The effects of internal control reporting regulation on Control Quality, Compensation and Audit Quality

Abstract

This paper analyzes the economic consequences of the new internal control reporting (ICR) requirements imposed by Sections 302 and 404 of the Sarbanes-Oxley Act of 2002 (SOX). I formulate a model that emphasizes the strategic interaction between internal control and external audit in detecting accounting manipulation as well as the multiple roles of accounting information in financial reporting. In the model, the audited financial report serves both valuation (in which potential investors use the report to assess a firm's expected future payoff) and stewardship (in which the current owner of the firm relies on the same report to monitor and incentivize the manager) roles, but might be misstated by the manager if the firm's internal control system is weak and the fraudulent act is not detected by the external auditor. The firm's unobservable investment in the quality of its internal control determines the probability that the actual internal control system is weak. The ability to override weak internal controls and hence misstate the audited financial report, which reflects the performance of the manager, will dampen the manager's incentive to exert effort that improves the value of the firm. Thus, lower internal control quality, if not rectified by higher external audit quality, will result in a loss of contract efficiency. A misstated audited financial report, however, allows the current owner of the firm to sell the firm's shares to outside investors at an inflated price. The external auditor chooses the optimal audit effort to minimize the sum of the cost of auditing and the expected legal cost arising from a possible audit failure. Anticipating how the external auditor will react to his/her choice, the current owner of the firm chooses a quality of internal control to tradeoff the valuation and stewardship values derived from the accounting information. This paper studies how this tradeoff is affected by the new ICR requirements under SOX that impose affirmative duties on managers and auditors to evaluate and attest to the effectiveness of internal controls and disclose any control weaknesses. I make predictions regarding the effects on a firm's choices of compensation policy and internal control quality as well as its external auditor's choice of audit effort; all these elements being important determinants of the accuracy of the firm's accounting information. Comparative static results are also provided to investigate how the above equilibrium variables are influenced by exogenous changes in the diverging financial reporting incentives, the auditor's legal penalty and the severity of the agency problem.