Sarbanes–Oxley Act and patterns in stock returns around executive stock option exercise disclosures

We document negative stock returns and elevated trading volumes around executives’ early option exercise disclosures post‐SOX, but not pre‐SOX. This stock price reaction is incomplete, and the negative stock price drift is smaller post‐SOX compared to pre‐SOX. We also show effects of media coverage in the stock price response to exercise disclosures in the post‐SOX period. These findings provide evidence that the requirement mandated by SOX to disclose executives’ stock option exercises within two business days, and the increased media coverage, improves investors’ ability to incorporate into stock prices in a timely fashion the information conveyed by these exercises.     

Board changes and CEO turnover: The unanticipated effects of the Sarbanes–Oxley Act

The board independence requirements enacted in conjunction with the Sarbanes Oxley Act of 2002 (SOX) provided motivation for firms that were already compliant with the regulations to alter their board structure. We consider actual board changes made by compliant firms and how such changes affect the monitoring efficiency of the boards. We find that the majority of compliant firms (approximately 56%) add independent directors following SOX. However, we find a nontrivial number of firms (approximately 26%) actually decrease the number of independent directors to move closer to the stated 50% requirement. For firms that decrease independence, the CEO turnover performance sensitivity significantly decreases following SOX. We also find that large board independence changes seem to be most detrimental to the monitoring function of the board. Our results highlight that SOX may have had unintended consequences.     

The effect of external audits of internal control over financial reporting on financial reporting for clients of Big 4, Second-tier,and small audit firms

The external audit of internal control over financial reporting (ICFR) is a very expensive and contentious aspect of the Sarbanes–Oxley Act (SOX). Larger public firms were first required to file a management report on 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 audit requirement. Whereas most related prior research investigates the combined effect of management and auditor reports on financial reporting, this study examines the distinct effect of auditor reports on reporting quality. For companies audited by small auditors, we find evidence that financial reporting quality improves with an auditor report on ICFR. We find no evidence that auditor ICFR reports improve reporting quality for clients of Big 4 or Second-tier audit firms. Our study adds to the debate on the applicability of SOX Section 404 to smaller 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.     

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.     

The association between corporate governance and earnings quality: Further evidence using the GOV-Score

This paper reexamines the relation between corporate governance and quality of earnings using a summary governance measure. Prior research has used many surrogates for corporate governance including size and composition of board of directors, existence and composition of audit committee, and extent of institutional ownership. However, the criticism of the extant research has been that corporate governance comprises many facets and is not uni-dimensional. In this study we fill this void by using the Gov-Score developed by Brown and Caylor [Brown, D., and Caylor, M.L., (2006). Corporate governance and firm valuation. Journal of Accounting and Public Policy 25, 409-434.] to measure corporate governance. In the post-Sarbanes-Oxley period, we find evidence of a significant inverse relationship, namely higher levels of corporate governance are associated with lower absolute discretionary accruals and higher quality of earnings. Furthermore, our results suggest that only firms in the highest category of corporate governance experience significantly improved quality of earnings. Finally, as a test of robustness, we document that corporate governance is negatively associated with small earnings surprises. This implies that firms with weak corporate governance are more likely to manage earnings in order to meet or beat analyst forecasts.     

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.     

Ideological reactions to Sarbanes–Oxley

The Sarbanes–Oxley Act of 2002 has been generally seen as a legitimate response to a significant crisis in the capital markets. Not often acknowledged, however, is the observation that the law's overarching emphasis on restoring credibility to the capital markets is revelatory of a deep ideological commitment to maintaining the capitalist system which is inherent in the American political structure. Intriguingly, several groups have emerged in recent years which stand in opposition to the Sarbanes–Oxley Act. On the face of it, the efforts of these groups appear to contradict the law's intent of restoring credibility to the capital markets. This paper describes certain of these groups and the ideological claims that have been advanced with respect to their arguments. While it will be seen that the Sarbanes–Oxley Act has some weaknesses which might be corrected, it has generally been a progressive piece of legislation that has contributed to increased levels of transparency in financial reporting and a greater independence of auditors. While these goals might be viewed as self-serving measures intended to protect the interests of capital, they may also be seen as beneficial to society in a larger sense. Credible financial reporting and independence of auditors helps to provide greater societal control over corporations. In the absence of explicit multinational structures to reign in corporate power, it is difficult to conceive of any other potential control mechanisms apart from effective systems of financial reporting and corporate governance.     

Strategic revenue recognition to achieve earnings benchmarks

I examine whether managers use discretion in revenue recognition to avoid three earnings benchmarks. I find that managers use discretion in both accrued revenue (i.e., accounts receivable) and deferred revenue (i.e., advances from customers) to avoid negative earnings surprises, but find little evidence that discretion is used to avoid losses or earnings decreases. For a common sample of firms with both deferred revenue and accounts receivable, I find evidence that managers do not prefer to exercise discretion in either account. However, further tests show that managers preferred to use discretion in deferred revenue before the Sarbanes–Oxley Act of 2002 went into effect, consistent with them choosing to manage an account with the lowest real costs to the firm (i.e., future cash consequences). My results suggest that the revenue recognition joint project undertaken by the FASB and IASB to reduce managerial estimation in revenue recognition may have the unintended consequence of leading to greater real costs imposed on shareholders as firms are likely to use even greater discretion in accounts receivable.     

How do independent directors view corporate social responsibility (CSR)? Evidence from a quasi-natural experiment

We investigate how independent directors view corporate social responsibility (CSR). Exploiting the passage of the Sarbanes-Oxley (SOX) Act and the associated exchange listing requirements as an exogenous regulatory shock, we document that independent directors view CSR activities unfavorably. In particular, firms forced to raise board independence reduce CSR engagement significantly relative to those not required to increase board independence. Our results are consistent with the risk-mitigation view and the agency cost hypothesis where managers over-invest in CSR to mitigate their own exposure to nonsystematic risk. The over-investments in CSR are curbed in the presence of a stronger, more independent, board of directors. Several robustness checks confirm the results, including fixed-effects and random-effects regressions, dynamic panel data analysis, instrumental-variable analysis, propensity score matching, Lewbel's heteroscedastic identification, and Oster's method for coefficient stability. We also confirm the risk-mitigation hypothesis by showing that CSR activities reduce firm risk significantly. Our research design is much less vulnerable to endogeneity and is therefore likely to show a causal effect of board independence on CSR.