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abstract

We investigate the impact of mandatory internal control and risk management (ICRM) reform on earnings-based attributes of accounting quality in Germany. Although prior studies examine changes in accounting quality under SOX Sections 302 and 404, there is scant evidence of the accounting quality effects of ICRM reform in foreign jurisdictions. Such evidence is warranted given the ongoing global policy debate of ICRM reform in the post-SOX era. We extend existing research by examining changes in earnings quality following the 1998 German legislation on control and transparency (KTG). The KTG regime provides a unique setting in which the regulatory scope extends beyond internal control over financial reporting (ICFR) to include broad business and enterprise risk control. Using both a differences and difference-in-differences research design, we find that German firms experience an increase in timely loss recognition and a decrease in earnings smoothing after KTG. We also find some evidence of a decrease in loss avoidance behavior. Additional analyses show that the sensitivity of capital investment efficiency to earnings quality increases in the German market after KTG, suggesting that earnings quality effects of mandatory ICRM reform has positive consequences for capital resource allocation. Together, our results are consistent with the achievement of one of the intended outcomes of ICRM regulation—increased accounting quality through effective ICRM systems.

6. Conclusion, limitations, and implications

We investigate the impact of the 1998 German ICRM reform (KTG) on earnings-based attributes of accounting quality. We find that German firms exhibit more timely loss recognition and lower levels of earnings smoothing after the KTG reform. We also find some evidence of a decrease in loss avoidance behavior by German firms. Together, these results are consistent with increased accounting quality as an intended outcome of ICRM reform. This study contributes to prior research by providing evidence of the accounting quality effects of broad risk-based ICRM regulation in a unique international setting. Our study also extends prior work by documenting the role of ICRM reform in improving earnings quality in an international capital market. Although our results are largely consistent across all our analyses, we are cautious in drawing inferences about causality. We note that the lack of a within-Germany control group limits our ability to control for time trends in earnings quality or concurrent macroeconomic shocks. We however find that our results are robust to the use of alternative control groups and the inclusion of firm- and country-specific controls. Given the limited public disclosure of ICRM weaknesses in Germany, we are also unable to identify firm-specific changes in ICRM quality after KTG. Lastly, given the broad scope of internal control under KTG, we acknowledge that internal controls aimed at monitoring or insuring against business risks could affect earnings quality independent of managers’ (intentional or unintentional) financial reporting choices. Therefore, our evidence of an increase in earnings quality following the KTG reform cannot be solely attributable to changes in managers’ reporting choices.