“Optimal internal control regulation: Standards, penalties, and leniency in enforcement”

In this article, published in May 2021 in the “Journal of Accounting and Public Policy” (JAPP), CAR’s Wagenhofer and former DART student Stefan Schantl (University of Melbourne) investigate how regulators increasingly rely on regulating firms’ internal controls (IC) over financial reporting to protect investors, but punish noncompliance only if an IC weakness enabled accounting manipulation. They develop an economic model with a manager who sequentially chooses IC quality and manipulative effort, and a welfaremaximizing regulator who determines an IC standard, the penalty size for IC weaknesses, and when to invoke such a penalty. IC regulation under manipulationcontingent enforcement not only provides incentives to invest in IC, but also improves manipulation deterrence when there are IC weaknesses. The optimal regulation takes advantage of this additional deterrence effect by using a very strict IC standard and an intermediate penalty that is only levied in the event of accounting manipulation. Overall, they rationalize why the commitment to lenient enforcement of IC regulation is optimal.