The Dark Side of 'Good' Corporate Governance: Compliance-Fuelled Book-Cooking Activities

Abstract:     
We argue 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. As 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.

Keywords: Corporate Governance, Earnings Manipulation, Auditing, Misreporting

JEL Classifications: D23, G34, G38, K20, M21, M41, M43

Working Paper Series