate the inherent risks of business operations and strategies that may affect the quality of reported information. While the demand for internal control quality exists in the absence of regulation, compliance with regulatory requirements can force managers to increase and/or maintain internal control quality (Kinney, 2000). Accordingly, internal control reforms such as the 1998 German legislation on control and transparency (Gesetz zur Kontrolle und Transparenz im Unternehmensbereich; KTG) and Sections 302 and 404 of the 2002 Sarbanes-Oxley Act (SOX) have been promulgated with the goal of improving the quality and transparency of financial information (Deutscher Bundestag, 1998; Donaldson, 2005).
Recent studies of internal control disclosures pursuant to SOX 302 and 404 document that firms reporting internal control weaknesses have ex ante poor earnings (or accruals) quality. However, there is limited empirical evidence on whether internal control regulation leads to systematic improvements in earnings or financial reporting quality (e.g., Ashbaugh-Skaife et al., 2008; Bédard, 2006). Moreover, despite the recent global adoption of internal control mandates, there is scant empirical evidence on the financial reporting effects of internal control reform in non-U.S. capital markets. In this study, we investigate these issues by focusing on the 1998 German KTG legislation. In particular, we examine whether German firms experience an increase in the quality of reported earnings following the KTG internal control reform.
The German regulation provides several advantages for examining the impact of mandatory internal control reforms. First, requirements for the implementation, assessment, and audit of internal controls under KTG became effective in 1998, thereby providing a long post regulation period over which to analyze subsequent changes in earnings quality. Second, internal control requirements as prescribed by KTG became effective for all firms—both large and small public companies—on the same date, i.e., there was no phase-in period for certain subsets of the German market. Thus, unlike prior studies of the SOX 404 regime, we are able to provide large-sample evidence on post-reform changes in reporting quality. Third, several studies document that earnings quality under the German stakeholder accounting system is low relative to the level observed in shareholder systems such as the U.S. (see, e.g., Ball et al., 2000; Hung, 2000; Leuz et al., 2003). Prior studies also suggest that the German accounting system provides greater incentives and opportunities for insiders to intentionally smooth earnings (or hide losses) using accruals and “cookie-jar” reserves (e.g., Ball, 2004; Bartov et al., 2005). Given these two factors, the German context provides a setting in which aggregate improvements in earnings quality following internal control reform could be more observable.
We examine changes in earnings quality for German firms after the KTG reform using two widely-used natural experiment designs. Our first research design is a “differences” approach based solely on a broad sample of German firms. Our second design is a “difference in-differences” (DID) approach, which tests for changes in the German sample relative to a group of firms not subject to the KTG mandates. This approach attempts to control for potential time trends in earnings quality and confounding macroeconomic shocks. Because the KTG reform affects all publicly listed firms in Germany, we face the challenge of identifying a suitable control group against which to gauge the impact of the KTG reform on earnings quality.
We address this issue empirically by selecting all firms domiciled in several comparative European countries as our benchmark group, namely, Austria, France, Switzerland, and the United Kingdom. We select Austria and Switzerland given the impact of German civil law tradition on their stakeholder-oriented economies. France is selected as another comparative stakeholder economy; the U.K. is included because it has the largest capital market in Europe, with Germany being the second largest. Further, in all our tests, we control for unobserved effects that are unrelated to the KTG reform by including several firm- and country-level control variables, time and industry fixed effects, and clustering by firm.
Download
PDF Ebook The effect of internal control regulation on earnings quality: Evidence from Germany
