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Weekly UpdatesAbstract The Sarbanes--Oxley ACT (SOX) was effective for many large U. S. companies for fiscal years ending on or after December 15, 2004. Some, cross listed, non U. S., companies must comply with the provisions of Section 404 (404) of SOX for fiscal periods ending on or after July 15, 2006. The purposes of this study are to review the implications of SOX 404, to assess SOX 404's potential impact on worldwide securities regulation, assess the impact of SOX 404 on external audit fees for the initial group of filers during the first 2 years it was effective and assess SOX 404's prospective economic impact on foreign companies that cross list their securities in the U.S. Our finding indicated that audit fees increased by an average of 65% for the initial group of filers in the first year SOX 404 was effective and by .9% in the second year. This increase was reflected in a .5% decrease in earnings for these companies. We conclude that although similar results might be expected for foreign companies that cross list, the implementation costs do not provide sufficient reason to weaken or eliminate SOX 404's requirements at this time.
Keywords Audit fees * Compliance cost * Cross listing * International implications * Sarbanes--Oxley
JEL M41
In July 2002, U. S. President George W. Bush signed into law the Sarbanes-Oxley Act (SOX) that imposes a number of corporate governance rules on publicly traded companies in the United States, and foreign companies wishing to list their securities on U. S. stock exchanges. SOX was created in an attempt to protect investors by improving the accuracy and reliability of corporate disclosures. The act covers issues such as establishing a public company accounting oversight board, increasing auditor independence, corporate responsibility and enhancing financial disclosure. One key element of this legislation is to require a report on the internal controls a company has in place in order to ensure compliance with its provisions. Specifically, Section 404 (404) mandates that CEOs and CFOs must file periodic reports outlining the internal control over financial reporting and a certification of the disclosures contained in the annual report. SOX was effective for companies meeting the definition of accelerated filers (having an equity market capitalization of over $75 million and filing a report with the SEC) for fiscal years ending on or after December 15, 2004; consequently December 31, 2004 was the effective filing date for most of these companies. Non-U.S. companies must comply with SOX's provisions for fiscal periods ending on or after July 15, 2006 if their market capitalization exceeds $75 million. In addition, foreign non-accelerated filers are subject to an incremental filing requirement that will result in full compliance for fiscal periods ending on or after December 15, 2008 (discussed below).
SOX 404 requires substantial compliance costs as discussed below. Some of the internal compliance costs are not directly measurable but one significant component of these costs is external audit fees. The purposes of this study are to review the implications of SOX 404, to assess SOX 404's potential impact on world-wide securities regulation, assess the impact of SOX 404 on external audit fees for the initial group of filers (during the first 2 years it was effective) and to assess SOX 404's prospective economic impact on foreign companies that cross list their securities in the U.S.
Background
During the early 2000s, dozens of major U.S. companies either went bankrupt or faced extreme financial difficulties. These included such familiar names as Enron, WorldCom, Xerox, Global Crossing and Halliburton Oil Services. As a result, investors lost billions of dollars, jobs vanished, and thousands of people lost their entire retirement savings, Subsequently, "corporate reform" became a watchword
In addition to the scandals, the cavalier attitude of the executives of some of the failed companies further unsettled the U. S. and the world. For example, in congressional testimony, Jeffrey Skilling, CEO of Enron, maintained that detailed financial reporting and disclosure vigilance was the proper domain not of a CEO, but of Enron's accountants and lawyers. Similarly, Bernie Ebbers, the CEO of WorldCom, alleged that he was totally unaware of his CFO's financial reporting wrongdoing. (1) Public unrest over these issues resulted in hearing before the United States Congress, and on April 25, 2002, the House of Representatives passed the Oxley Bill. On July 15, 2002, the Senate passed the Sarbanes Bill. Together these two bills became known as the Sarbanes--Oxley Act of 2002.
Section 404 Provisions
Section 404 of the Sarbanes-Oxley Act of 2002 is comprised of two distinct sections--404(a) and 404(b). 404(a) outlines management's responsibility and requires that the annual report include an internal control report by management which (1) acknowledges its responsibility for establishing and maintaining adequate internal control over financial reporting and (2) contains an assessment of the effectiveness of internal control over financial reporting as of the end of the most recent fiscal year. The provisions of SOX also require the principal executive and financial officers to make quarterly and annual certifications as to the effectiveness of the company's internal control over financial reporting.
Section 404(b) outlines the independent auditor's responsibility. It originally required the auditor to report on the internal control assessment made by management and also to make a separate independent assessment of the company's internal controls over financial reporting. As a result, the auditor was required to provide two separate opinions. The first opinion stated whether management assessment is fairly stated, in all material respects. The second opinion indicated whether, in the auditor's opinion, the company maintained, in all material respects, effective internal control over financial reporting as of the specific date, based on the control criteria used by management. In 2007, The Public Company Accounting Oversight Board issued Statement on Auditing Standards No. 5 (PCAOB 2007) which eliminated the need for the first opinion as discussed below.
Cost of Compliance
The cost of compliance with this legislation was seen by some as excessive. According to Zhang (Unpublished manuscript 2007) the net private cost amounted to $1.4 trillion. This amount was obtained by an econometric estimate of the loss in total market value caused by SOX. That is, the costs minus the benefits as perceived by the stock market as the new rules were enacted. She also attempted to investigate the sources of these additional costs by examining the implications of some of the major provisions of SOX. Her findings suggested that SOX's restriction on providing non-audit services to their clients by public accounting firms and the requirement for the internal control tests are costly. Zhang also found that the market reaction to the original announcement of postponing compliance with 404 was positive. Finally, her results indicated that companies with weak governance systems do not benefit from enhanced governance as commonly expected, but actually lose more as a result of SOX. Zhang maintained that this finding significantly challenges the value of SOX, as it is primarily characterized as legislation that improves corporate governance and increases shareholder value.
Zhang's study has since been criticized on the grounds that no single factor can be attributed as the cause of stock market behavior. Her critics note that all of the stock market trends around the time SOX was enacted were attributed to the legislation, while the subsequent increase in market value was ignored (Creelman 2006; Big Picture 2006). Additionally, the attribution of the suggested causes of these additional costs suffers from relatively low [R.sup.2] s (>0.15-<0.30), suggesting that much of the source of the variation in her dependent variables has not been identified. Nevertheless, a survey by the Financial Executives Institute in 2005 estimated that companies' total costs for the first year of compliance with SOX averaged S4.6 million (Financial Executive 2005).
The new provisions that emphasize the importance of internal control have obvious benefit; however, a standard rule of thumb for internal control measures is that their benefits should outweigh their costs. Some critics of SOX maintain that its effect has been that the costs of regulation exceed its benefits for many corporations (Carney 2006). Additionally, it has been suggested that internal controls, no matter how adequate, could not have done much to prevent the accounting scandals that precipitated the passage of SOX. That is, internal controls are generally designed to prevent small frauds, but the large frauds have generally been perpetrated by those with the authority to circumvent any policy. Enron and the others were not accounting failures, but enforcement failures. No matter how adequate the controls, someone with the ingenuity and authority can circumvent them (Sinnett 2004).
One other potential consequence is SOX's impact on the financial services industry. In 2006, Mayor Michael Bloomberg and Senator Charles Schumer asked the New York City Economic Development commission to work with McKinsey & Company to develop a better understanding of the contribution that strong, innovative financial markets can make to the economy. The result was a report (McKinsey 2007) which suggests the U. S. stands to lose between 4% and 7% of its share of the global financial market if lawmakers In the U. S. do not take action to improve the business environment. Of particular concern, was the fact U. S. exchanges attracted only one-third of the share of the market value of initial public offerings (IPOs) they obtained in 2001. At least part of this loss was blamed on excessive regulation including SOX that discourages new economic activity. As a consequence, one of the report's recommendations was that small and foreign companies be made exempt from 404. (2)
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