2014 International Conference on Management Science & Engineering (21 th) August 17-19,2014 Helsinki Finland ,

Earnings Quality and Voluntary Disclosure of Internal Control Audit Reports

WANG Mei-ying1,2 1 School of Accounting, Central University of Finance and Economics, Beijing 100072, P.R.China

2 School of Business, Beijing Wuzi University, Beijing 101149, P.R.China

Abstract: Following SOX, Japanese and Chinese regulators began to require domestic listed companies to disclose their self-evaluation and audit reports on internal control. however. in other countries non-mandatory requirements are adopted and companies are encouraged to disclose internal control reports. The effect of voluntary internal control reports becomes a problem that needs to be verified empirically. Based on the voluntary disclosure of listed companies in Chinese capital market prior to the implementation of mandatory internal control audit, we tind that voluntary internal control audits did not improve the quality of accounting information, listed companies chose to disclose the reports in order to send signals to investors to show that they have higher earnings quality . This paper provides reference to the choice of voluntary or mandatory internal control systems in other countries.

Keywords: audit, earnings quality, internal control, voluntary disclosure

1 Introduction

True and accurate financial information disclosed by listed companies is the basis for the effective capital market, internal control is important internal mechanisms to ensure the reliability of accounting information. With the internal control deficiencies disclosed by the U.S. companies in accordance with the requirements of SOX , previous studies indicate that the quality of internal control and earnings quality are significantly positively correlated in the U.S. stock market. However, increasing cost brought by internal control audit makes whether listed companies should be forced to conduct internal control audit controversial. Regulatory authorities in other countries are trying to verify whether the relatively loose internal control regulation system can achieve high-quality financial reporting objectives.

Different from the requirements of mandatory audit of internal control in the U.S. and Japan , Shanghai Stock Exchange and Shenzhen Stock Exchange in China, respectively, issued the "Guidelines for the Internal Control of Listed Companies "in 2006, encouraged listed companies to hire an accounting firm to conduct an audit of internal control .Since 2006, Chinese companies listed on the stock market have begun to voluntarily disclose internal control audit reports issued by the CPA in its annual reports. Zhang Long-ping, Wang Jun-zhi, and Zhang Jun (2010) fmd that these voluntary internal

control audit can improve the quality of earnings[11,however in their study the endogeneity are not considered, which may affect the reliability of their conclusions. Therefore, whether voluntary internal control audits can improve the quality of accounting information is still a problem needed to explore furtherly, the answer to this question has great influence on two different choices of the mandatory or the voluntary internal control audit regulation systems.

This paper selects A shares listed companies in shanghai stock exchange who voluntarily disclose internal control audit reports in 2007-2009 annual report as samples and studies whether voluntary internal control audit can improve the quality of accounting information. With the study of the implementation effect of the internal control audit in Chinese voluntary regulation environment, we intend to give suggestions on how to achieve reliability objectives of financial reporting through the internal control audit.

Why listed companies voluntarily disclose internal control audit reports? We present two possible explanations: on one hand, theories and practice have proved that effective internal control can guarantee the reliability of accounting information, so listed companies could detect internal control weaknesses, improve internal control and improve quality of financial reporting in the end through conducting internal control audit. On the other hand, information asymmetries between managements and shareholders may lead to "moral hazard" and "adverse selection." Therefore, companies which have high quality accounting information hope to send a good signal ,then reduce investors' uncertainty over financial reporting and increase company stock value, thus reduce financing costs through voluntarily disclosing unqualified internal control audit reports. Therefore, the study of whether voluntary internal control audit can improve earnings quality exists self-selection problem. Using Heckman's two-stage method to tackle the endogenous, we find that companies with higher earnings quality voluntarily disclose internal control audit reports to deliver a signal to investors, but voluntary internal control audit does not improve the quality of accounting information of listed companies.

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2 Related research, hypotheses and research design

2.1 Related research and hypotheses Financial reports disclosed by listed companies are

the most important information for investors to understand the business profitability, capacity development, and operating risks; therefore, reliable financial reports are the foundation on which investors can make the right investment decision. Listed companies' earnings manipulations for a variety of purposes mislead the investors and disturb the capital market order. External audits and internal controls are two important mechanisms to ensure the reliability of financial reporting (Yang De-ming, Lin Bin, Wang Yan-chao, 2009)lzl. The outbreak of a series of financial scandals in recent years has shown that only relying on external audits to achieve the goal of reliable accounting information is not enough, and as such internal control is an important mechanisms that can ensure the reliability in the preparing and production of financial reports, which is gaining more attention by regulatory authorities.

The correlation assumption between internal control and accruals quality has been suggested in previous literature (Kinney 2000)[31, but a large amount of empirical evidence appeared after the implementation of SOX. The main purpose of SOX is to encourage enterprises to strengthen internal controls. J, Lobo, etc. (2006) find that after the implementation of SOX, accounting profit manipulation by listed companies has significantly decreased and the reliability of the financial reports has been improved compared to before[41. Doyle et al.(2007) find that weak internal controls are generally associated with poorly estimated accruals and lower accruals quality is caused by overall company-level control deficiencies. Because of the substitution effect between internal controls and external audits, companies with account-level internal control deficiencies that are more auditable do not have lower accruals quality[51. Chan et al. (2008) give the evidence that companies with deficiencies in internal controls have more discretionary accruals[61. Ashbaugh-Skaife (2008) fmds that the accruals quality of the companies whose auditors confirm remediation of previously reported internal control deficiencies have been significantly improved[71. Feng et al. (2009) find that managers of companies with ineffective internal controls make less accurate forecast because they are based on erroneous internal management reports[81, their conclusion further supports that effective internal controls play an important role in accurate information disclosure.

As noted in Ashbaugh-Skaife (2008) [71, to estimate reliable accruals is difficult for the managements of the companies with weak internal controls and this could lead to less reliable financial information, and the management of the companies with weak internal controls are more likely to exceed internal control and provide the bias accruals to meet their opportunistic objectives. As a result, a low quality of internal controls

will lead to unreliable financial information. Yang Deming, Lin Bin and Wang Yanchao (2009) find that internal controls can limit the ability of managers and large shareholders to manipulate the accounting information and restrict the controlling shareholder to tunnel listed companies [21. Therefore, effective internal controls can ensure the reliability of financial reporting. The fundamental purpose of internal control audits is to ensure that enterprises establish effective internal controls as well as improving the quality of accounting information. The duty of CPA is to identify and report deficiencies m internal controls. CPA should communicate internal control deficiencies with management in a timely order to help companies establish effective internal controls. Considering the restriction of effective internal control to earnings manipulation (Hoitash, 2009) [91, we propose the following research hypothesis:

Voluntary internal control audits in China can improve the quality of accounting information.

2.2 Research design 2.2.1 Earnings quality

Accurate measure of a company's earnings quality is the key to this study, as mentioned previously, management's manipulation of earnings is mainly achieved by accruals and accruals are divided into discretionary and non-discretionary types. Earnings quality is the discretionary accruals estimated by the Jones modele 1991) [101, the model is as follows:

T� =atY�J+a2( MEX)+a3 (PP�JH; (1)

where:

TAj= the total accruals of firm i at year t

Aj = the company's total assets at year t-I, to eliminate the influence of different company sizes.

.lI. H'EVj=the change of revenue for the firm i from year t-I to year t

PPE.i =gross property, plant, and equipment for firm i at year t

Since 2007, listed companies in China began to implement new accounting standards. To maintain consistent accounting data,We use the beginning balance in financial statements of 2007, which have been adjusted from the ending balance of 2006 according to the new accounting standards. After excluding the samples less than eight companies in each industry and financial listed companies, the regression residuals of model (I) represent the DA of listed companies. Earnings management of listed companies include the forward earnings management to increase profits and the negative earnings management to reduce profits for smoothing purpose, therefore, as in previous studies, we use the absolute residual (ABSDA) as a proxy for earnings management [71 [Ill. The greater the ABSDA , the lower the earnings quality.

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2.2.2 Self-selection bias and Two-stage regressions As mentioned above, unqualified audit reports on

internal controls will convey a signal of high quality internal controls to stakeholders that reduce the uncertainty of financial statements. Companies with high quality financial information are motivated to voluntarily disclosure internal control audit reports to reduce information asymmetry, so studies of the relation between voluntary audit of internal controls and earnings quality there exist a self-selection problem. In statistical methods, unbiased use of regression must be based on a random sample. Voluntary disclosure of Internal control audit reports will have lower randomicity as listed companies exist a conscious choice behavior, the res�lts of statistical analysis will inevitably produce a bIas, which is self-selection problem, then the traditional OLS regression will lead to biased conclusions. Chaney, Jeter and Shivakumar (2004) [12]discover that, in the OLS regression, there are audit premiums in companies audited by BIG 5, but after adjustments to counter the self-selection bias from the choice of auditors, they found that the BIG 5 clients do not pay higher audit fees. So in our research, not taking into account the self-selection problem will draw the wrong conclusions. According to Heckman's two-stage method, this paper firstly set the internal control audit report selection model for probit regression to estimate which companies choose voluntary internal control audits. The coefficients IMR(Inverse Mill's Ratio)obtained from it is then used as a variable to correct the self-selection problem in the model which tests whether internal control audits can reduce earnings management. 2.2.3 Design of research model

Phase I: probit regression of voluntary disclosure model of internal control audit reports

fCR = fJo + fJ)ROE + fJ2CFO + fJPROWTH + (2) fJ4SIZE + fJ,AGE + fJ6STATE + fJ7LEV + fJ8BS + fJ9fNDUSTRY + OJ

Phase II: voluntary internal control audit and quality relationship model

ABSDA = Ko + KJCR +K2ROE + K3CFO +

K GROWTH + K.SIZE + K6AGE + K7SI4TE + 4 )

KsLEV + K91MR + KIOINDUSTRY +0

Of which:

IMR = .. , ,

l-¢<-a' 7)1 (P(-a'Z) ¢C-a'zY[I-(PC-a'z)]

fCR =0 ICR= 1

earnings

(3)

The discoveries by the existing study provide a basis for the selection of variables in the selection model of the auditor's internal control reports disclosed by listed corporations. we use variable size of company (SIZE), performance of the company (ROE and CFO), age to list (AGE), if a company is owned by state shareholders and whether issuing B-shares at the same time (BS) or not in the model, all these characteristics of companies have significant impact on the possibility of � company's voluntary disclosure of internal control audIt reports according to existing studies[13]. This paper adds

asset-liability ratio (LEV ) and dummy variable of industry (INDUSTRY) to control the influence of the debt financing and industry factors on the disclosure of the auditor's reports of internal controls.

In the second stage regression, this paper will make cross-sectional regression between ABSDA (absolute value of discretionary accruals), the proxy for earnings

quality, and voluntarily disclosure of internal control

audit reports (ICR) to explore the effect of voluntary internal control audits on earnings quality.

We add self-selection factor IMR (Inverse Mill ¢ s Ratio) calculated by the first stage regression to control the self-selection problem, ICR is the main study variable. We predict that an audit of internal controls can improve the quality of accounting information, thus Kl

should be significantly negative. Earnings management behavior of listed

corporations for various purposes has seriously aff�c�ed orderly competition in the capital market. AVOldmg losses and meeting "refinancing lines" of regulatory requirements is the main motivation of �arnin.gs management. Relatively speaking, the compames wIth good performance (we use operating cash flow and return on equity as the proxy variable), facing smaller pressure, do not have a strong motivation to manipulate their earnings. Zhang Zhaoguo, Liu and Xing (2009) believe that bigger companies always get more attention from supervision and their corporate governance is relatively perfect, so the quality of accounting is relatively high[14]. Chen Xin (2008) fmds that the operating cash flow and company size significantly

[15] •

affect the degree of earnings management . Enterpnses with debt financing are often constrained by the terms of the debt contract because the debt covenants are based on data from corporate accounting, firms often manipulate earnings to avoid debt covenant constraints to reduce the cost of debt financing, so companies with higher debt will have lower earnings quality. Studies have also found that the company growth (GROWTH), age to list (AGE) also affect the earnings quality [II] [16]. These above variables are used as control variables in our model, We also control the effect of shareholding structure(STATE) and industry (INDUSTRY).

3 The sample selection and descriptive statistics

3.1 The sample selection In 2007, there was 849 A-share listed companies in

Shanghai Stock Exchange of China excluding 20 financial listed companies. Because IPO companies must disclose internal control audit reports, we have removed 25 samples of IPO companies. The final sample contains 782 listed companies, including 115 companies which disclosed internal control audit reports. Following the same method of sample selection, there were 796 sample companies in 2008 and 789 in 2009, including 156 and

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Tab.1 Variable definitions

variable definition

ICR dummy variable, if the company voluntarily disclosed the internal control audit reports then the variable is I , otherwise 0

ROE return on equity

CFO cash tlow from operating activities Ithe tinal total assets

GROWTH growth of the sales

SIZE size of the company,and is the logarithm of the final total assets

AGE Time to market

STATE dummy variable, if the company is a state-owned listed company that is I, otherwise 0

LEV asset-liability ratio

BS dummy variables, the company issuing B shares at the same time take I otherwise 0

IMR self- selection factor, Inverse Mill's Ratio

INDUSTRY Dummy variables

ABSDA The absolute value of discretionary accruals, on behalf of the company earnings quality

Tab.2 All the descriptive statistics ofthe sample variables

variables undisclosed group CN=I924) Disclosed group CN=443) t-test of sample

median 25% quantile 75% quantile median 25% quantile 75% quantile mean

mean mean

ROE 0.056 0.071 -1.269 0.732 0.110 0.107 -0.356 0.477 -4.74*'* CFO 0.051 0.050 -0.201 0.282 0.063 0.060 -0.210 0.283 -2.62*'* GROWTH 0.220 0.106 -0.728 5.510 0.253 0.163 -0.515 4.773 -0.86 SIZE 21.68 21.53 19.25 25.32 22.29 22.09 19.92 26.35 -9.55*'* AGE 9.619 10 I 19 7.966 8 I 16 8.17'** STATE 0.653 I 0 1 0.776 0 1 -5.02*'* LEV 0.521 0.528 0.105 0.942 0.523 0.543 0.105 0.828 0.17 BS 0.063 0 0 0.005 0 0 0 5.02*** A BSDA 0.072 0.049 0.001 0.422 0.071 0.048 0.001 0.371 0.26

Note: *. **. and *** respectively represent the 1 %, 5% and 10% significanceleve!.

172 companies which disclosed internal control audit reports in each year. Finally, there was a total of 2,367 sample companies in 2007-2009, and among them 443 companies voluntarily disclosed internal control audit reports.

3.2 Descriptive statistics and univariate analysis Table 2 shows the descriptive statistics of the full

sample in 2007-2009. The number of the companies that disclosed internal control audit reports is 443 and 1924 companies have not disclosed such reports. As can be seen from the table, the companies which disclosed internal control audit reports show significantly higher ROE, CFO, SIZE and are mostly controlled by state than that of the companies which did not disclose, this shows that companies with a large-size, good performance, and state-owned ones are more likely to disclose the company's internal control audit reports. The mean of variable AGE and BS of voluntarily disclosing companies are less than that of the sample companies which did not disclose, this indicates that the companies who were listed in Chinese stock exchange earlier and issued shares to overseas investors at the same time have a lower probability to disclose internal control audit reports. The mean and median of discretionary accruals

between the two samples is not significantly different in the univariate regression analysis. Using a multiple regression analysis, we will further study the effect of internal control audits on earnings quality while controlling for other variables.

In correlation analysis, discretionary accruals ,the dependent variable ,is significantly correlated with LEV, CFO, SIZE, AGE, STATE, BIG4, among which cash flows from operating activities (CFO) and discretionary accruals (DA) have the strongest correlation. The correlation coefficients between the independent variables are less than 0.3, indicating that collinearity between the independent variables is small.

3.3 Empirical results 3.3.I.Probit regression of disclosing internal control audit reports

As show in Tab.3, coefficients of ROE, SIZE, STATE are significantly positive with the dependent variable at the I % level, indicating that companies who are larger, have higher returns on net assets, and state-owned are more likely to voluntarily disclose internal control audit reports. The coefficient of AGE, BS is significantly negative at the 1 % level, indicating that firms who are listed on the Stock Exchange for a longer

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amount of time and issue B-shares at the same time are less likely to disclose internal control audit reports. This paper does not report the regression results of industry control variables (the same as below).

Tab.3 Results of self-selection model

about disclosing the internal control reports

Constant ROE CFO GROWTH SIZE AGE STATE LEV BS Sample size Pseudo R2 Wald chi2

coefficient -4.501 0.634 0.377 -0.034 0.194 -0.057 0.242 -0.018 -1.112

ICR

2367 0.087

177.86

p-value 0.000'*' 0.002'*'

0.351 0.435

O.OOO'*' O.OOO'*' 0.00 I '*'

0.926 0.000'*'

3.3.2 Analysis of the influence of voluntary internal control audit on earnings quality

TabA reports the results of the two-stage regression. In addition to the regression results of all samples, we also report the regression results of each year. In 2007 and 2008, the inverse Mills ratio (IMR) is significantly negative, meaning that there is a self-selection bias in our research and it is necessary to control our sample selection bias in this model. On the other hand it shows that companies with lower degree earnings manipulation and higher quality of accounting information are inclined to voluntarily disclose internal control audit reports to investors to show that their financial information is more credible. In 2009, the Inverse Mills Ratio (IMR) is not significant. The possible reason is that more companies imitated the disclosure of internal control audit reports, so the signal effect disappears. The sign of control variables are just the same as what we expected. The coefficient of ROE and CFO is significantly negative, indicating that the better performance, the lower level of

earnings management. The coefficient of SIZE, STATE is significantly negative meaning that the larger the company and the more equity investments owned by state, a relatively higher accounting information quality . The coefficient of asset-liability ratio is significantly positive, so if a company has more bank loans, the management can more easily manipulate earnings for the contract constraint. The coefficient of GROWTH is positive, then the internal control of the rapidly developing companies can't be improved timely along with the expansion of the company's business, so these companies' existing internal controls are not effective any more and accordingly lead to lower company earnings quality. Different with our assumptions, coefficient of ICR is not negative (samples in 2007 and 2008 as well as all others available are significantly positive), indicating that the voluntary internal control audits at this stage do not improve the company's earnings quality. Therefore, the voluntary disclosure of internal control audit reports is random for the low disclosure costs, and has not been able to play a role in improving internal control of these companies and can not improve earnings quality correspondingly. A probable reason is that the CPA has not implemented enough audit evaluation procedures and enough testing of internal controls during an audit of internal controls because of insufficient training and experience, and also there are not strict regulations on internal control audits in the environment of voluntary disclosure thus auditors are short of sufficient evidence to support the auditing opmlOns about overall effectiveness of the client's internal control .

4 The robustness test

The calculation of discretionary accruals in this paper is a key factor on the reliability of conclusions. This paper uses another important method to calculate earnings quality which is the DO model to test the reliability of conclusions.

Tab.4:lmpact of internal control audit on earnings quality - two stage regression

The dependent variable (DA)

All the samples Year of 2007 Year of 2008 Year of 2009 Coefficient P-value Coefficient P-value Coefficient P-value Coefficient P-value

Constant 0.150 0.003'*' 0.160 0.017'* 0.193 0.001 '*' 0.134 0.379 ICR 0.080 0.056* 0.287 O.OOO'*' 0.084 0.021 *' -0.055 0.707

ROE -0.027 0.044*' -0.031 0.137 -0.046 0.001 '*' 0.022 0.436 CFO -0.116 0.028*' -0.173 0.064* -0.049 0.337 -0.211 0.076'

GROWTH 0.029 0.062* -0.000 0.847 0.013 0.066* 0.095 0.058' SIZE -0.005 0.085* -0.008 0.045* -0.006 0.054* -0.003 0.718 AGE 0.002 0.033*' 0.002 0.078* 0.003 0.002'*' -0.000 0.847

STATE -0.020 0.00 I '*' -0.023 0.002'*' -0.017 0.004'*' -0.017 0.266 3LEV 0.034 0.011 *' 0.009 0.582 0.021 0.110 0.079 0.048*' IMR -0.046 0.046* -0.157 0.000'*' -0.050 0.0I8*' 0.027 0.745

Adjusted R2 0.13 0.15 0.184 0.21 Sample size 2367 782 796 789

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Dechow and Dichev (2002) believe that low accruals quality means more accruals that can't achieve cash flow, as a result they developed the DD model on this basis [17l. McNichols (2002) and Francis et al. (2005) modify their model by adding two variables-- revenue and initial value of fixed assets[18][19l,the amended DD model is as follows:

ACCt =}'O + }�CFOt_1 + A2CFOt + }']CFOttI + }'4MEV + A/PEt + �t (4)

Where: ACCt is the total accrual (net income

minus cash flow from operating activities). CFOt_1, CFOt, CFOt+1 are cash flows from

operating activities on each period respectively, all the variables in the model are divided by average total assets. In model (4), regression residuals represent accruals quality. After usirIg ACC to substitute DA in model (3), the regression results do not change, and as such our research conclusion is supported.

The existing studies find that shareholding proportion of the controlling shareholders, and the second to the tenth largest shareholding proportion significantly affect the possibilities of the company's disclosure of internal control audit reports. Zhang Zhaoguo, Liu Xiaoxia, Xing Daoyong (2009) find that discretionary accruals are negatively correlated with the second to the tenth largest shareholding ratio and positively correlated with the shareholding proportion of the largest shareholder[20l, our research conclusions do not change after addirIg these two variables irI the two-stage model.

5 Research conclusions

The objective of the internal control audit is to promote enterprises to establish effective internal controls. Its ultimate purpose is to improve the quality of accounting information in order to protect the interests of investors. Under the regulatory environment that is absent of mandatory audits of internal controls, an increasing number of listed companies select to disclose internal control audit reports in their annual reports, indicating that listed companies pay more attention to the importance of irIternal controls. This paper examines whether voluntary implementation of the internal control audits can achieve the goal of improving the earnirIgs quality of listed companies. After controlling the self-selection problem, this article does not fmd evidence to support that the internal control audits of this stage can improve the quality of accounting information. The reason is that listed companies are more willing to show investors that their accounting information is more reliable through disclosing internal control audit reports, but because the irIternal control quality is difficult to directly observe and there is a correspondirIg lack of supervision in the voluntary disclosure stage, so voluntary disclosures are an opportunistic choice by the listed companies and their financial information has not

improved significantly. On the other hand, CPA doesn't have enough trainirIg and experience to carry out an audit of internal controls and they also don't have good enough corresponding rewards (we can not see obvious increase in the audit fees of the disclosing listed companies in their annual reports), which constrains the CPA to do enough test so that they haven't obtain sufficient supporting evidence to express audit opinions on the overall effectiveness of irIternal controls during an audit. Because internal control audits are an important guarantee for the enterprise to establish an effective internal control system and then can improve the operatirIg efficiency and effectiveness and the reliability of financial reporting, regulatory authorities need to strengthen their supervision and punishment mechanism, and intensify training for the CPA.

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