Sarbanes-Oxley Section 404: Effective Legislation or Expensive Window Dressing?

A Study on the (Lack of) Benefits from SOX 404 and Compulsory Internal Control Representations
Nicholas Hallman NJH8W9@mail.missouri.edu
Abstract: On July 30th, 2002, in response to an unprecedented wave of Wall Street scandals, the United States ushered in a new era of corporate regulation by passing the Sarbanes-Oxley Act (SOX). Despite almost unanimous support in Congress, SOX was met with resistance by many firms and investors who were wary of the significant costs involved. Although more than a decade has passed since SOX was signed into law, little consensus has been reached regarding the relative costs and benefits of the additional regulation. This is likely due in part to the uncanny speed with which the bill was passed. The nearly instantaneous action of the Congress left little or no time for the market to react to news of accounting fraud, much less to self-correct. Thus there is no counterfactual against which to measure the SOX effect. However, one particularly contentious and costly portion of SOX (section 404 concerning internal controls) was not enforced until nearly two years after SOX was initially passed. In this paper, I exploit the separate implementation of section 404 to provide evidence suggesting that the section has provided little or no discernible benefit in terms of earnings quality. On the contrary, I show that the time period in which 404 was implemented exhibits indications of reduced earnings quality. Keywords: Sarbanes-Oxley, SOX, Earnings quality, Internal controls

1. INTRODUCTION The years from 2000 through 2002 were strife with news of accounting fraud (these years will be referred to as the scandal period for the remainder of this paper). A partial list of notable companies involved includes: Waste Management, Xerox, Enron, Adelphia, AOL, Duke Energy, Freddie Mac, Kmart, Merrill Lynch, Nicor, Quest Communications, Sunbeam, Tyco International, and WorldCom. More than 1000 executives were criminally convicted, and billions of dollars were exchanged in settlements (Ball, 2009). Amid the ensuing public outcry, congress passed sweeping new regulation. That legislation, known as the Sarbanes-Oxley Act (SOX), was the largest increase in market regulation since the creation of the Securities and Exchange Commission in the 1930s (Ball, 2009). SOX has imposed significant costs on American firms. Referring to SOX in a 2003 speech, then Chairman of the SEC William Donaldson said These are landmark rules; they will require hard work and significant expenditure in the short run by corporations, but in the long term they will result in sounder processes and more reliable financial reporting (D'Aquila, 2004). There have been numerous attempts to measure exactly how significant the costs have been. When SOX was passed, Congress estimated that the additional compliance requirements would cost large US firms in excess of 4 million dollars and 15,000 man-hours to implement, an estimate that proved to be conservative (D'Aquila, 2004). One econometric study puts the total price tag of SOX at $1.4 trillion (Zhang, 2007). Whatever the amount, it is indisputable that the costs of SOX materialized in a very tangible way. It is less clear whether, and to what the extent, the reliability of financial reporting improved due to these additional costs. It may be impossible to completely disentangle all of the various costs and benefits of SOX. Legislative and natural market responses to the scandal period were contemporaneous and correlated in their effect, and parsing out their relative impacts is difficult at best. Moreover, it is impossible to know what additional action the market would have taken in the absence of legislation1. However, due to the significant effort required for implementation, enforcement of one section of SOX (section 404) was delayed until fiscal years ending on or after November 15th 2004 (D'Aquila, 2004). Section 404 is widely regarded as the most costly portion of SOX2, and thus its stand-alone benefit is an important question. Further, due to its delayed implementation, it is possible to evaluate its impact separately from the natural market reactions and other sections of SOX which primarily took effect in 2002. In this paper, I exploit the separate implementation of section 404 to provide evidence suggesting that the section has provided little or no discernible benefit in terms of earnings quality. On the contrary, I show that the time period in which 404 was implemented exhibits indications of reduced earnings quality. The remainder of this paper will proceed as follows: section 2 discusses prior research, section 3 develops the hypotheses, section 4 contains the empirical analysis, section 5 briefly discusses limitations of my analysis, and section 6 concludes.
1

For example, SOX included a section prohibiting auditing firms from providing many other types of services to their audit clients in order to limit perceived conflicts of interest. However, prior to the passing of SOX, 4 of the 5 largest audit firms in the United States had already announced that they would voluntarily cease providing such services to their audit clients (Ball, 2009). What other such measures would have been enacted by markets in the absence of legislation difficult to know. 2 Additional audit costs for large US firms increased by an average of $2.4M per firm, per year, due to SOX a cost which is directly attributable to section 404 (D'Aquila, 2004).

2. PRIOR RESAERCH As discussed above, several studies have attempted to measure the total costs of SOX and of section 404 in particular (Engel, Hayes, & Wang, 2007), (Zhang, 2007), (Carney, 2006), and (Alles, Kogan, & Vasarhelyi, 2004). Other research has studied the impact of SOX implementation on the cost of capital (Chang, Fernando, & Liao, 2009), on perceived earnings quality (Chang, Fernando, & Liao, 2009) and on the strength of internal controls and audit quality (Patterson & Smith, 2007), among other things. However, to my knowledge, the extent to which section 404 of SOX impacted actual earnings quality is an outstanding question. 3. HYPOTHESES DEVELOPMENT Below, I provide two reasons for skepticism of section 404s impact of reporting quality. The first addresses the incentives of those involved in crafting and passing the legislation. The second argues that if the requirements of 404 were effective and efficient they would have already been implemented voluntarily by the market. Building on economic theory originating with Stigler and Peltzman, Watts and Zimmerman (1986) argue that the politicians are incentivized to avoid being seen as responsible for investor losses, and that hasty legislation in the face of scandal is often an attempt to shift blame rather than to address any regulatory unbalance. This theory can be readily applied to the conditions under which SOX was passed. Less than nine months after Enron first announced it had misreported earnings in late 2001 (an event which many consider to be the epicenter of the scandal period), SOX had been written, passed by Congress, and signed into law by George W. Bush. In addition, Arthur Anderson, one of the then Big 5 auditing and consulting firms, had been effectively forced out of business by the SEC3. Such hasty and, at least in the case of the SECs case against Arthur Anderson, retrospectively spurious actions suggest that legislators were more concerned with avoiding perceived responsibility than in producing efficient solutions. A second (and perhaps more convincing) argument stems from the following question: if audited internal control representations are an effective and efficient method for ensuring high quality financial reporting, why had such methods not already been adopted by the markets? Unlike other aspects of SOX (most of which attempt to address conflicts of interest between auditors, shareholders, boards of directors and management), section 404 effectively mandates the method by which managers ensure accurate financial disclosures as well as the method by which auditors gain comfort around those disclosures. Although a valid argument can be made for increasing the incentives of auditors and managers to produce quality financial reports (via increased sanctions for misreporting, a more liberal tort system, or by decreasing conflicts of interest), it seems dubious to assume that legislators are more capable than managers and auditors of selecting the most effective and efficient methods of performing corporate financial reporting. Despite the logical appeal of these arguments, section 404s effectiveness remains an empirical question. Thus, I propose the following hypothesis: H1: Internal control representations as mandated by section 404 of SOX are an effective method of ensuring earnings quality.

This decision was later overturned by the Supreme Court, although not in time to save Arthur Anderson.

Note that drawing a conclusion regarding H1 depends on having a measure of earnings quality sensitive enough to detect meaningful changes. The following section discusses my selection, validation, and use of such a measure. 4. EMPERICAL ANALYSIS To measure earnings quality I use a proxy developed by Dechow and Dichev (2002). Their measure captures the extent to which cash flows map into earnings using the following formula: Equation 1: where WC is change in working capital, CFO is cash flow from operations, and the t subscript indicates period. All variables are scaled by average assets. See Table 1 of Appendix A for a full list of variable descriptions. I run the regression in Equation 1 for a sample of firms from the Compustat database, pooled by quarter, for the period from 1998 through 2008. Summary statistics and variable requirements for the sample are also included in Table 1 of Appendix A. Following Dechow and Dichev (2002), I interpret the standard deviation of the residuals from the regression (Quality ) as a measure of earnings quality. Note that higher values of this measure indicate lower quality4. Results from Equation 1 are included in Table 2 of Appendix A. I also fit Equation 1 pooling by year (not tabulated) and include plots of Quality from both the annual (Panel 1) and quarterly (Panel 2) regressions, over time, in Appendix B. Panel 2 shows that there is a clear pattern in Quality vis--vis quarter which makes the quarterly results difficult to interpret with regard to H1. For this reason, I control for quarterly fixed effects in the following model: Equation 2: where 2002D is an indicator variable equal to 1 if the year is 2002 or later and equal to 0 otherwise, 2004D is defined similarly to 2002D, NI is net income (used to control for profitability), and is a vector of indicator variables used to control for fixed quarterly effects (i.e. = 1 if the observation is from the third quarter and 0 otherwise)5. The use of both 2002 and 2004 indicators in the model serves two purposes6. First, inclusion of the 2002 indicator controls for effects related to the implantation of non-404 sections of SOX and natural market reactions to the scandal period. This will allow for interpretation of 2004D as the change in quality relative to the post scandal period. Second, without some validation of my earnings quality measure (Equation 1), a lack of significance of could simply indicate a lack of sensitivity in the measure. Accordingly, the 2002 indicator is
4

As the standard deviation of the error term captures the variability in the extent to which earnings map into cash flows (i.e. the variability in the extent to which accruals capture true claims to future benefits), higher values of standard deviation indicate lower levels of earnings quality. 5 Potential control variables for Equation 3 include those that are correlated with earnings quality and covary in time with SOX implementation. In a separate test (not tabulated) I included gross domestic product (GDP) as an additional control to account for the impact of the 2001 recession. Test results showed a coefficient for GDP that was not significantly different from zero at conventional levels and did not materially impact the results presented in Table 3 of Appendix A. For these reasons, and due to GDPs high correlation with another control variable (NI), it was removed from the primary analysis. 6 The year 2004 is used here because it was the first year of mandatory implementation of section 404. Using the year 2005 produces similar results as reported in Table 3 of Appendix A. Using the year 2003 produces a that is not significantly different from zero at conventional levels.

included to allow for a validation of Equation 1s ability to detect changes in earnings quality. If Equation 1 is sufficiently sensitive, and to the extent that a combination of natural market reactions to the scandal period and SOX provisions other than section 404 had an effect on earnings quality during the scandal period (i.e. 2002 - 2003), I expect such effects to produce a negative and significant . Thus the following scenarios outline the conclusions which can be reached depending on the results of Equation 2: Scenario 1) Scenario 2) Scenario 3) If neither If or is significant, no conclusion can be reached.

is negative and significant H1 can be accepted.

If is negative and significant but is either not significant or significant and positive we can conclude that section 404 of SOX is either not effective or detrimental to earnings quality, respectively.

Results from Equation 3 are included in Table 3 of Appendix A and show a significant (p < .01) and negative as well as a significant (with p < .01) and positive . Thus Scenario 3 holds and the evidence indicates that earnings quality decreased (or remained unchanged, see footnote 6) subsequent to the implementation of section 404 of SOX. See Panel 3 of Appendix B for diagnostic plots related to the fitting of Equation 2 and brief discussion of model assumptions. 5. LIMITATIONS The primary drawback to the approach discussed above is the inherent danger of omitted variable bias. To the extent that some unobserved phenomenon is correlated with earnings quality, as measured by Equation 1, and also varies over time, such a phenomenon could be the true explanation for changes in quality. Net income (and, in an additional test, GDP - see footnote 5) was included in Equation 2 to control to for this type of confounding effect. Nevertheless, other relevant variables for which I have not accounted may exist and, if included in Equation 2, could theoretically subsume the results presented in this paper. 6. CONCLUSION The evidence presented in this paper suggests that section 404 implementation may not have generated the earnings quality improvements that were predicted by Congress and the SEC (Aquila 2004). Unfortunately ex post evidence cannot reclaim the billions of dollars spent in section 404 implementation efforts. Even so, companies continue to spend significant amounts of money, time, and effort to maintain compliance with section 404. Additional research is needed so that we may better understand the relative costs and benefits of compulsory, audited, internal control representations. This is particularly true as regulators begin to discuss the possibility of rolling back portions of section 404 for smaller companies (Stuart, 2009).

APPENDIX A
Table 1: Variable Definitions and Summary Statistics
Mean Cash flow from operations (CFO ) Change in working capital (WC ) Net Income (NI ) Earnings Quality (Quality ) Total Assets (in millions) 0.079 -0.021 0.027 0.173 717 Standard Deviation 0.126 0.178 0.085 0.021 3078 Lower Quartile 0.013 -0.084 0.004 0.157 23 Median 0.053 -0.013 0.025 0.174 94 Upper Quartile 0.121 0.048 0.056 0.185 363

Variable definitions (all variable names on the RHS of equations below are per the Compustat Fundamentals Quarterly Database, t subscripts indicate period):

where OANCFY is year-to-date cash flow from operations, RECTQ is total accounts receivable, INVTQ is total inventory, APQ is total accounts payable, TXPQ is total taxes payable, LCOQ is other current liabilities, and ACOQ is other current assets. In order to be included in the sample, firm-quarter observations were required to have sufficient data to calculate the variables described above. All variables are scaled by firm-level average assets. Firm-quarter observations with net income, change in working capital, or cash flows from operations in the top or bottom 1 percent were truncated (consistent with Dechow et al. 2001) to avoid the effect of outliers.

Table 2: Results from Equation 1 (by quarter)

Mean T-statistic Lower Quartile Median Upper Quartile -0.017 -7.53* -0.032 -0.021 -0.011

0.093 9.21* 0.041 0.095 0.138

-0.047 -4.41* -0.084 -0.041 0.000

-0.086 -8.64* -0.132 -0.089 -0.053

n 3196 3063 3192 3359

WC is change in working capital, CFO is cash flow from operations and the t subscript indicates period. See additional variable descriptions in Table 1. T-statistics are included for the null hypotheses: = 0. * Indicates significance at the .01 level.

Table 3: Results from Equation 2

Parameter Estimate T-Statistic 0.200 47.35*

-0.010 -3.11*

0.017 3.26*

-0.255 -1.5

-0.008 -2.28**

-0.020 -5.53*

-0.021 -5.86*

2002D is an indicator variable equal to 1 if the year is 2002 or later and 0 otherwise), 2004D is an indicator variable equal to 1 if the year is 2004 or later and 0 otherwise, NI is net income scaled by average assets, and Q is a vector of indicator variables used to control for quarterly fixed effects (i.e. Q = 1 for observations from quarter 3 and zero for all other observations) . T-statistics are included for the null hypotheses: = 0. * and ** indicate significance at the .01 and .05 levels, respectively. Adjusted R-Square = 71%

APPENDIX B
Panel 1: Quality over time (by year)
Enron reveals multibillion dollar misstatement on 11/25/01 0.085 President Bush signs SOX legislation 7/30/02 Arthur Anderson prohibited from auditing public companies on 8/31/02

0.08

0.075

0.07

0.065

0.06 1999

2000

2001

2002

2003

2004

2005

2006

2007

2008

WorldCom discloses multibillion dollar misstatement on 6/25/02

2004 - First year of mandated section 404 compliance

Note: Lower values on the y-axis indicate higher quality, see footnote 4.

Panel 2 : Quality over time (by quarter)

0.23 0.21

0.19
0.17 0.15

Note 1 : Lower values on the y-axis indicate higer quality, see footnote 4. Note 2 : Panel 2 above clearly shows the quarterly effect on quality. Also note that the measure of quality is systematically higher for the quarterly data. This is expected due to the shorter period of time over which Equation 1 is monitoring cash flows when quarterly data is used.

1999Q1 1999Q2 1999Q3 1999Q4 2000Q1 2000Q2 2000Q3 2000Q4 2001Q1 2001Q2 2001Q3 2001Q4 2002Q1 2002Q2 2002Q3 2002Q4 2003Q1 2003Q2 2003Q3 2003Q4 2004Q1 2004Q2 2004Q3 2004Q4 2005Q1 2005Q2 2005Q3 2005Q4 2006Q1 2006Q2 2006Q3 2006Q4 2007Q1 2007Q2 2007Q3 2007Q4

Panel 3: Diagnostics for Equation 2

Table 1 Table 2

Note: There are relatively few outliers indicated by the plot above. Each outlier was investigated for accuracy and plausibility.

Note: Cooks D for all observations are well under a benchmark of 1. None of the outliers identified in Table 1 appear to be influential.

Table 3

Table 4

Note: The plot of residuals exhibits a slight curvature but is sufficiently straight to justify use of the normality assumption.

Note: Residuals appear to be distributed in a roughly bell-shaped manner. There is some indication of abnormal skew and kurtosis, however, the histogram seems sufficient to warrant use of the normality assumption.

APPENDIX C
Works Cited
Alles, M., Kogan, A., & Vasarhelyi, M. (2004). The Law of Unintended Consequences? Assessing the Costs, Benefits and Outcomes of the Sarbanes/Oxley Act. Information Systems Control Jounral, 1, 17-22. Ball, R. (2009, May). Market and Political/Regulatory Perspectives on the Recent Accounting Scandals. Journal of Accounting Research, 47(2), 277-332. Carney, W. J. (2006). Costs of Being Public after Sarbanes-Oxley: The Irony of Going Private. The Emory, 141. Chang, H., Fernando, G. D., & Liao, W. (2009). Sarbanes-Oxley Act, Perceived Earnings Quality and Cost of Capital. Reveiw of Accounting and Finance, 8(3), 216-231. D'Aquila, J. M. (2004, November). Tallying the Costs of the Sarbanes-Oxley Act. The CPA Journal. Dechow, P. M., & Dichev, I. D. (2002). The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors. The Accounting Review, 35-59. Engel, E., Hayes, R. M., & Wang, X. (2007, September). The Sarbanes-Oxley Act and Firms' Going-Private Decisions. Journal of Accounting and Economics, 44(2), 116-145. Patterson, E. R., & Smith, J. R. (2007, March). The Effects of Sarbanes-Oxely on Auditing and Internal Control Strength. The Accounting Reveiw, 82(2), 427-455. Stuart, A. (2009, November 18). CFOs High-five on 404 Rollback Bill. CFO, pp. 8-12. Watts, R., & Zimmerman, J. L. (1986). Positive Accounting Theory. Prentice-Hall Inc. Zhang, I. X. (2007, September). Economic Consequences of the Sarbanes-Oxley Act of 2002. Journal of Accounting and Economics, 44(2), 74-115.