Mandatory Internal Control Disclosure and Analyst Forecasts in China

What is it about?

Beginning January 1, 2012, all publicly listed firms in China are required, under the Basic Standard of Enterprise Internal Control (China SOX), to provide an internal control report (ICR). Prior to that, many firms had elected to voluntarily comply with this regulation. We use this setting to examine the change in internal control weakness (ICW) disclosure, and its impact on the properties of analyst earnings forecasts when a country moves from a voluntary disclosure regime to a mandatory disclosure regime. We compare the quantity and severity of ICWs disclosed under these two different regimes, and find evidence suggesting that the disclosure of more serious ICWs increases when ICW disclosures become mandatory. We then investigate the effect of ICW disclosures on analyst forecast error and dispersion. We find that measures of ICWs are negatively associated with desirable properties of analyst earnings forecasts. We also find a lower association between ICW disclosures and forecast error and dispersion in the mandatory regime; we attribute this to changes in the internal control reporting environment when filings are mandatory.

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Why is it important?

Our study contributes evidence to the debate on whether internal control regulations should be mandated by finding that ICW disclosures under the mandatory regime in China improved analyst earnings forecast properties. These results can assist regulators in developing countries that are currently considering mandating internal control regulations.