“Optimal Internal Control Regulation” by Dr. Stefan Schantl
Dr. Stefan Schantl
Department of Accounting
The University of Melbourne
Regulators increasingly rely on regulation of firms’ internal controls (IC) to prevent accounting fraud. This paper considers a welfare-maximizing regulator’s task to set the optimal tightness of an IC standard. We study an economy with strategic and compliant owners who sell their firms to investors who then make investment decisions based on the financial report. We show that IC standard tightness and the cost of non-compliance are complements if the cost is below a threshold and are substitutes if the cost becomes higher. The complementarity arises because a minimum non-compliance cost is necessary to induce strategic owners to invest in IC effectiveness. Once the non-compliance cost grows further, the optimal standard declines to avoid inducing too much costly investment in the IC system. The greater the proportion of strategic owners, the more effective is IC regulation and the higher is the welfare-maximizing IC standard.