The costs and benefits of Sarbanes.docx

The costs and benefits of Sarbanes.docx

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ThecostsandbenefitsofSarbanes

ThecostsandbenefitsofSarbanes-Oxley

By

XuyingChen

SanFranciscoStateUniversity

Collegeofbusiness

xuying@sfsu.edu

May,2010

Introduction

Scandalsareunavoidablewhilethesocietyisprogressingandtheeconomicisdeveloping.Butscandalshavebigimpactsof,sometimesdestroy,people’snormallife,especiallyeconomicscandals.Thedotcombubblesandaccountingscandalstriggerlastrecession,andthefinancialandaccountingscandalscausetherecentrecession.Thedisastersweresopainfulthateventhefreemarketvalueisdoubted.Itistherighttimetoreregulateafteralongperiodofderegulation.

Asthereflectionofaccountingscandals,suchasArthurAndersen,Enron,WorldCom,TheSarbanes-OxleyAct（SOX）whichaimatenhancepublicconfidenceofcapitalmarketbypromotingbetterethicalbehaviorandaccountabilityofgreaterexecutiveswasenactedin2002,attheendoflastrecession.Theeightyearspracticesmostlyachievethegoalofadvocators,forexamplelessaccountingscandals,moremarketconfidenceandmoreinvestments.However,raisemanyoppositevoices,liketheactistoocostlytocomply,thefinancialperformanceoftheSEC-registeredcompaniesareworsethanbefore,thecomplexregulationcripplesthecompetitivepowerofthefinancialmarketinUnitedStates.

AlthoughthecomplianceoftheSOXisveryexpensiveandtheresultsarenotasperfectasexpected,amorehealthymarketandpublicconfidencethatattractsmoreinvestmentsareadvantageswhichcanoverwhelmitsdefects.

ThecostsoftheSOX

ThecostsoftheSOXareahugenumberandverycomplextobedefined.Thecostsnotonlyincludedirectcost,likecompliancecostoftheSEC-registeredcompanies,andtheoversightcostofgovernmentanditsagents,butalsoincludeindirectcosts,forexampletheshareholder’slossduetotheprofit,thefinancialindustrylossduetothedeclinedcompetitivepoweroffinancialmarket.

First,thecompliancecostoftheSOXusedbycompaniesisthemostdirectcostthatcanbetraced,anditismainlyfromcomplyingwiththeSOX404.Thecompliancecostscanbeclassifiedintothreecategories:

internallaborcosts,externalconsultingandtechnologyexpenses,andauditorattestationcharges.（Krishnan,Rama,andZhang,2008）ThehighestcostoftheSOX,theSecurityexchangecommittee（SEC）said,istheinternallaborcosts,followedbyauditfees,andthencostsrelatedtoanotherthirdparty,suchasaconsultancy（SEC2009）.

FinanceExecutivesInternational（FEI）providesconsistentstudiesandannualsurveysontheSOX.InJuly2004,FEIsurveyindicatedthetotalcostofcompliancewasestimatedtobe62%morethantheJanuary2004survey（2004b）.A2005studyindicateda39%increasefromtheJuly2004survey（FEI2005）.Ina2007studythosecompanieswithmarketcapitalizationsmorethan$75millionhadanaveragecostofinternalcontrolcompliancetobe$2.9millionduringfiscalyear2006（FEI2007）.AlsotheSECconcludedthatcompaniespaidameantotalof$2.87millionwhentheyfirstbeganfollowingtheSOX,andexpecttopayameancostof$2.03millionfortheirnextinternal-controlsreport（SEC2009）.

Otherstudiesfoundsimilarissues.TheresearchpaperbyKrishnanstatesthatthemeantotalcompliancecostsforSection404is$2.2（$1.2）million,duringtheperiodfromJanuary2003toSeptember2005（Krishnan,Rama,andZhang,2008）.Theresearchalsopointoutthat,basedontheregressionanalyses,thetotalcompliancecostsarepositivelyassociatedwithfirmsize（Krishnan,Rama,andZhang,2008）.The2007Foley&LardnerSurveydemonstratesthatthetotalcostsofbeingaU.S.publiccompanyaffectedbytheSOXweresignificantlyincreasedfrom2001to2006.Suchcostsincludeexternalauditorfees,directorsandofficersinsurance,boardcompensation,lostproductivity,andlegalcosts.（Foley&Lardner,2007）

However,thecompliancecostsoftheSOX404havecontinuedtodeclinerelativetorevenuessince2004.The2007surveyindicatedthat,for168companieswithaveragerevenuesof$4.7billion,theaveragecompliancecostswere$1.7million,as0.036%ofrevenue（FEI2008）.The2006surveyindicatedthat,for200companieswithaveragerevenuesof$6.8billion,theaveragecompliancecostswere$2.9million,as0.043%ofrevenue（FEI2007）.TheSECbelievesthatovertime,theexpenseofcomplyinghasdecreasedascompaniesgotmoreusedtofollowingtherulesandastheregulatorstweakedthem（SEC2009）.

Second,theSOXiscostlytoadminister.BoththePublicCompanyAccountingOversightBoard（PCAOB）andtheSECareaddingstafftodealwiththeadditionalworknecessarytoimplementtheAct.PCAOBwasestablishedwitheightstaffsin2003.Bytheendof2005,thebudgetexcess$150million,whilehiringmorethan450staffmembers.Also,SEChiredanadditional1,000staffduetotheSOX.（Rouse,2005）

Third,thestockpricesandtheU.S.capitalmarketssufferlosses,becausethecompliancecostsofSOXgeneratenegativeeffectsonprofitability.TheresearchbyO’Shaughnessyindicatesthatthemeanofbothreturnonassets（ROA）andreturnonequity（ROE）haveamarkednegativedivergenceforSEC-registeredcompaniesasopposedtothosecompaniesthatdonotreporttotheSECinthebankingindustryfortheperiod2000through2005（O’Shaughnessy,2008）.Also,ZhangfindoutthatestimatedSOXcompliancecosts$1.4trillion,basedontheassumptionthatSOXwasthecauseofrelatedshort-durationmarketvaluechanges.Ontheotherhand,newsofpotentialrelieffromthelawpushesupUSstockprices（Zhang,2005）.Moreover,anewfindinghasaviewthatbecauseoftheSOX,U.S.firmsreducedtheirinvestmentsincapitalexpendituresandresearchofdevelopmentcomparedtofirmsintheU.K.andCanada（Bargeron,Lehn,andZutter）.Itwillultimatelyharmstockprice,becausetheSOXdiscouragesdirectorsfromapprovingriskyinvestmentsthatarecostlytomonitor.

However,thestockpricedeclinedmightcausebySEC-registeredcompaniesreserveearningstoavoidpotentiallawsuitriskfromtheSOX.IlievfindoutthattheSOX404indeedledtoconservativereportedearnings（Iliev,2007）.

Forth,thefinancialindustrysuffersloss,becausetheUScapitalmarketbecomeslessattractivethanbefore,especiallytheforeignandsmallcompaniesarehinderedbytheSOXtoparticipateinthecapitalmarket.SECstudystatesthatamajorityinasurveysaythatSection404hasmotivatedthemtoconsiderde-listingfromU.S.exchanges,andastaggering77%ofsmallerforeignfirmssaythatthelawhasmotivatedthemtoconsiderabandoningtheirAmericanlistings（SEC2009）.AccordingtotheNationalVentureCapitalAssociation,inallof2008therehavebeenjust6companiesgonepublic.Comparethatwith269IPOsin1999,272in1996,and365in1986（Freeman,2009）.

Fifth,smallerfirmsseektoderegisterfromSECinordertoavoidexpansivecomplaincost,anditmightbehiddencostofobeyingthegoaloftheact.Inthesameresearchasmentionbefore,althoughthecomplaincostarepositivelyassociatedwithfirmsize,smallerfirmsdoincurhighercostsperdollarofassetsorrevenuesthanlargerfirmsdo（Krishnan,Rama,andZhang,2008）.Also,anotherstudybySECconcludethatsmall,publiclytradedcompanieshavetopayadisproportionatelyhigheramounttocomplywiththeinternal-controlsportionsoftheSarbanes-OxleyActthanlargercompanies（SEC2009）.

ThebenefitsoftheSOX

TheSOXreceivemuchmorechallengesthansupporting,becausemostofitsbenefitsaredifficulttobeproved.

First,theSOXcanbenefitthesocietyandtheeconomicbyavoidingaccountingscandals.Theactisbuildtoavoidrisk,butnormally,whentheriskdidn’thappen,noonecancalculatethecostoftherisk.Itmeansthemainbenefitfromavoidingaccountingscandalsishardtobeproved,especiallytheimpacttosociety.Butstillsomefactscanaddressthebenefitdidexist.Alistofbigbusinessscandalsreportedbymediashowthattherearesignificantlylessaccountingscandalsafter2003.

Second,thecompaniescanbenefitfromTheSOXbymoretransparency,betterinternalcontrol,andgetloansatalowerinterestrate.Apaperindicatesthatborrowingcostsarelowerforcompaniesthatimprovedtheirinternalcontrol,bybetween50and150basispoints（Skaife,Collins,Kinney,andLaFond,2006）.AlsoSECsurveydemonstratethathalfofthe2,907SEC-registeredcompaniessaidthattheygetdirectbenefitssuchasimprovedfinancialreporting,andabetterabilitytoraisecapital.（SEC2009）

Third,theSOXhelptorebuiltmarketconfidence,andattractmorecapital.FEISurveyfindsoutthattheSOXhavepositiveeffectoninvestorconfidence,becauseofreliabilityoffinancialstatements,andfraudpreventioncontinuetorise（FEI2007）.BasedonthestaticfromU.S.BureauofEconomicAnalysis,theforeigndirectinvestmentinU.S.securitiesotherthanU.S.Treasurysecuritiesstronglygrowthsince2002（Nguyen,2009）.

Year

2000

2001

2002

2003

2004

2005

2006

2007

Investment（billion）

2,623

2,821

2,779

3,423

3,996

4,353

5,372

6,190

Growthrate

8%

-1%

23%

17%

9%

23%

15%

Conclusion

Althoughtherearemorestudiesandevidenceinthecost-benefitanalysissupportthatthecostoftheSOXexceedthebenefit,thenonbusinessconcernscannotbeignore.Businessoreconomicshouldtakesocialresponsibility.Basedonthesocialcontractethictheory,minorsshouldbetakecareastoharmonizewiththewholesociety.Comparetobigplayer,thesmallinvestorsarethemainbenefitersoftheSOX,becausetheyareweaktogetinformationandtheSOXmademarketinformationmoreaccurate.Furthermore,the