Size does matter: an examination of the economic impact of Sarbanes-Oxley.

Abstract

We employ an event study analysis to examine the market reaction to congressional agreement on the passage of the Sarbanes-Oxley Act of 2002. We find that as firm size increases, the negative impact of Sarbanes-Oxley's passage decreases. The results show that the difference in abnormal returns between the smallest and largest firms is 3.91%.

The Corporate Context of Sarbanes-Oxley

In a volatile world, burdened by corporate scandals and a decline in investors' confidence, lawmakers crafted the Sarbanes-Oxley Act of 2002 (hereafter abbreviated as SOX) with an enthusiastic desire for corrective action. Passed by Congress as a reaction to financial scandals such as Enron, WorldCom, Adelphia, Global Crossing, and Tyco, SOX enhanced standards for corporate accountability and penalties for corporate wrongdoing. SOX contains 11 extensive titles, ranging from extra responsibilities for audit committees to tougher criminal penalties for white-collar crimes such as securities fraud. In plain English, the objective of the law was to make financial reporting more transparent and executives more accountable, changes that were ultimately planned to restore investors' confidence in financial markets and enhance corporate governance.

SOX requires executives, boards of directors, and independent auditors to take specific actions that are intended to produce more reliable, timely, and useful financial information to the public. Greater transparency and more reliability in corporate reporting means that companies function in a moral and ethical environment that enhances their credibility. This is a key benefit that should lower the firm's cost of capital, which may improve growth. Thus, at least theoretically, SOX could provide a win-win situation for both companies and investors.

Although many agreed that the changes to the corporate governance system in the U.S. were necessary, some now believe that SOX has imposed an unnecessary burden on companies because of its high compliance costs. A challenging issue is Section 404 of SOX, Management Assessment of Internal Controls, which requires publicly held firms to identify financial reporting risks, establish related controls, assess their effectiveness, fix any material control deficiencies, and then re-test and re-document all of the above. A March 2005 survey by Financial Executives International shows that the first year compliance costs on section 404 of SOX alone averaged $4.36 million per company, and large companies with more than $5 billion in revenues spent more than $10 million per company.

Critics argue that for many firms, the costs of complying with SOX outweigh the benefits. For example, these costs are unreasonably high for small firms. If the compliance costs are at least in part fixed, small firms may bear a disproportionate burden. The American Electronics Association (AeA) claims that Section 404 compliance costs serve as a "regressive tax on small business." The purpose of this study is to examine the market impact of the enactment of SOX, in an effort to determine the market's reaction to the passage of this regulation with respect to firm size.

While the true costs of SOX compliance are not easy to measure, the benefits are even more difficult to estimate. The promised benefits of SOX, which include more transparent disclosure, improved corporate governance, and enhanced investor confidence, are difficult to measure in the short run. Thus, to investigate the impact of SOX on firms of different sizes, we use an event study analysis. Using an event study methodology allows us to gauge, in a single framework, the market's perspective of the benefits versus the costs of SOX. In particular, we find that small firms experienced a much larger negative abnormal return on the day that Congress agreed on the passage of SOX than did large firms. We find an almost monotonic relationship between firm size and adverse impact of SOX. In the next section, we discuss the major provisions of SOX, and we detail some of the provisions that have resulted in the highest compliance costs. In addition, we discuss how these costs are disproportionately burdensome to small firms.

SOX Provisions and Compliance Costs

Exhibit 1 includes the major titles of the Sarbanes-Oxley Act (SOX) of 2002. SOX addresses financial reporting, CEO and CFO certifications, internal controls, risk management, the composition of audit committees, corporate codes of ethics, whistleblower protection and attorney conduct.

Some of the most costly provisions include:

* Section 302, which requires the CEO and CFO to certify each annual or quarterly report filed;

* Section 906, which provides criminal penalties for the CEOs or CFOs who certify the reports knowing that they do not comply with requirements of the Security Exchange Act of 1934;

* Section 401, which requires that annual and quarterly reports disclose all material off-balance-sheet transactions and arrangements, and that pro forma financial information be presented appropriately.

However, according to many studies, the most costly provision of SOX is Section 404, which requires management oversight of the internal control structure of the firm, and requires an annual assessment of this control structure. The costs related to the fact that the CEO and CFO must certify the accuracy of financial statements are expected to ripple through the entire corporation, leading to increased monitoring by the audit committees.

Other costs are those related to increased audit fees and insurance premiums, larger expenses on internal control software, and higher consulting-related fees. These costs are extremely difficult to measure directly because firms may not have a direct method to measure the monitoring costs.

By many estimates, however, Sarbanes-Oxley's compliance costs have been much higher than expected, especially for smaller firms. Compliance costs for Section 404 alone have mounted to more than $35 billion, 20 times higher than regulators originally estimated. In Exhibit 2, three SOX cost-compliance studies are summarized. An AeA report entitled "The Sarbanes-Oxley Section 404: The 'Section' of Unintended Consequences and its Impact on Small Business" shows that Section 404 compliance costs for firms with $100 million or less in revenues amount to 2.55% of total revenues, while larger firm costs are lower (0.27% for firms $500-999 million; 0.16% for firms $1-4.9 billion; and 0.06% over $5 billion). In addition, Carney [5] and a Financial Executives International survey [8] both present evidence of mounting SOX compliance costs.

In addition to the explicit costs presented in Exhibit 1, several academic studies have examined the implicit cost of SOX compliance. For example, Engel et al. [7] find that the increased financial reporting and internal control requirements introduced by SOX are principal motives for companies in choosing to "go dark" or "go private." In a study using a comprehensive sample of 400 companies, Leuz et al. [9] note that on average, there is a large negative market reaction of approximately -10% to firms' decisions to go dark, the abnormal return at the announcement date being particularly negative for smaller firms. Investors anticipate that by deregistering, companies have lower-than-expected growth opportunities, lower profitability, and potential internal control problems. These results are in line with our conclusion that smaller companies are damaged more than large companies by the passage of SOX.

Block [3] notes that for some firms, the cost of remaining public more than doubled after the passage of SOX. This increase in costs is due to higher audit costs, increased insurance premiums, and outside director fees. Ribstein [14] finds that due to increased costs associated with passage of SOX, particularly in personal liability, executives may become more risk-adverse in the post-SOX environment. As a result, companies will tackle less-risky projects, which may reduce the value of their firms. Thus, even though in the short run the cost-saving rationale makes sense, in the long run, this decision to avoid risky projects will not only suppress creativity, but also have a negative impact on overall economic growth. Zhu and Small [17] find that American Depository Receipts (ADR) listings from foreign issuers decreased, and ADR delistings increase, after the passage of SOX. The increased cost of regulation has, in effect, discouraged foreign firms from being listed on the U.S. security exchanges.

Zhang [16] investigates the private cost and benefits of SOX by examining changes of the market index around the most significant legislative events. He finds that the cumulative abnormal returns around the events leading to the passage of SOX are significantly negative. Although the total market value loss of NYSE, AMEX and NASDAQ around the most significant three events amounts to $1.4 trillion, this loss is not directly attributed only to SOX. Li et al. [11] consider market reactions to the events by estimating the deviation of the market returns from the average raw returns of nonevent days in 2002. They find evidence of a positive association between stock returns and the extent of earnings management, suggesting that investors viewed SOX as beneficial. Chhaochharia and Grinstein [6] and Rezaee and Jain [13], using the same event-study methodology, also find that SOX is value-increasing. In the next section we detail our event-study analysis, and we reconcile possible reasons for the contradictory results of previous event study analyses of the passage of SOX.

Data and Empirical Method