Internal control reporting regulation: a law and economics perspective

Abstract

Purpose

The purpose of this paper is to analyze the efficiency of the internal control reporting (ICR) requirements imposed by Sections 302 and 404 of the Sarbanes‐Oxley Act of 2002 (SOX). The lessons learned are then applied to the current financial crisis.

Design/methodology/approach

The Coase Theorem is applied to the events leading up to the collapse of Enron and the enactment of SOX. The paper then analyzes the efficacy of the various examples of ICR regulation, both pre‐ and post‐SOX, noting the ways in which they effectively mitigate transaction costs and the ways in which they over‐regulate.

Findings

US investors continue to invest in foreign markets despite the fact that those markets maintain less demanding ICR requirements than those required by Section 404. Moreover, investors do not respond negatively to Section 404 disclosures. The research demonstrates that Section 404 does not provide useful information in the minds of investors. Considering Section 404's ineffectiveness and the burdensome costs it imposes on reporting companies, it is clear that Section 404 is an example of over‐regulation and should be repealed.

Practical implications

The transaction costs that caused the collapse of Enron and the enactment of SOX bear strong similarities to those causing the more recent subprime mortgage crisis. The lessons learned from the enactment of SOX Section 404 are directly applicable to the current financial crisis and should be noted moving forward.

Originality/value

By utilizing a law and economics perspective, the paper more clearly demonstrates how Section 404 is an example of over‐regulation and draws links to the current economic crisis.

Citation

Zolnor, M.A. (2009), "Internal control reporting regulation: a law and economics perspective", Journal of Investment Compliance, Vol. 10 No. 2, pp. 54-66. https://doi.org/10.1108/15285810910971300