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 40 4 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.