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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