Analysis Of The Relevance Between Internal Control And Earnings Management

One of the three objectives of internal control that the COSO report presented is toguarantee the reliability of financial reporting, and the reliability of financialinformation will affect investors’ decision-making to a large extent, thereby determiningwhether the capital market enables a sound development. Different sectors of thesociety gradually realize internal control’s functions to inhibit earnings managementbehavior of the management layer and to improve the quality of financial information,especially with the occurrence of financial fraud cases such as Enron and WorldCom. Inorder to urge listed corporations to improve their internal control, the US passed theSarbanes Act in2002, the No.303rd clause of which requires listed corporations todisclose situations of internal control, and the No.404th clause of which requires listedcorporations to disclose accounting firms’ audit reports on internal control. In recentyears the Chinese government has strengthened the construction of internal controlsystem, and promulgated the internal control guidelines and internal control auditguidelines in2010. The Guidelines request all domestic and overseas listed corporationsto disclose the internal control self-assessment and the internal control appraisalopinions, which will be implemented among all Chinese-A share listed corporationssince December31,2012.2011is a transitional period for internal control, fromnon-execution to gradual execution, and from voluntary implementation to mandatoryimplementation. China’s special institutional background provides a good opportunityfor researching the correlations between internal control and earnings management.Based on the information asymmetric theory and the principal agent theory, as wellas the annual reports of Shanghai and Shenzhen’s1540non-financial listed corporations,we compare the earnings management levels between the disclosure and non disclosureaudit reports of internal control companies to see whether a significant difference existsthrough dividing the earnings management into accrual-based earnings management andreal earnings management according to corporation’s earnings management methods.Then we subdivide571companies which disclose the audit reports on internal controlinto other voluntarily-implemented internal control listed corporations and enforcedinternal control A+H share listed corporations in order to study whether differentinternal control executions of listed corporations will cause a remarkable discrepancy intheir earnings management levels. In this paper, basic Jones model with intangible assets and other long-term assetsdesigned by Lu Jianqiao(1999) and Roychowdhury(2006) research results will be usedfor reference to measure accrual-based earnings management, and the operating cashflow model, the cost of production model, discretionary expense model will also beapplied to measure real earnings management activities. The empirical research will beconducted in the relations between corporation’s internal control and earningsmanagement based on the multiple regression model, and the usage of SPSS softwareand excel software. Some conclusions can be found in the research： first, after themultiple regression is used to analyze non-financial listed corporations of Shanghai andShenzhen’s security markets, the research conclusions are basically the same as theresults of case studies by Fang Hongxing(2011) and Zhang Longping(2010),namelyinternal control can significantly inhibit earnings management of listed corporations,including accrual-based earnings management and real earnings management, whichmeans the effect of a series of institutional construction with the aim to improve internalcontrol levels of listed corporations has been gradually emerging. Second, by comparingenforced internal control A+H share listed corporations with othervoluntarily-implemented internal control listed corporations, the research discovers thatenforced internal control can only inhibit the accrual-based earnings management oflisted corporations, but has no significant impact on earnings management behavior ofreal activities. Therefore, this paper will bring forward suggestions according to threeaspects: continuing to implement the system of internal control and increasing itscorresponding punishment mechanism, strengthening the involvement of accountingfirms in the internal control construction, and reinforcing policy guidance of internalcontrol audit in accounting firms. Only by constantly improving the internal controlmechanism, increasing the information disclosure quality of internal control andcompany’s earnings quality, can the improvement be further achieved, which will allowChina’s capital market to develop in a more orderly and healthy way.