BUS103: Introduction to Financial Accounting

A significant body of academic research and opinion exists regarding the costs and benefits of SOX, with significant differences in conclusions. This is due in part to the difficulty of isolating the impact of SOX from other variables affecting the stock market and corporate earnings. Section 404 of the act, which requires management and the external auditor to report on the adequacy of a company's internal control on financial reporting, is often singled out for analysis.

According to a 2019 study in the Journal of Law and Economics, "We find a large decline in the average voting premium of US dual-class firms targeted by major SOX provisions that enhance boards' independence, improve internal controls, and increase litigation risks. The targeted firms also improve the efficiency of investment, cash management, and chief executive officers' compensation relative to firms not targeted by SOX. Overall, the evidence suggests that SOX is effective in curbing the private benefits of control".

Compliance costs

• FEI Survey (Annual): Financial Executives International (FEI) provides an annual survey on SOX Section 404 costs. These costs have continued to decline relative to revenues since 2004. The 2007 study indicated that, for 168 companies with average revenues of $4.7 billion, the average compliance costs were $1.7 million (0.036% of revenue). The 2006 study indicated that, for 200 companies with average revenues of $6.8 billion, the average compliance costs were $2.9 million (0.043% of revenue), down 23% from 2005. Cost for decentralized companies (i.e., those with multiple segments or divisions) were considerably more than centralized companies. Survey scores related to the positive effect of SOX on investor confidence, reliability of financial statements, and fraud prevention continue to rise. However, when asked in 2006 whether the benefits of compliance with Section 404 have exceeded costs in 2006, only 22 percent agreed.
• Foley & Lardner Survey (2007): This annual study focused on changes in the total costs of being a U.S. public company, which were significantly affected by SOX. Such costs include external auditor fees, directors and officers (D&O) insurance, board compensation, lost productivity, and legal costs. Each of these cost categories increased significantly between FY2001 and FY2006. Nearly 70% of survey respondents indicated public companies with revenues under $251 million should be exempt from SOX Section 404.
• Butler/Ribstein (2006): Their book proposed a comprehensive overhaul or repeal of SOX and a variety of other reforms. For example, they indicate that investors could diversify their stock investments, efficiently managing the risk of a few catastrophic corporate failures, whether due to fraud or competition. However, if each company is required to spend a significant amount of money and resources on SOX compliance, this cost is borne across all publicly traded companies and therefore cannot be diversified away by the investor.
• A 2011 SEC study found that Section 404(b) compliance costs have continued to decline, especially after 2007 accounting guidance.
• Lord & Benoit issued a research report in 2008 called The Lord & Benoit Report: The Sarbanes-Oxley Investment. The average cost of complying with Section 404(a) for non-accelerated filers (smaller public companies) was $53,724. Total costs of complying with Section 404(a) ranged from as low as $15,000 for a smaller software company to as high as $162,000. The initial prediction by the SEC was an average cost of $91,000 for public companies complying with Section 404(a). "Accounting problems have traditionally been a small company phenomenon, and the stock exchange is talking about exempting those most prone to abuse," said Barbara Roper, the Consumer Federation of America's director of investor protection. "It's a bad idea". She noted a January study by consulting firm Lord & Benoit that found complying with Sarbanes-Oxley would cost small companies an average of $78,000 the first year, or less than the $91,000 initially predicted by the SEC.
  
  

Benefits to firms and investors

• Arping/Sautner (2010): This research paper analyzes whether SOX enhanced corporate transparency. Looking at foreign firms that are cross-listed in the US, the paper indicates that, relative to a control sample of comparable firms that are not subject to SOX, cross-listed firms became significantly more transparent following SOX. Corporate transparency is measured based on the dispersion and accuracy of analyst earnings forecasts.
• Iliev (2007): This research paper indicated that SOX 404 indeed led to conservative reported earnings but also reduced - rightly or wrongly - stock valuations of small firms. Lower earnings often cause the share price to decrease.
• Rice and Weber (2011) shows that only a minority of SOX 404 reports provide any advance warning of the possibility of impending accounting problems. Reporting incentives of the firms, like the need for raising additional external capital, larger firm size and decreased external auditor objectivity, might prohibit firms reporting the weakness of internal control in advance. Therefore, SOX 404 alone might not achieve its intended results.
• Skaife/Collins/Kinney/LaFond (2006): This research paper indicates that borrowing costs are much lower for companies that improved their internal control, by between 50 and 150 basis points (.5 to 1.5 percentage points).
• Lord & Benoit Report (2006): Do the Benefits of 404 Exceed the Cost? A study of a population of nearly 2,500 companies indicated that those with no material weaknesses in their internal controls, or companies that corrected them in a timely manner, experienced much greater increases in share prices than companies that did not. The report indicated that the benefits to a compliant company in share price (10% above Russell 3000 index) were greater than their SOX Section 404 costs.
• Institute of Internal Auditors (2005): The research paper indicates that corporations have improved their internal controls and that financial statements are perceived to be more reliable.
• Donelson, Ege and McInnis (2017): This research paper indicates that firms with reported material weaknesses have significantly higher fraud.
  

Effects on exchange listing choice of non-US companies

Some have asserted that Sarbanes–Oxley legislation has helped displace business from New York to London, where the Financial Conduct Authority regulates the financial sector with a lighter touch. In the UK, the non-statutory Combined Code of Corporate Governance plays a somewhat similar role to SOX. See Howell E. Jackson & Mark J. Roe, "Public Enforcement of Securities Laws: Preliminary Evidence" (Working Paper January 16, 2007). London based Alternative Investment Market claims that its spectacular growth in listings almost entirely coincided with the Sarbanes Oxley legislation. In December 2006, Michael Bloomberg, New York's mayor, and Chuck Schumer, U.S. senator from New York, expressed their concern.

The Sarbanes–Oxley Act's effect on non-U.S. companies cross-listed in the U.S. is different on firms from developed and well regulated countries than on firms from less developed countries according to Kate Litvak. Companies from badly regulated countries see benefits that are higher than the costs from better credit ratings by complying to regulations in a highly regulated country (USA), but companies from developed countries only incur the costs, since transparency is adequate in their home countries as well. On the other hand, the benefit of better credit rating also comes with listing on other stock exchanges such as the London Stock Exchange.

Piotroski and Srinivasan (2008) examine a comprehensive sample of international companies that list onto U.S. and U.K. stock exchanges before and after the enactment of the Act in 2002. Using a sample of all listing events onto U.S. and U.K. exchanges from 1995 to 2006, they find that the listing preferences of large foreign firms choosing between U.S. exchanges and the LSE's Main Market did not change following SOX. In contrast, they find that the likelihood of a U.S. listing among small foreign firms choosing between the Nasdaq and LSE's Alternative Investment Market decreased following SOX. The negative effect among small firms is consistent with these companies being less able to absorb the incremental costs associated with SOX compliance. The screening of smaller firms with weaker governance attributes from U.S. exchanges is consistent with the heightened governance costs imposed by the Act increasing the bonding-related benefits of a U.S. listing.