DLR TALUCOD 5-07 ZHANG (2007)

Economic consequences of the Sarbanes–Oxley Act of 2002

Ivy Xiying Zhang

In the late 1900s and early 2000s, consecutive accounting and corporate scandals in the

United States were exposed. High profile cases such as Tyco International plc, Enron, and

WorldCom has resulted to billion dollar losses shouldered by the investors as the share prices

of these companies’ stocks goes down. These accounting scandals were viewed as a result of

failed or poor governance, insufficient disclosure practices and lack of satisfactory internal

controls. The collapse of these companies has also resulted to the investors’ loss of confidence

in the American securities market as well as their confidence in the trustworthiness of the

corporate financial statements. As a response, the United States passed a federal law called the

Sarbanes-Oxley Act of 2002. This law was authored by Senator Paul Sarbanes and

Representative Michael Oxley in July 25, 2002 seeking to set standards and guarantee the

accuracy of financial reports. Sarbanes-Oxley Act aims to address the stakeholders’ concern

by making executives responsible for company accounting statements, redefining the

relationships between corporations and their auditors, and restructuring the internal audit

systems of public corporations.

Since the implementation of the law, SOX has redefined the corporate accounting

world. It is widely viewed to be the most important piece of corporate governance and

disclosure legislation since the Securities Act of 1933 and Securities Exchange Act of 1934.

Although there are numerous studies regarding the consequences of securities

legislation the results were still inconclusive. Motivated by the continuous debate on the impact

of securities legislation in the economy, and the growing concerns of the general public,

investors, as well as company managers that the cost compliance with SOX might outweigh its
DLR TALUCOD 5-07 ZHANG (2007)

intended benefit, author Ivy Xiying Zhang conducted a study that aims to investigate the

economic consequences of the law; the Sarbanes–Oxley Act of 2002 through a study of market

reactions around the legislative event prior and subsequent to the passage of SOX. This paper

focuses on the examination of private benefits and cost of the newly enacted law. The research

question is predictive in nature as such, the researcher uses event study as its major method of

achieving its goal.

The researcher uses stock returns as a measure of market reaction and applies the

efficient market theory with the assumption that stock prices unbiasedly incorporate all the

expected private costs and benefits of SOX based on available information. To achieve its goal,

the researcher examines the abnormal returns of the U. S. market around significant SOX

legislative events relative to returns of non U.S-traded foreign firms. The use of these foreign

markets controls for common global economic news that might also affect U.S firms. To further

analyze, the researcher also explores the sources of private costs of SOX by investigating its

major provisions and lastly, the researcher also examines the market reaction towards the SECs

announcement regarding the deferment of the compliance of Section 404 of the SOX.

The researcher developed a total of 6 Hypothesis for this study. First hypothesis: If SOX

imposed net costs on U.S. firms, firms’ cumulative returns adjusted for the impact of

contemporaneous economic news around the SOX rulemaking events would be negative. Here,

the researcher examines the overall U.S. market reaction to events leading up to SOX passage.

To control for the other contemporary news that might affect U.S firms, the researcher uses 22

major developed foreign stock markets and it excluded listed foreign firms in computing for

the foreign returns as these firms were required to comply with SOX. There are 16 events

observed during the rulemaking stage of SOX. The researcher examines the market reaction

per event through stock returns. Overall, the results show that a large fraction of the negative

returns that the U.S. market experienced in the SOX rulemaking period could be due to other
DLR TALUCOD 5-07 ZHANG (2007)

negative economic news; yet, the impact of SOX is still likely negative and statistically

significant. Lack of statistical significance is likely due to the inclusion of insignificant event

days reducing the power of the test.

Hypotheses 2-5 were related to the exploration of private cost source by examining

major provisions of SOX such as restriction on non-audit services, provision on corporate

responsibilities, forfeiture of incentive pay, insider trading, Section 404 internal control test.

In summary, the cross-sectional analysis based on cumulative returns rejects the hypothesis

that three major provisions entail no net costs on firms, providing additional support for the

hypothesis that the market initially expected SOX to be costly. However, the event-by-event

analysis does not consistently support the hypotheses, potentially due to the tests lacking

power.

Hypothesis 6 which examines the market reaction toward the SEC’s announcement on

deferment of Section 404. The result shows that the compliance costs of Section 404 are

particularly significant for small firms and delaying compliance appears beneficial for them.

In general, the researcher concluded that after taking to account all the evidence, the

result suggests that the null hypothesis that says compliance with SOX entails costs is rejected.

Overall, it can be deducted that compliance with the SOX entails additional costs to the firm

however, the researcher reminded that the findings on this study should be interpreted

cautiously.

The researcher is very much aware of the limitations of its studies. Although it is good

that the researcher thought of controlling for other contemporaneous economic news by using

foreign stock returns, future researcher in this field should take into consideration the country

effect that is inherent or unique to the foreign market that he/she may use. Also, the examination

of the major provisions of the act to examine the sources of private cost is just a mere support
DLR TALUCOD 5-07 ZHANG (2007)

for the main goal of this research as each provision of the whole act is correlated. Nevertheless,

the researcher was able to achieve its goal on examining the economic consequences of

Sarbanes-Oxley Act of 2002.

After reading the article, I realized the importance of research on implementing new

laws. Passing of this law has become a controversy as others thought that electoral

considerations were put in priority rather than carefully studying the probable effect of the

Sarbanes-Oxley Act of 2002 to the firms operating in the United States. A law should not be

too idealistic that it would only burden the generally public and it should not be too lenient that

it will not be able to address the problem areas that needs solution.