Stock price crash risk and internal control weakness: presence vs. disclosure effect

This study examines the stock price crash risk for a sample of firms that disclosed internal control weaknesses (ICW) under Section 404 of the Sarbanes‐Oxley Act (SOX). We find that in the year prior to the initial disclosures, ICW firms are more crash‐prone than firms with effective internal controls. This positive relation is more pronounced when weakness problems are associated with a firm's financial reporting process. More importantly, we find that stock price crash risk reduces significantly after the disclosures of ICWs, despite the disclosure itself signalling bad news. The above results hold after controlling for various firm‐specific determinants of crash risk and ICWs. Using an ICW disclosure as a natural experiment, our study attempts to isolate the presence effect of undisclosed ICWs from the initial disclosure effect of internal control weakness on stock price crash risk. In so doing, we provide more direct evidence on the causal relation between the quality of financial reporting and stock price crash risk.     

New evidence on what happens to CEOs after they retire

I analyze directorships held by CEOs who retired during the periods 1989–1993, 1995–1999 (before the Sarbanes–Oxley Act) and 2001–2005 (after the Sarbanes–Oxley Act). My results suggest that retired CEOs became less popular on boards after the Sarbanes–Oxley Act. In addition, although pre-retirement accounting performance helps explain the number of outside directorships a retired CEO held in the 1989–1993 sample, as Brickley et al. (1999) have found, it does not explain this number for the 1995–1999 sample and 2001–2005 sample. Third, a company's stock performance during a CEO's tenure is negatively related to the number of outside directorships only in the 2001–2005 sample. Fourth, the number of outside directorships is positively correlated with the size of a retired CEO's original firm before the Sarbanes–Oxley Act, but this is not the case after the Sarbanes–Oxley Act. Finally, if retired CEOs worked in regulated industries, their probability of serving at least one outside directorship 2 years after retirement falls by 21% in the 1989–1993 sample. However, this negative effect is marginally significant in the 1995–1999 sample, and vanishes in the 2001–2005 sample.     

Corporate Governance and Firm Value: The Impact of the 2002 Governance Rules

The 2001 to 2002 corporate scandals led to the Sarbanes–Oxley Act and to various amendments to the U.S. stock exchanges' regulations. We find that the announcement of these rules has a significant effect on firm value. Firms that are less compliant with the provisions of the rules earn positive abnormal returns compared to firms that are more compliant. We also find variation in the response across firm size. Large firms that are less compliant earn positive abnormal returns but small firms that are less compliant earn negative abnormal returns, suggesting that some provisions are detrimental to small firms.     

Auditor Independence,Non‐Audit Services,and Restatements: Was the U.S. Government Right?*

Do fees for non‐audit services compromise auditor's independence and result in reduced quality of financial reporting? The Sarbanes‐Oxley Act of 2002 presumes that some fees do and bans these services for audit clients. Also, some registrants voluntarily restrict their audit firms from providing legally permitted non‐audit services. Assuming that restatements of previously issued financial statements reflect low‐quality financial reporting, we investigate detailed fees for restating registrants for 1995 to 2000 and for similar nonrestating registrants. We do not find a statistically significant positive association between fees for either financial information systems design and implementation or internal audit services and restatements, but we do find some such association for unspecified non‐audit services and restatements. We find a significant negative association between tax services fees and restatements, consistent with net benefits from acquiring tax services from a registrant's audit firm. The significant associations are driven primarily by larger registrants.     

The governance of risk management: The importance of directors’ independence and financial knowledge

We test the effects of the independence and financial knowledge of directors on risk management and firm value in the gold mining industry. Our original hand‐collected database on directors’ financial education, accounting background, and financial experience allows us to measure the effect of financial knowledge on risk management activities. We show that directors’ financial knowledge increases firm value through the risk management channel. This effect is strengthened by the independence of the directors on the board and on the audit committee. Extending the dimension of education, we show that, following unexpected shocks to gold prices, firms with financially educated directors are more effective in hedging than average firms in the industry. Firms that hedge more also attracts highly educated directors on their board and audit committee. As a policy implication, our results suggest adding the experience and education dimensions to the 2002 Sarbanes–Oxley Act and New York Stock Exchange requirements for better governance.     

The effect of the Sarbanes-Oxley act on non-US companies cross-listed in the US

This paper uses a natural experiment to measure market response to the adoption of the Sarbanes–Oxley Act (ʽʽSOX"). Because SOX applies to all US public companies, US-based studies have difficulty separating the effects of contemporaneous events. However, controlled analysis is available: SOX applies to some cross-listed firms (those listed on level 2 or 3), but not to others (listed on level 1 or 4). By comparing reactions of SOX-exposed foreign firms to reactions of otherwise similar SOX-unexposed foreign firms, we can test investor beliefs about the costs and benefits of SOX in a way that is not cleanly available for US-based studies. We find that stock prices of foreign firms subject to SOX declined (increased) significantly, compared to cross-listed firms not subject to SOX and to non-cross-listed firms, during key announcements indicating that SOX would (would not) fully apply to cross-listed issuers. In cross-sectional tests, high-disclosing firms and firms from high-disclosing countries experienced the strongest declines, while faster-growing companies experienced weaker declines. This evidence is consistent with the view that investors expected the Sarbanes–Oxley Act to have a net negative effect on cross-listed foreign companies, with high-disclosing and low-growth companies suffering larger net costs, and faster-growing companies suffering smaller costs, particularly when they are located in poorly governed countries.     

How do public companies adjust their board structures?

We show that public companies frequently changed their board structures before implementation of the Sarbanes–Oxley Act, with two-thirds of firms changing board size or independence during an average two-year period. Board changes were associated with changes in firm-specific fundamentals, but the rate of change toward predicted structures was negatively associated with the level of CEO influence. Companies changed board structures in either direction as underlying firm fundamentals changed, consistent with the pursuit of economically efficient board structures. However, board changes have become less frequent since the Sarbanes–Oxley Act was enacted. We provide some evidence that companies became less likely to decrease board independence when changes in fundamentals suggested they should, which may reflect a loss of economic efficiency.     

Voluntary formation of audit committees by large municipal governments

The Sarbanes–Oxley Act of 2002 requires that publicly-traded U.S. corporations have an audit committee in their internal control structure. In contrast to publicly-traded commercial firms, municipal governments are not required to form audit committees. Given that regulators believe it is a crucial aspect of internal control, we examine the extent to which city governments feature audit committees in the internal control structure. Based on a survey of financial managers from cities with populations greater than 100,000, we find that approximately 58% of the municipalities have such committees. Results indicate that larger and more financially viable cities are more likely to have audit committees. However, the form of municipal government and the quality of the local government’s financial reporting and audit processes are not significant determinants of the presence of an audit committee.     

Auditors and the post-2002 litigation environment

In the wake of the disclosure of Enron and WorldCom and other dramatic financial reporting frauds, the Sarbanes–Oxley Act was passed on July 30, 2002. Thus, 2002 was a watershed year for auditors. Audits performed after the passage of Sarbanes–Oxley began to be reflected in litigation filed in 2003. Analysis of 1169 lawsuits filed between 2001 and 2008 finds that auditor litigation severity decreased in the lawsuits filed after 2002. Analysis of a reduced sample of 1017 lawsuits – where dollar resolution amounts are available – shows that the magnitude of auditor dollar resolution amounts decreased in the lawsuits filed after 2002. Thus, auditor liability risk decreased after 2002.     

Abnormal real operations,real earnings management,and subsequent crashes in stock prices

We study the impact of firms’ abnormal business operations on their future crash risk in stock prices. Computed based on real earnings management (REM) models, firms’ deviation in real operations (DROs) from industry norms is shown to be positively associated with their future crash risk. This association is incremental to that between discretionary accruals (DAs) and crash risk found by prior studies. Moreover, after Sarbanes–Oxley Act (SOX) of 2002, DRO’s predictive power for crash risk strengthens substantially, while DA’s predictive power essentially dissipates. These results are consistent with the prior finding that managers shift from accrual earnings management to REM after SOX. We further develop a suspect-firm approach to capture firms’ use of DRO for REM purposes. This analysis shows that REM-firms experience a significant increase in crash risk in the following year. These findings suggest that the impact of DRO on crash risk is at least partially through REM.     

The Effect of SOX Section 404: Costs,Earnings Quality,and Stock Prices

This paper exploits a natural quasi‐experiment to isolate the effects that were uniquely due to the Sarbanes–Oxley Act (SOX): U.S. firms with a public float under $75 million could delay Section 404 compliance, and foreign firms under $700 million could delay the auditor's attestation requirement. As designed, Section 404 led to conservative reported earnings, but also imposed real costs. On net, SOX compliance reduced the market value of small firms.     

Heterogeneity in the Effect of Managerial Equity Incentives on Firm Value

We document significant heterogeneity in the relation between chief executive officer (CEO) equity incentives and firm value using quantile regression. We show that CEO delta is more effective in the presence of ample investment opportunities, while CEO vega is more beneficial for firms lacking investment opportunities. Further, Tobin's Q increases in CEO delta for more risk‐tolerant firms but increases in CEO vega for more risk‐averse firms. We also observe that higher monitoring intensity after the Sarbanes‐Oxley Act reduces CEO delta's role in compensation. Risk aversion alters the optimal incentive‐value relation, and the nature of this relation also depends on the level of Tobin's Q.     

Firm Characteristics and Stock Price

This study examines the stock price reaction to the internal control reporting required under Section 404 of the Sarbanes‐Oxley Act of 2002 for three distinct groups of firms. After controlling for general stock price movements, we find that stock returns are most negative for firms that delay filing of their internal control reports, continue to be negative for firms with ineffective internal controls, and are positive for firms with effective internal controls. The decrease in stock prices of the first two groups is more pronounced for those with a lower return on assets, higher growth rate in sales, and no prior disclosure of their internal controls weaknesses. Our results indicate that market participants value the reliability of financial information ensuing from Section 404 compliance, irrespective of firm size and debt proportion. Thus, regulators and policymakers worldwide should consider mandating comparable SOX 404 compliance for all publicly held companies to improve the accuracy and reliability of financial reports.     

Strategies of resistance to internal control regulation

This paper applies the institutional concepts of resource dependence, power, resistance, and dramaturgical exchange to the legislative history of the Foreign Corrupt Practices Act (FCPA) of 1977, internal control proposals and regulations from the late 1970s to the late 1990s, and the internal control requirements under the Sarbanes–Oxley Act (SOX) of 2002. The analysis documents that from 1976 to 2001 powerful organizations and individuals employed active strategies of avoidance, defiance, and manipulation to successfully defeat proposals that would have required all public companies to assess and publicly report on their internal controls over financial reporting. During this same period, the US Securities and Exchange Commission (SEC) vacillated between actively advocating mandatory internal control reporting and passively acquiescing to industry and White House demands for voluntary internal control reporting. The resulting dramaturgical exchange between the SEC and its regulatees made it appear as if the voluntary initiatives were reasonably effective, but subsequent accounting and financial scandals challenged this view and eventually precipitated mandatory internal control assessment and reporting. The paper also considers how the ongoing dramaturgical exchange between regulators and regulatees could significantly weaken the internal control requirements of SOX (2002) [Sarbanes–Oxley Act of 2002 (2002). Public Law 107–204, 116 Stat. 745], and discusses implications for future research and recent critiques of neoinstitutional theory.     

Risk Shifts Following Sarbanes‐Oxley: Influences of Disclosure and Governance

The Sarbanes‐Oxley Act of 2002 (SOX) aimed to improve financial reporting by enhancing corporate disclosure and governance. We find statistically significant increases, from before to after the passage of SOX, in total return variance, market risk and idiosyncratic risk. The risk increases are consistent with predictions that the legislation would cause firms to disclose more negative information, resulting in increased investment risk. However, in cross‐sectional tests, post‐SOX improvements in information certainty, board independence and monitoring are associated with smaller increases or greater decreases in risk. If SOX is responsible for these improvements, its effects are consistent with its purpose.     

Costs and Returns on Graduates of the University of Bradford

Global repercussions of the Enron scandal and particularly the enactment of the Sarbanes–Oxley Act (SOX) in the USA, resulted in significant changes in the UK regulatory regime for audit and corporate governance, including an increased role for audit committees and independent inspection of audit firms. UK-listed company chief financial officers, audit committee chairs (ACCs) and audit partners were surveyed in 2007 to obtain views on the impact of 36 economic and regulatory factors on audit quality post-SOX. Four hundred and ninety-eight usable responses were received, representing a response rate of 36%. All groups rated various audit committee interactions with auditors among the factors most enhancing audit quality. However, International Standards on Auditing (ISAs) and the audit inspection regime, aspects of the ‘standards-surveillance-compliance’ regulatory system, are viewed as less effective. Exploratory factor analysis reduces the 36 factors to nine independent dimensions: economic risk; audit committee activities; risk of regulatory action; audit firm ethics; economic independence of auditor; audit partner rotation; risk of client loss; audit firm size and, lastly, ISAs and audit inspection. Post-SOX regulations have introduced additional dimensions to the factors influencing audit quality. Respondents commented that aspects of the changed regime are largely process and compliance driven, with high costs for limited benefits, a finding consistent with regulatory over-reaction.     

Financial restatements and Sarbanes–Oxley: Impact on Canadian firm governance and management turnover

Canadian firms have different roots (e.g., more concentrated ownership and smaller size) than U.S. firms and Canadian regulatory enforcement follows a different route (principle- versus rule-based) that embodies the underlying intent of Sarbanes–Oxley (SOX). Financial restatements are more likely when Canadian firms have lower blockholder or management ownerships, lower proportions of unrelated directors, no financial savvy audit committee members and are not audited by prestigious auditing firms. To signal that they are dealing with the impact of agency problems on cash flow uncertainties, restating firms exhibit significantly higher turnovers of CEOs, CFOs and external auditors post-restatement, and they converge towards control-group governance post-restatement by making changes to the identified determinants of financial restatement likelihood. Consistent with prior results for U.S. firms, SOX had a small (extraterritorial) impact on the likelihood of post-restatement turnovers of management and other corporate overseers for Canadian restating firms.     

Do management reports on internal control over financial reporting improve financial reporting?

Sections 404a and 404b of the Sarbanes–Oxley Act require management and external auditors, respectively, to report on the adequacy of a company’s internal control over financial reporting (ICFR). Larger public firms were first required to file a management report and have an external audit of ICFR in 2004. Smaller public firms were first required to file a management report on ICFR in 2007 but are exempt from the attestation requirement. We investigate the distinct effect of management reports on financial reporting quality. We find that management reports on ICFR improve reporting quality and demonstrate that there are financial reporting benefits from the management report requirement on its own without attestation.     

How Effective Is Internal Control Reporting under SOX 404? Determinants of the (Non‐)Disclosure of Existing Material Weaknesses

We study determinants of internal control reporting decisions under Section 404 of the Sarbanes‐Oxley Act (SOX 404) using a sample of restating firms whose original misstatements are linked to underlying control weaknesses. We find that only a minority of these firms acknowledge their existing control weaknesses during their misstatement periods, and that this proportion has declined over time. Further, the probability of reporting existing weaknesses is negatively associated with external capital needs, firm size, non‐audit fees, and the presence of a large audit firm; it is positively associated with financial distress, auditor effort, previously reported control weaknesses and restatements, and recent auditor and management changes. These results provide evidence that detection and disclosure incentives play a role in whether existing material weaknesses are reported, which has implications for the effectiveness of SOX 404 in providing investors with advance warning of potential accounting problems.     

Audit Committee Financial Expertise,Litigation Risk,and Auditor‐Provided Tax Services*

The Sarbanes‐Oxley Act (SOX) greatly expanded audit committees' oversight responsibilities by requiring that they preapprove all non‐prohibited non‐audit services (NAS). Using data from 2003 to 2011, we find that tax NAS are significantly lower when accounting financial experts (ACT‐FEs) serve on the audit committee, suggesting that ACT‐FEs consider auditor independence risk, perceived and/or real, more than other members, including supervisory experts, to the point of not accepting any tax NAS, not even compliance. However, in firms with higher ex ante litigation risk, ACT‐FEs approve relatively more tax NAS than other members, suggesting that they accept the costs of a perceived lack of auditor independence from tax NAS in return for the potential benefits of increased financial reporting quality arising from tax NAS. Our analysis by subperiod (2003–2006 vs. 2007–2011) shows that this result is significant only in the second period. ACT‐FEs' differential evaluation of the trade‐off between the benefits and costs of joint audit and tax NAS provision between the two periods suggests the need for additional research in later post‐SOX years.