SSRN-Id498083-The Sarbanes-Oxley Act of 2002 and Security Market Behavior Early Evidence

7/29/2019 SSRN-Id498083-The Sarbanes-Oxley Act of 2002 and Security Market Behavior Early Evidence

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The Sarbanes-Oxley Act of 2002 and Security Market Behavior: Early Evidence

PANKAJ K. JAIN, The University of MemphisMorgan Keegan Professor and Assistant Professor of FinanceFogelman College of Business and Economics300 Fogelman College Admin. BuildingMemphis, TN 38152-3120Phone: (901) 678-3810Fax: (901) 678-2685E-Mail: [email protected]

ZABIHOLLAH REZAEE, * The University of MemphisThompson-Hill Chair of Excellence & Professor of AccountancyFogelman College of Business and Economics300 Fogelman College Admin. BuildingMemphis, TN 38152-3120Phone: (901) 678-4652Fax: (901) 678-0717E-Mail: [email protected]

Posted March 2004

This Revision: May 16, 2005

* Corresponding Author.

We received useful comments from workshop participants, in December 2002, at the University of


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Abstract

The Sarbanes-Oxley Act of 2002 (the Act) was enacted in response to numerous corporate and accounting scandals,and was aimed at reinforcing corporate accountability and professional responsibility in order to restore investorconfidence in corporate America. This study examines the market reaction to the Act and finds a positive (negative)abnormal return at the time of several legislative events that increased (decreased) the likelihood of the passage of the Act. We find that the Act was wealth-increasing on average, and that the market reaction is more positive formore compliant firms with effective corporate governance, reliable financial reporting, and credible audit functionsprior to its enactment. Investors interpreted the Act as good news and led toward the restoration of investorconfidence in public financial information. Overall, our results suggest that the induced benefits of the Actsignificantly outweigh its imposed compliance costs.

Keywords: Financial scandals; the Sarbanes-Oxley Act of 2002; market reactions; corporategovernance

Data Availability: Data are commercially available from the sources identified in the study.

JEL Classification: G14; G28; M41


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1. Introduction

The wave of financial scandals in the late 1990s and the early 2000s has reinvigorated the debate

on regulating corporate governance and the accounting profession. Investors concerns about these scandals

and the resulting loss of confidence are commonly cited as a primary reason for the stock market slump in2002 (Browning and Weil 2002). To restore investor confidence and reinforce corporate accountability and

professional responsibility, Congress passed the Sarbanes-Oxley Act (hereafter, the Act) in July of 2002.

The Act was aimed at improving corporate governance, enhancing the quality of financial reports,

promoting audit effectiveness, creating the Public Company Accounting Oversight Board (PCAOB) to

regulate the auditing profession, and increasing criminal and civil liability for violations of Securities laws.

The Act addresses the conduct and professional accountability of those who produce, certify, audit,

analyze, and use public financial information. The Act is considered as broad an attempt to correct free-

market externalities as any legislation passed by the federal government in recent memoryit deals with

what people do, not where securities go (Wiesen 2003, 429). Anecdotal evidence (CRA 2005; Turner

2005) indicates that while the Act has induced significant benefits to investors, it has also imposed

substantial compliance costs of over 0.10 percent of the total revenues of public companies. However, there

is no empirical evidence regarding the potential costs and benefits of the Act. This study contributes

evidence to this debate by investigating shareholder wealth effects of the Act and possible determinants of

such effects. These effects are a function of both the expected benefits and costs imposed on publiccompanies by the Act (Healy and Palepu 2001; Bushee and Leuz 2005).

The Act assists public companies to identify and monitor conflicts of interest, and thus provides

incentives and opportunities for those involved with public financial information to become more vigilant


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publicized financial scandals, which imposes substantial costs on public companies with no direct impact

on improving corporate governance and financial disclosures, at least beyond those of market-based

mechanisms. 2

The purpose of this study is twofold. First, it examines the effect of the Act on shareholder wealth

by investigating the capital market reactions to several Congressional events leading up to the passage of

the Act using market-level data. Second, it investigates whether firm-specific attributes (corporategovernance, financial reporting, and audit functions) were associated with the detected market reactions.

Our time-series analysis provides a relatively powerful test of possible shareholder wealth effects of the Act

primarily because key events late in the legislative process (see Table 1) were unexpected. 3 We use newly

developed Transparency and Disclosure (T&D) scores by Standard & Poors (S&P) and other firm

attributes (accruals, size, leverage, growth, audit fees) in our cross-sectional analysis to link the observed

market reaction to the expected costs and benefits of the Act. We detect a positive (negative) abnormal

return at the time of several legislative events increasing (decreasing) the likelihood of the passage of the

Act. Our portfolio-level event analysis reveals that the capital markets reacted positively to Congressional

events leading up to the passage of the Act. The results support general perceptions that the Act is

achieving its intended purpose of restoring investor confidence. 4 Indeed, the chairman of the Securities and

Exchange Commission (SEC), William H. Donaldson, stated that: the Act has effected dramatic change

across corporate America and beyond, and is helping to reestablish investor confidence in the integrity of

corporate disclosures and financial reporting (Donaldson 2005). We find that the Act was wealth-

increasing, on average, and that the market reaction is more positive for firms that were closer tocompliance to the Act (measured by their corporate governance, financial reporting, and audit functions)

prior to its enactment. Our results are robust after controlling for other firm attributes such as size,

performance, audit fees, and leverage. These results are consistent with the findings of Bushee and Leuz


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The results of this study have implications for public companies and their executives, investors,

researchers, and policymakers. The results suggest that investors value regulations, such as the Act, that

create positive changes in corporate governance, the financial reporting process, and audit functions.

Results are consistent with the findings of La Porta, Lopez-de-Silanes, Shleifer, and Vishny (1997, 1998,

2002) and Greenstone, Oyer and Vissing-Jorgenson (2004) that mandatory disclosure requirements induced

by laws (the Act) provide higher levels of investor protection and are associated with higher valuations of equities. Policymakers (Congress) and regulators (SEC) should be interested in the results and assessment

of enacted legislations and regulations aimed at restoring public confidence in public financial information.

These results shed some light on the intended purpose of the Act toward the restoration of investor

confidence in public financial information. Thus, this study is important given recent initiatives by

lawmakers, regulators, national stock exchanges, the financial community, and the accounting profession to

provide investors with greater protection from financial scandals. This paper also contributes to academic

research on the economic consequences of mandatory financial disclosures, which have been claimed to be

virtually non-existent (Healy and Palepu 2001: 45).

The remainder of the paper proceeds as follows. The next section reviews the related literature. A

discussion of possible shareholder wealth effects of the Act, the events leading to the passage of the Act,

and the hypothesis development are presented in Section III. Section IV discusses our research design.

Results are presented in Section V, and a final section concludes the paper.

2. Prior Research

Several related studies examine securities price reactions to federal regulations including the

Securities Act of 1933, the Securities Act of 1934, and the Private Securities Litigation Reform Act

(PSLRA) of 1995. 5 Benston (1969) finds no value-relevance of compulsory disclosure requirements of the


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statement fraud by high profile companies (Enron, WorldCom, Global Crossing, Qwest) that encouraged

Congress to pass the Act; (2) there was evidence of the lack of transparency of financial reports prior to the

Act (e.g., excessive off-balance-sheet transactions, special purpose entities); (3) the PSLRA of 1995 limited

the extent of investor protection in competitive markets; and (4) provisions of the Act and SEC rules are

intended to improve not only financial disclosures but also corporate governance and audit functions.

Wiesen (2003, 429), in comparing the Act with its predecessor, the Securities Act of 1934, statesSarbanes-Oxley is more than just a fine-tuning of that legislationit puts flesh on a 70-year-old skeleton.

Spiess and Tkac (1997) and Johnson, Krasznik, and Nelson (2000) investigate stock price reaction

to several events leading to the enactment of the PSLRA. These studies conclude that investors considered

the PSLRA beneficial by documenting significantly negative abnormal returns for firms in high-litigation-

risk industries on December 18, 1995 (amid presidential veto rumors), and significantly positive abnormal

returns on December 20 1995 (after the House override of veto). Conversely, Ali and Kallapur (2001) find

evidence that suggests that investors considered the PSLRA harmful. Bushee and Leuz (2005) examine

economic consequences of a regulatory change requiring firms quoted on the Over-the-Counter Bulletin

Board (OTCBB) to comply with the disclosure requirements under the Securities Act of 1934. Bushee and

Leuzs (2005) study is one of the very few studies providing evidence on the perceived costs and benefits

of disclosure regulation by documenting that (1) the imposition of SEC disclosures results in significant

costs to noncompliant and newly compliant firms; and (2) previously compliant firms exhibit positive stock

returns, which suggest positive externalities from disclosure regulation. Greenstone et al. (2004) find that

increased disclosure results in significant cumulative abnormal returns.

Two contemporaneous studies examine the effects of the reported financial scandals and the

Congressional responses (the Act) on investor confidence. 6 Cohen, Dey, and Lys (2004) document that

earnings management activities of public companies increased substantially during the financial scandal


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evidence indicating improvements in liquidity measures after the passage of the Act both in the short and

long-term. Two recent studies, one by Li, Pincus, and Rego (2004) and another by Engel, Hayes, and Wang

(2004), were conducted after our initial study: Li et al. (2004) finds the Act has a beneficial effect as it

reflected in security prices while imposing greater costs on firms that were less compliant with its

provisions prior to the enactment; Engel et al. (2004) examine firms going-private decisions in light of

potential benefits and costs of compliance with provisions of the Act. Engel et al. 2004 find that the

detected abnormal return surrounding events that increased the likelihood of the passage of the Act were

positively associated with the firms size and share turnover, indicating that compliance costs were more

burdensome for smaller and less liquid firms. Although prior related research provides insights into the

effects of regulations on stock markets, earnings management activities, and market liquidity, it does not

address the determinants of such effects including firm-level issues of corporate governance, financial

reporting, and audit functions.

3. The Sarbanes-Oxley Act of 2002

The Acts main purpose is to foster integrity in financial markets and restore investor confidence

in corporate governance, financial reports, and related audit functions. The Act should be regarded as a

process that can: (1) identify and monitor conflicts of interest that provide opportunities and temptation to

mislead investors (independence of directors and auditors); and (2) establish the incentives and penalties

that encourage those involved with published financial reports to fulfill their professional responsibilities

(executive certifications, penalties for violations of Securities laws). Proper implementation of the

provisions of the Act and SEC related rules is expected to: (1) improve corporate governance by assisting

in aligning the interests of management with those of shareholders; (2) enhance the quality, reliability, and

transparency of financial information; and (3) improve audit objectivity and effectiveness in lending

credibility to published financial statements (Rezaee 2004). These provisions of the Act are summarized in


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The Process and Rationale Underlying the Legislation

The wave of financial scandals in the early 2000s encouraged lawmakers and regulators to argue

that Securities markets cannot be trusted to work on their own without strong regulatory support and that

new regulation was needed to restore investor confidence (Ribstein 2002). In the absence of adequate

market-based correction mechanisms, facing a volatile stock market and a frustrated investing public,

legislators responded to this crisis by passing the Act in an attempt to reinforce corporate accountability

and restore investor confidence. In July 2002, the Act moved with high speed through the legislature and

gained momentum with the revelation of reported financial scandals. A major obstacle in determining the

impact of regulations on shareholder wealth is the difficulty of identifying: (1) all likely major events in the

period leading up to the passage of the Act; (2) the precise dates on which information became available to

market participants; and (3) when the market first anticipated the possible effects of such events (Ali and

Kallapur 2001).

Consistent with prior research (Espahbodi, Espahbodi, Rezaee, and Tehranian 2002; Ali and

Kallapur 2001), we use multiple sources in identifying the significant legislative events. The initial step

taken to identify key events was to search the SEC and Congressional websites and to look for press

releases regarding the events pertaining to the Act as listed in Table 1. We next searched the Wall Street

Journal index (WSJI), the Wall Street Journal (WSJ), and the New York Times (NYT) to confirm and/or

identify the event dates. 8 Each of the 12 identified events are potentially significant to investors as they

inform investors of the likelihood of the passage of the Act and its possible impact on corporate

governance, the financial reporting process, and audit functions. The capital market might have anticipated

the possible effects of the 12 identified significant legislative events before they occurred. Following the

strategy used by Schipper and Thompson (1983) and Ali and Kallapur (2001), we classify these 12 events

into three categories based on their likelihood to alter expectations about the passage of the Act: (1)


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favorable periods during the legislative process along with their anecdotal evidence, provisions, and our

predictions of possible security price reactions.

Ambiguous Events

Legislators and regulators initially attributed reported financial scandals of the early part of 2002

(Enron, Global Crossing, Adelphia) as a few rotten apples requiring no regulatory responses

(Cunningham 2003). During this period, investors were frustrated with the wave of financial scandals, yet

they were either not convinced of the widespread effects of scandals or considered them as unrelated

events, as evidenced by a relatively stable investor confidence index around a value of 85 (GAO 2002).

Revelations of further corporate and accounting scandals started in March 2002, continued through June,

and galvanized with the SEC complaint against WorldCom on June 26, 2002. The reported financial

scandals in May and June 2002 caused the UBS/Gallup Index for investor confidence to decline to an all-

time low of 46 in June (GAO 2002).

During this period of ambiguity, more than 30 reform bills were introduced by legislators and

regulators (Schroeder 2002). However, there were basically three competing reform proposals. Senator

Paul Sarbanes, chair of the Senate Banking Committee, sponsored a bill that would: (1) impose tougher

rules on the accounting profession and financial analysts; (2) boost the budget for the SEC and strengthen

its power to discipline corporate executives; and (3) create an oversight board with broad powers to oversee

audit functions. This bill was viewed as a sensible regulation that would combat financial scandals, and was

supported by consumer groups and investor activists, but was strongly criticized by leading Republicans

(e.g., Senator Phil Gramm) and the Bush administration as being too prescriptive. The second proposed

reform was a Republican bill sponsored by Congressman Michael Oxley that would create an independent

audit oversight board but with far fewer powers. This bill was viewed as a regulation with no teeth and an

enshrinement of the status quo, far weaker than the Senate bill, and was favored by many Republicans and


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intensive legislative debate, market participants received controversial signals from the House, the Senate,

the SEC, and the White House regarding the content, substance, and likelihood of the passage of any

Congressional reform. Thus, we do not make predictions for the four legislative events during the

ambiguous period (See Figure 1 and Table 1 for lists of these events).

Unfavorable Events

Two versions of the reform bill received Congressional attention and public support. The

Republican-backed House bill (Oxley), favored by the accounting profession and considered by many as

weak reform, and the tougher bill proposed in the Senate (Sarbanes) viewed as being too prescriptive and

harsh to the financial community and corporations. However, there were considerable uncertainties over

which one would prevail and if either one would be passed by Congress (Geewax 2002a). The Senate

considered the bill in the first week of July 2002. President Bush made a highly publicized speech to Wall

Street on July 9, 2002, which was viewed by many as simply tinkering with the SEC plan for a private

regulatory board and other proposals to regulate public accounting firms (Kulish 2002). 11 The extent of

disagreements between the Senate and the House bill, coupled with the limited time to compromise on

these differences in the first part of July 2002 and the ineffectiveness of the Presidents proposal, created

significant doubt that any reform bill would pass before Congress departed Washington for the August

recess (Geewax 2002a and Oppel 2002b). The possibility of the passage of a meaningful reform bill was

very remote, primarily because lobbyists and some leading Republicans had pledged to rewrite it when it

got to conference committee (Oppel 2002b). We posited that investors perceived these differences as a

signal of a decreasing likelihood of the passage of the Act (events of July 9, 15, 16, and 19 of 2002) and

thus, we predicted negative market reactions to these events.

Favorable Events

The Act emerged under circumstances that virtually ensured its passage in the last week of July


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finally renamed as the Sarbanes-Oxley Act by the conference committee on July 24, and included a

majority of provisions from the perceived tougher Senate bill, which made the Act a symbolic victory for

Democrats. Fourth, President Bush said on July 24 that he would sign the Sarbanes-Oxley Act of 2002,

which he called a victory for Americas shareholders and employees (Geewax 2002b). Finally, Congress

moved rather swiftly to pass the Act after the wave of financial scandals eroded investor confidence in the

capital markets. Events pertaining to the Conference report on July 24, the Congressional legislation on

July 25, 2002, sending the compromised bill to the president on July 26, 2002, and all rumors about the

president signing the compromised bill sent signals to the market that indicated the increasing likelihood of

the passage of the Act and the resolution of uncertainty about its provisions. We posited that investors

viewed these events as favorable and the capital market reacted to them positively.

Theoretical Argument and Hypothesis Development

In this section, we describe the theoretical argument that motivates our hypothesis development

and empirical analysis. One argument is that there is no need for policy interventions (regulations) because

product market competition provides incentives for firms to adopt the most efficient and effective corporate

governance mechanisms. Firms that do not adopt effective corporate governance are presumably less

efficient in the long-term and ultimately are replaced. However, the wave of financial scandals in the late

1990s and early 2000s demonstrated that market-based mechanisms alone could not solve corporate

governance problems. The capital markets hit rock bottom in the early 2000s primarily because market

correction mechanisms, lax regulations, and disclosure standards failed to protect investors and thus

diminished trust in the capital markets.

The Act, by improving investor confidence, provides a compelling setting for assessing the

shareholder wealth effects of mandatory disclosure and corporate governance regulations for at least three

reasons. First, the Act equally applies to, and is intended to benefit, all publicly traded companies. Some of


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(3) enhancing the quality, reliability, transparency, and timeliness of financial disclosures through

executive certifications of both financial statements and internal controls; (4) prohibiting non-audit

services; (5) regulating the conduct of auditors, legal counsel, and analysts and their potential conflicts of

interest; and (6) increasing civil and criminal penalties for violations of security laws. If the Act improves

corporate governance, financial reporting, audit functions, and increases criminal penalties for willful

misrepresentation of financial information (which was previously unachievable through market

mechanisms), then the Act could lead to an increase in investor confidence, a decrease in the cost of capital,

an increase in firm value, and greater benefits to all public companies (Donaldson 2005; Turner 2005).

Second, the mandatory level of compliance with provisions of the Act regarding corporate

governance and accounting and auditing practices is much higher that presumably optimized level for all

public companies. This new mandated level in the post-Act period is much higher than the previously

practiced level primarily because of additional requirements for executive certifications of financial

statements and internal controls, the creation of the PCAOB, prohibiting non-audit services, more vigilant

audit committee oversights, more transparent and timely financial disclosures, and stiffer penalties for

corporate malfeasance among others. The achievement of this mandatory level of governance is required by

the Act and enforced by SEC-related implementation rules to restore investor confidence and trust in the

capital markets. In the absence of externalities, the achievement of the regulated level of governance and

financial reporting and auditing practices should benefit and generate positive return, on average, for all

public companies implying either that the mandated level of governance is much higher than the presumed

optimized level and/or there are strong spillover effects from the Act (e.g., improved investor confidence,

reduced cost of capital). Thus, all public companies will benefit from either the spillover effects of the Act

and/or the achievement of high levels of mandated governance.

Finally, the compliance costs vary depending on the firms level of compliance with the provisions


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involved with financial reporting; (2) costs associated with reporting and attestation requirements of

internal controls; (3) management and staffing requirements, such as the cost of hiring independent

members of the board of directors, a financial expert for the audit committee, legal counsel for monitoring

compliance, setting up a whistleblower program, and training employees; and (4) opportunity costs

associated with changes in corporate governance mechanisms and accounting and auditing practices to

comply with provisions of the Act. Recent anecdotal evidence (CRA 2005; Turner 2005) shows that the

cost of compliance with Section 404 of the Act on internal controls is, on average, about 0.10 percent of the

total revenue of public companies. Furthermore, SEC chairman William H. Donaldson has recently stated

that I believe it important to note that a substantial portion in the [compliance] cost may reflect initial

start-up expenses as many companies, for the first time, conducted a systematic review and documentation

of their internal controls (Donaldson 2005). We view these initial start-up expenses as a one-time cost of

compliance in our model of determinants of costs and benefits of the Act.

Like any regulations, shareholder wealth effects of the Act are a function of both the expected

benefits and costs imposed on public companies with the passage of the Act. Overall, if the induced

benefits of the Act exceed its imposed compliance costs, then we would expect a positive impact on

shareholder wealth resulting from positive market reactions to the Congressional events that increased the

likelihood of the passage of the Act and resolved uncertainties about its provisions. Alternatively, if the

imposed compliance costs exceed the induced potential benefits, we would expect a negative effect on

shareholder wealth resulting from negative market reactions to those events. Since the costs and benefits of

compliance with provisions of the Act are not observable a priori , the net benefit can be measured in terms

of any changes in market performance from the imposed regulatory changes. Although the direction of

capital market reactions to legislative events leading up to the passage of the Act is an empirical issue,

based on our discussion of Congressional events in the previous section and consistent with Espahbodi et


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The overall benefit induced by the Act in improving investor confidence must be weighted with

the imposed compliance costs at firm-specific. Brown and Caylor (2004) find that good (poor) corporate

governance associated with higher (lower) profits, less (more) risk, less (more) stock price volatility, higher

(lower) values and larger (smaller) cash payouts. The Act requires a poor (good) governance firm to make

many (few) changes to its pre-Act governance structure. Thus, compliance with provisions of the Act

pertaining to corporate governance, financial reporting, and audit functions would be more costly to poor

governance firms than good governance firms. We assume that all public companies affected by the Act

were in equilibrium in the pre-Act period. The Act raised the average return for all firms by improving

investor confidence in the capital markets, a pure externality effect that is not firm specific. Nonetheless,

for less-compliant (denoted by LC ) firms, ex ante , the imposed compliance costs outweighed the induced

benefits. Alternatively, for more-compliant (denoted by MC ) firms, ex ante , the induced benefits

outweighed the imposed costs. Thus, LC firms incurred more costs to comply with the new corporate

governance reforms (the Act, SEC-related implementation rules) but they may still show positive abnormal

returns because the positive pure externality (induced by improvement in investor confidence) outweighs

the excess of costs over benefits. MC firms, on the other hand, are expected to show higher positive

abnormal returns because of the positive pure externality effect.

More specifically, a formal argument is presented as follows in our model. Every firm maximizes

its stock price ( p) by maximizing net profits defined as earnings ( e) minus variable costs of compliance ( v),

and one time fixed compliance costs ( f ) of changing the firms corporate governance structure, financial

reporting process and auditing functions to comply with the provisions of the Act. In terms of

organizational complexity, there are several types ( ) of firms ranging from simple organizational structure

and to very complex organizational structure. Their choice variable is the level of continuous compliance

() with the provisions of the Act and they operate within a given set of regulatory parameters. Firms type,


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e is normalized to 1 for the firm with highest earnings;

v is expressed as a proportion of e and ranges from 0% to 100%, or 0 to 1 in fractions;

ranges from 0 for the simplest firms to 1 for the most complex firms; and

is a continuous variable, meaning that a firms compliance level can be none, partial or

full.

There is a pure externality effect of the Act which is crucial to our argument. The Act was intended to

improve investor confidence by increasing the price multiples from b before the Act to a after the Act

(where a > b). This increase in x (a pure externality effect) is caused by a lowering of cost of capital due

to an increased probability that the financial statements are more reliable after the Act (Cheng et al. 2004).

The interaction of v * * in the cost structure is justified as firms with simple organizational

structure will find it easy and less costly to comply. Similarly more compliance is more costly. The choice

variable can be thought of zero (0) percent if the firm decides not to comply with any of the provision of

the Act and 100 percent if the firm decides to comply fully with the Act. Compliance variable can take

any intermediate value as firms can comply with the easy provisions that avoid major damages and violate

the more tedious provisions of the law that are associated with lesser damages. This is an important choice

that firms make in two respects. First, compliance comes at costs v that can be avoided if a firm decides not

to comply. Second, compliance sends a signal to the investors who revise their probability about the

accuracy of financial statements upwards. Specifically, the ranking of adjusted price-earnings ratio for

different combinations of environment and compliance are as follows:

a * (1+) > a and b * (1+) > b

The first order condition for profit maximization is obtained by setting:

p / = 0

[ x * {e ( v * * )} + x * {e ( v * * )} ( f * )]/ = 0


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Equation 2 represents the optimal level of compliance, which is independent of the externality

( b xa

x / pre- and post-Act). Comparative statistic implies that the degree of compliance, , is: (1)

decreasing in complexity of firms type, implying that firms with higher will be in less compliance; and

(2) increasing in firms earnings and better regulatory environment implying that many firms that found it

optimal not to comply before the Act could find it optimal to comply after the Act. Note that the second

order condition that 2 p /

2= 2 xv < 0 is true because all three variables x, v, and are positive by

definition and their product with -2 is therefore less than 0.

We introduce some additional notation to clarify the implication of the propositions above.

Consider any 2 specific values of , M and L such that M < L, i.e. M has a simpler organizational structure

and is, therefore, closer to compliance with provisions of the Act ex-ante; L has a more complex structure

and is farther from compliance with provisions of the Act prior to its passage, which indicates that the

optimal level of compliance Mopt > L

opt

Substituting optimal value of compliance from equation (2) into equation (1),

pxopt = x e x e + x v + x e

2 /v x e ( xe2 /v -2 xe + xv) f

pxopt = x(e

2 /v + 2e + v ) f (3)

The difference in price reaction of more compliant firms (p aM pb

M), where a is after the Act and b is

before the Act, and less compliant firms (p aL pb

L) is as follows:

(paM pb

M) (paL pb

L) =

[{ a(e2 /vM + 2e + v M) f M} { b(e

2 /vM + 2e + v M) f M}]

[{ a(e2 /vL + 2e + v L) f L} { b(e

2 /vL + 2e + v L) f L}]

= ( a b)*( L M)*( e2 /vML v )

(paM pb

M) (paL pb

L) = ( a b)*( L M)*( e2 v 2ML) /vML (4)

We know that by definition the following inequalities are true:


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(iii) e > v > 0, which implies that e2 > v2. In addition, M, L (0,1) which implies that ML v 2ML. The denominator term, vML, is likewise positive

Thus, all terms on the right hand side of equation (4) are positive supporting our propositions that:

(paM pb

M) (paL pb

L) > 0 (5)

Alternative Specifications of Optimal Level of Compliance Function :

Note that a difference in firm complexity is not necessary to show (p aM pbM) (paL pbL) > 0. If

firms with similar complexity differed in the level of compliance merely because of a difference in their

cost structures, the above inequality can be shown to hold. Consider, for example, the following two

slightly modified situations where:

1. Firms with similar organizational structure ( M=L ) differ in their compliance level with provisions

of the Act, with firm J is more compliant than firm K prior to the Act because of a difference in

their variable cost of compliance, i.e., Jv < Kv . Then it can be readily shown that

(paJ pb

J) (p aK pb

K) ( )( )

=

KJ

2KJ

2

JK41

vvvve

vvba (6)

Furthermore, we know that:

(i) a > b, which implies that ( a b) is positive;

(ii) the variable cost Kv > Jv , which implies that ( )JK vv is positive;

(iii) e > v > 0, which implies that e2 > KJvv . Therefore, e2 > 2KJ vv .

These conditions indicate that all bracketed terms on right hand side of equation (6) are positive.

Thus, (paJ pb

J) (p aK pb

K) > 0 (7)

f f


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(pa

X pb

X) (pa

Y pb

Y)( )( )

++=

vvee

eeba2

4

1 YXYX

(8)

Furthermore, we know that:

(i) a > b, which implies that ( a b) is positive;

(ii) Xe > Ye , which implies that ( )YX ee is positive;

(iii) e > v > 0 and e > > 0. Therefore, ( ) 02YX >++ vee

These conditions indicate that all bracketed terms on right hand side of equation (8) are positive.

Thus, (paX pb

X) (paY pb

Y) > 0 (9)

Numerical examples of Equations 5, 7, and 9 are provided in Appendix B. As shown in these

equations, regardless of what drives the optimal compliance level, price change is always higher for more

compliant firms than for less compliant firms. This provides a basis for our second hypothesis. Evidence

consistent with our cross-sectional prediction provides an ex post indication that the observed market

reaction is attributable to a firms characteristics on corporate governance, financial reporting, and audit

functions, which forms the logic behind our cross-sectional hypothesis (stated in alternative form): 12

HYPOTHESIS 2. The observed positive capital market reactions are higher (lower) for firms withmore (less) effective corporate governance, financial reports, and audit functions prior tothe passage of the Act.

4. Research Design

Test of First Hypothesis (Time-Series Analysis)

The Act is applicable to all publicly traded companies. Therefore, we expect the stock market as a

whole to react positively (negatively) to the favorable (unfavorable) events around the passage of the Act,

as discussed in the previous section. Our initial test focuses on two broad based market indices, namely the

S&P 500 index and the Value-line index. The test period for our events is from February to July 2002. For


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CARs) are obtained by adding the abnormal returns on the event day, one day before the event, and one day

after the event. 14

Consistent with Ali and Kallapur (2001) Espahbodi et al (2002), and Rezaee and Jain (2005), we

examine the average impact of the 12 Congressional events on stock prices and for all 12 events for our

sample using the following model:

= ++=12

1 j j j jot e Da R (10)

where:

t R = average daily stock return of sample firms on date t ;

oa = the intercept coefficient that represents the average daily stock return across the 485 non-

event trading days in 2001-2002 for the S&P 500 portfolio;

j = the effect of the even j on the portfolio raw return, which represents mean-adjusted returns

of the portfolio raw return for event j minus the portfolio mean return over the non-event

days;

j D = a dummy variable that takes a value of 1 for the event window ( t = -1, t = 0, t = +1) relative

to the announcement date of event j and 0 otherwise. Our examined 12 events classified into

three categories of ambiguous, unfavorable, and favorable events are listed in Table 1; and

je = random disturbance, which is assumed to be normal and independent of the event.

We estimate equation (10) over the 485 trading days of stock return data for 2001 and 2002 using raw

returns for S&P 500 firms. Unlike Espahbodi et al. (2002) and Rezaee and Jain (2005), we did not adjust

equation (10) for market return because the Act was intended for all public companies and the entire market

ff d b h l ( ) f h l f ( ) b


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Test of Second Hypothesis (Cross-Sectional Analysis)

We perform a cross-sectional analysis to investigate determinants of shareholder wealth effects of

the Act by identifying the firm-specific characteristics that influence the magnitude of stock price reactions

to Congressional events that increased the likelihood of the passage of the Act. The cross-sectional analysis

simultaneously analyzes the impact of firm variables on abnormal returns and cumulative abnormal returns

in a regression framework. Because the security performance reflects the firms ex ante, shareholder

wealth effects of regulations (the Act), Congressional events leading up to the passage of the Act can

provide a unique empirical setting through which we can draw inferences about the otherwise unobservable

costs and benefits of compliance with the provisions of the Act. This is important because compliance with

applicable laws and regulations (the Act) is a key component of corporate governance and control

mechanisms. Our cross-sectional analysis provides evidence pertaining to the determinants of shareholder

wealth affects of regulations such as the Act.

Dependent Variable

We use the standard event study methodology for the cross-sectional analysis as outlined in

Campbell, Lo, and MacKinlay (1997). 16 The dependent variable for the first regression is abnormal returns

( AR it ) defined as follows under the Capital Asset Pricing Model ( CAPM ):

)(^

f Mt f it it R R R R AR = (11)

where Rit is the return on stock i on event date t ; -hat is the stocks beta, which measures the sensitivity of

a company's stock price to the fluctuation in the Standard & Poor's 500 (S&P 500) Index, calculated for a

5-year period ending in June 2002 using month-end closing prices including dividends; R f is the risk-free

rate of return from treasury bill (t-bill); and R Mt is the return on S&P 500 Index on the event date. The

dependent variable for our second regression is cumulative abnormal returns ( CARit ), which is obtained by

dd h b l h d d b f h d d f h


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financial reporting, and audit functions. Standard & Poors (S&P), on October 15, 2002, released its

Transparency and Disclosure (T&D) practices of S&P 500 firms as of June 30, 2002. The T&D scores

consist of the following three dimensions of corporate governance: (1) ownership structure and investor

rights ( OSIR ); (2) board and management structure and process ( BMSP ); and (3) financial transparency and

information disclosure ( FTID ). These three dimensions are developed based on 98 information items

(attributes). 17 We use the three S&P dimensions of corporate governance ( OSIR, BMSP, FTID ) along with

other explanatory variables in our cross-sectional analysis in order to determine the relation between the

observed capital market reactions and firms financial attributes and corporate governance characteristics. 18

Table 2 defines measures related to these characteristics along with their data source, and they are further

discussed in the following paragraphs.

Measures of Corporate Governance

Corporate governance addresses the potential conflicts of interest and agency problems induced by

the separation of ownership and control in corporations (Fama and Jensen 1983; Jensen 1986). These

agency problems may cause conflicts of interest and information asymmetry, which can be costly to

shareholders (Shleifer and Vishny 1997). The wave of financial scandals indicates that there was a serious

problem in public companies corporate governance in terms of an imbalanced power-sharing relationship

between investors and managers. The Act changes the balance of power between directors, executives, and

investors by shifting significant responsibilities from management to the audit committee. These changes

are expected to motivate and reinforce corporate boards, audit committee members, and executives to

become more vigilant, transparent, and accountable for financial reports (see Appendix A).

Recent studies (e.g., Khanna, Palepu, and Srinivasan 2003; Durnev and Kim 2002; Cheng,

Collins, and Huang 2003) have employed S&Ps T&D scores as proxies for corporate governance and

financial reporting attributes, and identify several concerns with using T&D rankings. 19 These concerns are


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ratings of firm level corporate governance practices used in prior research (La Porta et al. 1998). The three

dimensions of corporate governance rankings range from 1 for very weak corporate governance

processes and practices, to 10 for very strong corporate governance processes and practices. We posit

that firms with higher corporate governance scores ( OSIR and BMSP ) are more positively affected by the

Act.

Measures of Financial Reporting

High-quality financial reports enable investors to better assess the risk and return associated with

investments through more accurate and complete financial information. Many provisions of the Act (see

Appendix A) are aimed at improving quality, transparency, and reliability of financial reports of public

companies. Examples of the financial reporting effects of the Act are executive certifications of financial

statements and internal controls, increased disclosure of events affecting companies, elaboration of non-

GAAP financial statements and discussion of off-balance sheet financing and contingent liabilities. The

increased transparency of financial reports reduces the possibility that managements behavior is

opportunistic and such a behavior is not discovered by auditors, analysts and investors in a timely manner.

We use two measures of financial reporting including: (1) S&P T&D scores for financial transparency and

disclosure ( FTID );20 and (2) the absolute value of total accruals ( ATAC ) as proxies for the quality,

reliability, and transparency of financial reports. We predict that firms with higher FTID scores are more

positively affected by the Act. Prior research (Cohen et al. 2004; Frankel, Johnson, and Nelson 2002) use

magnitude and sign of accruals as a proxy for earnings quality in the examination of earnings management.

Thus, we expect a negative relation between the absolute value of total accruals and the observed market

reactions to the Act.

Measures of Audit Functions

Investor trust in auditors judgments, objectivity, and reputation plays an important role in


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provide incentives for the auditor to acquiesce to client pressure. Thus, disclosure of auditors fees and the

breakdown of total fees to audit and non-audit service fees can inform investors about audit objectivity and

financial reporting quality. 21 The Act, by reducing managements influence on audit tenure and prohibiting

non-audit services, can reduce conflicts of interest between management and auditors, which in turn can

improve audit credibility and quality. We use the ratio of non-audit fees to total auditor fees as a proxy for

the credibility of audit functions, and predict a negative relation between this ratio and the observed capital

market reactions to the Act.

Prior research (e.g., DeAngelo 1981; Beatty 1989; Craswell, Francis, and Taylor 1995) suggest

that audit quality varies among public accounting firms and that both auditor reputation and brand name

play an important role in determining the audit fee. Recent studies (Chaney and Philipich 2002; Asthana,

Balsam, and Krishnun 2003; Callen and Morel 2003; Rezaee, Hunt, and Lukawitz 2004) document that

Arthur Andersen clients experienced negative abnormal returns over a period of negative news disclosure

about Enron and Andersen. Furthermore, Rezaee et al. (2004) find a much stronger negative market

reaction to Andersen-specific events (e.g., document shredding, guilty verdict) than to Andersen-client

events that were damaging to Andersens reputation. Thus, we also use an Arthur Andersen (AA) variable

as a proxy for auditors reputation and credibility, and predict a negative relation between the AA variable

and the observed capital market reactions to the Act.

Control Variables

To determine the possible impact of the Act on corporate governance, financial reporting, and

audit functions, we control for several equity characteristics (firm size, performance, and leverage) that

have been documented in prior research (e.g., Fama and French 1993) as being associated with securities

return. We control for firm size using market capitalization. Large firms often have more resources and are

better equipped to observe high compliance costs of regulations such as the Act, and thus we predict size


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leverage increases. Thus, highly levered firms are more likely to benefit from monitoring mechanisms

provided by the Act in order to ensure compliance with the restrictive covenants specified in debt

agreements. We predict a positive relation for leverage. We also control for the cost of compliance with

provisions of the Act As discussed in Section 3, the compliance cost is higher for less-compliant firms than

more-compliance firms prior to the passage of the Act. CRA (2005) and Turner (2005) estimate the cost of

compliance with Section 404 of the Act (internal controls) about 0.10 percent of the total revenue for public

companies whereas Section 404 additional audit fees (audit report on internal control over financial

reporting) is about 0.02 of the total revenue. We use audit fees as a proxy for the cost of compliance with

the Act since audit fees are estimated to constitute a large portion of the total compliance costs. We predict

a negative relation for the audit fee variable ( AUT ) as a proxy for the compliance cost.

Regression Models

We developed two regression models based on cross-sectional variables as follows:

it it it it it it

it it it it it it

Aut LEV MTB MAC AA

NATA ATAC FTID BMSPOSIR AR

+++++

++++++=

109876

54321 (12)

it it it it it it

it it it it it it

Aut LEV MTB MAC AA

NATA ATAC FTID BMSPOSIRCAR

+++++

++++++=

109876

54321 (13)

Our sample for the cross-sectional analysis consists of 415 S&P 500 firms with available data on test

variables (40 firms were excluded for non-existence of S&P and T&D scores, and another 40 were

excluded for unavailability of data on auditor fees). The presence of the cross-sectional heteroscedasticity

and the contemporaneous correlation of the residuals is likely in our regression models (equations 12 and

13) primarily because Congressional events leading to the passage of the Act affect all sample firms. To

address these issues, we use the Generalized Method of Moments (GMM) estimation. The GMM

estimation, by using a correct variance-covariance matrix based on residuals, overcomes the two common


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415 companies in our cross-sectional regressions, (1) the average score for ownership structure and investor

rights ( OSIR ) is 5.65; (2) the average score for board and management structure and process ( BMSP ) is

8.19; (3) the average score for financial transparency and information disclosure ( FTID ) is 8.14; (4) the

mean of the absolute value of total accruals scaled by total assets is 8.68 percent; (5) the average ratio of

non-audit service fees to total auditor fees ( NATAA ) is 52 percent; and (6) the Arthur Andersen variable has

an average of 16.16 percent. The average market capitalization is 0.0179 trillions of dollars. Our sample

firms seem to have moderate leverage with an average of 57 percent debt-to-equity ratio. The average

market-to-book ratio of common equity, a measure of growth and risk is about 3.68 and the average audit

fee of $3.17 million.

5. Results

Time-Series Analysis

Table 4 reports daily abnormal returns (ARs) and three-day cumulative abnormal returns (CARs)

along with their predicted signs around each of the 12 events and for each of the three designated event

period of ambiguous, unfavorable, and favorable. 22 As indicated in Table 4 and consistent with Hypothesis

1, almost all events that we predicted to increase (decrease) the likelihood of the passage of the Act

appeared to contain both unanticipated and signaling news to the extent that they affected stock prices of

public companies and could be detected by our models. Of the eight dates, for which we predict whether

the event will increase or decrease the likelihood of the passage of the Act, the sign of daily abnormal

return conforms to our prediction for seven dates. The CARs for the calendar period starting from the

beginning of our sample events to the end are plotted in Figure 2. This Figure shows that the declining

trend of the market was arrested, and the market started moving up around the passage of the Act.

Furthermore, the predicted unfavorable events (numbers 5, 6, 7, and 8), with a decreasing probability of

passage of the Act, are associated with the market decline period whereas the predicted favorable events


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Panel A of Table 4 shows ARs and CARs results of our two constantmean return models based

on market indices (S&P 500, Value-Line) and portfolio of stocks. Columns 4 and 5 of Panel A present

both ARs and 3-day CARs results of value-line index, 23 whereas the last two columns show ARs and CARs

based on the portfolio of 500 firms in the S&P 500 for each of the 12 events. Panel B of Table 4 present

average daily abnormal returns ( ADAR) for both models for each of the three categories of the events: (1)

ambiguous events (events 1-4, February 14 to June 25); (2) unfavorable events (events 5-8, July 9 to July

19); (3) favorable events (events 9-12, July 24 to July 30); and (4) for all events (events 1-12, February 14,

2002 to July 03, 2002). Column 3 shows ADAR for value-line index whereas column 4 presents ADAR for

the portfolio of S&P 500 stocks.

We generally detected negative capital market reactions to ambiguous events (the first category of

events), particularly event number 3 regarding the SECs plan for a private regulatory board to regulate

public accounting firms. The detected abnormal returns for these events except event number 3 are not

statistically significant, suggesting investors did not view the early Congressional bills as value-relevant or

significant in addressing financial scandals (see panel A of Table 4). The SEC proposal (event 3) was

considered by investors as an ineffective reform that would allow the accounting profession too much

influence over its proposed regulatory board. Panel B of Table 4 shows that the average daily abnormal

returns during the ambiguous events period (events 1-4) was negative and statistically insignificant

indicating no market reactions to these events.

The second category consists of unfavorable events (5, 6, 7, and 8) that either decreased the

probability of the passage of the Act or that provided information regarding the difficulties in reaching

agreements on the final provisions of the Act in the House and the Senate. We detected negative abnormal

returns for these events as predicted. We calculated total cumulative abnormal returns during the

unfavorable event period (July 9July 19) for both the S&P 500 and value-line indexes. Total cumulative


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19, 2002 is -2.41 percent and -3.78 percent, which are significant at the 5 percent and the 1 percent levels

respectively. President Bush, on July 9, 2002, went to Wall Street and spoke in support of Securities Law

reform, which was viewed negatively by the market participants (3-day CAR for both models is negative

and statistically significant). On July 19, 2002, there were significant uncertainties regarding the form,

content, and possibility of passage of the Act, and thus managers on the part of the House and the Senate

met to possibly reconcile differences between the House bill and the Senate amendment. This event sent a

signal to the market that the Act may not be forthcoming and therefore the market reacted negatively to this

event (daily and cumulative abnormal returns are statistically significant at 1 percent level). Panel B of

Table 4 indicates that the average daily abnormal returns for both value-line index and portfolio of stocks

models were negative and significant at the 1 percent level (-1.33 and -1.51 respectively) during the

unfavorable events period (events 5-8).

The last group, consisting of favorable events (9 through 12) unambiguously increased the

probability of the passage of the Act, and the market reacted positively to these events. During July 24 to

July 30, the House and Senate reached a compromise on legislation, and Congress passed the Act by a vote

of 4233 in the House and 990 in the Senate; the compromised bill was sent to the president to sign into

law and was eventually enacted on July 30, 2002. We detect positive market reactions to these favorable

events, suggesting that investors view provisions of the Act as beneficial to them and important in restoring

their confidence in corporate governance, the financial reporting process, and audit functions. Panel B of

Table 4 shows that the average daily abnormal returns for value-line index and portfolio of stocks models

during the favorable events period (events 9-12) are 1.20 and 3.11 respectively and are both significant at

the 1 percent level. Total CAR for this event period (July 24July 30) is +12.95 percent with t-statistic of

+4.56, which is significant at 1 percent level (not reported). The value-line index abnormal return and the

average daily incremental returns of portfolio of S&P 500 companies on July 24, 2002 are 4.34 percent and


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increasing possibility of passage of the Act and reacted to this event positively. The positive 3-day CARs

for July 25, 26, and 30, 2002, during the last week of legislative events are statistically significant

indicating positive market reactions to these events.

Robustness Checks

Results of our time-series analysis indicate that the capital market reacted positively (negatively)

to events that increased (decreased) likelihood of the passage of the Act. We conduct two robustness tests

to validate these results that are likely to be offset by the likelihood of the existence of cross-sectional

correlation among the sample firms. First, we use two alternative market return measures of the Russell

1000 index and the Russell 3000 index in addition to S&P 500 and value-line indices. Consistent with

Chaney and Philipich (2002), we find that all four market return measures produce quantitatively similar

results. For example, untabulated results for CARs using Russell 1000 and 3000 indexes are negative andstatistically significant for events 3, 5, 6, and 8, and positive and statistically significant for events 9, 10,

11, and 12. These findings are consistent with and validate the results presented in Table 4.

Second, we divide our sample firms into two portfolios as a first pass test for our second

hypothesis that firms which were closer to compliance with provisions of the Act regarding corporate

governance, financial reporting, and audit functions experience more positive capital market reactions than

firms which were far from compliance. First, we form portfolios of more-compliant (less-compliant) firms

based on the measure of whether firms were closer to (far from) compliance with provisions of the Act

prior to its passage. We use measures of S&Ps FTID scores to establish these portfolios. Firms with the

score of higher than the median (8, see panel A of Table 3) are classified as the more-compliant portfolio,

and firms with a score of lower than the median are included in the less-compliant portfolio. Second, we

calculate excess returns for these two portfolios using the market model (see equation 10). 25 These two

portfolios should show zero (0) excess returns, if they do not outperform the market. The differences in


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possibility that the Act induced more net benefits to firms that were close to compliance with provisions of

the Act prior to its passage. Results (not reported) indicate that (1) both portfolios experienced net benefits

from the passage of the Act, and (2) the more-compliant portfolio outperformed the less-compliant

portfolio by about one percent more excess returns and the difference is statistically significant at the 1

percent level.

Cross-Sectional Analysis

Our cross-sectional analysis examines whether the magnitude of positive price reaction to

favorable events leading up to the passage of the Act varies with firm corporate governance characteristics,

financial reporting attributes, and audit functions. Table 5 reports regression results for each of the four

favorable events (events 8-12 of Table 4) and for the entire favorable events period. Each column in Table

5 reports the coefficients, standard error, significance level, number of observations, and adjusted R-squarefor each of the four favorable events and all four favorable events. 26 The adjusted R-square for the

abnormal return equation is 4.32 percent and for the CARs regression is 12.17 percent for all four favorable

events. The regression results support our hypothesis that firms: (1) with more effective corporate

governance measured by S&Ps composite scores for board and management structure and process ( BMSP )

are more positively affected by the passage of the Act; (2) with more reliable and transparent financial

reports measured in terms of S&Ps composite scores for financial transparency and information disclosure

(FTID ) and less the absolute value of total accruals ( ATAC ) are more positively affected by the passage of

the Act; and (3) with less credible audit functions as indicated by a higher ratio of non-audit fee to total

auditor fees ( NATA ) are more negatively affected by the passage of the Act.

We find a positive relation, as predicted, between the corporate governance variables and the

observed capital market reactions to the Act. The coefficients for the corporate governance variable

( BMSP ) are positive and statistically significant for the CARs model. This evidence supports our


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corporate governance prior to the passage of the Act. Prior research (e.g., Shleifer and Vishny 1986;

Agrawal and Mandelker 1990) documents that large outside blockholders have greater incentives to

monitor managers. However, we did not detect a statistically significant relation between the ownership

structure and investor rights ( OSIR ) variable and the observed abnormal returns experienced by public

companies resulting from the passage of the Act.

We find a positive and significant relation between the financial transparency and information

disclosure ( FTID ) variable and the observed capital market reactions to the Act and a negative and

significant association between absolute value of total accruals ( ATAC ) and detected abnormal returns. The

coefficients for the financial transparency and information disclosure ( FTID ) variable, for each of the

favorable events, for the daily abnormal returns regression and the cumulative abnormal returns regression

are statistically significant. The coefficients for the absolute value of total accruals ( ATAC ) are negativeand statistically significant. The negative relation between ATAC and the detected abnormal returns can be

interpreted as the capital market might view firms with higher accruals as having more opportunities to

engage in earnings management activities. These results suggest that firms with more reliable and

transparent financial disclosures experienced higher positive market reaction around events that increased

likelihood of the passage of the Act.

We find a negative and significant relation between the ratio of non-audit service fees to total

auditor fees ( NATA ) and the observed abnormal returns around events leading up to the passage of the Act.

The coefficients for the NATA variable for all events except event 12 (July 30, 2002) for the CARs

regressions and the daily ARs regressions are statistically significant. The Acts provisions on audit

functions address the important issue of the economic bonding and potential conflicts of interest that may

occur when auditors contemporaneously provide audit and non-audit services for their clients. Several

studies have also investigated this important issue of auditor independence (Frankel et al. 2002; Kinney and


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evidence that auditors controversial economic bond with their clients could adversely affected audit

credibility. Alternatively, the observed negative association can be interpreted as market participants

negatively viewing the loss of the perceived value-enhancing of non-audit services post-Act. We find no

statistically significant association between the observed capital market reaction to the Act and the firm

being audited by Arthur Andersen.

We detect positive relation between three of the four control variables ( MAC, MTB, and LEV ) and

the observed abnormal returns. Coefficients for growth ( MTB), market capitalization ( MAC ), and leverage

( LEV ) are statistically significant, indicating that larger and more levered and growth firms are positively

affected by the passage of the Act. The detected positive coefficient for leverage variable can be

interpreted as highly leverage companies benefit more from the Acts provisions regarding off-balance-

sheet transactions, possible conflicts of interest reduction, more control mechanisms, and more effectivecorporate governance to ensure compliance with the restrictive covenants specified in debt agreements.

The coefficients for MTB and MAC are also of interest. These coefficients are positive and significant,

indicating that the market was upgrading larger firms with high growth potential because these firms were

perceived to (1) benefit more from provisions of the Act intended to control earnings management

activities; and (2) be better able and equipped to observe high compliance costs of the Act. These results

suggest that for more levered and high growth potential firms, the benefits of the Act outweigh its

compliance costs. We detect a negative relation between audit fees variable ( AUT ) as a proxy for the cost of

compliance with provisions of the Act and the observed capital market reactions to the Act. The

coefficients of AUT are only statistically significant for events of July 24, 25, and 26. This lends support to

our prediction that the Act was more costly for less-compliant firms than more-compliant firms.

Limitations and Suggestions for Future Research

There are a few caveats to our study. First, provisions of the Act affect all publicly traded


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hypothesis does not rule out the possibility that events other than Congressional actions could have

produced the results. To the extent that there are confounding events or omitted variables that are also

correlated with our events or cross-sectional model, it is possible that our analyses are being driven by

these factors and not by provisions of the Act. However, searches for confounding events reveal that no

other relevant event of similar magnitude is known to have occurred around the Congressional actions. 27

Second, prior studies (e.g., Cheng et al. 2003; Patel and Dallas 2002; Khanna et al. 2003; Durnev

and Kim 2002) caution that S&P scores are not necessarily proxies for corporate governance. Our results

pertaining to the effect of the Act on firm characteristics rely on the extent to which the selected S&P

scores measure the strength of corporate governance, reliability, and transparency of financial reports.

These scores for individual firms reflect the ratio of the number of present attributes out of the total 98

informative items, and do not necessarily measure the quality of the attributes. Measures of corporategovernance and some measures of financial reporting are quantitative not qualitative, which does not allow

us to distinguish between the quantity and quality of disclosures. Finally, as with any study of the passage

of legislation, our findings should be interpreted with caution primarily because of the difficulty in

identifying (1) the timing of information about the Act to the market and (2) firm-specific effects due to the

fact that the Act affects all firms simultaneously.

6. Conclusion

The wave of financial scandals coincided with substantial drops in stock prices and public anxiety

over the economy in July 2002, which encouraged Congress to pass the Sarbanes-Oxley Act. Marketplace

mechanisms do not always provide timely, reliable, and effective self-corrections, as evidenced by reported

business and accounting scandals. Thus, regulations are expected to create an environment that promotes

strong marketplace integrity and investor trust in the quality and transparency of financial disclosures. The

Act is intended to restore eroded public confidence in financial reports by reinforcing corporate


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the passage of the Act is that the Act provides incentives and mechanisms for both public companies and

their auditors to better signal the quality, reliability, and transparency of their financial statements as well

as the effectiveness and credibility of audit functions.

This study also sheds light on the determinants of the observed market reaction using firm-specific

variables. We find that more compliant firms with more effective corporate governance, more reliable and

transparent financial reports, and more credible audit functions prior to the Act were more positively

affected by the Act than other firms. One interpretation of this finding is that although the Act equally

benefits all firms, it imposes higher costs of compliance on firms with poor governance and lower

transparency and disclosure standards. Results suggest that the Act, by either generating what investors

considered as good news or creating an environment that promotes strong marketplace integrity has served

as a stimulus to encourage initiatives for rebuilding the public confidence in corporate governance, thefinancial reporting process, and audit functions. Overall, our results suggest that the induced benefits of the

Act significantly outweigh its imposed compliance costs as measured by stock prices. This can also be

interpreted that the capital markets expected that the Act would improve corporate governance and take

their optimal level of governance in the pre-Act period to the higher level, which ultimately maximizes

shareholder value.


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31

APPENDIX A, cont.

Corporate Governance Financial Reporting Audit Functions Others

8. Forfeiture by CEO or CFO of certain bonuses and profits when thecompany restates its financialstatements due to its material non-compliance with any financialreporting requirements.9. Improper influence on conduct of audits.10. Insider trades during pension fundblackout periods.11. Officers and directors bars andpenalties for violations of Securitieslaws or misconduct.

11. Periodic review of published financial statementsby the SEC at least once everythree years.12. SEC-enhanced authority todetermine what constitutesU.S. GAAP.

11. Disclosure of fees paid to theauditor.12. Requirements for pre-approval of audit and permitted non-audit servicesby the audit committee.13. Retention of audit work papers anddocuments for five years.

14. Increased penalties for destructionof corporate audit records.

13. Increased criminal penaltiesunder Securities laws and mailand wire fraud.14. Future studies onconsolidation of public accountsby firm, audit firm rotation,accounting standards, credit

rating agencies, and investmentbanks.


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APPENDIX B

1. NUMERICAL EXAMPLE with different firm complexity:

A discrete example clarifies the propositions. Suppose e = 1, v = 0.3, f = .2, b = 3.5, a = 5.5. Suppose,there are only 2 types of firms = 0.1 for firm type M and = 0.9 for firm type L.

opt =

121

ve

f ve p x += )}(){1(

Type 1( =0.1) :

Mopt =

11.03.0

121

=16.1667

1.02.0)}1667.161.03.0(1){1667.161(5.5)}(){1( +=+= f ve p a M a

= 48.6047

1.02.0)}1667.161.03.0(1){1667.161(5.3)}(){1( +=+= f ve p b M b = 30.9230

Type 2( =0.9) :

Lopt =

121

ve

=

19.03.0

121

=1.3518

1.02.0)}3518.11.03.0(1){3518.11(5.5)}(){1( +=+= f ve p a La

= 12.38971.02.0)}3518.11.03.0(1){3518.11(5.3)}(){1( +=+= f ve p b

Lb

= 7.8771

(paM pb

M) (paL pb

L) = (48.6047 30.9230) (12.3897 7.8771) =13.1691 > 0

2. NUMERICAL EXAMPLE with different variable costs:

Note that difference in firm complexity is necessary to show (p aM pb

M) (paL pb

L) > 0. If firms with

similar complexity differed in the level of compliance merely because of a difference in their cost

structures the above inequality can be shown to hold Consider for example a slightly modified situation:


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(paJ pb

J) (p aK pb

K) = (12.0228 7.6145) (6.6375 4.1875) = 1.9583

3. NUMERICAL EXAMPLE with different earnings:

Another possibility is difference in earnings of the 2 firms driving their level of compliance. For example:

Suppose e = 1 for firm type X and e = 0.7 for firm type Y, v = 0.3 for both firms, f = .2, b = 3.5, a = 5.5,and = 0.5 for each firm.

Xopt =

1

5.03.0

1

2

1= 2.8333; Yopt =

1

5.03.0

7.0

2

1= 1.8333

(paX pb

X) (paY pb

Y) = (12.0228 7.6145) (6.5228 4. 1145) = 2 >0


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End Notes

1. In signing the Act, President George W. Bush described it as the most far-reaching reforms of

American business practice since the time of Franklin Delano Roosevelt (Bumiller 2002). The

SEC Commissioner, Harvey Goldschmid, called the Act the most sweeping reform since the

Depression-era Securities Laws (Murray 2002).

2. See Cunningham (2003) and Ribstein (2002) for in-depth critiques of the Act, and the discussion

of market versus regulatory responses to financial scandals.

3. See Easton (1999) and Ali and Kallapur (2001) for implications of this type of research in market

event studies.

4. The chief executive officer of Deloitte and Touch in a testimony before the House Committee on

Financial Services states that, the Act is already having a significant impact and, over time, it

should help in fulfilling its intended purpose of restoring investor confidence (Quigley 2004).

Turner (2005), in a presentation to the April 2005 SEC Roundtable, states that the Act has resulted

in significant benefits to investors, the capital markets, and public companies.

5. These Acts (1933, 1934) were intended to protect investors from fraudulent or misleading

information by increasing the general extent of accounting disclosures and restricting accounting

alternatives. The PSLRA had increased restrictions on private litigants ability to sue for

investment losses from securities fraud.

6. In a related study, Bhattacharya, Groznik, and Haslem (2002) find no evidence of capital market

reactions to the CEO and CFO certification requirements imposed by the SEC on large public

companies prior to the passage of the act.

7. See Rezaee (2004) for a more in-depth discussion of provisions of the Act addressing corporate

governance, the financial reporting process, and audit functions. See Wiesen (2003) for the impact


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Congressional websites. To capture the full impacts of these events we use a three-day event

window around event dates.

9. The New York Times quoted Democratic leaders who attacked the House bill as toothless (Oppel

2002a).

10. Financial Times , on June 22, 2002, reports that A Senior White House official said yesterday

President George W. Bush does not support legislation backed by Senate Democrats that would

place stringent new regulations on the accounting industrythe White House backed reforms

unveiled on Thursday by Harvey Pitt (Adetunji, Humes-Schulz, and Spiegel 2002).

11 The New York Times reported that the Presidents rhetoric calling for a new ethic of personal

responsibility in the business community was a gaping gum, no teeth (Jennings 2002, 15).

12. Table 2 describes measures of corporate governance, financial reporting, and audit function

characteristics used in our cross-sectional analysis.

13. Prior studies (e.g., Rezaee 1990; Stice 1991; Bhattacharya et al. 2002) use the constant-mean

return model for investigating the capital market reactions around accounting standards and

legislative events. The market reaction in Table 4 is tested using the constant-mean return model

based on the following equation:

21,142, = Mt Mt Mt R R AR

where Mt AR = abnormal market return on the event date, Mt R = actual market return on the

event date, and 21,142, Mt R = the mean market return (benchmark) during the 121 trading

days during the estimation period. Prior research (e.g., Brown and Warner 1980, 1985; Boehmer,


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the commonly-used methods to detect abnormal returns. Schipper and Thompson (1983, 217) state

that in the case of powerful regulations (e.g., the Williams Amendments Act in their study or, the

Sarbanes-Oxley Act in our study), the same conclusions will be drawn from tests based on a

variety of econometric methods.

14. The abnormal returns (daily and cumulative) are standardized over the estimation period using the

event-induced variance method (Standardized Cross-sectional Procedures) suggested by Boehmer,

Musumeci and Poulsen (1991). We form the standardized cross-sectional test by dividing the

average event-period standardized residual by its contemporaneous cross-sectional standard error.

Mt AR , a measure of excess returns, is assumed to be normally distributed with mean zero and

variance2

Mt . A standardized residual ( Mt SAR ) is then defined as:

=

++

=

T

t

M Mt

M Mt M

Mt Mt

R R

R R

T S

ARSAR

1

2

2

)(

)(11

When N = number of firms in the portfolio

T = number of days in the estimation period (-142 through -21)

RM = average market return during the estimation period

SM = estimated standard deviation of abnormal returns during the estimation period.

Our test statistic is:

= =

=

N

i

N

i

Mt Mt

N

i Mt

N

SARSAR

N N

SAR N

1

2

1

1

)1(1

1


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16. We use the market model in testing hypothesis 2 to relate firms abnormal returns to its specific

attributes about corporate governance, financial reporting, and auditing practices. We use the

constant-mean-return model to test our first hypothesis because the portfolio under investigation is

the market portfolio itself. Nevertheless, we repeat our second test using the constant-mean-return

model in addition to the market model and obtain the same findings.

17. Appendix 2 and 3 of Patel and Dallas (2002) outline the methodology of calculating individual

ranking for each of the three dimensions based on the 98 disclosure items as of June 30, 2002.

OSIR category includes 28 attributes (e.g., description of the voting rights, review of shareholders,

description of the share classes), BMSP consists of 35 attributes (e.g., a list of board members, a

list of board committees, a list of audit committee members, related party transactions), and FTID

is composed of 35 attributes (e.g., the companys accounting policy, consistency of company

accounting with GAAP, efficiency indicators, return on assets, return on equity, related party

transactions, information about auditors). One point is awarded when information on an item is

disclosed. The results from questions in each category are first summed up and then converted into

a percentage and translated into scores from 1 to 10, with a higher score indicating greater

disclosure. For example, a percentage between 91 and 100 is assigned a ranking of 10, whereas a

percentage from 1 to 10 is given a score of 1. The T&D contains qualification rankings of the

relative quantity of financial disclosures of both annual report ranking (AR) and composite

ranking (CR, the required regulatory filings).

18. Cheng et al. (2003) document that (1) S&P rankings measure the strength of corporate

governance; and (2) these various composite rankings are positively associated with abnormal

returns and earnings response coefficient and negatively related to systematic risk (market betas).

19. First, the majority of the 98 questions included in the scoring process are based on U.S. best


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and reliability of financial reports. Finally, there may be some overlapping questions in the three

classified dimensions (OSIR, BMSP, FTID).

20. FTID variable is used in prior studies (Cheng et al. 2003; Patel and Dallas 2002; Khanna et al.

2003; Durnev and Kim 2002) as a proxy for financial transparency and disclosure.

21. Frankel et al. (2002) document a negative relation between non-audit fees and security prices.

Ashbaugh et al. (2003) find no evidence of auditors violating their independence due to receiving

high audit fees or having a high ratio of non-audit to total auditor fees.

22. We also calculated 2-day CARs for days -1, 0 as well as 0, +1 for the S&P index. The results of 2-

day CARs are similar to those of 3-day CARs. Thus, we only present results of 3-day CARs to

capture both the possibility of the information leakage prior to the event date and the fact that the

popular press (WSJ, NYT) reported the event typically one day after its announcement.

23. The S&P 500 market index produces the same results as the value-line index.

24. We search the WSJ and the NYT for these event dates (particularly July 9, 15, 16, and 19) to find

media reports on the likelihood of the passage of the Act, its possible contents, and any

confounding events that might have affected stock prices. The main reason for market declin

Documents

SSRN-Id498083-The Sarbanes-Oxley Act of 2002 and Security Market Behavior Early Evidence