High Cost of SOX Pays Dividend

By CIOinsight  |  Posted 07-30-2007
By Robert A. Prentice

Research by finance and accounting academics strongly suggests that in its first five years of life the Sarbanes-Oxley Act (SOX) has improved both the quantity and quality of corporate disclosure. Studies of Sections 302 (officer certification of efficacy of internal financial controls) and 404 (auditor verification of that certification), in particular, indicate provision of valuable information to the markets. Although the studies are not unanimous and remain far from conclusive at this relatively early date, their results are plausible because they are consistent with much preexisting empirical literature indicating that rigorous securities disclosure requirements in developed economies tend to correlate with efficient capital markets.

SOX 404 undoubtedly imposes significant costs on firms that must install the required internal controls and pay auditors to inspect them. But by improving the flow and accuracy of information provided to investors, SOX 404 and other mandatory disclosure provisions reduce risk. When investor risk is mitigated, disclosing firms can raise more capital faster and at less cost than they can in the absence of such disclosure. Other, smaller firms, particularly those with poor internal controls or tenuous financial status, pay a high price. But overall capital market efficiency is improved.

Still, even five years after enactment on July 30, 2002, it is impossible to conclude whether these manifest benefits outweigh their substantial costs. Indeed, we may never know. But the empirical academic literature makes a plausible case for SOX 404, especially regarding larger public companies for which the costs of implementation and monitoring are relatively small and declining. The SEC continues to delay application of SOX 404 rules for smaller corporations, on whom it would no doubt impose a greater burden. But the evidence is overwhelming that these smaller firms also tend to struggle with internal control problems, so they—and their investors—would enjoy outsized benefits from SOX-mandated improvements.

And, of course, laws can change attitudes. The civil rights acts of the 1960s led many Americans to view segregation as illegitimate, for example, and the insider trading laws of the 1980s caused many in the financial community to question the morality of such trading. But such change only occurs if the laws are perceived as legitimate. SOX had the potential to change the attitude of CFOs from "I must make my company's financials look as good as possible to keep up with our competitors" to "I must make my company's financial statements as accurate as possible."

Unfortunately, however, criticism of Section 404, which has exaggerated the costs and ignored the benefits of SOX compliance, has undermined its legitimacy for many and hurt its chances of bringing about this kind of positive attitude change.

Robert A. Prentice is a professor of information, risk and operations management at the University of Texas at Austin.