We argue on theoretical grounds that obligatory compliance with stricter financial reporting rules (e.g., the US Sarbanes-Oxley Act) may entail important unintended consequences. Paradoxically, the amount of misreporting may increase because corporate boards spend more valuable resources fulfilling statutory mandates rather than involving themselves in forward-looking strategy setting. As these surveillance devices are substitute methods of gauging management quality, when boards focus on the firm's internal control and accounting system they become semi-detached from strategy - their business acumen falters. Top executives are then judged primarily on the basis of financial metrics as opposed to long-term fit. Since the balance sheet review carries more weight in the board's decision-making process, the return to managerial book-cooking (a purely "influence" activity) and the risk of endorsing flawed business plans swell. This confirms a burgeoning sentiment among business leaders and scholars that boards should perhaps pay less rather than more heed to codified, verifiable 'good' governance principles.
Financial Markets Group Discussion Papers DP 559