The Impact Of Performance-Based CEO And CFO Compensation On Internal Control Quality

Abstract

We examine the effects of compensation on the quality of internal control and provide the first evidence relating the time horizon of ex ante performance-based compensation incentives and internal control quality over financial reporting in the SOX 404 era. Specifically, we find that for CEOs and CFOs, the sensitivity of the option portfolio to stock price changes and the proportion of compensation received from long-term incentive plans are related to the propensity to report internal control weaknesses during the period 2004-2006. These effects are negative for long-term incentives but positive or insignificant for short-term incentives for both CEOs and CFOs, who have the primary responsibility for the financial reporting process. Compensation sensitivity is also more strongly related to more severe company-level than account-specific control weaknesses. This company-level weakness relation is stronger for the CFO, who has the primary responsibility for the processes generating financial information and for the financial reporting by the firm. Our findings indicate that SOX disclosures harness the power of compensation schemes to improve internal control quality.