Internal Control Reporting Regulation: A Law and Economics Perspective

Abstract

The Sarbanes-Oxley Act (SOX) was enacted in 2002 in response to the collapse of several previously highly regarded firms, including Enron and Worldcom. The goal of SOX was to increase investor confidence in financial markets. However, there has been much debate about whether the costs of compliance with SOX outweigh the benefits it produces, particularly with respect to its internal control reporting (ICR) requirements under section 404. After a brief introduction in Part I, Part II of the paper discusses the Coase Theorem, which posits that economic regulation serves no purpose in the absence of transaction costs. The Coase framework is then applied to financial markets in the abstract and it is explained how ICR regulation can, in fact, expand total output. Part III then analyzes the efficacy of the various ICR regulations, both pre- and post-SOX, and determines that Section 404 of SOX is an example of over-regulation. The paper then closes by explaining how the lessons learned from SOX's shortcomings and Section 404 in particular are relatable to our current economic crisis.