Optimal internal control regulation: Standards,penalties, and leniency in enforcement |
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| Authors: | Stefan F. Schantl Alfred Wagenhofer |
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| Affiliation: | 1. University of Melbourne, Australia;2. University of Graz, Austria;1. Department of Accounting, Box 8113, North Carolina State University, Raleigh, NC 27695-8113, United States;2. Department of Management, Ca’ Foscari University, Cannaregio 873, 30121 Venice, Italy;1. School of Business, University of Connecticut, 2100 Hillside Rd., Unit 1041A, Storrs, CT 06269, United States;2. College of Business, Colorado State University, 501 W. Laurel St., Fort Collins, CO 80523, United States;1. University of Colorado Denver, 1475 Lawrence Street, Denver, CO 80202, USA;2. Bentley University, 175 Forest Street, Waltham, MA 02452, USA;3. Northeastern University, 404 Hayden Hall, 360 Huntington Avenue, Boston, MA 02115, USA;1. Tampere University, Faculty of Management and Business, 33014 Tampere, Finland;2. University of Vaasa, P.O. Box 700, 65101 Vaasa, Finland;3. The University of Auckland Business School, 12 Grafton Road, Auckland, Private Bag 92019, Auckland 1142, New Zealand |
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| Abstract: | To protect investors, regulators increasingly rely on regulating firms’ internal controls over financial reporting, but they punish noncompliance only if an internal control weakness enabled accounting manipulation. In other words, enforcement is manipulation-contingent. We develop an economic model with a manager who sequentially chooses internal control quality and manipulative effort, and a welfare-maximizing regulator who determines an internal control standard, the penalty size for internal control weaknesses, and when to invoke such a penalty. Internal control regulation under manipulation-contingent enforcement not only provides incentives to invest in internal controls, but also improves manipulation deterrence when there are internal control weaknesses. The optimal regulation takes advantage of this additional deterrence effect by using a very strict internal control standard and an intermediate penalty that is only levied in the event of accounting manipulation. Overall, we rationalize why the commitment to lenient enforcement of internal control regulation is optimal. |
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| Keywords: | Accounting manipulation Internal controls Enforcement Internal control regulation D60 M41 M48 K42 |
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