Does Executive Compensation Incentivize Managers to Create Effective Internal Control Systems?
Posted: 7 May 2007 Last revised: 21 Oct 2008
Date Written: September 18, 2008
Using newly available data from accelerated filers of Section 404 of Sarbanes-Oxley, we examine the degree to which components of executive compensation are related to the effectiveness of firms' internal control systems. We estimate a two-stage regression to examine this possibility. In our first stage, we decompose compensation into its fitted (i.e., explained by firm's economic characteristics) and residual components. In our second stage, we estimate a logit regression of internal control effectiveness on the fitted and residual components of compensation. Overall, we find that internal control effectiveness is related to the fitted components of compensation, but unrelated to the residual components. These findings are consistent with (1) the explained portion of compensation providing managers with the incentives to exert effort towards producing effective internal controls, and (2) consistent with prior evidence, the unexplained portion may represent another form of "pay without performance.
Keywords: internal controls, executive compensation
JEL Classification: M41, G18, G28, G38, J30
Suggested Citation: Suggested Citation