On the Economics and Optimal Design of Internal Control Regulation
37 Pages Posted: 12 Feb 2018 Last revised: 30 Jul 2019
Date Written: July 29, 2019
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: Suggested Citation