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The Effect of SOX Section 404

Street Photography, Centro, Madrid, España
Image by publikaccion.es via Flickr

Another excellent article from Harvard Law School. Below is an excerpt. There is no doubt that SOX has increased the cost of doing business and the article explains this in great detail.

“Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on Monday September 21, 2009 at 9:24 am

(Editors note: This post comes to us from Peter Iliev of Pennsylvania State University.)

In my paper, The Effect of SOX Section 404: Costs, Earnings Quality and Stock Prices, which was recently accepted for publication in the Journal of Finance, I investigate the costs, the benefits, and the overall value impact of SOX Section 404. This provision requires that managers report on the effectiveness of the controls that monitor the internal financial reporting systems, and an outside auditor attests to the managements assessment of company controls.

Section 404 and its practical application have been under intense attack from business groups and lawmakers who generally view compliance as overly burdensome. Despite calls for a small company exemption, the SEC only gave a five month extension to small companies compliance. This exemption provides an ideal quasi-experiment for this study. Specifically, I use a regression discontinuity design that compares the companies that were just above the rule cutoff and had to file the report to companies that were just below the cutoff and did not have to file the report. This is a good quasi-natural experiment because the exact cutoff is not related to firm fundamentals. In addition, one must consider whether firms actively manipulated their public float to escape compliance. This paper uses the public float rule in 2002 to predict (instrument) the actual compliance in 2004. Firms with a public float over $75 million in 2002 had to comply with Section 404 in 2004. However, in 2002 firms had no information about the way Section 404 would be implemented. Therefore, companies did not know that this threshold would be used to define 2004 compliance and were less likely to actively avoid having a public float above $75 million.

The big advantage of the regression discontinuity design is that it can isolate the effects of SOX Section 404 compliance from the effects of the changing business climate (and any contemporaneous event) that would have affected all firms. The disadvantage of this approach is that it can look at small firms only. It is possible that the effect of Section 404 compliance is different for larger firms and hence the results do not to generalize to, for example, Fortune 500 type firms. However, small firms are interesting in themselves. First, there are, of course, more small firms than large firms. Second, the big complaint about Section 404 (and SOX compliance in general) has been that small firms pay disproportionately high costs because of the fixed cost nature of compliance. Third, small firms are likely to suffer more from asymmetric information and low reporting quality, and they could benefit most from the new regulation.

I investigate the audit fees as a direct measure of the costs of Section 404, the changes in reporting behavior proxied by firm accruals, and the stock returns around SOX related announcements as a measure of the net benefits of compliance. I find that the attestation of the managements report (MR) by outside auditors imposed significant costs for small firms. Filing an MR in 2004 increased audit fees by 98%, or $697,890. With a median firm market size of $110.9 million in 2004 and negative average earnings, this is not a small amount……”

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The three guys in the photo above are dealing with serious issues while strolling home from work in Madrid’s financial district.   The guy on the right is saying:  Look Pepe, when I get home my wife will have Chorizos in garlic sauce and olive bread with a nice red wine waiting for me, and I will be as happy as a Merino sheep.   The guy in the center is saying:  Chorizos….. what a cheap bastard you are, eating Chorizos as a main meal!   And, the guy on the left doesn’t care about any of this stuff and is instead wondering if his mistress is sleeping with other men.   The life of these financial executives is truly stressful!

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