We study firms’ investment in internal controls to reduce accounting manipulation. We first show that peer managers’ manipulation decisions are strategic complements: one manager manipulates more if he believes that reports of peer firms are more likely to be manipulated. As a result, one firm’s investment in internal controls has a positive externality on peer firms. It reduces its own manager’s manipulation, which, in turn, mitigates the manipulation pressure on managers at peer firms. Firms do not internalize this positive externality and, thus, underinvest in their internal controls over financial reporting. The problem of underinvestment provides one justification for regulatory intervention in firms’ internal controls choices.
Bibliographical noteFunding Information:
We are grateful for comments from Roland Benabou, Qi Chen (discussant), Phil Dybvig, Jonathan Glover, Pierre Liang, Zhiguo He, Mirko Heinle, Steven Huddart, Tsahi Versano, Baohua Xin (discussant), and participants of workshops at The Hong Kong University of Science and Technology, The University of Chicago, The University of Texas at Dallas, Southwest University of Finance and Economics in China, the 2016 Purdue Accounting Theory Conference, 2016 Midwest Accounting Research Conference at The Pennsylvania State University, 2016 Conference on Financial Economics and Accounting (CFEA) at University of Toronto, 2016 National Taiwan University Accounting Symposium, 2017 New York University Summer Camp, and Tsinghua University. We also thank Jinzhi Lu for able research assistance. All errors are our own. We also acknowledge the generous financial support from The University of Chicago Booth School of Business, University of Minnesota Carlson School of Management, and National Nature Science Foundation of China (project 71620107005, ‘‘Research of Capital Market Trading System and Stability’’).
- Accounting manipulation
- Internal controls
- Peer pressure