WORKING
P A P E R
Non-pecuniary Costs of
Sarbanes Oxley
FRED KIPPERMAN, R. PRESTON MCAFEE,
NICHOLAS V. VAKKUR
WR-554-CCEG
November 2008
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C ent er for C orporat e Ethics a nd G over na nce
A RAND INSTITUTE FOR CIVIL JUSTICE CENTER
iii
ABSTRACT
Sarbanes Oxley is widely considered the most comprehensive business legislation since
the New Deal.1 While research has evaluated its financial costs, relatively little is known
about the non-financial impact the law has had upon firms. We develop a series of
hypotheses regarding the non-pecuniary costs of Sarbanes Oxley, drawing from a
comprehensive literature review from multiple disciplines. To evaluate our theory, we
developed an original survey and implemented it on a random sample of Fortune 500
firms (n = 206). An ordered probit model was used to quantify the results. While
business surveys are considered by many economists to be at least as important as official
statistics,2 they tend to be characterized by a lack of information content. Our
methodological approach is beneficial since the model permits the inclusion of
respondent-specific variables that increase the precision of the estimates and substantially
reduce the width of the confidence bounds corresponding to the quantified survey
results. We find general support for our theory that as a result of Sarbanes Oxley, firms
have incurred specific effects which are perceived to have harmed the firm and/or
decreased its value.
1
The Economist, Special Report, May 19, 2005
2
Oppenlander, K.H., 1997
v
PREFACE
The Center for Corporate Ethics and Governance, is committed to improving
public understanding of corporate ethics, law and governance, and to identifying specific
ways that businesses can operate ethically, legally, and profitably at the same time. The
Center’s work is supported by voluntary contributions from private-sector organizations
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The Center is part of the RAND Institute for Civil Justice (ICJ), which is
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with the results of objective, empirically based, analytic research. The ICJ facilitates
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Robert Reville, Director
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Michael Greenberg, Associate Director
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vii
ACKNOWLEDGEMENTS
The authors would like to thank Bob Reville, Michael Greenberg, and the RAND
Center for Corporate Ethics and Governance for their support in making this study
possible.
1
I. Introduction
On June 25, 2002 WorldCom revealed that it had overstated its earnings by more than
$3.8 billion during the past five quarters, primarily by improperly accounting for its
operating costs (Beresford, Katzenbaum and Rogers, 2008). Senate Bill 2673 was
introduced to the full Senate that very same day. Within three weeks the Sarbanes Oxley
Act of 2002 (SOX), named after sponsors Senator Paul Sarbanes (D–Md.) and
Representative Michael G. Oxley (R–Oh.), was approved in the Senate by a unanimous
vote of 99-0. It represents one of the most influential pieces of corporate legislation in
modern history (The Economist, 2005).
A distinctive feature of this law is that it places responsibility on individuals and
systems (e.g. directors, auditors, internal controls) to prevent fraud before it occurs.
Previously, deterrence focused on punishing wrongdoers after the fact and compensating
victims through civil damage recovery (Wallison, 2005). Its merit has been hotly
contested. Supporters of Sarbanes Oxley suggest that corporate malfeasance justified the
need for a stringent law mandating oversight of corporate managers. Opponents suggest
that relying on the previous system of imposing civil or criminal penalties after the fact
would have sufficiently deterred future violations (Wallison, 2005). A 2006 survey of
1200 board directors revealed that more than half believed the law should be repealed or
overhauled (Korn-Ferry International, 2006). Even U.S. Treasury Secretary Henry
Paulson has repeatedly expressed concerns over the Act’s impact on US firms and
markets.
2
A recent report by the US Committee on Capital Markets Regulation has emphasized
the need for cost-effective regulation (Committee of Capital Markets Regulation, 2007).
Ideally, a cost-benefit analysis of Sarbanes Oxley might discover that total benefits
exceed total costs3, as follows:
Total Benefits > Total Costs4
Where: Total Benefits5 = (Decrease in fraud costs) + (Increase in Market Stability)6
Total Costs
= Pecuniary Costs + Non-pecuniary costs
The pecuniary costs – expenditures on accountants and other direct compliance costs
– of Sarbanes Oxley are well documented. Non-pecuniary costs, roughly speaking, are
indirect costs incurred as a way of minimizing the direct costs of compliance, and thus
are challenging to observe. This paper explains why firms might reorganize operations
and engage in other methods of mitigating compliance costs, and it provides a test of the
theory proposed. If the objective of future reform is to strike a better balance between the
costs and benefits of regulation, non-pecuniary costs must be taken into consideration.
3
This would mean that the benefits received by shareholders from the few, unknown firms where fraud
was prevented would exceed the costs incurred by shareholders of all firms—including those who
wouldn’t have suffered fraud losses under the prior system.
4
As this study is not a Cost-Benefit Analysis, no conclusions are drawn, implied or otherwise, as to
whether the law’s Benefits outweigh the Costs, or vice versa.
5
These are hypothetical benefits for illustrative purposes only; other benefits may exist.
6
Due to a hypothesized increase in investor confidence, decreasing fears and increasing market values.
3
In general, the paper is intended to serve two broad purposes. First, it introduces the
notion that accounting requirements may provide incentives for firms to adapt processes,
production, and logistics in order to reduce the regulatory burden imposed by Sarbanes
Oxley. Second, it surveys CEOs and directors from major corporations as a direct test of
our theory, which is strong supported.
Furthermore, even the proposition that operations and accounting are designed to
minimize total cost isn’t universally accepted. This study is important in that it tests a
basic premise of transaction cost economics—that firms are designed to minimize the
cost of production + distribution + accounting + management. If management were to
alter the way non-accounting operations work in response to changes in accounting and
reporting requirements, this would suggest an effort to minimize overall costs, including
transaction costs.
II. Background
A) Sarbanes-Oxley as Regulation
The strongest case for regulation is in instances of market failure, where
competition is unable to provide an optimal outcome (e.g. quality, price, efficiency)
(Buckley and Michie, 1996). Natural monopoly markets serve as a classic example. A
second argument for regulation is as an effective substitute for the tort system. For
instance, the FDA’s pre-testing and licensing of drugs is ultimately included in the cost of
pharmaceuticals. However, pre-emptive regulation is exceptional, since it imposes
regulatory costs on everyone to prevent a few cases of loss. Pre-emptive regulation may
also be employed when a particular abuse is widespread, with a high probability for
4
frequent losses, such that providing compensation through the tort system would be
difficult. All states review insurance contracts before they are offered to consumers,
under this rationale, even though it increases insurance costs.
Sarbanes-Oxley does not readily fall into any of these categories. There is no
evidence that fraud and financial manipulation are endemic to corporate America.
Shareholder losses at Enron, WorldCom, and other well-known cases are currently being
compensated by civil actions under the securities or tort laws. Furthermore, the civil and
criminal actions taken against the wrongdoers can be expected to exercise a strong
deterrent effect in the future, if it has not already. Many key managers involved in the
most publicized frauds of 2000-2002 are unemployed, indicted, and/or convicted.
Furthermore, their firms have suffered major stock market losses, collapsed, or merged.
Therefore, future managers are unlikely to make similar choices.
Congress, however, enacted an enhanced corporate governance structure placing
responsibility for the detection and prevention of fraud on gatekeepers (e.g. independent
directors, auditors) and a complex system of internal controls. An important question—
though beyond the scope of this paper—is whether it more effectively prevents fraud than
the system it replaced—after-the-fact civil or criminal punishment—such that the
additional costs it imposes are outweighed.7
B) Sarbanes-Oxley: Basic Motivation & Provisions (U.S. Senate, 2002)
7
If this relationship does not hold, then Sarbanes Oxley represents a tax on business.
5
Several common themes linked the major corporate ethical lapses that occurred
between 2000 and 2002, including (Farrell, 2005):
1. A failure of Boardroom leadership: The Board of Directors provides a necessary
oversight mechanism for financial reporting on behalf of investors. However, board
members either failed to exercise their responsibilities or lacked the expertise required to
comprehend the business.
2.
Material conflicts of interest with auditing firms: Auditing firms were permitted
to perform significant non-audit work for client firms. At times, these side engagements
were more lucrative than the auditing contract, resulting in a potential conflict of interest.
3. Conflicts of interest with securities firms: Securities analysts make buy and sell
recommendations on company securities, while investment bankers help firms issue
securities and acquire assets. A potential conflict of interest exists when a bank issues a
buy or sell recommendation for the equity of a firm that is a major investment banking
client.
4. Investor response to market corrections: Many investors were negatively
impacted in 2000 by a significant correction in technology stocks. The psychological
attraction theory suggests that regulation following a market correction typically results
from a need to find someone to blame (Hirshleifer, 2007). Attributing a market bubble to
rational processes, chance, and/or personal incompetence may be a less satisfying way to
explain personal loss than the idea of external manipulation.
5. Problems with CEO compensation: Prior to Sarbanes Oxley, stock options were
not treated as a form of executive compensation, making them more appealing. Due to
6
the volatility in stock prices for firms that even narrowly miss earnings’ projections,
coupled with CEO compensation that is heavily tied to firms’ stock performances,
managers had a strong incentive to try to manage earnings (Levitt, 1998).
Congress sought to address these concerns through the following provisions of the
Sarbanes Oxley Act of 2002 (U.S. Senate, 2002):
x
Creation of the Public Company Accounting Oversight Board (PCAOB), as an
independent, private entity to oversee the implementation of Sarbanes Oxley.
x
Stringent penalties for violations of securities law under two separate
certifications–one civil and the other criminal8 to discourage violations.
x
Chief executive officers and chief financial officers must certify financial reports
(e.g. Section 3029) to encourage transparency and protect investors.
x
Section 404 requires public firms to evaluate and disclose the effectiveness of
their internal controls as related to financial reporting. Independent auditor must
"attest" to disclosure.
x
Increased minimum qualifications for Board members as well as stipulations to
ensure Board independence and oversight.
8
See 15 U.S.C. § 7241 (Section 302: civil provision); 18 U.S.C. § 1350 (Section 906: criminal provision).
9
See 15 U.S.C. § 7241(a)(4).
7
x
Outright bans on certain types of work for audit clients and pre-certification by
the firm's Audit Committee for all other non-audit work to encourage auditor
independence.
x
Ban on most personal loans to any executive officer or director to discourage
fraud.
x
Accelerated reporting of trades by insiders and prohibition on insider trades
during pension fund blackout periods to encourage transparency and prevent
market manipulation.
x
Protections for corporate fraud whistleblowers to increase the probability that
insiders might reveal related acts of corporate malfeasance in a timely manner.
B) Pecuniary Costs
This section summarizes the financial costs associated with Sarbanes Oxley. Sarbanes
Oxley is controversial, in part, because compliance expenditures have greatly exceeded
original forecasts (The Economist, 2005). The SEC, in 2003, estimated average annual
compliance costs of approximately $91,000 per firm. In 2006, public firms, on average,
spent $2.92 million, not including audit fees (Bloomberg News, 2007). A recent
econometric study estimated that the total costs imposed by Sarbanes Oxley—measured
as the aggregate loss in market value at the time of its enactment—were $1.4 trillion
(Zhang, 2005).
The largest source of pecuniary costs under the law is as a result of the requirement
that firms must document and monitor their internal controls, which is a complex, time
8
consuming, and expensive process.10 Section 404 requires firms to hire an independent
auditor to attest to the effectiveness of these controls. Since auditing firms, in essence,
determine which firms “pass”, they have successfully increased the market demand for
their services, simply by requiring that firms perform more work than the law actually
requires. In 2004, it is estimated that firms spent on Section 404 alone anywhere from
$15-20 billion, (Committee on Capital Markets Regulation, 2007). or $4.36 million per
firm—an amount that does not include approximately $1 million per firm additional in
auditing fees.
Year One Resources Spent on Section 404 Compliance11
Roundtable Survey, December 2004, by Revenue
Company Revenue
< $5 B
$5 B - $10 B
$10 B – $50 B
> $50 B
Average Additional Audit Hours
6,285
20,756
11,540
19,000
$1.9
$6.1
$20.6
$1230.3
Average Total Compliance Cost
(millions)
III. A Theory of Non-pecuniary Compliance Costs (Wallinson, 2005)12
10
For small firms, costs are likely to be more burdensome, when viewed as a percentage of firm revenues.
However, large firms may easily have several thousand controls, if not more.
11
Although these costs have decreased as much as 30% after year one, net costs remain significant.
12
Peter J. Wallison made reference to the concept of indirect or intangible costs as applied to Sarbanes
Oxley. His brief list has only one cost in common with that provided in this paper.
9
Non-pecuniary cost, a term that comes originally from the law, refers to a loss that
cannot be quantified monetarily,13 a common example being “pain and suffering.” Nonpecuniary damages detract from individual well-being or utility. As they are not traded in
markets, there is no market price from which to calculate damages (Rogers, 2001). As
applied to the firm, non-pecuniary costs can be said to detract from the utility of the firm,
including its managers and owners (Encarnación, 1964). For the purposes of this paper,
the term simply refers to costs, potentially incurred by firms, which are not financial in
nature, and therefore—as an illustration—cannot be expensed by the firm on its income
statement.
Research on non-pecuniary costs spans a wide range of topics, including the
impact of unemployment on life satisfaction, (Knabe and Rätzel, 2007) and the relative
effect of financial vs. non-financial costs (Rubin and Calfee, 1992). Non-pecuniary costs
have been shown to reduce the market value of the firm (Buckley and Michie, 1996).
Economists introduced non-pecuniary costs to demonstrate that empirical estimates of the
welfare losses from monopoly substantially understate the total magnitude of such losses
(Crain and Zardkoohi, 1980). This paper adheres to a similar approach, by hypothesizing
that the total costs of Sarbanes Oxley are currently underestimated.
There are several reasons why any non-pecuniary costs incurred by firms under
Sarbanes Oxley have not been acknowledged or studied to date. Research suggests that
13
The authors are not lawyers and no effort is being made to apply an existing term to a new context for
future legal use.
10
were firms to incur non-pecuniary costs, even if significant, as a result of a particular
regulation they may still go unrecognized. It is an individual tendency to underweight the
probabilities of event contingencies that are not explicitly available for consideration
(Fischoff, Slovic, and Lichtenstein, 1978; Tversky and Koehler, 1994). Managers are
less likely to notice a cost they were not instructed to consider. Non-pecuniary costs
incurred by the firm, which negatively impact shareholders, but yet cannot be quantified
monetarily, are not as compelling as moving stories about families ruined by lies and
cheating, as in the Enron or WorldCom scandals. Furthermore, non-pecuniary costs are
easily overshadowed by the overall profit firms generate, such that shareholders are less
likely to perceive these costs upon their holdings. In general, the weighty financial costs
of a particular regulation are usually much less apparent than the exceptional
wrongdoings that incited it (Perkins, 2007).
This study hypothesizes firms will incur six distinct types of non-pecuniary costs
under Sarbanes Oxley as follows:
H1: Sarbanes Oxley will induce firms to centralize core processes
The hypothesis suggests the Act increases the rate of firm centralization, resulting in
increased rigidity, due to two factors: A) to increase business efficiency and B) as a
safeguard.
A) Increase business efficiency: Centralization is not an easy change, as the social,
technical, and financials costs of changing can be substantial. Nonetheless, many firms
have found that the additional costs—not all of which are financial—imposed by
Sarbanes Oxley more than warrant the decision to centralize a wide variety of processes
11
from auditing, security administration, treasury functions, software licensing and
administration, to management, manufacturing, and logistics (Griffith, 2008). As an
illustration, Springer Carrier centralized its core processes—IT systems, core operations,
manufacturing—in order to reduce the cost and complexity of compliance with the law
(Market Wire, 2006). Sarbanes Oxley compliance requirements emphasize the need for
economies of scale, (Ernst & Young, 2006) such that effective compliance is now
considered next to impossible without a centralized management structure (Marchetti,
2005).
The motivations to centralize under Sarbanes-Oxley are numerous and span all areas
of the firm: reduce the redundancy in operations, leverage management time and
attention, increase economies of scale, facilitate changes and implement best practice
approaches, achieve defined career paths for support functions, reduce maintenance cost
and effort, and more efficient utilization of IT resources. (Marchetti, 2005). Even a shift
towards centralizing auditing processes may be expected to motivate other types of
centralization within the firm. Multinational corporations currently face huge challenges
in managing transactions across multiple locations and time zones while coordinating
with multiple outside banks. The greater the geographic reach of a company, the more
difficult it is to access and track accurate and timely cash flow information. When
production is spread across multiple locations throughout the globe, transparency can be
difficult to achieve. New technology implemented by treasurers has mitigated this
problem without entirely solving it. (Marchetti, 2005) Centralization, in the past, was
12
more volitional. Today, however, firms are increasingly discovering that centralization is
important if not necessary (Ernst & Young, 2006).
B) As a safeguard: Centralization, to a large degree, is a response to the draconian
nature of the law. Managers rightly view a failure to comply with the law—even if it is
entirely unintentional—as a potential death sentence. Stringent repercussions apply to
even inadvertent managerial failures, including the threat of being tried in criminal court
and spending 20 years in jail for committing an honest mistake. Furthermore, many firms
would quickly lose their customer base and go broke if regulators were to even hint at the
threat of a criminal action.
Centralization—not just in terms of accounting but of core processes—makes the
compliance process easier and more secure for managers. Core centralization makes it
easier for firms to achieve transparency in the numbers, and therefore to ensure the
financial statements are accurate. Since the CEO and CFO are now required, under strict
penalty of the law, to sign off on the firm’s quarterly financial statements, centralizing
manufacturing, logistics, and other core processes, such as accounting and IT, provides
needed assurances that the firm’s senior managers will successfully avoid a criminal trial.
As a result, managers—and directors, who are also subject to increased liability
measures—can be expected to increasingly view centralization as a cost of doing
business, in the business climate produced by Sarbanes Oxley.
H2: Sarbanes Oxley will produce managerial bias in project selection
This hypothesis proposes three mechanisms—A) board independence measures that
limit the flow of information and increase decision making stress, B) heightened liability
13
concerns and C) adverse selection—by which Sarbanes Oxley will cause managerial
decision making to become more conservative, resulting in a reduction in firm value
(Wallison, 2005):
A) Board independence measures:14 Corporate America, in a very brief period of
time, has evolved from the age of the celebrity CEO to the age of the downsized CEO
(Clark, 2005). Prior to the law, the CEO almost unilaterally defined strategy. The board
provided feedback, but only in exceptional circumstances did it ever countermand the
CEO. Research demonstrates a myriad of benefits when the CEO is empowered to
provide the firm with strong, uncontested leadership (Dalton and Dalton).
Sarbanes Oxley empowers the board to fulfill its role as monitor, and establishes
board independence from the CEO. However, extensive research on the impact of board
independence fails to show a positive effect (Clark, 2005). Research has demonstrated
that board independence has politicized the CEO-board relationship, causing CEOs to
devote more attention to ingratiation-like behaviors, and less to firm strategy (Clark,
2005); reduced cooperative interaction between top managers and directors in the
strategic decision-making process (Westphal, 1999); failed to increase monitoring
behavior, while decreasing the level, quality, and timeliness of board involvement in
corporate policy (Westphal, 1997). Consistent with this research, the CEO’s ability to
14
Board independence wasn’t key to the corporate meltdowns of 2002. In 2001, the boards of Tyco, Xerox
and WorldCom were roughly 68% independent, equivalent to all three major S&P indices. Enron
had 10 out of 14 directors who were independent outsiders. Its audit committee was 5-for-6, and
was chaired by a professor emeritus of accounting and former business school dean at Stanford.
14
receive candid, expert advice from trusted advisers has reportedly decreased due in part
to a sharp shift in the balance of power (Lewis, 2003). Candid conversations between the
CEO and the board are less frequent (Clark, 2005). The once cooperative decision
making process has become more legalistic, antagonistic, and formal (Henry, France, and
Lavelle, 2005).
Under these circumstances two outcomes are likely: a) the CEO may experience
increased decision making stress as a result of being further insulated from the support of
the board, who are strategic advisors to the firm, and b) the CEO’s access to quality
decision making information may decrease. Research suggests this environment will
produce a conservative bias in decision making in which simple decisions will be favored
over complex alternatives (Leddo, Chinnis, Cohen, et al., 1986). CEO’s will be more
likely to approach the board with relatively conservative strategies that are more likely to
win their approval, versus risk the increased scrutiny and/or confrontation that a bolder,
more comprehensive, plan may require (Henry, France, and Lavelle, 2005).
B) Heightened liability concerns: Firm executives and directors are now subject to a
significantly increased threat of personal litigation, harsh penalties, and the potential for
significant jail time (Committee on Capital Markets Regulation, 2007).15 Not only were
the penalties for white-collar crimes dramatically escalated, but the mens rea16 (i.e.
15
The Committee on Capital Markets Regulation suggests that litigation is a major problem.
16
Because the law operated, at least traditionally, only against those who had formed a specific mental
intent to do harm, or mens rea, persons inclined to be law-abiding could signal their efforts to obey
the law by investing in precautions.
15
"guilty mind") requirement for criminal regulatory offenses was significantly diluted
(Lerner and Yahya, 2007). The result is that an increasing number of activities involving
publicly traded corporations fall within the potential scope of the criminal law.
Additionally, prosecutors and juries now have more discretion than perhaps ever before
to determine what corporate and/or managerial acts fall within the jurisdiction of the
criminal law. For many firms—especially those built on public trust—this risk is
unacceptable since the mere act of being charged with a crime produces an immediate
death sentence (Henry, France, and Lavelle, 2005).
Congress has now stepped closer towards life imprisonment as the maximum
sentence for white-collar crimes. One of the most notorious provisions, Section 302,
requires CEOs and CFOs to certify that all financial filings contain no "untrue
statement[s]" and "fairly present in all material respects the [firm's] financial condition"
(U.S. Senate, 2002). The penalty for violating section 302 is $5 million plus 20 years in
prison. The result is a climate of pervasive fear. Directors, managers, and lawyers are
worried, first and foremost, about protecting their hides.17 A recent survey of 1200
directors from public firms found that nearly 75% are unwilling to take risks necessary to
achieve growth due to personal liability concerns (Korn-Ferry International, 2006)
Managers are more likely to pursue a strategy of restrained growth and steady profits,
versus seeking a dominant market position. Due to these factors, Apple Computer chose
17
Apparently with good reason, as a major investigation is likely to uncover some form of wrongdoing.
The investigation of Tyco involved 15,000 lawyer hours and 50,000 accountant hours. Forensic
SWAT teams interviewed employees at 45 operating units in 13 countries.
16
not to offer consumers faster wi-fi cards at no additional cost, a significant potential
source of competitive advantage (Klein, 2007). Apple feared that in selling a product,
then later adding a feature to that product, it would be held liable for improper accounting
when it recognized revenue at the time of sale, as product delivery was not yet complete.
While specific accounting rules predating Sarbanes-Oxley contributed to Apple’s
decision, it was the heightened magnitude and likelihood of penalties under Sarbanes
Oxley that forced Apple to abandon plans to provides consumers this important benefit,
free of charge.
C) Adverse selection: The “ideal” business executive is likely to have a conflicted
attitude towards risk. In business matters, she is likely to be risk-neutral so as to forego a
project with a certain 4% gain in favor of a riskier project with expected returns greater
than 4%. However, in regards to the criminal law, the same executive is likely to be riskaverse. This infers she will pay the certain costs of compliance rather than risk being
found guilty of a crime, even when a risk-neutral individual would select the criminal
option since the low probability of detection renders the expected penalty less than the
cost of compliance (Lerner and Yahya, 2007).
From a societal perspective, the optimal regulatory environment enables the ideal
executive to succeed and thrive, since she is willing to assume the entrepreneurial risks
that benefit society. Furthermore, she willingly complies with the criminal law. However,
when the law becomes extremely punitive, and the application of criminal law is
17
increasingly subject to the discretion of individual juries and prosecutors rendering it
unpredictable, CEOs can be held liable for damages regardless of fault.18
In this environment, research suggests that the executive with ideal risk preferences
will be more likely to depart the public firm in favor of a less regulated environment
(Lerner and Yahya, 2007). Senior and mid-career level professionals have fled in greater
numbers to private firms in large part because managerial risk taking is rewarded
(Thornton, Byrnes, Henry, et al., (2006). However, risk averse managers (e.g. both in
terms of strategy and legal compliance) are more likely to remain, if not thrive, in the
stringent regulatory environment produced by Sarbanes Oxley. Such managers are less
willing to take calculated, strategic risks, which can be expected to decrease firm value.19
H3: Sarbanes Oxley will decrease the rate of firm innovation20
This paper hypothesizes that Sarbanes Oxley reduces innovation by a) increasing
rigidity, b) by diverting capital away from R&D, and c) adverse selection.
A) Increasing rigidity: In general, research suggests a general tendency in favor of
excessive regulation such that innovation is curtailed (Hirshleifer, 2007). An inflexible
rules-based regime (Shortridge and Myring, 2004), with multiple overlapping regulators,
is likely to produce this effect (Zhang, 2005). The law requires firms to formally
18
This is the definition of strict liability, which according to one CEO, is like having a “gun to your head”.
19
As with most of these effects, non-pecuniary costs are likely to produce and/or be associated with
pecuniary costs as well.
20
To the degree that the hypothesis is true, the potential benefits of innovation are less apparent. As a
result, the effect is less perceptible, reducing public appeals to improve the law.
18
document any operational changes, such as the installation of new software or the
introduction of a new line of business, which is costly. The result is that the marginal cost
associated with change, including those changes that are beneficial to the firm, is
effectively increased. As a result of an increase in the marginal cost associated with
change among publicly owned firms, the willingness of such firms to enact change
decreases. Since firms learn through trial and error, a decrease in the willingness to enact
change, by increasing the costs associated with change, can be expected to decrease firm
innovation. Even a minor decrease in the types of change that produce innovation can be
expected to have long term ramifications for the firm.
B) Diverting capital:21 Especially for small firms that are not resource intensive, the
compliance requirements of the law are likely to prove onerous (Kamar, Karaca-Mandic,
and Talley, 2006). For instance, the amount of capital required to comply with the law at
leading bio-tech firm is equivalent to the annual budget for its entire R&D department
(Miller, 2007). For firms with limited capital for R&D spending, innovation is likely to
be reduced. However, small firms are responsible for a disproportionate amount of
innovation in the economy, indicating that any effect to decrease the rate of innovation
will be more pronounced that it otherwise would be.
C) Adverse selection:22 As discussed in detail under H1, executives with “ideal” risk
preferences may be more likely to depart public firms in the current regulatory
21
This is hypothesized to be primarily a small firm effect and therefore is not covered in detail in this
paper, as we focus on large Fortune 500 firms.
22
The same basic argument under Adverse Selection for H1 is applied here as well.
19
environment. However, managers who are risk averse in their business decisions and
compliance behaviors are likely to remain—even thrive. Consequently, the probability
that firm leaders will take the types of risks required to champion innovation is
decreased. This effect is echoed by executives who chose to depart public firms because
they were required to devote more time to regulatory matters and less to growing the
company (Lerner and Yahya, 2007). Under the law, the administrative function of the
CEO has grown, while the strategic role has shrunk. As a result, the law has encouraged
the replacement of entrepreneurial executives with managers who enjoy the minutia of
regulatory compliance (Lerner and Yahya, 2007). This is not likely to bode well for
innovation. At least one recent study has found that Sarbanes Oxley deters innovation
(Shadab, 2008).
H4: Sarbanes Oxley increases the managerial role for accountants
This hypothesis relies upon two general sources of authority auditors received under
the law—implementation authority and (indirectly) punitive authority—enabling them to
influence managerial decisions.
A) Implementation authority: Internal controls, under the law, are defined in the
broadest terms as "controls over all relevant financial statement assertions related to all
significant accounts and disclosures in the financial statements" (Berlau, 2005). This
definition encompasses nearly all of the firm’s processes, such that large firms may have
thousands upon thousands of controls to monitor and evaluate. The term "attestation",
which applies to Section 404, has been interpreted to require an intensive audit of each of
these controls, in the same manner that firms’ financial statements have traditionally been
20
audited. As a result, the law placed onerous requirements upon public firms.
Simultaneously, it has given the accounting industry the ultimate responsibility for
ensuring that firms are in compliance with the law. The result is an enormous transfer of
power, capital, and prestige to benefit auditing firms (Pollock, 2006).
Furthermore, the law’s requirements are vaguely worded and complex, such that they
require continual clarification from the PCAOB, the private entity responsible for
overseeing its implementation. The PCAOB, in turn relies upon input from the auditing
firms, who conduct the audits, to guide the development of the law. This widens their
scope of influence and increases their authority. In terms of managerial decision making,
compliance requirements are intricately linked to the firm’s strategic business function,
such that they cannot be easily compartmentalized (e.g. managerial decisions vs.
compliance issues). Therefore, it is to be reasonably expected that managers will at least
consult with their auditor prior to making important strategic decisions that can be
expected to impact firm compliance with the law. Additional incentives to consult the
auditor are provided by the serious repercussions awaiting managers whose compliance is
less than perfect. Therefore, it is reasonable to assume managers will rely extensively
upon the external auditor when making important decisions affecting the firm.
Reportedly, auditor influence is extensive, to include firm strategy, acquisition decisions,
succession planning, crisis response, and what can be booked as earnings (Henry, France,
and Lavelle, 2005).
21
B) Punitive authority: The law encourages managers to trust—as well as perhaps
fear23—the external auditor as a business consultant. In terms of compliance, good faith
effort is not a sufficient defense to avoid legal prosecution. Adding to the strain is
requirements that are complex and ambiguous. Therefore, the external auditor must guide
the client through the morass of legal technicalities and ambiguities to a safe harbor.
Auditors who allege that a CEO is not doing enough to remedy a material error in the
financial statements must notify the SEC within 24 hours (Henry, France, and Lavelle,
2005). Auditors have sufficient influence under the law to impact a firm’s future, for
better or worse. Consequently, managers can be expected to seek regular assistance from
the auditor on a wide variety of issues, including the weighing of strategic options in
regards to their impact upon the cost and complexity of compliance under the law.
Auditors are reportedly making the most of their power under the law (Henry, France,
and Lavelle, 2005), and have been accused of abusing it to artificially inflate the demand
for auditing services to a point of “socially inefficient hyper-vigilance” (The Economist,
2006) beyond the level required by law (Johnson, 2006a).
Auditors are professionally trained to systematically examine the activities of the firm,
such as its systems, controls, and records. However, strategic decision making requires
expertise in problem identification, analyzing alternative solutions, and in implementing
potential solutions. Auditors are not formally trained as managers.
23
Deloitte & Touche forced the firing of the CEO of a client firm for failing to disclose a bookkeeping
error worth 1% of net income in the audited results.
22
H5: Sarbanes Oxley produces limited transparency gains
This hypothesis suggests three mechanisms by which transparency gains may be
limited, relative to a principles based mechanism: A) a misguided focus, B) adverse
selection, and C) a decrease in information quality as it relates to financial reporting.
A) Misguided focus: A prescriptive, rules-based format provides even well
meaning firms with a perverse incentive to engage in certain gaming (e.g. evasive,
deceitful, manipulative) behaviors intended to give the appearance they are in total
compliance when this may not be true (Pitt, 2006). Firms engaging in fraudulent activity
not only violate the law but established business norms as well. Good laws provide an
incentive for firms to behave ethically. Transparency in financial reporting is an
important ethical issue. However, Sarbanes Oxley, as an inflexible, rules-based system
imposes a one-sized-fits-all approach to accounting, which prevents firms from full and
accurate disclosure (Paulson, 2006). Accounting is not a science, but requires extensive
judgment and flexibility to produce useful, reliable information. Firms are left with a
difficult choice: rigid adherence to the law, which means producing financial reports
whose utility to investors is compromised vs. full and accurate financial reporting in
violation of the law. Faced with these extremes, firms can be reasonably expected to
choose a middle path, trying to satisfy both the regulator and the investor public.
Bear Stearns was compliant with Sarbanes Oxley. Days prior to its demise, firm
executives, along with SEC Chairman Chris Cox, were claiming Bear’s liquidity was
sound. Sarbanes Oxley—and most especially Section 404—should have highlighted the
firm’s obviously inadequate risk assessment (Steffy, 2008). However, it failed to do so,
23
and investors are now left to pay the price. Sarbanes Oxley contributed to the implosion
of Bear Stearns, by bureaucratizing the risk assessment process, which reduced the focus
on risk. In other words, Section 404 forced executives to focus on compliance with the
law while overlooking investors’ main source of concern: the firm’s risk profile. Bear
Stearns complied with a law whose strict, inflexible rules forced management to focus on
the wrong issues, and the firm failed (Steffy, 2008). Conversely, a principles based
regime would have permitted management to find creative ways to protect investors,
while complying with the law.
B) Adverse selection: As the criminal law becomes increasingly stringent, and its
application less predictable, the “ideal”24 CEO is likely to flee for other environments
(Lerner and Yahya, 2007). In general, two types of managers will remain: those who are
risk averse in all matters—the business and the law—and those who are either riskneutral or risk-loving in regard to both matters. The risk-averse leader will comply with
the law. However, the risk-neutral/risk-preferring CEO can be expected to select the
criminal option due to the low probability of detection, which renders the expected
penalty less than the cost of compliance (Lerner and Yahya, 2007). This can be expected
to decrease transparency. For instance, Sarbanes Oxley did not prevent Dell from
misleading its auditors for several years, manipulating results to meet performance goals
24
This leader is willing to take entrepreneurial risks that benefit society, while complying with the criminal
law, even at substantial cost.
24
(Associated Press, 2007). It can be reasonably assumed that mangers did not expect to be
caught.25
C) A decrease in the information quality: This hypothesized outcome is again
motivated by fear induced under a stringent regulatory regime. The accounting industry
fears incurring excessive liability risks, resulting in an implosion similar to Arthur
Andersen. To protect themselves, accounting firms can be expected to interpret and apply
rules very stringently.26 This is the same concept as defensive medicine, but applied to
financial accounting—actions are taken not in order to provide investors with useful
information, but to forestall future liability risks. Accounting firms painfully recall the
collapse of Arthur Anderson, and fear that in the next wave of lawsuits, one of them may
be next. As a result, the entire industry is vigilant in its efforts to avoid incurring an
increase in liability risks. For instance, firms are making clients restate financial reports
for increasingly smaller amounts, sometimes over even debatable issues. KPMG forced
Countrywide Financial Corp. to restate its earnings because it held a 0.1% to 2.2% stake
in assets that were booked as sold (Henry, France, and Lavelle, 2005). Reports submitted
to the SEC are now longer, more complex, and contain extensive footnotes—most of
which is not intended for investors. Firms’ 10-K reports in the Dow Jones industrial
average currently average approximately 200 pages, double the length of just six years
ago (Henry, France, and Lavelle, 2005). Some firms are now opting to disclose, even
25
We acknowledge this violation was likely motivated by many factors, not necessarily adverse selection.
26
Independent of Sarbanes Oxley, the Big 4 have already billions in fines to the SEC.
25
when not required, non-material, non-significant bookkeeping weaknesses with only a
remote chance of affecting their financial statements.
While the accounting industry is urging this type of excessive caution, the result is
a dilution in the quality and usefulness of financial statement information to investors.
H6: Sarbanes Oxley produces a reduction in worker incentives
This hypothesis suggests due to Sarbanes Oxley worker productivity may decline
as traditional work related activities are de-emphasized in favor of compliance functions.
While not to the level of a wholesale change in logistics or operations, some firms have
reported altering employee compensation schemes in order to include compliance-related
activities in performance objectives. The objective is to motivate employees to engage in
required compliance activities so as to decrease the future probability that the firm will be
penalized by auditors for late or incomplete documentation.
However, individuals possess a limited capacity to engage in multiple problem
solving activities simultaneously. As a result, offering workers incentives to comply with
the requirements of Sarbanes Oxley may be equated to a de-emphasis, or reduction in the
incentives attached to other work related activities.27 To the degree that workers are less
productive in meeting the objectives of their employers due to the legislation, in
Organizational terms total output per worker is decreased. While firms are unable in the
27
This is a principle insight of multitasking theory. For a more complete discussion, see Holmstrom, Bengt
and Milgrom.
26
short run to decrease workers’ compensation, they now receive less in exchange for that
salary. The result may potentially harm U.S. competitiveness (Johnson, 2006b).
IV. Survey
A) Methodology, Sample & Limitations
A survey was conducted to test the hypothesis that Sarbanes Oxley imposes nonpecuniary costs upon firms. The survey was carefully designed in order to avoid biasing
respondents’ answers, and it was pilot tested prior to being implemented.28 This study
focused exclusively on large firms. The SEC is vitally concerned about the Act’s impact
upon large firms given their significant role in the U.S. economy. In 2005, total revenues
reported by Fortune 500 firms accounted for 73.4 % of U.S. GDP, and will likely surpass
US economic output in the next generation (The Labor Research Association, 2006).
The study population selected was a random sample of 350 firms, taken largely
from the most recently published list of the Fortune 500. Senior managers (e.g. CEO,
Chief Compliance Officer) were the primary target of the survey. However, surveys were
also distributed to a random sub sample of firm boards (n = 100), which were selected
from the original sample. Follow-up phone calls were made to increase the response rate.
In all, responses were received from 149 firms—149 CEO’s and 57 board members—for
a 42.5% response rate.29 Subsequent statistical analyses revealed no consistent pattern of
28
A copy of the survey is included in the appendix.
29
The response rate for firm boards was 57%.
27
differences between firms that did and did not respond. Only public firms were included
in the final sample as the law regulates public firms.
Respondents were senior officers (e.g., CEO, CFO, Chief compliance officer) of
the firm. The majority of respondents noted that the information provided represented a
consensus within the firm, and was achieved through substantive deliberation. As a
result, the information provided reflects the view of the firms’ senior managers, not
merely that of the individual respondent.
An important limitation of this study is that no effort was made to quantify the
magnitude of each effect in terms either in dollars or in relative proportion to one another.
Furthermore, the mechanisms contained within each individual hypothesis were not
tested—only the hypothesis itself. While the data provides a means for assessing the
degree to which firms have incurred non-pecuniary costs under the law, a rigorous costbenefit analysis cannot be achieved using qualitative data. Additionally, no effort was
made to ascertain the benefits of the law.
B. Survey Results
The survey evaluated the seven hypothesized non-pecuniary costs. Respondents
were asked to rate, on a scale of 0 to 10 (e.g. “0” - not at all, “5” - moderately, and “10” extensively), the degree to which their firm incurred the hypothesized Non-pecuniary cost
28
under Sarbanes Oxley. Unless otherwise noted, all results reported are based upon the full
sample of 149 CEOs and 57 Directors.30
H1: Sarbanes Oxley induces a centralization of core processes
The average response, using the full sample, was a “6”, indicating the average
firm had incurred significant costs related to Centralization of firm assets. CEOs and
Directors reported extensive changes made to the firm in response to Sarbanes Oxley.
While many firms reported centralization of the accounting function, this was neither the
most common nor the most significant change reported. Firms reported, just as
commonly, centralization of the manufacturing, production, and/or logistics function in
order to streamline the firm, improve transparency, and simplify managerial requirements
under the law. Approximately 5% of CEOs and directors reported no structural or process
related changes to the firm under Sarbanes Oxley.
H2: Sarbanes Oxley induces managerial bias in project selection
Both CEOs and Directors reported a strong influence on managerial decision
making. CEOs reported an average cost of “7” while Directors reported a mean effect of
“3”. From either perspective, both the CEOs and the Directors in our random sample
confirm that the law has had a significant effect on managerial decision making, by
inhibiting necessary risk taking. The primary cause of this effect seems to be heightened
liability concerns under the law.
30
Separate figures will be reported only when there was a statistically significant difference between the
mean response provided by the Directors and the CEOs.
29
H3: Sarbanes Oxley decreases the rate of firm innovation
Based upon a full-sample mean response of “1”, decreased innovation did not
seem to be a primary concern for the CEOs and directors in our sample. While some
CEOs noted a potential concern, more than half did not. This may be because we focused
on large firms, whereas smaller firms are more likely to struggle with resource
constraints, as needed to fund R&D.
H4: Sarbanes Oxley increased the managerial role for auditors
This hypothesis was strongly supported, with a mean response of “8”. The
majority of CEOs (i.e. 89%) and Directors (54%) in our survey sample reported that
auditors had assumed a fairly extensive managerial role under Sarbanes Oxley, to the
extent that firm autonomy had declined. The rising influence of the auditor in managerial
decision making has resulted in a noted decrease in managerial flexibility and discretion.
The CEOs and Directors of our sample report that auditors are more powerful and more
influential than ever before, and that they are perceived as an indispensable member of
the managerial decision making team, due largely to the sheer complexity of the law and
the dire consequences of violating it for firm managers.
H5: Sarbanes Oxley limits transparency gains for investors
The hypothesis, that after an enormous investment in time, energy, and finances,
firms are no more transparent than prior to the law was not appealing to the CEOs and
Directors in our sample, who report a general increase in firm transparency under
Sarbanes Oxley. Nevertheless, firm CEOs and directors did support this hypothesis (e.g.
mean response = “3”), suggesting that any transparency gains achieved are less than
30
optimal. First, investor losses in the growing mortgage crisis were not averted by
Sarbanes Oxley, while many financial services firms are currently struggling. The CEOs
and Directors surveyed were dismayed by these events, and the inability of the law to
prevent them. Furthermore, the majority of those in our sample believe significant
improvements in terms of efficiency—by achieving the current level of transparency at a
lower cost—and effectiveness—achieving more transparency than the current system
permits—is as possible as it is necessary.
H6: Sarbanes Oxley reduces worker incentives
This hypothesis received broad, though modest, support (i.e. mean response =
“2”) from the sample of CEOs and directors. The primary concern was in terms of
managers—at every level of the firm—who multi-task on a daily basis. After
addressing compliance issues, they now have less energy to devote to the firm’s
profit functions. For the large firm CEOs and Directors in our sample, who
possess ample resources to comply with the law, Sarbanes Oxley has a less
noticeable impact than it might upon smaller firms. However, it does have a
modest impact upon large firm managers.
C. Statistical Analysis
Regression analysis was performed in order to test the theory that firm
characteristics moderate the degree to which non-pecuniary costs are incurred under
Sarbanes Oxley. The following information from 2006 was recorded for each sample
firm: Industry, Market Capitalization, P/E ratio, 3 year trailing Beta, Profit Margin, and
31
Debt: Market Capitalization ratio. Summary statistics are displayed in the following
table31:
Mkt. Cap (billions)
Mean
27.03
Median
2.79
Mode
#N/A
Std. Dev.
90.27
P/E Ratio
Mean
Median
Mode
Std. Dev.
13.80
13.01
11.00
6.54
Beta
Mean
Median
Mode
Std. Dev.
0.98
0.91
1.00
0.42
Margin
Mean
Median
Mode
Std. Dev.
4.03
0.10
0.10
5.98
Debt: Mkt. Cap
Mean
0.37
Median
0.17
Mode
0.91
Std. Dev.
0.37
All major industry classifications were represented in the survey, including
numerous Financial Services firms, as is consistent with the Fortune 500. Correlation
analysis did not indicate the presence of multicollinearity between independent variables.
Basic Model
The general linear statistical model can be described in matrix notation as:
The OLS estimator is a best linear unbiased estimator (BLUE) according to the GaussMarkov theorem as long as the following conditions hold:
Several estimation approaches may be used when analyzing survey data.32 If the survey
31
In order to protect firm confidentiality, the largest Market Capitalization is not provided.
32
is fairly complex, a design based approach may be feasible, though an expanded version
of linear model is likely preferred (Kott, 1991). For the purposes of this study, OLS
estimation was sufficient, given the relative simplicity of the survey.33
Variables
Yi = Degree to which firm incurred Non-pecuniary Cost (i)
B1 = Impact of Firm Size on degree to which firm incurs Non-pecuniary Cost (i)
B2 = Impact of P/E Ratio on degree to which firm incurs Non-pecuniary Cost (i)
B3 = Impact of Beta on degree to which firm incurs Non-pecuniary Cost (i)
B4 = Impact of Profit Margin on degree to which firm incurs Non-pecuniary Cost (i)
B5 = Impact of Debt: Market Cap. on degree to which firm incurs Non-pecuniary Cost (i)
Successive models were run. In each model, the degree to which the firm incurred
Non-pecuniary costs, as reported by the CEO and/or Director, served as the dependent
variable(s). The independent variables did not change between models. Results are
displayed in the attached table. Beta coefficients for the independent variables are not
reported as no literal significance is attached to their numerical value. However,
32
Most software packages today are able to perform several different types of tests.
33
Alternative approaches were performed and did not change the results.
33
statistical significance as well as the direction of that influence as indicated by their sign
(e.g. +/-) is reported for each.
A brief interpretation of the statistical results is provided as follows. (All
regressions were statistically significant with, at minimum, Į = .05).
1. Centralization of Core Processes: Firm size (Į = .01), Beta (Į = .05), and Debt:
Market Cap. (Į = .05), were all statistically significant predictors of the decision
to centralize the firm in response to the law. The coefficient on Market Cap. is
negative indicating that, ceteris parabis, the larger the firm, the less likely it was
to undergo centralization. This makes intuitive sense for several reasons. Larger
firms are likely to find it more difficult to centralize. Furthermore, larger firms are
already struggling with rigidity and may be hesitant to centralize further. The
coefficients on Beta and Debt: Market Cap. are both positive. Riskier firms and
those with higher relative debt loads were more likely to centralize core
processes. Firms already viewed as risky may be more risk averse in terms of
compliance under the law, and therefore may centralize at a higher rate to reduce
the risk of non-compliance.
Managerial Bias in Project Selection: Firm size (Į = .05), Beta (Į = .01), and Debt:
Market Cap. (Į = .05), were statistically significant predictors of managerial bias in
project selection due to the law. The coefficient on Market Cap. is positive indicating
that, ceteris parabis, the larger the firm, the more likely it was that managerial
decision making would become conservative. This may occur for several reasons.
Enron, WorldCom and Tyco all were large firms. The law was largely a legislative
34
response to their failure. In this environment, CEOs of large firms, that command
enormous assets, can be expected to be subjected to heightened scrutiny from the
board, external auditors, and regulators, relative to smaller, less visible firms. The
coefficients on Beta and Debt: Market Cap. are both negative. Riskier firms and those
with higher relative debt loads, as a percentage of their market capitalization, were
more likely to resist managerial bias. High risk firms, such as technology companies,
may be more likely to view managerial autonomy as an integral component of the
firm’s strategy, relative to firms with stable business models.34 For firms with
relatively high degrees of leverage—also a significant source of risk—a bias towards
conservative decision making may be less attractive given the need to make periodic
interest payments, while offering equity investors an attractive return on their
investment.
2. A Decrease in the Rate of Firm Innovation: Beta (Į = .05) was the only
statistically significant predictor of a decrease in the rate of firm innovation—as
reported by firm CEOs and Directors. The coefficient on Beta is negative
indicating that, ceteris parabis, the riskier a given firm’s equity performance
relative to the market, the less likely the firm CEO was to report a decrease in the
rate of innovation. This may occur for several reasons. Riskier firms, such as
technology companies, stay alive by innovating at a faster rate than other firms.
34
An analogy may be a football team that relies upon a scrambling quarterback to score points versus a
staid offense with little variation.
35
Innovation is often their chief competitive advantage. As a result, CEOs at these
firms may take extra precautions, when implementing Sarbanes Oxley, to ensure
that innovation is not affected.
3. Increased Managerial Role for Auditors: Firm size (Į = .05) and Profit Margin (Į
= .05), were the only two statistically significant predictors of an increased
managerial role for auditors. The coefficient on Market Cap. is positive indicating
that, ceteris parabis, the larger the firm, the more likely the external auditor was to
become involved in managerial decision making. This effect may occur for
several reasons. Large Fortune 500 firms possess enormous resources and occupy
the public spotlight, more so than other firms. Therefore, managers at these firms
are likely to be subject to a heightened degree of external pressures (e.g. board,
shareholders, news media). These external forces may work together to demand
that auditors have an increased role in decision making, so as to mitigate risk to
the investor public. CEOs may less choice but to comply with these demands,
while including the external auditor in decision making may reduce liability
exposure. The coefficient on Profit Margin is negative, meaning that auditors
were less likely to assume a role in managerial decision making at firms with
relatively higher profit margins. There may be less pressure upon external
auditors from regulators, shareholders, and boards to take an active role in
managerial decision making if the firm appears financially healthy. Conversely,
CEOs and boards may be less likely to request such involvement if the firm’s
financial condition appears sound, versus weak.
36
4. Limited Transparency Gains for Investors: Beta (Į = .05), and Debt: Market Cap.
(Į = .05), were statistically significant predictors of the degree to which CEO’s
and directors reported that the law limited transparency gains for investors
(relative to a flexible, principles based regime). The coefficient on each regressor
is positive indicating that, ceteris parabis, the higher the beta and the amount of
leverage, relative to market capitalization, the stronger the support for this
hypothesis. This makes intuitive sense for several reasons. Relatively high-beta
firms are more likely to possess non-stable processes making transparency gains
under Sarbanes Oxley more difficult to achieve. The finding in regards to
leverage may reflect the inherent complexity of recording liabilities, a weakness
for many firms that has been exposed by the recent mortgage crisis.
5. A Reduction in Worker Incentives: Firm size (Į = .05) and Margin (Į = .05) were
statistically significant predictors of a reduction in worker incentive under the
law. The coefficient on Market Cap. is positive indicating that, ceteris parabis, the
larger the firm, the more likely worker incentives would be reduced. This might
occur for several reasons. Managers at large firms likely possess enormous
responsibilities and pressures to perform. The additional compliance pressures—
exposure to personal liability, board scrutiny, auditors—under the law can be
expected to create stress while diverting attention and vital energy away from
their other roles. Such pressures may be less significant for managers at relatively
smaller firms. The coefficient on Profit Margin is negative, meaning that firms
with larger profit margins, ceteris parabis, were less likely to incur a reduction in
37
worker incentives. These firms can devote additional profits to ensure compliance
with the law without hire sufficient personnel without causing as much strain on
their existing staff.
Results Table
Model
1
2
3
4
5
6
Regressors
Mean
Response (0-10) Market Cap.
Dependent Variable
To what degree did your firm
"0" = None
incur the following under the law?: "10" = Extensive
Centralize Core Processes
Managerial Bias in Decisions
Decrease in Innovation
Managerial role for Auditors
Limited Transparency
Reduced Worker Incentives
6
6
1
8
3
2
**(Negative)
*(Positive)
*(Positive)
*(Positive)
P/E Ratio
-
Beta
Margin
Debt:Mkt. Cap.
*(Positive)
**(Negative)
*(Negative)
*(Negative)
*(Positive)
*(Negative)
*(Positive)
*(Negative)
*(Positive)
-
Legend:
(Positive) = Positive Coefficient
(Negative) = Negative Coefficient
* = Statistically significant, Į = .05
** = Statistically significant, Į = .01
D. Discussion
Perhaps the most notable finding is evidence suggesting a potential tradeoff
between transparency and rigidity. Creating centralization and making the behavior of
corporations more rigid clearly was not a purpose of the law. The vast majority of those
surveyed reported changing core processes in response to Sarbanes-Oxley, conceivably in
order to minimize the cost of production + distribution + accounting + management. This
is consistent with the view that Sarbanes Oxley has a smaller impact on larger firms,
because centralization is a way of making firms larger. The disadvantage is that the firms
become more cumbersome, more difficult to change, more entrenched, and less nimble.
The finding of centralization is worrisome, especially in light of international competition
with firms that are not governed by Sarbanes Oxley. These firms may be able to react
38
more swiftly and effectively to changes in their environment, resulting in superior
operating performance.
Large corporations already have trouble with rigidity. Kmart went out of business
largely because it was unable to change,35 Sears experienced similar problems, and Dell
has recently stumbled (Zehr, 2006). Managers continuously seek to preserve the firm’s
ability to respond proactively to a dynamic environment. Centralization is extremely
costly because it increases rigidity, decreasing a firm’s ability to respond nimbly and
favorably to changes in its environment. Whether it may improve short-term stock
performance is a different question. However, the apparent tradeoff between transparency
and rigidity is notable.
Overall, the survey uncovered two primary forms of interference upon firms:
o An increased tendency towards centralization
o A greater managerial role for auditors
No prior studies have discussed changing operations and/or the structure of the
firm in regards to the impact of Sarbanes-Oxley. Rather, the discussion has focused on
accounting and auditing. Therefore this study is the first to indicate that the effects,
although not yet quantified in dollars, are potentially much broader.
The survey revealed an increased managerial role for auditors as a key finding. In
one sense, an increased managerial role for auditors is the intended effect of Sarbanes
35
For a more detailed discussion, refer to page 431 of An Experiential Approach to Organization
Development, Seventh Edition by Donald R. Brown (Prentice Hall, 2005)
39
Oxley – the entire point of the law is to prevent actions by firms that endanger the
financial security of the firm. On the other hand, auditors are poorly trained for making
operational decisions, and may decrease the competitiveness of the firms they are
protecting. In the same way that the general counsel of a firm serves an important role in
preventing actions that could lead to class action or antitrust lawsuits, auditors can
prevent firms from taking unnecessary risks, while also promoting transparency and
accuracy in numbers. Auditor interference in management is problematic, however, when
it prevents the firm from undertaking profitable activities or results in unnecessary delay.
V. Conclusion & Policy Implications
We propose specific recommendations that would improve the efficiency of
implementation without compromising the Act’s fundamental objectives.36 As these
suggestions are prescriptive, they extend beyond the survey in order to minimize the
negative impact of the unintended consequences documented in the study. Each
suggestion is intimately connected to the study in that it is intended to maximize the
freedom of the firm’s efforts to comply with the intention of the law, while doing so in
the least cost way, versus imposing a rigid set of rules.
These suggested improvements include:
ƒ Focus auditing on critical issues
ƒ Use random audits
ƒ Introduce a Transparency Ratings Mechanism (TRM)
36
These recommendations are consistent with stated law, while some may require additional legislation.
40
As currently implemented, Sarbanes Oxley fails to distinguish between
transparency that has a material effect on the firm versus transparency that deters
relatively inconsequential incidents of fraud. A small fraud, while bad for a company, is
unlikely to result in a complete collapse of the firm or to negatively impact general
investor confidence. In contrast, large, management-inspired frauds can ruin an entire
firm while also threatening investor confidence in the entire stock market. It is the latter
problem that Sarbanes Oxley was intended to mitigate. However, implementation of the
law has extended beyond the prevention of large frauds, to the provision of limits on the
daily behavior of employees at all levels. As such, implementation of the law appears to
be creating much greater interference than is required to safeguard the integrity of US
stock markets.
Second, implementation of the law involves assurance that internal controls are
adequate. The most effective means of verifying the adequacy of a particular process is
through the use of broad-based random audits.37 Under Sarbanes Oxley the current
verification process is both narrowly applied and highly predictable, which is easy to
defeat relative to a verification system that was both broader in scope as well as more
random in frequency. A predictable process can usually be circumvented, merely by
studying the process for flaws. However, were the audit process to be random, it would
be much more difficult to forecast what frauds will not be detected. Thus, a more
37
We believe this approach is more efficient as well as consistent with the intent of the law than the multi-
year rotational testing approach suggested by the Committee on Capital Markets Regulation.
41
effective method would be to randomly audit a fraction of a company very deeply, rather
than to audit the whole company lightly.
Third, the development of a Transparency Ratings Mechanism (TRM) that rates
firm compliance with Sarbanes Oxley—as does Moody’s for corporate bonds—would
provide the investor public with a detailed understanding of firms’ internal control
processes. Currently, investors know only whether or not a firm is in compliance with the
Act, while lacking any basis for assessing the quality or degree of that compliance. More
importantly, careful implementation of a TRM might lessen the current reliance upon
rules based accounting that has created rigidity and limited the use of discretion.
Taken together, these three suggested improvements would represent a shift
towards a principles based approach that has the potential to enhance flexibility and
reduce cost, in part by simplifying the compliance requirements and introducing market
dynamics. The objective is to achieve transparency at a reduced cost.
This study suggests that the measured costs of Sarbanes Oxley are likely to be
underestimated because some of the costs involve organizational changes beyond audit
costs. Such costs, including a loss of managerial discretion and centralization of core
processes, are indirect consequences of compliance, but nonetheless are consequences of
the law. These findings are extremely relevant given the SEC’s view that curbing
excessive regulation and improving the cost: benefit ratio of regulation are critical to
fostering the competitiveness of U.S. capital markets.
Future research might seek to estimate in dollar terms the non-pecuniary costs
uncovered in this study, as well as to assess the impact of Sarbanes Oxley using
42
international firms as a comparison group. It also may be of interest to investigate
whether differential firm specific factors influence how companies perceive and respond
to regulation such as Sarbanes Oxley.
43
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