| Policymakers advocate that effective internal controls are paramount to generating reliable financial statements, and thus, required to improve investor confidence. In order to motivate managers to improve internal controls, the Sarbanes-Oxley Act of 2002 (SOX) extends managers' personal legal liability to include internal control disclosures. In addition, SOX and related PCAOB standards also require that external auditors issue an opinion on the effectiveness of a firm's internal controls over financial reporting. Some argue that in the presence of increased managers' legal liability, the mandatory external audit of internal controls implemented by SOX is not cost effective. Using laboratory experiments, this study investigates the effects of managers' personal legal liability and external audits of internal controls on (1) managers' internal control spending and disclosures, and (2) investors' confidence in managers' reported earnings and required risk premium. Results suggest that these regulatory mechanisms motivate managers to improve internal controls, improve investor confidence, and reduce investors' required risk premium. Also, results indicate that the combination of manager liability and an internal control audit is additive with respect to the amount managers spent on improving internal controls. However, with respect to investor confidence and required risk premium, results suggest that these two regulatory mechanisms are substitute. |
