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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.