The Sarbanes-Oxley Act was passed by the U.S. Congress in 2002, following financial reporting disasters of Enron Corp. and WorldCom Inc. (see Section1.

2). Section 404 of the act requires that senior management and an independent auditor certify the proper operation of a public company's controls over financial reporting. Undoubtedly, Sarbanes-Oxley has benefited investors and contributed to restoration of investor confidence in capital markets, since it reduces investors estimation risk that investment values will not suddenly disappear due, for example, to opportunistic manager behaviour covered up for a time by misleading financial reporting However, Section 404 has drawn increasing criticism from companies, due to the costs of implementing the section. These costs have been estimated to average as high as $4.36 million U.S. per firm for 2004, and up to $10 million for very large firms. Section 404 is particularly onerous for small companies since the costs of establishing, evaluating, and auditing internal controls over financial reporting contain a significant fixed cost component-they do not decrease in proportion to lower firm size. Also, United States Treasury Secretary Henry Paulson, in a November 2006 speech, stated that excessive regulation stifles innovation, and that a significant portion of management time, energy, and expense devoted to Section 404 might have been better spent on more direct business matters.

Furthermore, it appears that U. S. capital markets are losing market share to foreign capital markets such as those in London and Hong Kong. Foreign firms that had been previously attracted to listing their shares on U.S. capital markets, because of the availability of large amounts of capital and a share price premium due to lower investor estimation risk on well-regulated markets, are going elsewhere in increasing numbers.

These concerns led to the creation in the United States of the Committee on Capital Markets Regulation, an independent panel of business and academic leaders. The Committee's first report, issued in December 2006, identified reasons for lower market share. These included foreign companies fear of lawsuits, perceived overzealous regula- tion by agencies such as the SEC, and costs imposed by Section 404 of Sarbanes-Oxley. Among the Committee's recommendations were easing of Section 404 and measures to reduce the number of prosecutions and lawsuits. Also, foreign companies should be exempt from some Sarbanes-Oxley requirements if they meet similar regulations in their home countries.

In 2007, the SEC announced some relaxation of Section404.

Managers were given some flexibility to identify and test only the most critical financial reporting risks, and the audit requirements were reduced In Canada, NI 52-109 of the CSA proposes similar requirements to Section 404, but. does not require auditor certification.

 Required

a. Certifying the adequacy of companies controls over their financial reporting is a form of information production. It is difficult for a regulator to determine the socially correct amount of information to require. What is the socially correct amount of information? Did Section 404 of the Sarbanes-Oxley Act require too much information production or too little? In your answer, consider both the costs and the benefits of Section 404

b. The Committee report criticized the SEC, recommending that it should adopt a principles-based approach, focused on establishing general rules of behavior for capital market participants and monitoring the operation of these rules to ensure they were accomplishing their desired effect of protecting investors (this is somewhat ironic since the SEC has urged accounting standard setters to become more principles based-see Section13.

4). The Committee felt that the SEC was too rules-oriented- issuing too many detailed rules and regulations, the enforcement of which sidetracked it into securing settlements and convictions for violations with relatively little attention: to whether the rules and regulations were cost effective in improving the operation of capital markets Is a principles-based approach to regulation of financial accounting and reporting feasible in the complex environment in which securities commissions, auditors, and accountants operate? Justify your answer