Optimal Internal Control Regulation: Standards, Penalties, and Leniency in Enforcement

34 Pages Posted: 12 Feb 2018 Last revised: 13 Jun 2023

See all articles by Stefan Schantl

Stefan Schantl

The University of Melbourne - Department of Accounting

Alfred Wagenhofer

University of Graz

Date Written: September 25, 2020

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.

Keywords: internal controls; compliance; enforcement; regulation; accounting manipulation

JEL Classification: D60, M41, M48

Suggested Citation

Schantl, Stefan and Wagenhofer, Alfred, Optimal Internal Control Regulation: Standards, Penalties, and Leniency in Enforcement (September 25, 2020). Journal of Accounting and Public Policy, Vol. 40, No. 3, 2021, Available at SSRN: https://ssrn.com/abstract=3117980 or http://dx.doi.org/10.2139/ssrn.3117980

Stefan Schantl

The University of Melbourne - Department of Accounting ( email )

Victoria
Melbourne, Victoria 3010 3010
Australia

HOME PAGE: http://sites.google.com/view/stefan-f-schantl

Alfred Wagenhofer (Contact Author)

University of Graz ( email )

Austria
+43 316 380 3500 (Phone)
+43 316 380 9565 (Fax)

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