Policy Finance & Accounting Nov 1, 2009

Ben­e­fi­cial or Detri­men­tal Legislation?

The pros and cons of Sarbanes-Oxley

Based on the research of

Daniel Cohen

Aiyesha Dey

Thomas Lys

The U.S. Con­gress heard rum­blings of cor­rupt busi­ness behav­ior by Enron, Tyco, and oth­er large cor­po­ra­tions, the U.S. Con­gress in 2002, and in response, it passed the Sar­banes-Oxley Act (SOX). The act gave the fed­er­al gov­ern­ment pow­ers over cor­po­ra­tions that had tra­di­tion­al­ly been the province of indi­vid­ual states. It also thrust sig­nif­i­cant amounts of extra respon­si­bil­i­ty for cor­po­rate gov­er­nance, includ­ing crim­i­nal lia­bil­i­ty, on CEOs.

But new research sug­gests that the leg­is­la­tion has fall­en short of its goal of con­trol­ling ille­gal busi­ness prac­tices. Two papers coau­thored by Thomas Lys (Pro­fes­sor of Account­ing Infor­ma­tion and Man­age­ment at the Kel­logg School of Man­age­ment) cast doubts on the effi­ca­cy of the leg­is­la­tion. Our data tend to sup­port the fact that SOX was nec­es­sary, because peo­ple were real­ly cook­ing the books,” Lys says. But the ques­tions are: Should it have been this act? And was the cure worse than the dis­ease? There’s some evi­dence that the leg­is­la­tion was detri­men­tal to the U.S. econ­o­my and the com­pet­i­tive­ness of U.S. markets.”

Lys and two col­leagues — Daniel Cohen (Assis­tant Pro­fes­sor of Account­ing at the Stern School of Busi­ness, New York Uni­ver­si­ty) and Aiye­sha Dey (Assis­tant Pro­fes­sor of Account­ing at the Booth School of Busi­ness, Uni­ver­si­ty of Chica­go) — exam­ined the impact of SOX on two aspects of cor­po­rate behav­ior: man­age­ment of earn­ings and the effect of CEOs’ com­pen­sa­tion on their will­ing­ness to take busi­ness risks. The study of earn­ings man­age­ment con­vinced the researchers of the need for some sort of control.

The most sig­nif­i­cant thing is that every­body was cheat­ing dur­ing this scan­dal peri­od; it wasn’t just the prob­lem of a few bad apples,” Lys says. If you want­ed to make a case for reg­u­la­tion, it was an easy case to make.” How­ev­er, they found that com­pa­nies can still use earn­ings man­age­ment strate­gies to mis­lead investors, and that SOX reduces cor­po­ra­tions’ will­ing­ness to take risks, out­comes that raise seri­ous ques­tions about the val­ue of the leg­is­la­tion. We sug­gest,” Lys says, that a more con­sid­ered ver­sion of SOX may have been better.”

Earn­ings Man­age­ment Pre- and Post-SOX
Lys and his col­leagues out­line the aim of their first study: It was unclear whether there real­ly was a wide­spread break­down of the reli­a­bil­i­ty of finan­cial report­ing pri­or to the pas­sage of SOX or whether the high­ly pub­li­cized scan­dals were iso­lat­ed instances of indi­vid­u­als engag­ing in bla­tant finan­cial manip­u­la­tions,” they write. And if it were the for­mer, how did the pas­sage of SOX affect firms’ report­ing prac­tices?” To answer those ques­tions, they exam­ined the preva­lence of accru­al-based and real earn­ings man­age­ment before and after SOX became law.

Accru­al account­ing reg­is­ters sales when they are made, regard­less of when they are actu­al­ly col­lect­ed. Real earn­ings man­age­ment, by con­trast, records only actu­al pay­ments. Why should a firm choose one over the oth­er? You change the account­ing method to get the desired earn­ings,” Lys explains. Real earn­ings man­age­ment means that you make actu­al trans­ac­tions. You might sell some­thing to record a gain that you might not oth­er­wise have con­sid­ered sell­ing to book a prof­it, or if you want a low­er net income you might sell an asset that has declined in val­ue to real­ize a loss.”

But even more prob­lem­at­ic is cut­ting R&D (research and devel­op­ment) expen­di­tures,” Lys says. Because R&D is expensed under GAAP (U.S. Gen­er­al­ly Accept­ed Account­ing Prin­ci­ples), a reduc­tion in R&D increas­es cur­rent earn­ings but has the poten­tial of reduc­ing long-term prof­itabil­i­ty. So from the per­spec­tive of share­hold­ers, real earn­ings man­age­ment is a much more expen­sive way of man­ag­ing earn­ings.” SOX has also made accru­al account­ing more expen­sive,” Lys says. As a result, SOX makes real earn­ings man­age­ment seem­ing­ly cheap­er to management.”

Using pub­licly avail­able finan­cial reports and relat­ed data, the team exam­ined earn­ings man­age­ment over­all before the scan­dals emerged, between that time and the pas­sage of SOX, and after the leg­is­la­tion. Rather than focus­ing on offend­ers, we focused on the mar­ket,” Lys explains. We found that was much more wide­spread than most peo­ple believe it was.”

Sus­pect” Firms
The team also stud­ied some indi­vid­ual cas­es. They exam­ined the pre- and post-SOX earn­ings man­age­ment of a sub­set of firms that they regard­ed as more like­ly than oth­ers to have man­aged their earn­ings to meet or beat pre­vi­ous years’ earn­ings or ana­lysts’ fore­casts or sim­ply to avoid report­ing loss­es. We looked at sus­pect’ firms that were either indict­ed or had alle­ga­tions of impro­pri­ety against them,” Lys says. When For­tune mag­a­zine pub­lished a list of thir­ty dis­graced firms, the met­ric that the team had devel­oped cor­rect­ly iden­ti­fied twen­ty-nine of them. The team’s met­ric missed only one firm: Enron. Enron worked in a very sophis­ti­cat­ed man­ner,” Lys explains. They were real­ly smart. They were good crooks — the smartest peo­ple in the room.”

The data for firms over­all and the sus­pect group yield­ed a clear con­clu­sion. Accru­al-based earn­ings increased before pas­sage of SOX, but then declined there­after. Firms were prone to switch to real earn­ings man­age­ment that dis­ad­van­taged share­hold­ers but are more dif­fi­cult to detect. The change in sus­pect firms’ earn­ings behav­ior was par­tic­u­lar­ly notice­able — they tend­ed to rely more on real earn­ings man­age­ment post-SOX than they pre­vi­ous­ly had under sim­i­lar conditions. 

The data also revealed what Lys describes as a very large cor­re­la­tion between the per­cent­age of com­pen­sa­tion from stock options and the amount of earn­ings man­age­ment.” He sees two pos­si­ble rea­sons for that. When you have lots of stock options, man­age­ments have a big incen­tive to manip­u­late, as a small change in the stock has a large impact on their wealth. Also, com­pa­nies that are very risky have more stock options and are also more like­ly to have big­ger account­ing effects.” What­ev­er the cause, Lys draws one firm con­clu­sion from the data. If I were on the board of a com­pa­ny that offered a lot of stock options,” he asserts, I would want to make sure that my audit com­mit­tee is work­ing diligently.”

Risky Behav­ior
In its sec­ond study, the team set out specif­i­cal­ly to find SOX’s impact on CEOs’ com­pen­sa­tion con­tracts, as well as CEOs’ respons­es to any changes by reduc­ing their firms’ invest­ments in risky projects. Again using pub­lic sources, the researchers exam­ined sev­er­al vari­ables: changes in total com­pen­sa­tion; indi­vid­ual com­po­nents of that com­pen­sa­tion such as salaries, bonus­es, and option grants; and the ratio of incen­tives to fixed salaries.

The data showed a clear pat­tern. While over­all com­pen­sa­tion lev­els did not increase after SOX passed Con­gress, Lys and his col­leagues did find that salaries and bonus­es grew fat­ter while option grant lev­els dwin­dled. The ratio of incen­tive com­pen­sa­tion to fixed salary also dropped. The team rea­sons that those changes stem from the heavy respon­si­bil­i­ties that SOX places on CEO. This shift is like­ly to rep­re­sent firms’ response for shield­ing exec­u­tives from some of the risks imposed by SOX,” the paper states. In fact, the team com­put­ed the change in CEO wealth when CEOs increase the risk of their firms. The data clear­ly show that boards of direc­tors reduced the incen­tives to invest in risky projects fol­low­ing SOX.

The team also cal­cu­lat­ed cor­po­ra­tions’ risky invest­ments, defined as the sum of R&D expen­di­tures, acqui­si­tions, and net cap­i­tal expen­di­tures. After all, the team notes, One poten­tial dele­te­ri­ous effect of gov­er­nance reforms such as SOX is reduced risk-tak­ing activ­i­ties by man­agers — incen­tives to take risks are reduced when man­agers face penal­ties for bad out­comes.” The result: CEOs made sig­nif­i­cant­ly few­er risky invest­ments after SOX was passed. Thus, man­agers reduced invest­ments beyond what was expect­ed from the changes in com­pen­sa­tion contracts.

The results, of course, raise the pos­si­bil­i­ty that oth­er events, such as the stock mar­ket crash of 2000 – 2001 or the pas­sage of SFAS 123R (State­ment of Finan­cial Account­ing Stan­dards 123R, which man­dat­ed the expens­ing of stock options) are respon­si­ble for the results in the study. How­ev­er, the results clear­ly point to SOX — through a change in incen­tives, the act induced boards to encour­age their CEOs to take less risk and also cre­at­ed incen­tives for man­agers to take less risk. As a result, firms reduced their invest­ments in risky endeav­ors for two rea­sons: changes in com­pen­sa­tion and changes in per­son­al liability.

Ben­e­fi­cial or Detri­men­tal?
Doubt also remains about SOX’s broad role in chang­ing cor­po­rate behav­ior. For at the same time the leg­is­la­tion passed, the FBI start­ed to arrest cor­po­rate male­fac­tors in a very pub­lic way. Was the rea­son for the changes SOX or see­ing your neigh­bor schlepped away in hand­cuffs on the evening news?” Lys asks. The arrests empha­sized the per­son­al cost of cook­ing the books.”

What over­all con­clu­sions does Lys’s team reach about the leg­is­la­tion as a result of its two projects? We have a very strong sus­pi­cion that SOX was detri­men­tal,” he says. Reg­u­la­tion some­times goes over­board.” But he does not hold much hope that Con­gress will rem­e­dy the weak­ness­es exposed in the SOX leg­is­la­tion. Politi­cians nev­er make a mis­take,” he says. To com­pen­sate for a piece of bad leg­is­la­tion, they pro­duce more legislation.”

Featured Faculty

Thomas Lys

Professor Emeritus of Accounting Information & Management

About the Writer

Peter Gwynne is a freelance writer based in Sandwich, Mass.

About the Research

Cohen, Daniel A., Aiyesha Dey, and Thomas Z. Lys (2008). “Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes Oxley Periods,” Accounting Review, May, 83(3): 757-787 [dx.doi.org/10.2308/accr.2008.83.3.757]

Cohen, Daniel, Aiyesha Dey, and Thomas Lys (2008). “The Sarbanes-Oxley Act of 2002: Implications for Compensation Contracts and Managerial Risk-Taking,” working paper, Social Science Research Network, last revised April 2008.

Read the original

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