An Ex-Post Evaluation of Sarbanes-Oxley Act on Firms' Intrinsic Value: A Principal-Agent Framework
Scott, Winifred D., Nganje, William, Academy of Accounting and Financial Studies Journal
In 1998, the Chairman of the Securities and Exchange Commission (SEC) warned the financial community about aggressively managing reported earnings and making deliberate misstatements regarding firm performance because it was eroding the quality of financial reporting (Levitt 1998). Within a few years, a string of accounting scandals and forced restatements of financial reports emerged by very large companies among the Fortune 500, such as Enron, WorldCom, Tyco, HealthSouth, and Global Crossing who were seemingly oblivious to the warning. Managers had pursued their own self-interests despite the SEC's warning about the numbers game eroding the integrity of the financial reporting system. The problem manifested by material misrepresentations, inaccurate reporting by managers and ineffective auditing by auditors. It resulted in wiping out billions of dollars in shareholder wealth and, consequently, impaired the efficiency and liquidity of the US capital markets. Not only does such action lead to low investor confidence about the reliability of financial statements, it also impacts the intrinsic value of the firm.
In response, the U.S. Congress passed the Public Company Accounting Reform and Investor Protection Act of 2002, commonly called the Sarbanes-Oxley Act of 2002 (SOX), which was signed by the President into law on July 30, 2002, with the objective of restoring investor confidence in the quality of financial reporting (U.S. Congress 2002) and aligning the goals of management and stockholders. We assert that the uncertainty about managers telling the truth about the outcome of their reported actions is a moral hazard problem that makes it difficult for shareholder principals to evaluate the true profitability and risks of their capital investments. An agency problem exists when an agent puts their own self-interest ahead of the principals' (shareholders'), who compensates the agent to make reporting decisions that benefit the firm in the long run (i.e., Berle and Means 1932; Ross 1973; Jensen and Meckling 1976; Jensen and Murphy 1990). In the Pre-SOX period, we assert that two types of agents, the manager and the independent auditor, contribute to the moral hazard agency problem related to inaccurate financial reporting. First, if the manager-agent plays the numbers game and excessively manages earnings, then the quality of financial reporting erodes. (For example, in 2001 and 2002, many headlines linked Fortune 500 companies to a wave of accounting irregularities and securities fraud.) Consequently, such erosive and self-interested actions can destroy billions of dollars of shareholders wealth. Second, failure of the auditor-agent to conduct effective independent monitoring of its large audit clients and not obfuscate their interest with the client's may contribute to auditor-agent's own demise (e.g., Arthur Andersen LLP). Prior to SOX, however, each of the Big 5 accounting firms had several large audit clients under SEC investigation (Scott and Gist 2010).
The Sarbanes-Oxley Act is aimed at re-aligning the behaviors of the manager-agent and auditor-agent with those of the shareholder-principal by providing incentives for accurate financial reporting by managers and reliable assurance services by auditors to the shareholders. Whether SOX was effective in realigning the agents' goals in line with those of the shareholders is an empirical question, requiring ex-post comparison of risk and return data in a behavioral modeling framework. Some studies have focused on surveys to draw implications about the perceived benefits of SOX relative to the expected internal control compliance costs (Carney 2005; Solomon and Bryan-Low 2004 WSJ; Serwer 2006 Fortune; DaVay 2006; Bedard 2006). Other studies have examined the market reaction to SOX-related events (i.e., Zhang 2007, Li, Pincus and Rego 2008); documented changes in firm behavior by adopting strategies to avoid SOX requirements, such as going private or delisting (i. …