Accounting Manipulation, Peer Pressure, and Internal Control∗

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 that 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 do not internalize this positive externality and thus underinvest in their internal control over financial reporting. The problem of underinvestment provides one justification for regulatory intervention in firms’internal control choices. JEL classification: G18, M41, M48, K22,