The Costs and Benefits of Compulsory Internal Control Representations (PDF)

7/30/2019 The Costs and Benefits of Compulsory Internal Control Representations (PDF)

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Sarbanes-Oxley Section 404: Effective

Legislation or Expensive Window Dressing?

A Study on the (Lack of) Benefits from SOX 404

and Compulsory Internal ControlRepresentations

Nicholas Hallman

[email protected]

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 wereexchanged 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 firmsin 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), amongother 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 404’s 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, andthat 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 SEC’s 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 auditedinternal 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 404’s 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.

3 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 measurecaptures 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-à-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 β₂ 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 GDP’s 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 1’s 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) If neither or is significant, no conclusion can be reached.

Scenario 2) If is negative and significant H1 can be accepted.

Scenario 3) 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

Standard

Deviation

Lower

Quartile Median

Upper

Quartile

Cash flow from operations (CFO ) 0.079 0.126 0.013 0.053 0.121Change in working capital ( ∆WC ) -0.021 0.178 -0.084 -0.013 0.048

Net Income (NI ) 0.027 0.085 0.004 0.025 0.056

Earnings Quality (Quality ) 0.173 0.021 0.157 0.174 0.185

Total Assets (in millions) 717 3078 23 94 363

Variable definitions (all variable names on the RHS of equations below are per the Compustat

Fundamentals Quarterly Database, t subscripts indicate period):

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.

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.

Table 2: Results from Equation 1 (by quarter)

β₀ β₁ β₂ β₃ n

Mean -0.017 0.093 -0.047 -0.086 3196

T-statistic -7.53* 9.21* -4.41* -8.64*

Lower Quartile -0.032 0.041 -0.084 -0.132 3063

Median -0.021 0.095 -0.041 -0.089 3192Upper Quartile -0.011 0.138 0.000 -0.053 3359

* Indicates significance at the .01 level.

T-statistics are included for the null hypotheses: β = 0.

∆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.



Table 3: Results from Equation 2

β₀ β₁ β₂ β₃ βₓ₁ βₓ₂ βₓ₃

Parameter Estimate 0.200 -0.010 0.017 -0.255 -0.008 -0.020 -0.021

T-Statistic 47.35* -3.11* 3.26* -1.5 -2.28** -5.53* -5.86*

T-statistics a re included for the null hypotheses: β = 0.

* and ** indica te si gnificance at the .01 and .05 levels , respectively.

Adjusted R-Square = 71%

2002D is an indicator variable equal to 1 i f the year i s 2002 or l ater and 0 otherwise), 2004D is a n

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 x is a vector of indicator variables used to control for quarterly fixed effects

(i.e. Q ₃ = 1 for observations from quarter 3 and zero for all other observations) .



APPENDIX B

Panel 1: Quality over time (by year)

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

0.06

0.065

0.07

0.075

0.08

0.085

1999 2000 2001 2002 2003 2004 2005 2006 2007 2008

Enron reveals multibi llion

doll ar misstatement on

11/25/01

Arthur Anderson prohibi ted

from auditing public

companies on 8/31/02

WorldCom discloses

multibillion dollar

miss tatement on 6/25/02

President Bush signs

SOX legislation

7/30/02

2004 - First year of mandated

section 404 compliance

Panel 2 : Quality over time (by quarter)

Note 1: Lower values on the y-axi s indicate higer quality, see footnote 4.

Note 2: Panel 2 above clearl y shows the quarterly effect on quali ty. Also note that the measure of qual ity i s

systematically higher for the quarterly data. This is expected due to the shorter period of time over which

Equation 1 i s monitoring cas h flows when quarterly data is used.

0.15

0.17

0.19

0.21

0.23

1 9 9 9 Q 1

1 9 9 9 Q 2

1 9 9 9 Q 3

1 9 9 9 Q 4

2 0 0 0 Q 1

2 0 0 0 Q 2

2 0 0 0 Q 3

2 0 0 0 Q 4

2 0 0 1 Q 1

2 0 0 1 Q 2

2 0 0 1 Q 3

2 0 0 1 Q 4

2 0 0 2 Q 1

2 0 0 2 Q 2

2 0 0 2 Q 3

2 0 0 2 Q 4

2 0 0 3 Q 1

2 0 0 3 Q 2

2 0 0 3 Q 3

2 0 0 3 Q 4

2 0 0 4 Q 1

2 0 0 4 Q 2

2 0 0 4 Q 3

2 0 0 4 Q 4

2 0 0 5 Q 1

2 0 0 5 Q 2

2 0 0 5 Q 3

2 0 0 5 Q 4

2 0 0 6 Q 1

2 0 0 6 Q 2

2 0 0 6 Q 3

2 0 0 6 Q 4

2 0 0 7 Q 1

2 0 0 7 Q 2

2 0 0 7 Q 3

2 0 0 7 Q 4



Panel 3: Diagnostics for Equation 2

Table 1 Table 2

Table 3 Table 4

Note: There are relatively few outliers indicated by the

plot above. Each outlier was investigated for accuracy

and plausibility.

Note: Cook’s D for all observations are well under a

benchmark of 1. None of the outliers identified in Table 1

appear to be influential.

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.

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