Random inspections and corporate information disclosure

Abstract

This study investigates the effectiveness of public enforcement in financial markets with weak investor protection, specifically examining the impact of China's random inspection policy on corporate disclosure. This policy is designed to prevent selective enforcement by randomly selecting the inspected firms and the inspectors. Our findings indicate that inspected firms significantly improve their disclosure quality by adopting a more conservative tone in subsequent years. Cross-sectional tests reveal a more significant effect among state-owned enterprises (SOEs) and firms with stronger social connections, lower media coverage, and higher litigation risk, which can be attributed to the random inspections reducing regulatory capture, narrowing the information gap, and increasing firms' exposure to regulatory oversight and market participants. However, the influence of these inspections is moderated by market incentives of corporate managers, as proxied by financing demands and insider trading incentives. In addition, a plausible mechanism for this improvement in corporate disclosure quality is the intensified monitoring by external auditors following random inspections. Further evidence indicates a reduction in firms' crash risk due to enhanced disclosure quality after random inspections. Finally, we observe that CSRC random inspections also improve the disclosure quality of non-inspected firms within the same industry, thereby creating a spillover effect. These findings suggest that public enforcement has a significant regulatory impact in financial markets where investor protection is weak through enhancing regulatory transparency and curbing regulatory discretion.