Accepted by Rick Antle. The author would like to thank Bruce Miller, David Finley, Susanne Lohmann, Cheong Yi, and two anonymous referees for their invaluable help. The University of California at Los Angeles and Stanford University provided financial support. All remaining errors are the author's sole responsibility.
Designing Internal Controls: The Interaction between Efficiency Wages and Monitoring*
Article first published online: 20 APR 2010
1997 Canadian Academic Accounting Association
Contemporary Accounting Research
Volume 14, Issue 1, pages 129–163, Spring 1997
How to Cite
HANSEN, S. C. (1997), Designing Internal Controls: The Interaction between Efficiency Wages and Monitoring. Contemporary Accounting Research, 14: 129–163. doi: 10.1111/j.1911-3846.1997.tb00522.x
- Issue published online: 20 APR 2010
- Article first published online: 20 APR 2010
Abstract. I examine how an internal auditor, called the firm, designs a control system for a strategic employee who conditions his thefts on the amount and types of controls. Society sets minimum testing amounts and fines for detected theft, whereas the firm determines the employee's wages and the amount of monitoring above the minimum. The results fall into three separate cases. When society's minimum testing standards and fines are sufficiently high, the employee never steals in any period. In this case, the firm performs the minimum amount of testing and pays the lowest feasible wage. In the remaining two cases, the testing standard and fines are too low to prevent theft by themselves. In these two cases the firm's control system determines whether there will be theft in the first period. I show that if the firm chooses to prevent all first-period theft, then it uses only one type of control. She offers a wage premium and monitors the minimum amount. The wage premium substitutes for a tine large enough to prevent all theft. If the firm designs controls that do not prevent all theft, then the firm also uses only one control. In contrast to the no-theft case, the firm pays the lowest feasible wage and monitors above the minimum. This choice reflects the increasing returns to scale of monitoring in preventing theft.