Does environmental law enforcement matter for financial reporting quality?

The Chinese government's recent Environmental Inspection Program (EIP) eliminates a layer of regulatory actions and holds local government officials accountable for enforcement of environmental laws. We examine two aspects of the impact of the EIP on financial reporting quality. First, we derive a simple analytical model to show that the level of earnings management (EM) depends on the cost and probability of EM detection. This increase in environmental law enforcement (due to the EIP) raises the cost of environmental violation to a firm and managers. To respond to the increased costs, a firm engages in less EM. Second, consistent with the model prediction, we find firms subject to the EIP engage in less EM than otherwise equivalent firms located in non-EIP jurisdictions. The effect of the EIP on EM is more pronounced for firms with adverse agency problems and poor internal controls. Additional analysis suggests that air quality level is a moderating factor for the impact of the EIP on EM. Collectively, using the natural experiment of the EIP, we find a new determinant of EM. Environmental law enforcement deters EM and enhances financial reporting quality.