Academic journal article Financial Management

Information Asymmetry Determinants of Sarbanes-Oxley Wealth Effects

Academic journal article Financial Management

Information Asymmetry Determinants of Sarbanes-Oxley Wealth Effects

Article excerpt

We investigate the roles of information asymmetry and governance in the wealth effects associated with passage of the Sarbanes-Oxley Act (SOX) for a sample of 1,158 firms. For events suggesting adoption of stringent reform legislation, we find more (less) favorable abnormal returns (ARs) for firms with high (.low) information asymmetry and for firms with weak (strong) governance. More favorable effects could result from expected improvements for firms with high information asymmetry or weak governance. Firms with positive ARs experience information asymmetry reductions post-SOX, indicating the market was able to discern the firms that would most benefit from the legislation's passage.

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The start of the new millennium found industry plagued with the outbreak of accounting scandals, prompting the passage of landmark legislation in the form of the Sarbanes-Oxley Act of 2002 (SOX). With its focus on improving corporate governance and disclosure, the Act addresses board composition and responsibilities, auditor independence, and auditor review of internal controls. Additionally, the legislation requires reporting off-balance sheet transactions, communicating material information in a timely fashion, and certifying financial statements.

While the intent of SOX is to improve firms' oversight and disclosure practices in order to increase investor protection, it is unclear whether imposing uniform governance and disclosure structures on all firms will provide shareholders net benefits. Among the studies of the legislation's wealth effects, the results are mixed. Chhaochharia and Grinstein (2007) and Li, Pincus, and Rego (2008) find net benefits, whereas Zhang (2007), Litvak (2007), and Li (2007) attain evidence consistent with net costs imposed by SOX. It may be that enforcement of uniform structures will have different implications for firms with differing characteristics.

For example, Li, Pincus, and Rego (2008) determine that the greater the extent of earnings management, the more favorable the SOX wealth effects. Chhaochharia and Grinstein (2007) find more favorable effects for firms needing to make greater governance adjustments to comply with the legislation. However, Chhaochharia and Grinstein (2007) also indicate that the wealth benefits are concentrated in large firms and argue that this may be because for large firms, compliance costs are more easily absorbed and adjustments in governance are likely to be more beneficial.

Zhang (2007) finds negative and significant CAR surrounding key events of the SOX's passage. She cites evidence that compliance with the law's Section 404, which requires firm management and auditors to assess and document the effectiveness of internal controls, imposes significant costs on small firms in particular. Litvak (2007) finds more negative responses for high-disclosure firms and low-growth firms, while Li (2007) observes more negative responses for better governed firms.

To date, the role of information asymmetry has not been considered. We believe the wealth effects of SOX may vary with firms' level of information asymmetry. For firms with high information asymmetry and resultant discounted equity prices, shareholders may benefit from the SOX requirements to improve transparency. Alternatively, a requirement for independent board or board committee members may not be an efficient governance structure for firms with high information asymmetry if there is a need for flexibility and discretionary power for these firms (Linck, Netter, and Yang, 2005).

The purpose of this study is to examine the roles of information asymmetry and governance in determining the wealth effects of events leading to the passage of the SOX. We hypothesize that the valuation effects depend on investors' expectations of the net effects of: 1) improved transparency with more favorable effects projected for firms with high information asymmetry (Krishnaswami and Subramaniam, 1999); 2) stronger governance with more favorable effects expected for firms with weak governance (Chhaochharia and Grinstein, 2007); 3) compliance costs with relatively high costs projected for small firms, transparent firms, and well-governed firms (Holmstrom and Kaplan, 2003; Li, 2007; Zhang, 2007); and 4) costs associated with reduced risk taking (Cohen, Dey, and Lys, 2008) with relatively high costs expected for firms prone to litigation risk (Holmstrom and Kaplan, 2003). …

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