The bomb-crater effect of CSRC random inspections: evidence from internal control quality

This study examines the efficacy of an innovative public enforcement mechanism: the China Securities Regulatory Commission (CSRC) random inspections. Since 2016, the CSRC has carried out random inspections in which both inspectors and inspection targets are randomly selected. The selected inspectors conduct on-site inspections focusing on information disclosure, corporate governance, and other normative operations of the selected listed companies. Unlike other public enforcement mechanisms, the inspection targets in this approach are completely random. Random inspections are thought to save regulatory costs and overcome problems such as selective enforcement, with the potential to create an effective deterrent for listed companies, resulting in a “governance effect”. However, random inspections may also induce a “gambler’s fallacy” among executives in the inspected companies, resulting in the “bomb-crater effect”. We find that internal control quality decreases significantly in randomly inspected companies, supporting the bomb-crater effect hypothesis. Moreover, the deterioration in internal control quality caused by CSRC random inspections is more pronounced in firms with overconfident executives and in non-state-owned enterprises. In addition, the reduced quality of internal controls triggered by random inspections leads to lower-quality accounting information, an increased likelihood of financial restatements, and more frequent non-standard audit opinions. Overall, our results reveal the presence of bomb-crater effect in CSRC random inspections.