Last year I raised the question: Is Sarbanes-Oxley choking innovation?. The fundamental issue here is whether SOX is encouraging inaction over action and paralysis by analysis.

Added to this debate is a new paper Innovation and Corporate Governance:
The Impact of Sarbanes-Oxley by Houman B Shadab .

Shadab makes the excellent point that innovative companies are highly decentralized and have systems in place that induce managers to overcome myopia and get into long-term, risky and knowledge-intensive activities that result in new goods, services and methods of production. The trouble with Sarbanes-Oxley, however is that it undermines this by increasing the objective monitoring of managers. There is also a problem with the way companies have to report and account for their numbers, he says.

"Innovation and related activities exhibit the same characteristics identified by the SEC and others as contributing to the risk of financial misstatements," Shadab writes. "Because innovation requires that management has substantial discretion to focus
on long-term activities not easily measurable in the short term, it necessarily involves transactions where managers can potentially manipulate financial data or entrepreneurship also tend to be higher risk activities that rely upon managers' subjective judgment regarding the potential value of hard-to-quantify assets and opportunities.

"Accordingly, subjective judgment may be required to properly implement controls for such transactions. Furthermore, because many of the activities involved in innovation are interdependent, changing controls over one activity may impact controls over another. Finally, innovation activities may involve nonroutine and unusual transactions, and properly accounting for innovation activities inherently runs the risk of capitalizing the value of intangible assets (i.e., ideas) before a new product is commercially feasible.

"Innovation activities are thus relatively high sources of financial reporting risk, and are therefore a more costly component of management's assessment of internal control under Section 404."

He says it also reduces flexibility by increasing the the involvement of managers, whose job it otherwise is to run the company, in the financial reporting aspects of the business. And it also creates bigger boards when smaller, and relatively less independent boards facilitate innovation.

This does not mean that companies complying with SOX won't innovate. It will just get harder, he says.

"Public companies complying with SOX will undoubtedly continue to innovate and grow, and likely even at a record pace in absolute terms. However, the foregone benefits from SOX reducing the innovative potential of public companies are likely to increase because the importance of innovation seems to be increasing."