Accounting Manipulation, Peer Pressure, And Internal Control

Pingyang Gao
University of Chicago – Booth School of Business

Gaoqing Zhang
University of Minnesota

April 20, 2016

Abstract:

We study firms’ investment in internal control to reduce accounting manipulation. We first show the peer pressure for manipulation: one manager manipulates more if he suspects reports of peer firms are more likely to be manipulated. As a result, one firm’s investment in internal control has a positive externality on peer firms. It reduces its own manager’s manipulation, which in turn mitigates the manipulation pressure on managers in peer firms. Firms don’t internalize this positive externality and thus under-invest in their internal control over financial reporting. The under-investment problem provides one justification for regulatory intervention in firms’ internal control choices.

Accounting Manipulation, Peer Pressure, And Internal Control – Introduction

The wave of accounting frauds and restatements in early 2000 (e.g., Enron, WorldCom) have exposed the staggering failure of internal control over financial reporting in many firms (GAO (2002)). Until then a firm’s internal control decisions had long been deemed as its private domain and outside the purview of the securities regulations that had traditionally focused mainly on disclosure of those decisions (Ribstein (2002), Coates (2007)). However, the prevalence and magnitude of the internal control failures eroded the support for such practice and eventually led to the Sarbanes’ Oxley Act of 2002 (SOX) in United States and similar legislatures in other countries. In addition to the enhanced disclosure requirements SOX has also mandated substantive measures to deter and detect accounting frauds1. Their mandatory nature has made these measures controversial (e.g., Romano (2005), Hart (2009)). Even for those who felt that something had to be done with the firms’ internal control over financial reporting, it may not be clear why it should be done through regulations. Is there a case for regulation that intervenes in firms’ internal control decisions? Why don’t firms have right incentives to choose the optimal level of internal control to assure the veracity of their financial statements? In fact, Romano (2005), in an influential critique of SOX, argues that “The central policy recommendation of this Article is that the corporate governance provisions of SOX should be stripped of their mandatory force and rendered optional for registrants.”

We construct a model to study firms’ investment in internal control over financial reporting. In the model firms can invest in costly internal control to detect and deter its manager’s accounting manipulation. We show that such investment by one firm has a positive externality on its peers. At the core of the channel for this externality is the peer pressure for accounting manipulation among firms: one manager’s incentive to manipulate is increasing in his expectation that reports from peer firms are manipulated. As a result, a firm’s invest- ment in internal control reduces its own manager’s manipulation, which, in turn, mitigates the pressure for manipulation on managers in peer firms. Since the firm doesn’t internalize this externality, it under-invests in the internal control over financial reporting. Regulatory interventions can improve the value of all firms by mandating a floor of internal control investment for all firms.

In our model, there are two firms with correlated fundamentals, indexed by A and B. Each manager’s payoff is a weighted average of the current stock price and the fundamental value of his own firm. Investors rely on accounting reports to set stock prices. Accounting manipulation boosts accounting reports and allows the bad manager with successful manipulation to be pooled with the truly good ones. Investors rationally conjecture this pooling result and discount the pool accordingly to break even. In the equilibrium, the bad manager with successful manipulation receives an inflated stock price at the expense of the truly good manager. Accounting manipulation is detrimental to firm value and firms do have private incentives to invest in their internal control over financial reporting.

In such a setting peer pressure for accounting manipulation arises. By peer pressure we mean that one manager manipulates more if he expects that the other firm’s report is more likely to be manipulated in equilibrium. In other words, the two managers’ manipulation decisions are strategic complements in the sense of Bulow, Geanakoplos, and Klemperer (1985). The mechanism works as follows. Consider manager A’s manipulation decision. Rational investors utilize reports from both firms in setting the stock price of firm A due to their correlated fundamentals. Investors compare report A with report B to distinguish between the truly good firm A and the bad firm with successful manipulation. Manipulation of report B reduces its informativeness and makes it less useful for investors of firm A to cull out the bad one with successful manipulation. Anticipating that his fraudulent report is less likely to be confronted by report B, manager A expects a higher benefit from manipulation and thus increases his manipulation. The manipulation of report B creates a “pressure” on manager A to manipulate because the opportunity cost for manager A not to manipulate is higher.

Accounting Manipulation

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