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Transcript of THEORY Group Paper TURN IN
University of Washington-Tacoma’s Milgard School of Business
TACCT501: Financial Accounting Theory
Spring, 2016
The Effects of the Sarbanes-Oxley Act on Corporate Governance, Accounting Conservatism,
and Earnings Management
Prepared by:
Group 6
Authors: Caron Schmidt, Rui Su, and Shirley Santiago Flores
Presented to:
Dr. Ehsan H. Feroz
May 16, 2016
As is well known in the accounting world, the Sarbanes-Oxley Act (“SOX”
or “the Act” hereafter) came at a time of rampant scandals and economic
hardship and was enacted to limit management’s opportunity to abuse
accounting rules. The central goal of SOX was to fix the auditing process of
public companies (Coates IV, 2007). In the time period leading up to the
enactment of SOX, the laws concerning corporate governance were not
adequate enough to prevent financial fraud. For this reason, SOX had 5 main
focuses: strengthening the independence of auditing firms, improving the quality
and transparency of financial statements and corporate disclosure, enhancing
corporate governance, improving the objectivity of research, and strengthening
the enforcement of the federal securities laws (Linck, 2008).
SOX set into motion numerous changes, both expected and
unexpected, in the way business was conducted. Some of the most noteworthy
changes in the post-SOX period include a shift in corporate governance
landscape, an increase in financial reporting conservatism, and a move from
accrual-based earnings management to real earnings management. These
changes all took place shortly after the passage of SOX, thereby suggesting that
SOX, rather than a multitude of other factors, instigated these changes. In this
paper, we will discuss the studies examining these changes in further detail. We
will also provide our critiques of the ideas presented within the studies and
recommendations for future research. First we examine the SOX-imposed
changes on corporate governance.
CORPORATE GOVERNANCE
Likely the most well known effect of SOX was its very large and
undeniable impact on the corporate governance of both public and private
companies. Robert Clark, a distinguished professor at Harvard University,
grouped the post-SOX corporate governance changes into three categories:
audit-related changes, board-related changes, and changes in disclosure and
accounting rules. Following his example, we will discuss the governance
changes in these categories, though we will also discuss the costs and benefits
associated with these SOX-imposed governance changes. First we examine
what corporate governance is.
Definition of Corporate Governance
While the term “corporate governance” may be a challenge to define in
itself, defining its core themes does not pose such a challenge. Cheffins (2012)
suggests that corporate structure, shareholder activism, and executive pay have
been important elements of corporate governance for at least the last 30 years.
Shadab (2008) explains that, “corporate governance consists of the rules,
entities, and processes that govern how corporations use their assets to
generate and distribute revenues among shareholders, employees, and other
parties.”
Audit-Related Changes
The first change in corporate governance to discuss is that concerning
audit. The goal of SOX, with respect to audit firms, was to strengthen their
independence. One of the main ways the Act did this was through the creation of
a new auditing process regulator called the Public Company Accounting
Oversight Board (PCAOB), which was intended “to oversee the independent
auditors of public companies, replacing a self-regulatory scheme and mandating
true independence” (Maleske, 2012). This new regulator required accounting
firms that audit public companies to register with it and subjected these firms to
inspections.
Clark (2005) further breaks the audit-related changes into two categories:
conflict-reducing rules and action-forcing rules. Examples of conflict-reducing
rules imposed or encouraged by SOX include limiting the roles and services of
auditors and placing the power to hire and compensate external auditors in the
hands of independent members of the audit committee as opposed to in the
hands of managers or the board of directors. Examples of action-forcing rules, on
the other hand, include requiring internal control processes and the certification
of financial reports. SOX Sections 302 and 404 “require all public companies to
report on the effectiveness of internal control over financial reporting” (Wang,
2010). Section 404 “requires management to evaluate the effectiveness of the
internal control system in the annual report that is subject to auditor attestation”
(Wang, 2010). The costs and benefits of the implementation of this rule will be
discussed later in the paper. Section 302 requires that the SEC adopt rules
requiring the CEO and CFO to attest to the effectiveness of internal controls over
financial reporting as well as to disclose any and all material changes in internal
controls during the financial reporting period.
Board-Related Changes
According to Houman B. Shadab, a professor of law at the New York Law
School, “The three primary functions of a board are to monitor and hold top
management accountable, to be indirectly involved in operational decision
making (such as providing advice to top managers and setting broad corporate
policies), and to provide a network of contacts to the corporation.” The effect that
SOX had on the board of directors, as it relates to its composition, size, and
independence, has resulted from both conflict-reducing and action-inducing
standards. Cost-reducing standards led to changes in the board of directors
because they encouraged and provided a stricter definition for director
independence. Because of these changes companies were responsible for
having key committees: audit, compensation, and nominating (Clark, 2005).
These key committees could only be made up of independent directors that
satisfied the stricter definition of independent. Another important conflict-reducing
change SOX brought about was the separation of positions; for instance the CEO
was not to be the chairperson, and the chairperson should be an independent
director. Standards that were meant to induce or encourage action were those
that set limits on over-boarding, required a financial expert to have a seat on the
board of directors, mandated director stock ownership, or provided governance
guidelines and codes of ethics (Clark, 2005). Though SOX did not require
companies to adopt a code of ethics, the Act made it apparent that the SEC
would expect one.
The role of the board of directors shifted post-SOX as well. Managers,
post-SOX, were “perceived to be working for the board instead of the board
serving management” (Maleske, 2012). Boards more strongly focused on their
responsibilities and duties. The workload and responsibilities of independent
board members increased and shifted “from providing strategic advise to
management to establishing and maintaining risk management processes”
(Shadab, 2008). SOX also increased board size and director and manager
turnover, and made the company’s focus primarily on processes and regulatory
compliance.
Risks born by directors are also an important change to recognize. These
risks were brought on by an increase of reforms as a result of, or as encouraged
by, SOX. “Section 804 of the Act provides for a longer statute of limitations for
securities claims, giving private litigants additional time to discover and file for
claims” (Linck, 2008). Board compensation then increases as a result of the
increased risk for directors. However, Linck says that although director pay has
been increased, the director workload has also increased to the point where their
compensation has not been significantly influenced by SOX, though it is much
more performance-sensitive. Another increase that is seen, post-SOX, as a result
of directors’ risks is in Director and Officer (D&O) insurance premiums.
Disclosure Enhancements and Accounting Rule Changes
These rules, as imposed by SOX, require “greater, faster, and different
disclosures” (Linck, 2008). Disclosures that must be made post-SOX include off-
balance-sheet arrangements, critical accounting policies, related party
transactions and much more. Also, as mentioned in the audit-related changes
section of this paper, SOX § 302 required that the CEO and CFO personally
certify the company’s financial statements. The mandated increase in disclosure
improves performance evaluations of CFOs by reducing information asymmetry
between the board and the CFO.
Costs and Benefits of Corporate Governance Changes
An important critique of SOX is that the costs of complying with its rules
outweighed the benefits received. It is said that in the first year of adjusting to
comply with SOX the cost exceeds the benefit. It is possible, however, that in the
years following the benefit outweighs the costs.
Costs incurred by companies aiming to comply with the Act include
“testing, improving, and reporting on internal controls pursuant to SOX Section
404” (Clark, 2005) as well as hiring “third-party independent auditors to assess
their internal controls” (Maleske, 2012). Companies, however, are not the only
parties that are exposed to costs as a result of SOX. A lesser-known cost is that
to society, which forgoes benefits from innovation as a result of SOX’s
requirement of all companies to have more independent directors and an
increased emphasis on internal control over financial reporting. Benefits gained
through compliance include “a better understanding of control design and
increased effectiveness and efficiency of operations” (Maleske, 2012).
Critique of Studies Examined
We find the critique regarding the costs and benefits of SOX to be
fascinating. Because studies on this topic are mixed, with some believing that the
costs outweigh the benefits and some believing that over time the benefits will
exceed the costs of complying with SOX, we do not believe that enough research
has been done on this topic to be able to come to a general consensus.
Furthermore, we find it hard to believe that board compensation did not rise
enough relative to the increase in workload to be a substantial pay increase
resulting from SOX. It is understandable that the responsibilities and duties of the
board of directors would increase as a result of the reforms and other impositions
of SOX, but because of the increase in risk to management, some of which may
serve as members on the board, we would assume that the compensation to
board directors would have increased substantially as a result of SOX.
Recommendations for Future Directions
Additional research on the overall net cost or benefit of SOX would aid in
understanding whether the critique that SOX costs companies more than it
benefits them is valid. Research could also include examining if “the mandates of
SOX increased director workload and changed board structure so materially that
it has affected the advisory role of boards” (Linck, 2008). Other concepts that
should be further researched in the future include how firms choose to meet the
independence requirements imposed by the Act, whether SOX had more of an
impact on firms with more or less independent boards of directors, and whether
takeovers are a risk born by companies as a result of SOX.
FINANCIAL REPORTING CONSERVATISM
Another significant effect that SOX had on the accounting profession was
an increase in conservatism in financial reporting. A number of prior studies have
reviewed SOX’s effects on financial reporting conservatism in the pre-SOX and
post-SOX periods. These studies seem to indicate that there was an increase in
conservatism for a short period of time after SOX’s enactment and that the
increase was not persistent in later years. These studies also conclude that the
internal control requirements of SOX have encouraged firms to report more
conservatively.
Interpretation of Conservatism
Basu (1997) interpreted conservatism as “the accountant's tendency to
require a higher degree of verification to recognize good news as gains than to
recognize bad news as losses." Therefore, in his model, bad news related to
earnings is reported more quickly than good news. This type of asymmetric
timeliness is also called conditional conservatism. Conditional conservatism is
different from normal conservatism, in that normal conservatism is the cautious
propensity in financial reporting, whereas conditional conservatism indicates the
incremental prudence to report good news of earnings (Verleun 2010).
Watts (2003) interpreted conservatism as providing higher quality earnings.
Investors would benefit from the information they obtain from firms’ conservative
financial statements. Watts (2003) explained several reasons that investors might
benefit from conservatism; one explanation being that conservatism is helpful in
addressing the moral hazard problem caused information asymmetry. The
alternative explanations are that conservatism helps to decrease litigation costs,
delay tax expenses, and benefits standard setters by decreasing their regulatory
costs (Watts, 2003).
Conservatism in the pre-SOX and post-SOX period
Lobo and Zhou (2006) examined financial reporting conservatism in the pre-
SOX and post-SOX period. They used two methods to compare conservatism
before and after SOX. First, they compared the level of discretionary accruals in
these two periods. Second, they measured the sensitivity of earnings recognition
to positive and negative stock returns. Increases in conservatism would result
from lower discretionary accruals and would delay the recognition of gains in the
post-SOX period. The two methods of comparison confirm that increases in
financial reporting conservatism occurred in the two years after SOX (Lobo and
Zhou, 2006). The results of this study only indicate an increase in financial
conservatism in a quite short period following SOX.
The finding reported in the study of Lobo and Zhou was primarily because
SOX emphasizes that management is held personally responsible for the
accuracy and completeness of corporate financial statements. As mentioned in
the corporate governance section of this paper, the SEC increases executives’
responsibility by requiring CEOs and CFOs certify periodic financial reports of
companies. CEOs and CFOs therefore would be punished with criminal penalties
for knowingly certifying financial statements that did not follow SOX and GAAP
rules and requirements. Since SOX imposes criminal penalties on responsible
executives, CEOs and CFOs are more likely to engage in litigation. Basu (1997)
stated in his paper that an increase in conservatism occurs in high litigation
growth periods and that no increase occurs in low litigation growth periods. This
argument indicates that increases in financial reporting conservatism potentially
occur if SOX increases litigation against CEOs and CFOs (Lobo and Zhou,
2006). Lobo and Zhou only investigated the short-term effects of SOX, so the
question is whether the effects of SOX on financial reporting conservatism are
sustainable.
Verleun (2011) investigated SOX’s effects in a longer post-SOX period.
Verleun developed several hypotheses to examine the persistency of increases
in conservatism in the post-SOX period. He predicted that in the post-SOX
period, accounting quality had significantly improved and the improvement in
accounting quality was persistent over the post-SOX period. However, the
findings in his model suggested that conservatism increased in a short time right
after SOX’s enactment but the increase was not sustainable in later years.
Verleun also predicted that SOX’s influence on accounting quality does not differ
between technology and non-technology firms. Although some insignificant
evidence show that technology firms seem to be less conservative than non-
technology firms, no significant findings could disprove his prediction.
Relation between Internal Controls and Conservatism
A significant impact of SOX is improving corporate internal controls. Goh
and Li (2011) explored the relationship between internal controls and accounting
conservatism. He compared firms with disclosed material weaknesses to firms
without such disclosures to examine whether a higher quality of internal controls
increased accounting conservatism. He found that firms with material
weaknesses were less conservative than firms with no such weaknesses.
Conversely, firms that disclosed material weaknesses and later remediated such
weaknesses showed greater conservatism than firms that continued to have the
weaknesses. Therefore, companies with a lower quality of internal controls
practice less conservative accounting, while those with stronger internal controls
practice more conservative accounting. Considering that internal controls
improved significantly post-SOX, this study suggests that firms had increased
financial reporting conservatism after the enactment of SOX.
Critique of Studies Examined
One critique of the ideas in the studies discussed within this section is that
the Lobo and Zhou (2006) study examines only one year after the enactment of
SOX as the post-SOX period. Therefore, this study only reflects the initial impact
of SOX on financial reporting conservatism. Similarly, Verleun (2010) uses a
slightly longer post-SOX period of 3 years to investigate whether SOX’s effects
are persistent. Verleun’s sample, however, was not convincing enough to make
the conclusion that conservatism was not sustainable in later years. The sample
should have included a fairly longer post-SOX period of at least five years.
Additionally, the Goh and Li (2011) study concludes that firms that
disclosed material weaknesses were less conservative than firms with no such
weaknesses. However, Mitra et al. (2013) shows that firms with weak internal
controls before SOX had greater conservatism in the post-SOX period compared
to firms that already had strong internal controls before SOX. Although the
findings from the two studies seem contradictory, the results of both studies
suggest that the internal control requirements of SOX have caused firms to
increase accounting conservatism.
Recommendations for Future Direction
Future research that focuses on a substantially longer post-SOX period
would make a more robust conclusion as to whether SOX’s effects on financial
reporting conservatism have been persistent or were just revealed in a short
period of time following SOX. In addition, previous studies have provided
evidence that accounting quality has significantly improved in the post-SOX
period, despite the fact that conservatism increased substantially only for a short
time right after SOX’s enactment. The findings from previous studies were helpful
in identifying the regulatory effects on the recent financial crisis. Unfortunately,
the recent improvements in regulations resulting from the enactment of SOX
were not enough to prevent the most recent crisis from occurring (Verleun 2011).
Hence, further research should focus more on the means by which regulations
could be improved to better react to future financial crises.
EARNINGS MANAGEMENT
There was one effect of the passage of SOX that might have not been as
foreseeable as the improvements in corporate governance and the increase in
accounting conservatism: a change in the type of earnings management used by
firms. Several studies have looked at earnings management before and after the
passage of SOX. These studies seem to conclude that firms switched their
preferred method of earnings management from accrual-based earnings
management to real earnings management.
Definition of Earnings Management
Real earnings management is best defined by Zang (2012) as the altering
of reported earnings “which is achieved by changing the timing or structure of an
operation, investment, or financing transaction, and which has suboptimal
business consequences.” Examples of real earnings management include
decreasing discretionary spending on R&D and delaying the start of a new
project (Graham, Harvey, & Rajgopal, 2005). Accrual-based earnings
management is what typically comes to mind when thinking about the broad
subject of earnings management. Accrual-based earnings management can be
defined as “changing the accounting methods or estimates used when presenting
a given transaction in the financial statements” (Zang, 2012). Examples of this
can include changing depreciation methods for fixed assets or estimates for
doubtful accounts (Zang, 2012).
Switch from Accrual-Based to Real Earnings Management
Several studies examine the changes in earnings management methods
after the passage of SOX (Cohen et al., 2007; Cunningham et al., 2015; Cohen &
Zarowin, 2008). The most well known research concerning this topic comes from
Cohen et al. (2007). This study looks into the general earnings management
trends before and after SOX, paying particular attention to the years just before
and after its passage. The researchers found that before the passage of SOX,
accruals-based earnings management was already on the rise. In fact, earnings
management in general had increased significantly in just the two years prior to
the passage of SOX. In contrast, real earnings management appeared to be
declining in popularity up until the passage of SOX (Cohen et al, 2007).
However, just after SOX was put into effect as a way to curb instances of
earnings management and fraud, earnings management trends reversed. What
the researchers discovered was that accrual-based earnings management
decreased in the three years following the passage of SOX, whereas real
earnings management significantly increased in that same time period (Cohen et
al, 2007). The assumption made by the researchers was that managers were
switching from accrual-based to real earnings management in the post-SOX
period. To strengthen this theory, they further examined what they considered to
be “suspect firms.” These were firms that had either just managed to avoid a loss
or just managed to meet-or-beat last year’s earnings or the current earnings
target. Their results showed that these suspect firms pre-SOX were more likely to
use accrual-based earnings management than suspect firms post-SOX. They
also found that suspect firms post-SOX more frequently used real earnings
management than the suspect firms pre-SOX (Cohen et al, 2007).
A later study by Cohen & Zarowin (2008) also examined pre- and post-
SOX earnings management methods. In their study, the researchers specifically
examined earnings management activities, both accrual-based and real, around
seasoned-equity offerings. What they found was that firms with seasoned-equity
offerings after SOX were less likely to use accrual-based earnings management
and more likely to use real earnings management than firms with seasoned-
equity offerings before SOX.
The latest study by Cunningham et al. (2015) examined the effect of SEC
comment letters on earnings management activities. Comment letters are issued
when the SEC finds a potential deficiency during their review of the firm’s filings.
These comment letters are used as a form of disciplinary action for managers
and firms who do not follow proper accounting or disclosure methods
(Cunningham et al., 2015). The study by Cunningham et al. (2015) is significant
because it looks at earnings management activities post-SOX, when reviews
were required to be done more frequently. The first finding of the study is that
firms who had received comment letters increased their use of real earnings
management and decreased their use of accrual-based management shortly
after receiving the letter. The study further examined whether the increased
threat of receiving an SEC comment letter post-SOX changed earnings
management activities. Their conclusion aligned with that of Cohen et al (2007)
and Cohen & Zarowin (2008). They found that post-SOX, when the threat of
receiving a comment letter was much higher, there were fewer instances of firms
using accrual-based earnings management and more instances of firms using
real earnings management. The researchers assumed that this was an indicator
that firms were switching from accrual-based earnings management to real
earnings management.
Explanations for the Switch in Earnings Management Methods
There are a few reasons to explain why this switch might have occurred.
One explanation is that “accrual-based earnings management is more likely to
draw auditor or regulatory scrutiny than real decisions” (Cohen et al, 2007). After
the passage of SOX, there was a “higher level of scrutiny of accounting practice”
(Zang, 2012); therefore, firms would likely be less inclined to use this more
detectable form of earnings management. Cunningham et al. (2015) further
elaborates on this idea. They explain that the significant changes in the comment
letter review process after the passage of SOX, such as increased transparency
and increased frequency of reviews, contributed to an increased scrutiny in
accounting practices. Because SEC reviews are much less likely to scrutinize
real accounting transactions, firms became more inclined post-SOX to switch to
real earnings management in order to mitigate the threat of receiving an SEC
comment letter.
An explanation given by Cohen & Zarowin (2008) is unrelated to changes
that occurred as a result of SOX, but could potentially be used in conjunction with
other explanations. Cohen & Zarowin (2008) explain that it can be risky for
companies to use only accrual-based earnings manipulation. This is because in
cases where companies do not use real earnings manipulation, accrual-based
earnings management might not always be enough to bring income up to the
threshold (Cohen & Zarowin, 2008). In this case, because real earnings
management can no longer be used at year-end, firms would be better off using
real earnings management throughout the year and use accrual-based
accounting as needed at year-end.
Critique of Studies Examined
One critique of the ideas mentioned above is that the Cohen & Zarowin
(2008) study provides the explanation for the post-SOX switch to real earnings
management as being a result of managers realizing that using only accrual-
based earnings management is risky. Although that explanation does seem
plausible, the fact that the switch coincides with the passage of SOX does not
allow much room for that explanation to be true. The strong evidence that real
earnings management was declining before the passage of SOX and then
reversed its trend shortly after suggests that a more legitimate reason for the
switch is SOX-related.
Recommendations for Future Directions
In regards to earnings management changes, future research should look
at the long-term effects of SOX on earnings management. Many of the studies
that look at the post-SOX changes in earnings use only the first few years after
the implementation of SOX. New research should focus on whether firms
continue to use more real earnings management or if they eventually switch back
to accrual-based earnings management because of any costs associated with
real earnings management.
CONCLUSION
As can be seen from our discussion, SOX made sweeping changes to the
business and accounting landscape. Some changes were foreseeable, such as
increased financial conservatism and improved corporate governance. Others,
such as the change in earnings management methods, were not as predictable.
Overall, the literature concerning these changes provides compelling evidence
that these changes occurred as a result of SOX. However, we do find that more
research needs to be done in order to further elaborate on the evidence. For
example, we find that more studies need to use longer post-SOX periods when
considering the changes in earnings management methods and conservatism.
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