On the Economics and Optimal Design of Internal Control Regulation

37 Pages Posted: 12 Feb 2018 Last revised: 30 Jul 2019

See all articles by Stefan Schantl

Stefan Schantl

The University of Melbourne - Department of Accounting

Alfred Wagenhofer

University of Graz

Date Written: July 29, 2019

Abstract

In their mission to protect investors, regulators increasingly rely on regulation of firms’ internal controls (ICs) over financial reporting. We examine when this is desirable and how tight the IC standard should be set conditional on the strength of the enforcement regime. In our model an owner-manager can manipulate the financial report, which induces investors to overinvest in the firm. The manager can choose to establish ICs to mitigate overreporting. Without regulation, the manager underinvests in ICs in equilibrium as long as IC effectiveness is not perfectly observable. IC regulation with sufficiently strong enforcement can provide incentives for the manager to establish ICs. The optimal IC standard trades off IC underinvestment incentives, IC costs, and regulatory exposure to penalties. We find that no investment, low or the socially optimal investment can result depending on IC tightness and penalty size. IC standard tightness and penalty size are complements for low penalties and substitutes for high penalties. We also show that deterrence (IC underinvestment incentives) is strongest (weakest) for intermediate penalties.

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

JEL Classification: D60, M41, M48

Suggested Citation

Schantl, Stefan and Wagenhofer, Alfred, On the Economics and Optimal Design of Internal Control Regulation (July 29, 2019). 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://https://findanexpert.unimelb.edu.au/display/person761836

Alfred Wagenhofer (Contact Author)

University of Graz ( email )

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

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