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Does executive compensation incentivize managers to create effective internal control systems?

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  • Henry, Theresa F.
  • Shon, John J.
  • Weiss, Renee E.

Abstract

We examine the relation between CFO compensation and the effectiveness of internal control structures under SOX, Section 404. Given the growing evidence of an uncoupling of pay from performance, we conduct our analysis using a two-stage regression. In our first stage model, we decompose compensation into its fitted (i.e., explained by firms’ economic characteristics) and residual (i.e., unexplained) components. In our second stage model, we estimate a logit regression of internal control effectiveness on both the fitted and residual components of compensation. Overall, we find that internal control effectiveness is related to the fitted components of compensation, but unrelated to the residual components. These relations exist for aggregate compensation, as well as its individual components (i.e., salary, bonus, equity-based). Our findings suggest that fitted compensation increases the probability of effective internal controls. Conversely, residual compensation does not affect this probability, suggesting that it reflects pay without performance. Our findings inform regulators and standard setters of the often unforeseen costs of increased regulation.

Suggested Citation

  • Henry, Theresa F. & Shon, John J. & Weiss, Renee E., 2011. "Does executive compensation incentivize managers to create effective internal control systems?," Research in Accounting Regulation, Elsevier, vol. 23(1), pages 46-59.
    • Handle: RePEc:eee:reacre:v:23:y:2011:i:1:p:46-59
    DOI: 10.1016/j.racreg.2011.03.007
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    References listed on IDEAS

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    1. Kevin J. Murphy, 1986. "Incentives, Learning, and Compensation: A Theoretical and Empirical Investigation of Managerial Labor Contracts," RAND Journal of Economics, The RAND Corporation, vol. 17(1), pages 59-76, Spring.
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    Cited by:

    1. Kun Zhang & Yuanyuan Wang & Xuegang Cui & Hong Yue, 0. "Can the academic experience of senior leadership improve corporate internal control quality?," Asian Business & Management, Palgrave Macmillan, vol. 0, pages 1-30.
    2. Paula Faria & Franscisco Vitorino Martins & Elísio Brandão, 2013. "The level of CEO compensation for the short and long-term - a view on high-tech firms," FEP Working Papers 519, Universidade do Porto, Faculdade de Economia do Porto.
    3. Xu, Qiuhua & Deng, Li & Li, Sen & Huang, Wen, 2021. "Do hometown connections affect corporate governance? Evidence from Chinese Listed Companies," International Review of Economics & Finance, Elsevier, vol. 73(C), pages 290-302.
    4. Kun Zhang & Yuanyuan Wang & Xuegang Cui & Hong Yue, 2022. "Can the academic experience of senior leadership improve corporate internal control quality?," Asian Business & Management, Palgrave Macmillan, vol. 21(2), pages 231-260, April.

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