How Does Disclosure of Internal Control Quality Affect Management's Choice of that Quality
49 Pages Posted: 10 Jan 2006
Date Written: April 5, 2006
We utilize a single period model to investigate the tradeoffs that management might make when faced with the necessity of disclosing the quality of the internal control over financial reporting (henceforth ICOFR) and the outcomes that would result from such tradeoffs.
Our analysis indicates that requiring reporting on internal control effectiveness can lead to higher control quality if management's performance-related compensation is dominated by stock options. However, if management's performance-related compensation is mainly in the form of cash bonuses, then the required disclosure leads to lower control quality. Attempts by management to bias reported information can reduce internal control quality when internal control quality is not disclosed, but have no impact on control quality when internal control is disclosed.
Keywords: Internal control quality, internal control disclosure, management's compensation
JEL Classification: M4
Suggested Citation: Suggested Citation