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The overall and differential effect of the Sarbanes-Oxley act on US publicly traded companies
| Content Provider | Semantic Scholar |
|---|---|
| Author | Wong, May |
| Copyright Year | 2007 |
| Abstract | The Sarbanes-Oxley Act was enacted in July 2002 in response to major accounting scandals. This thesis investigates the announcement effects surrounding the passage of SOX to examine the differential impact of SOX on U.S. publicly traded companies. As the Act requires greater transparency of financial reporting and imposes burden on managers through mandatory CEO/CFO certification of financial statements, the associated compliance costs create a significant loss in total market value that amounts to $1.4 trillion (Zhang 2005). It is predicted that SOX has a disproportionate negative impact on small firms due to the fixed cost component of the compliance costs and the characteristics of small firms (i.e. they compete on flexibility but SOX limits it). Previous studies show that the imposed compliance costs lead to a significant number of firms going dark or private in the post-SOX period, which suggests that the imposed compliance costs outweigh the induced benefits of SOX to shareholders (Engel 2004). While past studies have been done to examine the effect of SOX on public firms in general, this thesis is specifically interested in how different firm sizes react differentially to the events leading the passage of SOX. Through the event study methodology, the event day effect on stock returns and abnormal returns will be examined to see if the market also perceives the Act to have a negative impact on firms. I. BACKGROUND With the high-profile corporate corruptions in the U.S. in 2001-2002, the Congress swiftly enacted the Sarbanes-Oxley Act (the Act or SOX hereafter) to improve the accuracy and reliability of financial reporting. SOX creates a regulatory body to oversee the accounting industry and imposes numerous significant and potentially far-reaching reforms in public company governance and disclosure requirements. The confluence of surrounding events, including the plummeting stock markets, approaching elections, and the summer recess, created a charged political environment that put tremendous pressure on Congress and the President to pass the legislation (Zhang 2005). The complexity of the Act and the lightning speed of its passage raise questions on its economic consequences on U.S. publicly traded firms and its purpose in restoring investors’ confidence. SOX is one of the most sweeping revisions of the federal securities laws in the last 60 years. When President Bush signed the Act into law, he described it as “the most far-reaching reforms of American business practices since the time of Franklin Delano Roosevelt.” (White House Corporate Accountability Reform) Unlike previous federal regulations that are mainly concerned with disclosure requirements, SOX has a number of major provisions that are actual mandates. They introduce significant changes in both management’s reporting responsibilities and the scope of the responsibilities of the auditor. The Public Company Accounting Oversight Board (PCAOB) that SOX creates requires external auditors to submit opinions on manager’s assessments as well as their own evaluation of control effectiveness (Li 2006). Other responsibilities of PCAOB include registering public accounting firms, establishing standards related to preparation of audit reports to issuers, and overseeing public accounting firms. SOX includes other major provisions that prohibit auditors from performing non-audit services for their audit clients, call for audit committee independence, require executive certification concerning the quality of internal controls, and prohibit corporations from extending credit to executives. Among these provisions, Section 404 of the Act is considered the most costly provision to corporations. Section 404 imposes an extensive obligation on managers to assess the quality and effectiveness of internal controls (Butler et al. 2006). While these provisions improve corporate governance and enhance the quality of financial reporting, they also promote audit effectiveness by regulating the potential conflict of interest between auditors, legal counsel, and analysts, and increasing the criminal and civil liability for violations of securities laws. (For further details of SOX provisions, please refer to Appendix II.) Given the extensive provisions of SOX, the Act affects social costs in a two-fold manner. SOX is socially beneficial to investors by protecting investors and increasing investors’ confidence. By minimizing accounting frauds, SOX shields investors from potential investment risks due to corporate frauds. As the Act increases transparency of financial reporting, it also prevents investors from making ill-informed investment decisions due to the accounting manipulations of firms. However, SOX increases social costs by restricting companies from making changes. As explained further in the next few paragraphs, SOX provisions may increase social costs by discouraging acquisitions of smaller firms by larger firms. Firms often want to avoid the lengthy work of reevaluating their internal controls as required by the executive certification provision, so they may give up the opportunities for new acquisitions or other significant changes that would affect their internal controls. As a result, companies would rather stay safe and avoid implementing new ideas. Although SOX is claimed to restore investors’ confidence, the associated direct compliance costs may also outweigh the stated benefits. As SOX requires deeper oversight of financial reporting, it changes managements’ reporting responsibilities and imposes more stringent responsibilities on the auditor. According to the SEC’s initial estimate, implementing Section 404 “would impose an additional 5 burden hours (equivalent to $375) per issuer in connection with each quarterly and annual report.” (Butler et al. 2006) This estimate was later revised to around $91,000 per company, not including “additional cost burdens that a company will incur as a result of having to obtain an auditor’s attestation.” (Butler et al. 2006) Nonetheless, SEC’s revised cost estimate was far lower than the estimated compliance costs computed by Financial Executives International (FEI) and AMR Research. While FEI surveyed 224 public companies and estimated that the first year compliance cost would increase 53% to $3 million, AMR Research estimated that companies will spend $6 billion to comply with SOX in 2006 (Butler et al. 2006). The likelihood that the compliance costs of SOX outweigh its benefits is again asserted by an August 2003 survey of executives by CFO Magazine. This survey indicates that 70% of the respondents did not believe that the benefits of complying with SOX justify with its costs (Zhang 2005). The SOX provisions concerning internal control place a disproportionately negative burden on small firms. Small firms have higher overhead costs per unit of capitalization compare with large firms. These firms often compete through flexibility – the ability to change business plans rapidly to meet customer needs. SOX may have a disproportionately negative impact on small firms by imposing stringent and inflexible rules and increasing overhead costs. For instance, one study found that the provision regarding audit committee independence imposes an increased cost from $5.91 to $9.76 to independent directors per $1,000 in sales after SOX for small firms, while it only imposes an increased cost from $0.13 to $0.15 per $1,000 in sales for large firms (Butler et al. 2006). Small firms may also be disproportionately affected, because they tend to have a larger portion of non-independent board members. As a result, they need to make more changes to internal control in order to comply with the new rules (Butler et al. |
| File Format | PDF HTM / HTML |
| Alternate Webpage(s) | https://ecommons.cornell.edu/bitstream/handle/1813/8167/May%20Wong%20Honors%20Thesis%20May%202007.pdf?isAllowed=y&sequence=2 |
| Language | English |
| Access Restriction | Open |
| Content Type | Text |
| Resource Type | Article |
