The Effect of SOX Section 404

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

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

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

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

I investigate the audit fees as a direct measure of the costs of Section 404, the changes in reporting behavior proxied by firm accruals, and the stock returns around SOX related announcements as a measure of the net benefits of compliance. I find that the attestation of the management’s report (MR) by outside auditors imposed significant costs for small firms. Filing an MR in 2004 increased audit fees by 98%, or $697,890. With a median firm market size of $110.9 million in 2004 and negative average earnings, this is not a small amount. I show that the increase in audit fees was not driven by the general increase in auditing costs, but was SOX specific. Section 404 also led to more conservative reporting. MR filers had significantly lower accruals and discretionary accruals in 2004. The effect is economically significant, with MR filers booking an estimated $15.1 million less in discretionary accruals than non-filers. For small firms, this change is substantial. The mean and median earnings of my sample are negative $4.8 million and $1.4 million with a standard deviation of $23.3 million. Finally, MR filers had higher event study returns around announcements of delays in Section 404 implementation. The buy-and-hold returns of MR filers was 17% lower than non-filers over the two year period starting with the announcement of the rule and ending after the filing of the 2004 annual reports. These results are confirmed with a sample of foreign firms that were near the 2006 implementation cutoff of $700 million. Foreign firms that did not provide audit reports had 30% lower audit fees and 2.3% lower discretionary accruals. Event study evidence of foreign firm returns further indicates that the costs outweigh the benefits. Some firms might have manipulated their public float in 2004 to avoid filing an MR.

The full paper is available for download here.