Economic Incentives for Voluntary Reporting on Internal Risk Management and Control Systems

Abstract

This paper investigates managers' economic incentives for voluntary reporting on risk management and internal control using a sample of publicly traded firms in The Netherlands in the late 1990s. In this particular setting, internal control reporting was voluntary and covered a wide business-based approach as defined in key internal control frameworks. We create an index to measure the extent of disclosure by identifying six reportable items related to internal control. Regarding managers' incentives to report, we hypothesize that voluntary disclosure increases with the extent of information and agency problems, as proxied by management and block holder ownership and financial leverage. Supporting our hypotheses, we find a negative relationship between the extent of internal control disclosure and management and block holder ownership, and positive relationship between the extent of disclosure and financial leverage. We interpret these findings as evidence for a conscious trade-off by managers, which is linked to the costs and benefits of making internal control disclosures. Additionally, we find some evidence that the extent of disclosure varies with firms' inherent risk exposure, as proxied by a number of firm operating characteristics. One implication of our findings is that regulators may wish to allow firms flexibility in their internal control reporting choice, as firms take a broad approach to internal control that goes beyond SOX-based regulations, and tailor their internal control reports to suit their specific environments.