Research

The Interactive Effects of Internal Control Audits and Manager Legal Liability on Managers’Internal Controls Decisions, Investor Confidence, and Market Prices

Authors

Published

Contemporary Accounting Research, December 2013

Abstract

An underlying objective of accounting regulation is to foster investor confidence by promoting reliable financial information. Related to this objective, recent regulatory actions simultaneously increased managements’ legal liability for internal controls over financial reporting (ICFR) and mandated internal control audits (IC Audits). Differing views persist regarding whether IC Audits incrementally improve the reliability of financial information, and in turn investor confidence, particularly in the presence of manager liability. Our study informs this debate by investigating the individual and joint effects of these two regulatory mechanisms on investor and manager behavior. Using a laboratory experiment, we examine the effects of manager liability and IC Audits on market prices and its antecedents: managers’ IC spending, managers’ ICFR disclosure, and investor confidence. Results from experimental markets suggest that investors’ reactions do not mirror managers’ actions because investors operate in a different decision context, one with substantially more ambiguity. We find that manager liability and IC Audits independently motivate managers to improve the reliability of financial statements by spending on IC. Furthermore, IC Audits improve the accuracy of managers’ disclosures whereas manager liability does not. In contrast, results for investor confidence and market prices suggest that investors do not behave as though these two regulatory mechanisms are independent but rather as substitutes for one another. Our results are important to policymakers as they demonstrate the need to consider the differing effects of regulation on managers and investors. Further, from an efficiency standpoint, our results suggest that both IC Audits and manager liability may not be necessary to improve investors’ confidence, and in turn market prices.

Yi-Jing Wu