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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
More than 1000 executives were criminally convicted. Sunbeam. Merrill Lynch. an estimate that proved to be conservative (D'Aquila. Nicor. due to SOX – a cost which is directly attributable to section 404 (D'Aquila. Further. What other such measures would have been enacted by markets in the absence of legislation difficult to know. section 5 briefly discusses limitations of my analysis. enforcement of one section of SOX (section 404) was delayed until fiscal years ending on or after November 15th 2004 (D'Aquila. section 3 develops the hypotheses. and billions of dollars were exchanged in settlements (Ball.1. prior to the passing of SOX. then Chairman of the SEC William Donaldson said “These are landmark rules. Freddie Mac. and section 6 concludes. 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. 2004). 2 Additional audit costs for large US firms increased by an average of $2. and to what the extent. was the largest increase in market regulation since the creation of the Securities and Exchange Commission in the 1930s (Ball. due to its delayed implementation. and thus its stand-alone benefit is an important question. Section 404 is widely regarded as the most costly portion of SOX2. known as the Sarbanes-Oxley Act (SOX). 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). 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. Tyco International. 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.4 trillion (Zhang. When SOX was passed. One econometric study puts the total price tag of SOX at $1. 2007). 2004). section 4 contains the empirical analysis. The remainder of this paper will proceed as follows: section 2 discusses prior research. 2004).4M per firm. due to the significant effort required for implementation. In this paper. 2009). Moreover. 1 For example. but in the long term they will result in sounder processes and more reliable financial reporting” (D'Aquila. Amid the ensuing public outcry. 2004). Duke Energy. per year. On the contrary. congress passed sweeping new regulation. it is possible to evaluate its impact separately from the natural market reactions and other sections of SOX which primarily took effect in 2002. it is indisputable that the costs of SOX materialized in a very tangible way. they will require hard work and significant expenditure in the short run by corporations. There have been numerous attempts to measure exactly how “significant” the costs have been. Kmart. 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. and WorldCom. Whatever the amount. However. 2009). A partial list of notable companies involved includes: Waste Management. Adelphia. Legislative and natural market responses to the scandal period were contemporaneous and correlated in their effect. 2009). it is impossible to know what additional action the market would have taken in the absence of legislation1. SOX has imposed significant costs on American firms. Enron. That legislation. . Xerox. AOL. Referring to SOX in a 2003 speech.000 man-hours to implement. I show that the time period in which 404 was implemented exhibits indications of reduced earnings quality. It is less clear whether. Congress estimated that the additional compliance requirements would cost large US firms in excess of 4 million dollars and 15. and parsing out their relative impacts is difficult at best. Quest Communications. However.
I provide two reasons for skepticism of section 404’s impact of reporting quality. (Zhang. although not in time to save Arthur Anderson. section 404’s effectiveness remains an empirical question. Kogan. & Vasarhelyi. 2007). Watts and Zimmerman (1986) argue that the politicians are incentivized to avoid being seen as responsible for investor losses. 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. & Liao.2. (Carney. and (Alles. Fernando. I propose the following hypothesis: H1: Internal control representations as mandated by section 404 of SOX are an effective method of ensuring earnings quality. and that hasty legislation in the face of scandal is often an attempt to shift blame rather than to address any regulatory unbalance. 2009). & Liao. The second argues that if the requirements of 404 were effective and efficient they would have already been implemented voluntarily by the market. 2007). on perceived earnings quality (Chang. a more liberal tort system. retrospectively spurious actions suggest that legislators were more concerned with avoiding perceived responsibility than in producing efficient solutions. PRIOR RESAERCH As discussed above. 3. and signed into law by George W. 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). or by decreasing conflicts of interest). Arthur Anderson. HYPOTHESES DEVELOPMENT Below. 2007). Bush. shareholders. at least in the case of the SEC’s case against Arthur Anderson. boards of directors and management). 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. Hayes. Thus. Despite the logical appeal of these arguments. 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. 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. Such hasty and. 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. to my knowledge. & Wang. had been effectively forced out of business by the SEC3. However. . 3 This decision was later overturned by the Supreme Court. The first addresses the incentives of those involved in crafting and passing the legislation. Building on economic theory originating with Stigler and Peltzman. several studies have attempted to measure the total costs of SOX and of section 404 in particular (Engel. 2006). passed by Congress. In addition. SOX had been written. 2004). the extent to which section 404 of SOX impacted actual earnings quality is an outstanding question. 2009) and on the strength of internal controls and audit quality (Patterson & Smith. Other research has studied the impact of SOX implementation on the cost of capital (Chang. This theory can be readily applied to the conditions under which SOX was passed. among other things. one of the then “Big 5” auditing and consulting firms. Fernando.
First. NI is net income (used to control for profitability). pooled by quarter. This will allow for interpretation of 2004D as the change in quality relative to the post scandal period. . The use of both 2002 and 2004 indicators in the model serves two purposes6. validation. For this reason. Accordingly. 6 The year 2004 is used here because it was the first year of mandatory implementation of section 404. All variables are scaled by average assets. over time. 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. 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. 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. in Appendix B. and is a vector of indicator variables used to control for fixed quarterly effects (i. 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. it was removed from the primary analysis. = 1 if the observation is from the third quarter and 0 otherwise)5. without some validation of my earnings quality measure (Equation 1). Using the year 2003 produces a that is not significantly different from zero at conventional levels. EMPERICAL ANALYSIS To measure earnings quality I use a proxy developed by Dechow and Dichev (2002). I interpret the standard deviation of the residuals from the regression (Quality ) as a measure of earnings quality. Following Dechow and Dichev (2002). and use of such a measure. 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. I run the regression in Equation 1 for a sample of firms from the Compustat database. Panel 2 shows that there is a clear pattern in Quality vis-à-vis quarter which makes the quarterly results difficult to interpret with regard to H1. Note that higher values of this measure indicate lower quality4. Summary statistics and variable requirements for the sample are also included in Table 1 of Appendix A. Second. For these reasons. and due to GDP’s high correlation with another control variable (NI). 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. higher values of standard deviation indicate lower levels of earnings quality. a lack of significance of β₂ could simply indicate a lack of sensitivity in the measure. 4. CFO is cash flow from operations.e. 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. Using the year 2005 produces similar results as reported in Table 3 of Appendix A.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. 2004D is defined similarly to 2002D. 5 Potential control variables for Equation 3 include those that are correlated with earnings quality and covary in time with SOX implementation.e. for the period from 1998 through 2008. and the t subscript indicates period. the variability in the extent to which accruals capture true claims to future benefits). See Table 1 of Appendix A for a full list of variable descriptions. Results from Equation 1 are included in Table 2 of Appendix A.
other relevant variables for which I have not accounted may exist and. companies continue to spend significant amounts of money.e. If Equation 1 is sufficiently sensitive. Thus Scenario 3 holds and the evidence indicates that earnings quality decreased (or remained unchanged. no conclusion can be reached. audited. Net income (and. Unfortunately ex post evidence cannot reclaim the billions of dollars spent in section 404 implementation efforts. 2002 .included to allow for a validation of Equation 1’s ability to detect changes in earnings quality. This is particularly true as regulators begin to discuss the possibility of rolling back portions of section 404 for smaller companies (Stuart.2003). internal control representations. Additional research is needed so that we may better understand the relative costs and benefits of compulsory. Nevertheless. Results from Equation 3 are included in Table 3 of Appendix A and show a significant (p < . LIMITATIONS The primary drawback to the approach discussed above is the inherent danger of omitted variable bias. and effort to maintain compliance with section 404. 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. respectively. 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. is negative and significant H1 can be accepted. as measured by Equation 1.see footnote 5) was included in Equation 2 to control to for this type of confounding effect. if included in Equation 2. 6. see footnote 6) subsequent to the implementation of section 404 of SOX. could theoretically subsume the results presented in this paper. time. To the extent that some unobserved phenomenon is correlated with earnings quality. . Even so. GDP . and also varies over time. 5. in an additional test. See Panel 3 of Appendix B for diagnostic plots related to the fitting of Equation 2 and brief discussion of model assumptions. 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.01) and positive . 2009).01) and negative as well as a significant (with p < . such a phenomenon could be the “true” explanation for changes in quality. 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).
027 0. firm-quarter observations were required to have sufficient data to calculate the variables described above.004 0.053 n 3196 3063 3192 3359 ∆WC is change in working capital. or cash flows from operations in the top or bottom 1 percent were truncated (consistent with Dechow et al.021 -0.174 94 Upper Quartile 0.053 -0. All variables are scaled by firm-level average assets.021 3078 Lower Quartile 0.121 0.084 -0. and ACOQ is other current assets.011 β₁ 0.132 -0.089 -0.056 0.084 0.041 0.000 β₃ -0.047 -4.048 0.013 0. 2001) to avoid the effect of outliers. APQ is total accounts payable. TXPQ is total taxes payable. INVTQ is total inventory.085 0.021 0.157 23 Median 0. RECTQ is total accounts receivable.185 363 Variable definitions (all variable names on the RHS of equations below are per the Compustat Fundamentals Quarterly Database. In order to be included in the sample.41* -0.093 9. change in working capital. LCOQ is other current liabilities.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. See additional variable descriptions in Table 1. t subscripts indicate period): where OANCFY is year-to-date cash flow from operations.126 0.178 0.173 717 Standard Deviation 0. T-statistics are included for the null hypotheses: β = 0. Table 2: Results from Equation 1 (by quarter) β₀ Mean T-statistic Lower Quartile Median Upper Quartile -0.095 0. * Indicates significance at the . CFO is cash flow from operations and the t subscript indicates period.013 -0.53* -0.01 level.041 0.079 -0. Firm-quarter observations with net income.64* -0.025 0.032 -0. .017 -7.138 β₂ -0.21* 0.086 -8.
53* βₓ₃ -0. Q₃ = 1 for observations from quarter 3 and zero for all other observations) . 2004D is an indicator variable equal to 1 if the year is 2004 or later and 0 otherwise. * and ** indicate significance at the .05 levels.86* 2002D is an indicator variable equal to 1 if the year is 2002 or later and 0 otherwise). and Q ₓ is a vector of indicator variables used to control for quarterly fixed effects (i.28** βₓ₂ -0.255 -1.021 -5.Table 3: Results from Equation 2 β₀ Parameter Estimate T-Statistic 0.017 3.5 βₓ₁ -0. respectively.26* β₃ -0.35* β₁ -0.200 47. T-statistics are included for the null hypotheses: β = 0.020 -5.010 -3. Adjusted R-Square = 71% .008 -2.01 and .11* β₂ 0.e. NI is net income scaled by average assets.
065 0.17 0.23 0.07 0.15 Note 1 : Lower values on the y-axis indicate higer quality.06 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 WorldCom discloses multibillion dollar misstatement on 6/25/02 2004 .085 President Bush signs SOX legislation 7/30/02 Arthur Anderson prohibited from auditing public companies on 8/31/02 0. see footnote 4.19 0.21 0. 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 .First year of mandated section 404 compliance Note: Lower values on the y-axis indicate higher quality. Note 2 : Panel 2 above clearly shows the quarterly effect on quality. see footnote 4.075 0.APPENDIX B Panel 1: Quality over time (by year) Enron reveals multibillion dollar misstatement on 11/25/01 0. Also note that the measure of quality is systematically higher for the quarterly data.08 0. This is expected due to the shorter period of time over which Equation 1 is monitoring cash flows when quarterly data is used. Panel 2 : Quality over time (by quarter) 0.
None of the outliers identified in Table 1 appear to be influential. Note: Residuals appear to be distributed in a roughly bell-shaped manner. however. . 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: Cook’s D for all observations are well under a benchmark of 1.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. There is some indication of abnormal skew and kurtosis. the histogram seems sufficient to warrant use of the normality assumption.
Prentice-Hall Inc.. (2009. E. & Smith. Journal of Accounting and Economics. (2007. M. Fernando. Patterson. CFOs High-five on 404 Rollback Bill. Ball. 216-231. R. (2004).. & Zimmerman. (2007. Engel. Zhang. 8(3). J. (2004. 141. L. Dechow. (2002). & Vasarhelyi. 82(2). The Accounting Reveiw. R. The Law of Unintended Consequences? Assessing the Costs. March). W. M.. 8-12... A. A. R. Watts. (1986). & Dichev. D'Aquila. Journal of Accounting Research. Market and Political/Regulatory Perspectives on the Recent Accounting Scandals.. 74-115. J. (2009). Chang. P. 277-332. Journal of Accounting and Economics. Perceived Earnings Quality and Cost of Capital. J. Kogan. H. 47(2). M. X. X. Positive Accounting Theory. & Wang. R. 35-59. . I. (2007. Stuart.. Information Systems Control Jounral. R. M. E. & Liao. CFO. The CPA Journal. M. 1. 44(2).APPENDIX C Works Cited Alles. Benefits and Outcomes of the Sarbanes/Oxley Act. W. 116-145. November). J. 17-22. The Effects of Sarbanes-Oxely on Auditing and Internal Control Strength. Reveiw of Accounting and Finance. The Sarbanes-Oxley Act and Firms' Going-Private Decisions. May). G. Economic Consequences of the Sarbanes-Oxley Act of 2002. The Accounting Review. D. The Emory. The Quality of Accruals and Earnings: The Role of Accrual Estimation Errors. September). D. 44(2). Costs of Being Public after Sarbanes-Oxley: The Irony of Going Private.. Sarbanes-Oxley Act. November 18). 427-455. pp. (2009. (2006). Carney. September). I. Tallying the Costs of the Sarbanes-Oxley Act. Hayes..