The Effects of Internal Control Reporting Regulation on Control Quality, Compensation and Audit Effort

Abstract

The new internal control reporting (ICR) requirements under the Sarbanes-Oxley Act of 2002 (SOX) imposed affirmative duties on managers and auditors to evaluate and attest to the effectiveness of internal controls and disclose any control weaknesses. This paper studies the role of ICR regulation in enhancing incentives for internal control quality and audit effort which jointly alleviate accounting manipulation. I formulate a model that emphasizes the strategic interaction between internal control and external audit in detecting accounting manipulation as well as the stewardship and valuation roles of accounting information in financial reporting. I show how and why the ICR regulation enhances incentives for internal control quality and audit effort, and make predictions regarding the regulatory effects on the audit failure rate, manager's expected compensation, audit fee and current owner's expected payoff.