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.
Publication Date
Financial Markets Group Discussion Papers DP 559
