The effect of internal control regulation on earnings quality: Evidence from Germany†

Prior studies of internal control disclosures under the 2002 Sarbanes-Oxley Act (SOX) provide limited evidence on the impact of internal control regulation on reporting quality. Moreover, there is no empirical evidence on the reporting quality effects of mandatory internal control reforms in non-U.S. environments. Thus, it is still an open question whether internal control regulation leads to systematic improvements in reporting quality. We examine this issue, with specific focus on the 1998 German legislation on control and transparency (KTG). In particular, we examine whether German firms experience an increase in earnings quality following the 1998 internal control reform. Using both differences and difference-in-differences research designs, our results suggests that after the KTG reform, German firms experience an increase in timely loss recognition and a decrease in earnings management as indicated by various measures of earnings smoothing and managing toward small positive earnings. These results are robust to various sensitivity analyses. Taken together, our results are consistent with the achievement of one of the main goals of internal control regulation—increased earnings quality through effective internal controls. JEL Classification: G14; G15; K22; M41; M42.