CAPITAL MARKET REACTIONS TO THE
SARBANES-OXLEY ACT OF 2002
Zabihollah Rezaee*
Thompson-Hill Chair of Excellence & Professor of Accountancy
Fogelman College of Business and Economics
300 Fogelman College Admin. Building
The University of Memphis
Memphis, TN 38152-3120
Phone: (901) 678-4652
Fax: (901) 678-0717
E-Mail: zrezaee@memphis.edu
Pankaj K. Jain
Assistant Professor of Finance
Fogelman College of Business and Economics
300 Fogelman College Admin. Building
The University of Memphis
Memphis, TN 38152-3120
Phone: (901) 678-3810
Fax: (901) 678-2685
E-Mail: pjain@memphis.edu
Submitted for presentation at the Spring 2003 Accounting Research Consortium
Comments welcome. Please do not quote or circulate without permission.
Current version: March 2003
*
Corresponding Author.
CAPITAL MARKET REACTIONS TO THE
SARBANES-OXLEY ACT OF 2002
ABSTRACT
The Sarbanes-Oxley Act of 2002 (the Act) was enacted in response to numerous corporate and
accounting scandals and aimed at reforming business practices of the financial community and
the accounting profession. This study examines the market reaction to the Act and finds a
positive abnormal return at the time of several events leading to the passage of the Act.
Furthermore, firms with higher market capitalization, earnings to price ratio, and stock price
volatility are affected more by the Act compared to other firms. Results suggest that the Act
created news which was viewed as good news by investors in increasing the market’s confidence
in firms’ corporate governance and accounting systems.
Keywords:
Financial scandals; the Sarbanes-Oxley Act of 2002; market reactions;
corporate governance
Data Availability:
Data are commercially available from the sources identified in the study.
JEL Classification: G14; G28; M41
CAPITAL MARKET REACTIONS TO THE
SARBANES-OXLEY ACT OF 2002
I - INTRODUCTION
Two thousand two was a challenging and rather difficult year for corporate America as
evidenced by the stock market’s swift decline, a significant number of earnings restatements,
substantial corporate and accounting scandals and resulting loss of confidence in corporate
governance, financial reports, and related audit functions. To restore public confidence,
lawmakers enacted bipartisan legislation by passing the Sarbanes-Oxley Act of 2002 (hereafter
the Act) in July 2002. A major reason for enactment of the Act and establishment of the
Securities and Exchange Commission (SEC) related implementation rules was the belief that
new regulations were necessary to make corporations more accountable to shareholders and to
restore the confidence of investors in the capital market. However, the Act has received a mixed
response from the financial community and the accounting profession. The Act was viewed by
many as the most sweeping measures taken by legislators addressing corporate governance,
financial reports, and audit functions.1 Results of a real-time poll of 450 CFOs and senior
financial executives during a live webcast with former SEC chairman Arthur Levitt revealed that
90 percent of participants believe new regulations intended to make corporations more
accountable to shareholders are necessary (Levitt 2002). Others consider the Act as patchworks
and codification responses by Congress to widely publicized business and accounting scandals,
with no direct impacts on improving corporate governance and financial disclosures, at least
beyond those of market-based mechanisms.2 Sorin, et al. (2002) argue that although the Act may
In signing the Act, President George W. Bush described it as “the most far-reaching reforms of American business
practice since the time of Franklin Delano Roosevelt” (Bumiller 2002). The SEC Commissioner, Harvey
Goldschmid, called the Act the “most sweeping reform since the Depression-era Securities Laws” (Murray 2002a).
2
See Cunningham (2003) and Ribstein (2002) for the indepth critique of the Act and the discussion of market versus
regulatory responses to financial scandals.
1
1
improve future investor confidence, it does not provide restitution to investors who lost their
investments because of financial scandals, and to securities professionals the Act gives the
illusion of increased accountability.
There exists an extensive literature, propagated mostly by economists, accountants and
lawyers, on the Act and its possible impacts on public companies’ corporate governance,
financial reporting process, and audit functions. These writings (Rezaee 2002; Osterland 2002;
IIA 2002; Ribstein 2002; Sorin et al. 2002; Cunningham 2003) concentrate on analyzing specific
provisions of the Act and their impacts on financial, business, and accounting communities. The
conclusions reached on the various effects of the Act, therefore, are based generally on this
descriptive evidence which range from “sweeping measures” that will eventually reform
corporate governance and the financial reporting of public companies to “patchworks,
codifications and further studies” of the existing corporate governance and financial disclosures
regulations and requirements. The major theme of these studies is that despite characterization
of the Act as either “sweeping reform” or “patchworks and codifications,” it is intended to and
will restore investor confidence in the capital markets. The purpose of this study is to
empirically test capital market reactions to several events (Congressional bills) leading to the
passage of the Act.
Empirical market-based accounting research3 typically examines the market reactions to
the announcement of particular events (e.g., accounting standards, regulations) via analysis of the
relation between these events and various market variables. Consistent with empirical marketbased accounting research, this study examines whether the announcement of nine events (see
Table 1) leading to the passage of the Act provided any new information to investors that may
have affected their perceptions of the likelihood of the passage of the Act and its impacts on
3
See Easton (1999) for implications of this type of research in market event studies.
2
public companies’ corporate governance, financial reports, and audit functions. Specifically, we
(1) examine capital market reactions to nine events leading to the passage of the Act to determine
whether the Act conveys value-relevant information to investors in restoring the market’s
confidence in corporate America, and (2) investigate whether the detected market reactions are
associated with company characteristics and attributes (e.g., corporate governance, financial
reports, and audit functions). We detected positive abnormal returns around dates corresponding
to the passage of the Act suggesting the capital market reacted positively to the Act. We also
investigated the determinants of the detected price reaction by using firm specific variables. We
found that firms with higher market capitalization, earnings to price ratio, and stock price
volatility were affected more by the Act compared to other firms. Results also indicate that
financial scandals were not limited to a handful of companies because investors perceived them
to be an industry-wide problem.
The results of this study have implications for public companies and their executives,
investors, and policy makers. The results suggest that investors value regulations such as the Act
that create positive changes in corporate governance, the financial reporting process, and audit
functions. Public companies and their senior executives should realize that they will be under
scrutiny to conduct their business ethically and thus should have a long-term focus on improving
corporate governance and financial reports, as the capital markets and rating agencies will likely
factor these improvements and firm characteristics, including corporate governance, more
explicitly into their valuation and rating processes. Policy makers (Congress) and regulators
(SEC) should be encouraged regarding the important oversight role of restoring public
confidence in corporate America. Our results suggest that the Act has created a climate of
confidence in financial information and therefore more investors’ confidence in the capital
3
markets and the economy. This study contributes to the extant literature on law and finance,
examining the relationship between the legal protection of investors and the development of
financial markets. Results support the findings of Laporta et al. (1998), documenting that legal
systems including legislations and regulations are important integral components of corporate
governance and corporate finance.
The remainder of the paper proceeds as follows: The next section discusses the effects of
major provisions of the Act. Section III briefly reviews the related literature. Theoretical
framework, events leading to the passage of the Act, and testable hypotheses are presented in
Section IV. Section V discusses data and methodology. Results are presented in Section VI and
a final section concludes the paper.
II – PROVISIONS OF THE ACT
President Bush signed into law, on July 30, 2002, the Public Company Accounting
Reform and Investor Protection Act of 2002, better known as the Sarbanes-Oxley Act of 2002
(the Act). This Act addresses the conduct and role of corporate boards, executives, accountants,
auditors, lawyers, investment banks, financial analysts, regulators, and standard-setting bodies in
the financial reporting process. The Act’s main purpose is to restore integrity to financial
markets and confidence in corporate conducts, financial reports, and related audit functions. The
Act establishes an independent regulatory structure for accountants who audit public companies,
creates increased disclosure and reporting requirements to improve transparency of financial
reports, changes accountants’ relationships with their clients and audit committees, increases
criminal penalties for violations of securities and related laws, requires senior executives to
certify reports filed with the SEC, and imposes substantial and unprecedented requirements on
public companies, their directors, officers, and accountants to improve corporate governance.
4
The Act was enacted to respond to an increasing number of financial restatements by prominent
companies, a series of high profile alleged financial statement fraud, an erosion in market
confidence, and extreme market volatility.
The Act requires corporate executives to certify the accuracy of company financial
reports with the threat of civil and criminal penalties. There are primarily two types of
certification requirements. The first type, certifications of periodic financial reports filed with
the SEC after August 29, 2002, requires each officer (chief executive officer, CEO and chief
financial officer, CFO) to affirm that the filed report is accurate and complete and accordingly,
the financial statements and other financial information are in all material respects fairly
presented.4 The second certification pertains to the company’s “disclosure controls and
procedures” which goes beyond the existing requirements of internal control. In every periodic
report filed with the SEC for periods ending after August 29, 2002, CEOs, CFOs and/or other
certifying officers affirm, among other things, that they are responsible for establishing and
maintaining disclosure controls and procedures, and they have evaluated the effectiveness of the
disclosure controls and procedures.
Many provisions of the Act require the SEC and other regulators to establish additional
regulations and rules (certification, disclosure controls and procedures, codes of ethics) or
perform further studies (audit firm rotation, investment banks). Although the implications of
some provisions of the Act are not immediately obvious (establishment a of public company
accounting oversight board, attorney reporting, audit committee requirements), many of the
Act’s provisions take effect currently (reporting requirements, senior executives’ certifications,
4
Prior to the passage of the Act, the SEC, on June 27, 2002, ordered the principal executing and financial officers
(CEOs, CFOs) of each registrant with revenue over $1.2 billion during its last fiscal year to file statements under
oath on the registrant’s cover reports. The sworn statements were required to be filed on or after August 14, 2002 on
the first date that a Form 10-K or 10-Q must be filed (SEC 2002).
5
actions prohibiting fraudulently influencing an audit, loans to directors and officers). Survey
studies (IIA 2002) and anecdotal evidence (Makinson-Cowell 2002; Osterland 2002) document
that the passage of the Act has had considerable effects on corporate governance structure
(composition and functions of boards of directors and audit committees), the financial reporting
process (off balance sheet financing, executive compensation, more conservatism, certification
of financial statements), and audit functions (auditors’ objectivity, effectiveness, and credibility).
These effects are expected to improve investors’ confidence in capital markets, which has
significantly eroded in recent years, and therefore investors will benefit from provisions of the
Act and related SEC implementation rules. Critics of the Act (e.g., Sorin et al. 2002;
Cunningham 2003) argue that all the changes made by the Act had either already been in effect
as a matter of custom, practice, and/or regulatory requirements or been discussed and/or
proposed by corporate governance advocates or organized stock exchanges. Proponents of the
Act (e.g., Congress, SEC) believe that the Act contains many sweeping measures that will
eventually reform corporate governance, financial reports, and audit functions.
III - REVIEW OF LITERATURE
In this section, the relationship between regulations and stock prices is reviewed in
providing a framework for our study. Several related studies examine securities price reactions
to the Securities Act of 1933, the Securities Act of 1934, and the Private Securities Litigation
Reform Act of 1995. These Acts (1933, 1934) were intended to protect investors from
fraudulent or misleading information by increasing the general extent of accounting disclosures
and restricting accounting alternatives. Ingram and Chewning (1983) examine the percentages
of annual cumulative abnormal returns for years before and after the Securities Acts and find
aggregate market responses during fiscal years of the pre-Act periods (1926-1933) than during
6
the fiscal years post-Act periods (1935-1940). Chow (1983, 1984) examines the impacts of the
Acts (1933 and 1934) on bondholder and shareholder wealth and concludes that the Securities
Act of 1933 reduced shareholder wealth through inter-firm wealth transfers, out-of-pocket
compliance costs, and reduced opportunity sets. Benston (1973) investigates the impact of the
Securities Act of 1934 on the behavior of securities and finds no significant and measurable
effect of the Act, suggesting that there was no benefit of the legislation for investors. These
studies document that although both the 1933 and 1934 Securities Acts considerably increased
public companies’ financial disclosures, they did not have significant impacts on security market
behavior.
The Private Securities Litigation Reform Act of 1995 (PSLRA) had increased restrictions
on private litigants’ ability to sue for investment losses from securities fraud. Several studies
examine the capital market reactions to the PSLRA for firms in high-litigation-risk industries
(e.g., computers, electronics, pharmaceuticals/ biotechnology, and retailing). Spiess and Tkac
(1997) and Johnson et al. (2000) investigate stock price reaction to several events leading to the
enactment of the PSLRA including the presidential veto on 12/19/95 and the congressional votes
to override the veto on 12/20/95 (House) and 12/22/95 (Senate). These studies conclude that
investors considered the PSLRA beneficial by documenting significantly negative abnormal
returns for firms in high-litigation-risk industries on 12/18/95 (veto rumors) and significantly
positive abnormal returns on 12/20/95 (the House override of veto). Ali and Kallapur (2001)
find evidence that is inconsistent with results of Spiess and Tkac (1997) and Johnson, et al.
(2000). Ali and Kallapur (2001) document that: (1) conventional statistical procedures overstate
the negative abnormal returns on 12/18/95 detected by previous studies; (2) the positive excess
returns observed on 12/20/95 are more likely in response to the presidential veto than the House
7
override; and (3) the detected significant abnormal returns for events other than the presidential
veto suggest that investors consider the PSLRA harmful. Thus, empirical results pertaining to
the important PSLRA are inconsistent and controversial.
Like the Securities Acts of 1933 and 1934 as well as the PSLRA of 1995, the SarbanesOxley Act of 2002 was enacted to address corporate misconducts and the related business and
accounting scandals that eroded investors’ confidence in the capital markets. Unlike the
previous Acts, the Sarbanes-Oxley Act contains sweeping measures dealing with corporate
governance, financial reporting, conflicts of interest, corporate ethics, disclosure controls and
procedures, new civil and criminal penalties, and the new regulatory structure for the oversight
of the accounting profession. In addition, unlike other related regulations, certain provisions of
the Sarbanes-Oxley Act are effective immediately, whereas other provisions require the SEC to
issue implementation rules to carry out the purposes of the Act. Thus, the potential impacts of
provisions of the Sarbanes-Oxley Act on investors confidence are worthy of investigation.
Laporta et al. (1988) document that the extent to which a country’s laws and regulations protect
investor rights and the extent to which those laws and regulations are enforced determine the
ways in which corporate governance and corporate finance evolve in the country. Laporta et al.
(1997) find that better legal protection improves investor confidence and leads investors to
accept a lower rate of returns which in turn encourages companies to use external finance when
rates are lower. Marketplace mechanisms often, as evidenced by recent business and accounting
scandals (e.g., Enron, WorldCom, Global Crossing, Xerox, Tyco, Qwest, among others), do not
provide timely and effective self-corrections. Therefore, laws (the Act) are expected to create an
environment which promotes strong marketplace integrity and investor trust in the reliability,
quality, and transparency of financial disclosures.
8
IV - THEORETICAL FRAMEWORK, EVENTS, AND HYPOTHESIS
1. The Possible Impacts of the Act
A survey of institutional investors shows that investors are unimpressed with Section 302
of the Act requiring certification of financial statements by corporate executives, and they
believe that the implementation of other provisions (e.g., audit committee composition and
functions, disclosure controls, new public oversight board, severe penalties for violations of
Securities laws) of the Act will be more effective in restoring public confidence in financial
reports (Makinson-Cowell 2002). Despite all attention by media and financial press, certification
of financial reports, initially required by the SEC for large companies and subsequently extended
by the Act to all publicly traded companies, has always been a requirement of the federal
securities laws (Langevoort 2002). Bhattacharya et al. (2002) document that the capital market
was not surprised by the SEC certification requirements. Certification requirement events
provide no new value-relevant information to the capital market because they neither established
any credibility of management financial disclosures nor did they create an environment which
can be used to evaluate the truthfulness of management’s representation. Thus, any possible
information content of certification events has been impounded into the market price long before
the requirement becomes available. Although, the Bhattacharya et al. study focuses on the SEC
initial certification requirements for large companies, it incidentally finds an increase in market
volume on July 25, 2002 (congressional legislation), and positive abnormal market return on
August 14, 2002.
The Act is intended to restore the investing public’s confidence in corporate America,
financial reports, and audit functions. The Act could also have psychological rather than
substantive effects (Cunningham 2003). Despite the significance of the substantial effects of the
9
Act, it created news that investors could consider as “good news” in revitalizing the capital
markets. Anecdotal evidence and results of surveys (IIA 2002) indicate that affected public
companies are changing their corporate governance structure (composition and functions of the
board of directors and audit committee), relationship with their independent auditors (restricting
the scope of non-audit services), and design and structure of their disclosure controls and
procedures to comply with provisions of the Act. It is expected that these required changes will
improve public companies’ corporate governance, the quality, reliability, and transparency of
financial reports, and the effectiveness of audit functions. Market participants should view these
improvements as a major step toward restoring confidence in financial reports and capital
markets.
2. Events Leading to the Passage of the Act
The final passage of the Act, on July 30, 2002, was affected by many congressional
proposals and bills that anticipated the eventual enactment of the Act, starting with the
introduction of H.R. 3763 on February 14, 2002 in the House of Representatives. During this
deliberation process, several congressional legislations were introduced and debated (See Table
1). When the Act was finally enacted, the capital market was saturated entirely with bad news of
corporate and accounting scandals as well as the lengthy economic depression. Therefore, it is
difficult to separate the effect of the Act on the stock market from other business and economic
events. Furthermore, it is necessary to determine when and how the legislation might have
affected the capital market because of possible anticipation by the market during the deliberation
process in a manner that when passed, its effects had already been discounted. The main
difficulty in determining stock price reactions to a set of related legislative events is identifying
when the market first anticipates the possible effects of such events (Binder 1985; Ali and
10
Kallapur 2001). It is expected that the capital market, during almost one year of legislative
debate after the collapse of Enron and the introduction of several bills in both the House and the
Senate, would have anticipated the likelihood of the passage of the Act and its possible effects.
Consistent with prior research (Espahbodi et al. 2002; Cornett et al. 1996), we used
multiple information sources in identifying the events. The initial step taken to identify key
events was to search the SEC and congressional websites looking for press releases for the
events pertaining to the Act as listed in Table 1. We next searched the Wall Street Journal index
(WSJI), the Wall Street Journal (WSJ), and the New York Times (NYT) to confirm and/or
identify the event dates.5 Each of the nine events are potentially significant to investors as they
inform investors of the likelihood of the Act being passed and its possible impact on corporate
governance, the financial reporting process, and audit functions. Two major reform bills were
initially introduced. The weaker bill was proposed in the House by Financial Services
Committee Chairman Michael Oxley (R-Ohio), and the tougher one was introduced in the Senate
by the Senate Banking Committee Chairman Paul Sarbanes (D-Maryland) (see Table 1).6 As of
June 2002, the likelihood of the passage of either bill or combination of both was uncertain.
The WorldCom debacle in June 2002, which resulted in the largest corporate bankruptcy
in the United States history, necessitates Congressional action. Cotton (2002) reports that
shareholders lost $460 billion in the Enron, WorldCom, Qwest, Global Crossing, and Tyco
debacles. The substantial investment loss by shareholders, employees, and pensioners, widelypublicized earnings restatements, and alleged financial statement fraud by high profile
companies along with the perceived inability of market self-corrections created political capacity
5
The WSJI, WSJ, and NYT typically report the press release announcements of these events one day after the event
date. The announcement dates listed in Table 1 are from the SEC and congressional websites. To capture the full
impacts of these events we use a three-day event window around event dates.
6
There were other versions of the reform bills introduced in both the House (H.R 3818, LaFalco, the Committee on
Financial Services) and in the Senate (S.2004, Dodd, the Committee on Banking, Housing, and Urban Affairs).
11
in Congress for reform-minded legislators to regulate corporate and accounting reforms. The
result was the compromised bipartisan Sarbanes-Oxley Act which gained momentum rapidly in
the weeks before its enactment on July 30, 2002. However, there were some uncertainties
regarding the form, content, and the possibility of the passage of the Act in the weeks prior to its
enactment. During these six months of intensive legislative debate, the capital market received
controversial signals from both the House and the Senate regarding the content, substance, and
likelihood of the passage of the Act. Langevoort (2002, 5), in discussing post-Enron reform
agenda and referring to the initial bills introduced in the House and the Senate, argues that “the
Republican agenda was hardly real institutional reform at all, except timidly in the accounting
area… The Democratic agenda more willingly tapped into that discontent, but still faced a
difficult implementation problem.”
Although the intent of both Congressional bills (S. 2673 and H.R. 3763) was to restore
investors’ confidence in corporate governance and financial reports, there were significant
differences between the House bill and the Senate amendment. The capital market perceived
these differences as a signal of the decreasing likelihood of the passage of the Act (events of July
15, 16, and 19, 2002). Events pertaining to the conference report indicating the congressional
conference committee reached an agreement to comprehensive reform legislation (the Act) on
July 24, 2002, the congressional legislation on July 25, 2002, sending the compromised bill to
the president on July 26, 2002, and all rumors about the president signing the compromised bill
sent signals to the market which indicated the increasing likelihood of the passage of the Act.
Thus, the focus of this study is on the events that changed the likelihood of the passage of the
Act. The occurrence of several legislative events prior to the enactment of the Act (from
February 2002 through July 2002) and the availability of data provide an opportunity to test the
12
capital market reactions to these congressional events. Thus, it is possible to measure the stock
market effect of the legislation during this relatively short and distinct period.
3. Hypothesis
Many provisions of the Act might have symbolic value and through signaling effects,
influence market participants’ confidence in the securities market. Examples of these provisions
are: (1) senior executive certification requirements disclosing the already mandated certifications
under Securities Laws; (2) real-time disclosure of key information concerning material changes
in financial condition or operations signaling the potential business and financial risks and a
discussion of their probability and magnitude from management’s perspective; (3) separation of
audit and non-audit services which can signal the markets about the objectivity and effectiveness
of audit functions and resulting impacts on credibility of published audited financial statements;
(4) improved corporate governance by signaling a more vigilant board of directors and audit
committees (e.g., approval of audit and non-audit services, code of ethics, financial expertise,
loans to directors); (5) disclosure controls and procedures requiring public report on
management’s assessment of controls effectiveness and auditors’ attestation and report on
management’s control assertions; (6) whistle-blowing protections for employees who lawfully
provide information which they reasonably believe constitute violations of Securities Laws; (7)
increased criminal penalties for violations of securities and other applicable laws and regulations;
and (8) creation of the public company accounting oversight board (PCAOB) signaling the
improved changes needed in the self-regulatory structure of the auditing profession.
Proponents and opponents of the Act have presented several descriptive theoretical
arguments to support their views of the Act as either “sweeping reforms of corporate America”
or “patchwork responses to recent financial scandals” respectively. Our study contributes to this
13
ongoing debate by empirically examining capital market reactions to the Act. The main issues
addressed in this study are (1) whether the capital market reacted positively to the events leading
to the passage of the Act, and (2) whether the implementation of provisions of the Act affects
companies differently. Thus, we propose the following (alternative) hypotheses against the null
hypothesis of no reaction:
H1:
Ceteris paribus, stock prices reacted positively to events leading to the passage of
the Sarbanes-Oxley Act of 2002.
H2:
The detected market reactions were associated with the firm’s attributes
(corporate governance characteristics).
The firm-specific characteristics that we examine include market capitalization as a proxy
for firm size, market to book ratio, earnings to price ratio, earnings retention rate, debt to capital
ratio, firm’s auditor, auditor’s opinion of the financial statements, earnings restatements, and
firm’s idiosyncratic risk. These variables can directly or indirectly influence the quality,
reliability, and transparency of financial reports. Bigger firms with diverse operations are
perhaps more susceptible to accounting irregularities. Higher market to book ratio and lower
earning to price ratio also indicate that a larger proportion of firm assets are intangibles that are
difficult to measure accurately. Thus, these firms are under closer scrutiny for accounting
irregularities. Higher earnings retention ratios also empower the management’s capability to
create fictitious earnings and assets. In contrast, lower retention and higher payout make it more
costly to engage in such activities because then the earnings increases have to be supported by
hard cash. Auditor brand name can have an important effect on investor’s confidence especially
in light of the high profile scandals that have emerged recently. Auditor’s opinion on a firm’s
financial statements can also reflect their reliability and credibility. We include a firm’s overall
variance of stock prices as an additional measure of the accuracy with which a firm’s potential
14
can be forecasted. Although most financial models suggest that only systematic risk is priced
and idiosyncratic risk can be diversified away, some recent papers suggest that idiosyncratic risk
matters to investors (Goyal and Santa-Clara 2002). Accounting manipulation and resulted
earnings restatements have received considerable attention from regulators. For example, former
SEC chairman Levitt (1998) expressed concern about erosion of the quality of accounting
earnings and its impact on investor confidence and market volatility. Earnings restatements
during 1995-2002 are used as proxies for earnings management and manipulation.
V. DATA AND METHODOLOGY
The Sarbanes-Oxley Act of 2002 is applicable to all publicly traded companies.
Therefore, we expect the stock market as a whole to react positively to the events around the
passage of the Act. Our first test focuses on two broad based market indices, namely, the S&P
500 index and the Value-line index. 7 The sample period for our events is from February to
August 2002. For each index, abnormal returns around the relevant events are calculated using
the constant-mean return model.8 The estimation period for the normal (benchmark) return starts
from 142 trading days before February 2, 2002 and ends at 21 trading days before that date. The
event-day abnormal returns (AR) are then calculated as the day’s gross return minus the normal
7
S&P 500 is a value-weighted index and is widely regarded as the standard for measuring large-cap U.S. stock
market performance. In contrast, the Value-line index is an equally-weighted index, which averages the returns on
1700 stocks. The historical values for the indices we use are readily available on their respective websites
http://www.spglobal.com and http://www.valueline.com.
8
Procedures for estimating abnormal returns (AR) are standard in the literature (see Brown and Warner 1985;
Campbell et al. 1997). Two distinct models are typically used in calculating ARs – the constant-mean return and the
market model. We could not use the more popular market model for our first test primarily because the Act affects
all publicly traded companies and thus the portfolio under investigation is the market portfolio itself. Prior studies
(e.g., Rezaee 1990; Stice 1991; Bhattacharya et al. 2002) use the constant-mean return model for investigating the
capital market reactions around accounting standards and legislative events. The market reaction in Table 4 is tested
using the constant-mean return model based on the following equation:
ARMt  RMt  R Mt , 142,21
where ARMt = abnormal market return on the event date, RMt = actual market return on the event date, and
R Mt , 142, 21 = the mean market return (benchmark) during the 121 trading days during the estimation period.
The conventional t-test was used to determine the statistical significance level of observed abnormal returns.
15
return. The 3-day cumulative abnormal returns (3-day CARs) are obtained by adding the
abnormal returns on the event day, one day before the event, and one day after the event. These
time-series tests help us investigate the market reaction around each event leading to the passage
of the Act, as set out in Table 1. We investigate the time series capital market reactions to the
Act as reflected in the price relatives derived from the Standard and Poors 500 Series.
After identifying the events with significant overall market reaction, we conduct a crosssectional analysis of the constituent firms in the S&P 500 index. The purpose of these tests is to
identify the firm-specific characteristics that influence the magnitude of stock price reactions to
the passage of the Act. Firm-specific variables are obtained from various sources. Definitions of
these variables used in the cross-sectional analysis and their data sources are presented in Table
2. The cross sectional analysis simultaneously analyzes the impact of these variables on
abnormal returns and cumulative abnormal returns in a regression framework. We use the
standard event study methodology for the cross sectional analysis as outlined in Campbell, et al.
(1997). The dependent variable for the first regression is abnormal returns (ARit) defined as
follows under the Capital Asset Pricing Model (CAPM):
^
ARit  Rit  R f   ( RMt  Rf )
(1)
where Rit is the return on stock i on event date t; -hat is the stock’s beta which measures the
sensitivity of a company's stock price to the fluctuation in the Standard & Poor's 500 (S&P 500)
Index, calculated for a 5-year period ending on June 2002 using month-end closing prices
including dividends; Rf is the risk-free rate of return from treasury bill (t-bill); and RMt is the
return on S&P 500 Index on the event date.
16
The dependent variable for our second regression is cumulative abnormal returns (CARit)
which is obtained by adding the abnormal returns on the event date, one day before the event and
one day after the event as follows:
CARit  ARit 1  ARit  ARit 1
(2)
We developed two regression models based on cross-sectional variables as follows:
ARit    1 MCapi   2 MBi   3 EPi   4Qi   5 DTC   6 AuditAA   7 Opn   8   9 Res tate  
(3)
CARit    1 MCapi   2 MBi   3 EPi   4Qi   5 DTC   6 AuditAA   7 Opn   8   9 Res tate  
(4)
Table 2 presents definitions of variables used in equations 3 and 4 along with related
data sources. Panel A of Table 3 lists descriptive statistics (mean, standard deviation minimum,
maximum) for all variables and Panel B reports correlations between variables. The first row of
Panel B shows the Pearson’s correlation coefficients, the second row presents the p-value, and
the third row provides the number of pair-wise observations from which the first two rows are
calculated.
Sensitivity Analyses
The possible impacts of the Act may differ from industry to industry depending on the
industry business and accounting practices as well as the corporate governance structure and the
quality of financial reports. Although the implementation of provisions of the Act is expected to
affect publicly traded companies in all industries, it was originally aimed at addressing financial
scandals of high profile public companies. The Enron, WorldCom, Global Crossing, and Qwest
scandals have reinvigorated the debate over corporate regulation to restore confidence in the
capital markets. Marketplace and corporate governance mechanisms were unable to detect and
17
prevent these scandals, investors suffered substantial losses and Congress responded with the
Act. Cunningham (2003) refers to these four financial scandals as the “Big-Four” accounting
frauds, which set the stage for which the Act was established. Indeed two of the Big-Four
companies, Enron and Global Crossing, are mentioned by name in the Act. Cunningham (2003)
argues that these Big-Four companies share several common characteristics: (1) they used
various accounting shenanigans to cook the books; (2) they employed Andersen as their
independent auditor; and (3) three of the Big-Four are in the telecommunications industry with
Enron being in the petroleum products industry.9
The pervasiveness of business and accounting scandals in 2002 encouraged Forbes to
create “The Corporate Scandal Sheet” online to keep track of these scandals. Starting with the
Enron debacle in October 2001, Forbes identifies 21 financial scandals through July 2002
(Forbes 2002).10 We classify these scandals into 11 industries according to their SIC Code and
then we reduce the number of industries to five industries with two or more alleged financial
statement fraud firms therein. These selected five industries are electric power generation,
natural gas distribution, pharmaceutical, petroleum, and telecommunications.
To examine shareholders’ response to the Act in these industries, we calculate for event 7
(when the Act was passed by Congress because this event shows higher CAR (See Table 4) and
it was assumed that the President would sign it into law) abnormal returns for a portfolio of firms
in these five industries. Consistent with Karpoff and Malatesta (1989) and Ali and Kallapur
9
Two of these three common characteristics (financial restatements proxies for the use of accounting schemes and
audited by Andersen) were incorporated into our cross-sectional analysis (equations 3 and 4) as proxies for
likelihood of financial statements fraud. The third variable of the industry specialization is tested in equation 5 of
our sensitivity analysis.
10
The 21 reported scandals in alphabetical order are: Adelphia, AOL Time Warner, Bristol-Myers Squibb, CMS
Energy, Duke Energy, Dynegg, El Paso, Enron, Global Crossing, Halliburton, Homestore.com, Kmart, Merck,
Mirant, Nicor Energy LLC, Peregrine Systems, Qwest, Reliant Energy, Tyco, WorldCom, and Xerox.
18
(2001), we use the following model to compute abnormal returns for a portfolio of firms in the
five industries:
R pt     1 R Mt    2e De  
(5)
where Rpt is the return from the portfolio of stocks in the selected industry p on day t, RMt is the
return from the S&P 500 market portfolio, De is for indicator variables representing the
legislative events, and  is the error term. Each indicator variable takes a value of 1 on its event
date t, one day before i.e. t-1, and one day after i.e. t+1. The indicator variable is set to 0 on
other dates. The coefficient of β2e represents the average abnormal return of firms on event date
i. Since all selected events occur in July 2002, we estimate equation (5) using daily-return data
for 150 trading dates from April 1, 2002 to October 30, 2002. We calculate equation (5) for each
of the five industries.
VI - RESULTS
Table 4 reports daily abnormal returns (ARs) and three-day cumulative abnormal returns
(CARs) based on the constant-mean return model for the three-day period (t = -1, 0, and +1
relative to the announcement day) around each of the nine events using the returns on the S&P
500 value weighted index and the Value-line equally weighted index.11 The predicted signs on
the abnormal returns are also reported. As indicated in Table 4 and consistent with Hypothesis 1,
almost all events regarding the passage of the Act appear to have contained unanticipated and
signaling news to the extent that they affected stock prices of publicly traded companies and
could be detected by our model. Of the seven dates, for which we predict whether the event will
increase or decrease the likelihood of passage of the Act, the sign of daily abnormal return
11
We also calculated 2-day CARs for days -1, 0 as well as 0, +1 for the S&P index. The results of 2-day CARs are
similar to those of 3-day CARs. Thus, we only present results of 3-day CARs to capture both the possibility of the
information leakage prior to the event date and the fact that the popular press (WSJ, NYT) reported the event
typically one day after its announcement.
19
conform to our prediction for six dates. Abnormal return on July 19, 2002 is -3.78 percent,
which is significant at 1 percent level. On this date, there were significant uncertainties
regarding the form, content, and possibility of passage of the Act and thus, managers on the part
of the House and the Senate met to possibly reconcile differences between the House bill and the
Senate amendment. This event sent a signal to the market that the Act, in restoring investor
confidence may not be forthcoming and therefore the market reacted negatively to this event.
Abnormal return on July 24, 2002 is 5.78 percent, which is statistically significant at 1 percent
level. On July 24, 2002 the Congressional Conference Committee reached an agreement on
comprehensive reform legislation (the Act) and issued a conference report, which was perceived
as an indication that the Act would be passed by Congress and signed into law by the president.
The market viewed the conference report as signaling the increasing possibility of passage of the
Act and reacted to this event positively. Results in Table 4 are based on the 121 day estimation
period that started 142 days before our first event of February 14, 2002. As a robustness check
we randomly chose 100 alternative benchmark periods of 120 days each in the preceding five
years and found that the results in Table 4 are robust. The direction and statistical significance of
the ARs and CARs are too sensitive to the specification of benchmark.
The cumulative abnormal returns for the calendar time starting from the beginning of our
sample events to the end are plotted in Figure 1. This Figure shows that the declining trend of
the market was arrested and the market started moving up around the passage of the Act.
Furthermore, the events with a decreasing probability of passage of the Act are associated with
the market decline period whereas events with an increasing likelihood of passage are related to
the market increasing period.
20
The examined nine events are associated with the likelihood of the passage of various
provisions of the Act. These events are classified into three categories. The first group consists
of two events (1 and 2) pertaining to the early introduction of two bills by the House and the
Senate, which were considered either as hardly real institutional reform, difficult to implement,
or controversial (Langevoort 2002). We detect negative but insignificant abnormal returns (both
daily and 3-day cumulative) for these events, suggesting investors did not view these
congressional bills as relevant or significant in addressing financial scandals.
The second category consists of events (3 through 5) that either decreased the probability
of the passage of the Act or provided information regarding difficulties in reaching agreements in
the House and the Senate regarding the final provisions of the Act. We detected negative
abnormal returns for these events as predicted, suggesting decreasing probability of the passage
of the bill which would have positive impacts on corporate governance, the financial reporting
process, and audit functions. We calculate total cumulative abnormal returns during the
decreasing event period (July 15-July 19) for both the S&P 500 and value-line indexes. Total
cumulative abnormal return for the S&P 500 index during the decreasing event period is -7.94
percent, with the t-statistic of -2.29, which is significant at 5 percent level. We search the WSJ
and the NYT for these event dates (particularly July 15, 16, and 19) to find media reports on the
likelihood of the passage of the Act and any confounding events that might have affected stock
prices. The main reason for market decline during the announcement dates of these events as
reported in the WSJ was concerns regarding the likelihood of passage of an effective Act in
restoring already eroded investor confidence in the capital market. The Wall Street Journal
reported on July 15, 2002 that even though the Senate will approve changes in accounting
regulations, “the Senate bill won’t be complete unless it addresses stock options. This is the No.
21
1 post-Enron reform” (Murray 2002b). On July 16, 2002, the New York Times raised some
doubt about “what form a final bill might take by the time it emerges from a conference
committee” (Sanger and Oppel 2002). The New York Times reported on July 17, 2000 that Alan
Greenspan, the Federal Reserve Chairman, blamed corporate greed as the cause of the
breakdown in confidence among investors and advised House Republican leaders not to rush to
legislate a bill which reflects how questions of business integrity are reshaping both politics and
economic policy (Stevenson and Oppel 2002). The WSJ reported on July 19 that “Investors
continued to suffer from an acute crisis of confidence regarding both Wall Street and corporate
integrity. The thought of accounting irregularities still made investors flinch” (O’Brien 2002).
Overall, these event announcements raised some doubt about the likelihood of the passage of the
Act and its ultimate provisions and possible impacts. The progress on the passage of the Act was
not encouraging and these events reduced the probability of its ultimate enactment. Investors
viewed these events as bad news and the capital market reacted negatively to these events.
The last group of events (6, 7, 8, and 9) unambiguously increased probability of the
passage of the Act, and the market reacted positively to these events. Total cumulative abnormal
return for this increasing event period (July 24-July 30) is +12.95 percent with t-statistic of +4.56
which is significant at 1 percent level. During July 24 to July 30 the House and Senate reached a
compromise on legislation, and Congress passed the Act by a vote of 423-3 in the House and 990 in the Senate; the compromised bill was sent to the president to sign into law and eventually
was enacted on July 30, 2002. We detected positive market reactions to these events suggesting
that investors view provisions of the Act as beneficial to them and important in restoring public
confidence in corporate governance, the financial reporting process, and audit functions. Our
conclusion from Table 4 is that markets did react positively to the key events leading to the
22
passage of the Act. This suggests investors viewed the Act necessary to make corporations more
accountable to them and thus benefited from its enactment.
Results suggest that the Act improves investor confidence in the market at least in the
short term. Our results are consistent with those of La Porta, et al. (1997, 1998) which suggest
that better shareholder laws and their enforcement can significantly increase the willingness of
investors to buy and own shares in listed corporations, which ultimately leads to higher
valuations. Investor confidence is a complex issue depending on the perceived and actual risks
and returns. However, there are several plausible explanations for the observed positive market
reaction to the Act. First, despite characterization of the Act as either “far-reaching reforms” or
“patchworks and codifications” of the existing requirements, it created news which was
considered by investors as “good news”. Second, the Act might have been viewed by investors
as value-increasing in the sense that it improves the probability of detection and prevention of
corporate misconducts by increasing funding for more effective enforcement of Securities Laws,
creating new criminal and civil liabilities for securities fraud, and imposing more severe
penalties for wrongdoers. Third, the Act changed the auditors’ monitoring and disciplinary
system from the perceived ineffective self-regulated environment to a more independent,
regulatory framework under the SEC oversight function which was considered to be valueincreasing by investors. Fourth, the Act provides several measures that reduce management
authority and control over audit functions by requiring the audit committee to be responsible for
hiring, firing, retaining, compensating, and overseeing the work of auditors and making it
unlawful to mislead auditors. This change in the balance of power between management and the
board of directors, which traditionally has favored management, was viewed by investors as
value-increasing. Finally, the Act directs the SEC and the Comptroller General to conduct
23
several studies (e.g., audit industry consolidation, mandatory audit firm rotation, investment
banks and financial reports, rating agencies, off-balance sheet transactions, aiding and abetting)
aimed at improving corporate governance, financial reporting, and audit functions. Investors
might have considered the directions of these studies and their potential improvements as valueincreasing primarily because of the indication of continuous and direct congressional oversight
of corporate America.
We now shift our focus to the four events with positive market reactions as identified in
Table 4 and discussed in the previous paragraphs (events 6, 7, 8, and 9). For these event dates,
we run the regressions specified in equations (3) and (4). The results for the regression are
presented in Table 5. The R-square for abnormal return equation is 3.89 percent and for
cumulative abnormal returns is 15.01 percent. The regression suggests that bigger firms
experienced a higher abnormal return. This is because the focus of the Act has been on the large
high profile conglomerates. Higher earnings to price ratio has resulted in higher abnormal
returns. Stock price volatility has a negative and statistically significant co-efficient, which goes
against our hypothesis. The other variables such as market to book ratio, debt to capital ratio,
auditor brand name, auditor opinion, and earnings restatements have not passed the test of
statistical significance. Overall, the results appear to suggest that firms with greater scope for
earnings misrepresentation due to size or low dividend payout ratios experienced the biggest
impact of the Act.
We separately analyzed the impact of the Act for five industries. Any negative stock
price impact of the Act on these industries would suggest that investors view the Act as bringing
to limelight a more than normal level of irregularities in these industries. Alternatively, if the
firms in these industries were positively affected by the Act, it could be viewed that investors’
24
concerns about these industries will be mitigated, and therefore result in a positive market
reaction. Table 6 shows abnormal returns for each of the five selected industries sampled
separately. Results indicate that financial scandals were not limited to a handful of companies
because investors perceived them to be an industry wide problem. Although investors in all
industries viewed the Act positively and the market reacted positively, investors were skeptical
about the two industries of petroleum and telecommunications, as we detected negative
coefficients for them (see Table 6).12
CONCLUSION
Market participants must trust the quality, integrity, reliability, and transparency of
financial reports published by public corporations. Numerous earnings restatements and alleged
financial statement fraud cases have eroded investor confidence in corporate America and its
financial disclosures. Marketplace mechanisms do not always (as evidenced by recent business
and accounting scandals) provide timely, reliable, and effective self-corrections. Thus,
regulations are expected to create an environment which promotes strong marketplace integrity
and investor trust in the quality and transparency of financial disclosures. The Sarbanes-Oxley
Act of 2002 came into force in July 2002 to restore the eroded public confidence in financial
reports. The purposes of the Act are to improve corporate governance, protect investors by
improving the quality and reliability of corporate disclosures, establish the Public Company
Accounting Oversight Board (PCAOB) to govern the accounting profession, enhance the
standard setting process for accounting and auditing practices, improve SEC resources, and
establish rules on obstruction of justice and penalties for fraud. The implementation of
provisions of the Act is intended to restore public confidence in corporate America and its
12
The Big-Four financial scandals of Enron, WorldCom, Global Crossing, and Qwest, as previously discussed, are
in these two industries.
25
financial reporting process. Thus, investors are expected to benefit from the Act and react
positively to several events leading to the passage of the Act.
This study examines capital market reactions to the events (Congressional actions)
leading to the passage of the Act. We detected significantly negative abnormal returns around
the events that decreased the probability of the passage of the Act. Alternatively, we find
significantly positive abnormal returns around the events that increased the probability of the
passage of the Act and the actual passage of the Act. Results of our time-series analysis indicate
that the capital market reacted positively to the Act. This suggests that the Act is value relevant
in boosting the market’s confidence in the corporate governance and accounting systems. This
study also sheds light on the determinants of this price reaction using firm-specific variables.
Firms with larger market capitalization, higher earnings to price ratio, and higher stock price
volatility are affected more by the Act than compared to other firms. Results also reveal that the
healthcare industry was more positively affected by the passage of the Act. Results suggest that
the Act, by either generating news which was considered as good news by investors or creating
an environment which promotes strong marketplace integrity, has served as a stimulus to
encourage initiatives for rebuilding the public confidence in corporate America and its financial
reporting process. Results also suggest that the capital markets function more efficiently when
investors have confidence in the market, and it appears that new regulation (e.g., the Act) was
needed to restore investor confidence in the wake of high profile corporate and accounting
scandals.
There are a few caveats to our study. First, provisions of the Act affect all publicly
traded companies. We were neither able to classify affected firms into treatment versus control
groups nor could we use the more popular market model to test stock price reactions to the Act.
26
Thus, we use the constant-mean return model to investigate the reaction of the entire market
portfolio of firms in the S&P 500 and value-line indexes to the events leading to the passage of
the Act. To the extent that there are confounding events or omitted variables which are also
correlated with our events or cross-sectional model, it is possible that our analyses are being
driven by these factors and not by provisions of the Act. However, this should not negate
interest in our findings because confounding events and correlated and omitted variables remain
an issue in all time series and cross-sectional studies. In addition, we searched the Wall Street
Journal, the Wall Street Journal Index, and the New York Times to identify any confounding
events that might have affected stock prices during June and July 2002 (see Table 4). We found
that the Act, the likelihood of its passage, and its possible impacts on restoring the public’s
confidence and prevention of future business and accounting scandals were dominating news
during our test period and there were no other confounding events.
Second, we investigate the possible immediate signaling effects of the Act on market
participant’s confidence in the securities market and whether investors viewed the Act as valuerelevant and beneficial. Many provisions of the Act require the SEC and other regulators to
establish rules to implement those provisions regarding corporate governance, financial reports,
and audit functions. An interesting extension of our study would be to examine impacts of these
implementation rules on corporate governance, the financial reporting process (management
reporting conservatism), and audit functions (auditors’ reporting conservatism). In the shortterm, the Act created news which was considered by investors as “good news.” We leave the
issue of whether, in the long term, the Act is capable of rebuilding public trust in corporate
America and its financial reporting process to future research.
27
REFERENCES
Ali, A., and S. Kallapur. 2001. Securities price consequences of the private securities litigation
reform act of 1995 and related events. The Accounting Review 76 (July): 431-460.
Benston, G.J. 1973. Required disclosure and the stock market: an evaluation of the Securities
Exchange Act of 1934. The American Economic Review 63.1 (March): 132-155.
Bhattacharya, U., P. Groznik, and B. Haslem. 2002. Is CEO certification of earnings numbers
value-relevant? Working paper, Indiana University.
Binder, J. 1985. Measuring the effects of regulation with stock price data. Rand Journal of
Economics 16 (2): 167-183.
Brown, S.J., and J.B. Warner. 1985. Using daily stock returns: the case of event studies.
Journal of Financial Economics (14): 3-31.
Bumiller, E. 2002. Bush bill aimed at fraud in corporations. The New York Times (July 31).
Campbell, J.Y., A.W. Lo, and A.C. Mackinlay. 1997. The econometrics of financial markets.
Princeton: Princeton University Press, Chapter 4.
Chow, C.W. 1983. The impacts of accounting regulation on bondholder and shareholder
wealth: the case of the securities acts. The Accounting Review (July): 485-520.
Chow, C.W. 1984. Financial disclosure regulation and indirect economic consequences: an
analysis of the sales disclosure requirement of the 1934 securities and exchange act.
Journal of Business Finance & Accounting 11 (Winter): 469-483.
Cornett, M.M., Z. Rezaee, and H. Tehranian. 1996. An investigation of capital market reactions
to pronouncements on fair value accounting. Journal of Accounting & Economics 22:
119-154.
Cotton, D.L. 2002. Fixing CPA ethics can be an inside job. The Washington Post (October 20):
BO2.
Cunningham, L.A. 2003. The Sarbanes-Oxley yawn: heavy rhetoric, light reform (and it might
just work). Forthcoming, University of Connecticut Law Review, vol. 36.
Easton, P.D. 1999. Security returns and the value-relevance of accounting data. Accounting
Horizons 4 (December): 399-412.
Espahbodi, H., P. Espahbodi, Z. Rezaee, and H. Tehranian. 2002. Stock price reaction and
value-relevance of recognition vs. disclosure: the case of stock-based compensation.
Journal of Accounting and Economics (August): 343-373.
Forbes. 2002. The corporate scandal sheet. Available at
http://www.forbes.com/home/2002/07/25/accountingtracker.html.
Goyal, A., and P. Santa-Clara. 2002. Idiosyncratic risk matters. Journal of Finance,
forthcoming.
Ingram, R.W., and E.G. Chewning. 1983. The effect of financial disclosure regulation on
security market behavior. The Accounting Review (July): 562-580.
28
Institute of Internal Auditors (IIA). 2002. Research brief: CEO and CFO certifications to SEC
company response and the internal auditor’s role. (July 26) available at
http://www.gain2.org/ceosample.doc.
Johnson, M., R. Kasznik, and K. Nelson. 2000. Shareholder wealth effects of the private
securities litigation reform act of 1995. Review of Accounting Studies (513): 217-233.
Karpoff, J., and P. Malatesta. 1989. The wealth effects of second-generation state takeover
legislation. Journal of Financial Economics 25 (2): 291-322.
Langevoort, D.C. 2002. Managing the ‘expectations gap’ in investor protection: the SEC and
the post-Enron reform agenda. Working paper, Georgetown University Law Center.
La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny. 1997. Legal Determinants of
External Finance. Journal of Finance 52: 1131-1150.
La Porta, R., F. Lopez-de-Silanes, A. Shleifer, and R. Vishny. 1998. Law and finance. Journal
of Political Economy 106: 1113-1155.
Levitt, A. 1988. SEC Chairman from the Speech. The numbers game. NYU Center for Law
and Business (September), Available at http://www.sec.gov.
Levitt, A. 2002. CFOs and financial executives favor more, not less regulations. Today’s
News, Available at http://www.bfmag.com/Levitt.
Makinson-Cowell. 2002. US institutional investors give securities reforms mixed reviews.
Available at http://www.makinson-cowell.co.uk/about_us/press%20please%wjj.pdf.
Murray, S.D. 2002a. Is SEC ready for its own sweeping changes? New York Law Journal
(August 29).
Murray, S.D. 2002b. Senate faces stock-option issue in accounting bill. The Wall Street
Journal (July 15): C4.
O'Brien R. 2002. So much for up, as stocks fall: Siebel Systems, Kraft decline. The Wall Street
Journal (July 19): C3.
Osterland, A. 2002. No more mr. nice guy: a CFO survey suggests that recently passed rules for
auditors may be a wise idea. CFO Magazine (September 1), available at
http://www.cfo.com/printarticle/0,5317,7614|,00.html.
Rezaee, Z. 1990. Capital market reactions to accounting policy deliberations: an empirical
study of accounting for foreign currency translation 1974-1982. Journal of Business
Finance and Accounting 17 (Winter): 635-648.
Rezaee, Z. 2002. Financial statement fraud: prevention and detection. John Wiley & Sons,
New York, N.Y.
Ribstein, L.E. 2002. Market vs. regulatory responses to corporate fraud: a critique of the
Sarbanes-Oxley Act of 2002. Working paper (September), University of Illinois College
of Law, available at http://ssrn.com/abstractid=332681.
Sanger, D.E., and R.A. Oppel. 2002. Senate approves a broad overhaul of business laws:
tougher than house bill. The New York Times (July 16): D8.
29
Sarbanes-Oxley Act of 2002. The Public Company Accounting Reform and Investor Protection
Act. Available at http://www.whitehouse.gov/infocus/corporateresponisbility.
Securities and Exchange Commission (SEC). 2002. Sworn statements pursuant to section
21(a)(1) of the SEC Act of 1934, File No. 4-460, June 27. Available at
http://www.sec.gov/rules/other/4-460.htm.
Sorin, D.J., K.K. Pappa, and E. Ragosa. 2002. Sarbanes-Oxley Act: politics or reform? Statut’s
effects are not as profound as legislators would have us believe. New Jersey Law Journal
(September 2).
Spiess, K., and P. Tkac. 1997. The private securities litigation reform act of 1995: the stock
market casts its vote. Managerial and Decision Economics 18 (7-8): 545-561.
Stevenson, R.W., and R.A. Oppel. 2002. Fed chief blames corporate greed: house revises bill.
The New York Times (July 17): A1, 5.
Stice, E.K. 1991. The market reaction to 10-K and 10-Q filings and to subsequent the Wall
Street Journal earnings announcements. The Accounting Review 66 (January): 42-55.
30
CARs
-0.05
Aug-27-02
Aug-22-02
Aug-19-02
Aug-14-02
Aug-09-02
Aug-06-02
Aug-01-02
Jul-29-02
Jul-24-02
Jul-19-02
Jul-16-02
Jul-11-02
Jul-08-02
Jul-02-02
Jun-27-02
Jun-24-02
Jun-19-02
Jun-14-02
Jun-11-02
Jun-06-02
Jun-03-02
May-29-02
May-23-02
May-20-02
May-15-02
May-10-02
May-07-02
May-02-02
Apr-29-02
Apr-24-02
Apr-19-02
Apr-16-02
Apr-11-02
Apr-08-02
Apr-03-02
Mar-28-02
Mar-25-02
Mar-20-02
Mar-15-02
Mar-12-02
Mar-07-02
Mar-04-02
Feb-27-02
Feb-22-02
Feb-19-02
Feb-13-02
FIGURE 1
CUMULATIVE ABNORMAL RETURNS (CAR) FROM FEBRUARY 1, 2002 TO NOVEMBER 19, 2002 a
CAR
0.1
0.05
0
Increasing
Events
-0.1
-0.15
Decreasing
Events
-0.2
-0.25
-0.3
Calendar Dates
a. Cumulative abnormal returns for S&P 500 in calendar time. (These are not the 3-day cumulative return) For instance, cumulative
return for February 28 is the sum of abnormal returns from February 1 to February 28.
31
TABLE 1
CHRONOLOGICAL EVENTS LEADING TO THE PASSAGE OF THE SARBANES-OXLEY ACT OF 2002
EVENT #
DATE
EVENT
DESCRIPTION
1
February
14, 2002
Introduction of H.R.
3763
The House of Representatives (Oxley, the Committee on Financial Services) introduced H.R. 3763
to protect investors by improving the accuracy and reliability of corporate disclosures made pursuant
to the Securities Laws.
2
June 25,
2002
Introduction of S.
2673
Senator Sarbanes introduced S.2673 (similar to S. 2004) to (1) improve the quality and transparency
in financial reporting; (2) designate an independent Public Accounting Board; (3) enhance the
standard setting process for accounting practices; and (4) improve SEC resources and oversight.
3
July 15,
2002
Passage of S.2673
The Senate passed S. 2673, the Public Company Accounting Reform and Investor Protection Act of
2002.
4
July 16,
2002
Passage of H.R. 3763
The House passed H.R. 3763, the Public Company Accounting Reform and Investor Protection Act
of 2002.
5
July 19,
2002
Conference
Committee Meeting
There were some uncertainties regarding the form, content, and the possibility of passage of the Act.
Thus, the managers on the part of the House and the Senate met to reconcile the differences between
the House bill and the Senate amendment.
6
July 24,
2002
Conference Report
The Congressional Conference Committee reached an agreement on comprehensive reform
legislation (the Sarbanes-Oxley Act of 2002).
7
July 25,
2002
Congressional
Legislation
8
July 26,
2002
Compromised Bill
Sent to the President
Congress sent a compromised bill to the President to sign into law.
9
July 30,
2002
Sarbanes-Oxley Act
of 2002
President Bush signed into law the Sarbanes-Oxley Act of 2002.
Congress passed the Sarbanes-Oxley Act of 2002 by a vote of 423-3 in the House and 99-0 in
Senate.
32
TABLE 2
DEFINITIONS OF VARIABLES USED IN THE CROSS-SECTIONAL ANALYSIS AND DATA SOURCES
Variables
Definition
Data Source
1. Dependent Variables:
AR
CAR
Daily abnormal returns (AR) calculated for events 6, 7, 8, and 9.
Equation 1:
www.finance.yahoo.com
Three-day cumulative abnormal returns (CAR) calculated for events 6, 7, 8, and 9.
Equation 2:
www.finance.yahoo.com
2. Independent Variables:
Firm Size (Mcap)
Market capitalization of the firm calculated as the market value of the equity at the end of June
2002.
Market to Book Ratio Market to book ratio of total assets at the end of June 2002.
(MB)
Earnings to Price
Ratio (EP)
COMPUSTAT
COMPUSTAT
Earnings to price ratio of the firm in June 2002.
COMPUSTAT
Income before extraordinary items minus cash dividends divided by income before
extraordinary items calculated for the quarter ended June 2002.
COMPUSTAT
Debt to capital ratio calculated for the year ended December 2001.
COMPUSTAT
A dummy variable coded 1 if Arthur Andersen was the auditor, 0 otherwise.
COMPUSTAT
A dummy variable coded 1 if the auditor’s opinion was unqualified for the year ended
December 2001, 0 otherwise.
COMPUSTAT
Volatility
( )
A proxy for the firm’s idiosyncratic risk calculated as the standard deviation of monthly stock
price changes during the last 60 months starting July 1997 and ending June 2002.
COMPUSTAT
Financial
Restatements
(Restate)
A dummy variable coded 1 if the firm has voluntary, auditor recommended, or SEC enforced
financial restatement(s) during 1995-2002, 0 otherwise.
The Dow Jones Interactive
and Lexis-Nexus
information services
Earnings Retention
Rate (Q)
Debt to Capital Ratio
(DTC)
Auditor
(Audit AA)
Opinion
(Opn)
33
TABLE 3
DESCRIPTIVE STATISTICS AND CORRELATIONS FOR REGRESSION VARIABLES
Panel A: Descriptive Statistics
Abnormal returns
Cumulative abnormal returns
Market capitalization
Market to book ratio
Earnings to price ratio
Earnings retention ratio
Debt to capital ratio
Auditor is Arthur Andersen
Qualified audit
Stock price volatility
Earnings Restatement
Abbreviation
AR
CAR
Mcap
MB
EP
Q
DTC
AuditAA
Opn
σ
restate
Standard
Mean Deviation
0.0004
0.0548
-0.0082
0.1210
0.0180
0.0348
0.0354
0.1171
0.0010
0.2184
0.8013
0.7979
0.4518
3.2558
0.1608
0.3674
0.6243
0.4844
10.5279
7.1207
0.0374
0.1897
Minimum Maximum
-0.4742
0.6300
-1.3868
1.5492
0.0005
0.2962
-1.5796
1.4176
-2.9096
0.6712
-3.9491
8.8333
-73.1707
5.1440
0
1
0
1
1.4639
71.6531
0
1
Panel B: Pearson Correlation Coefficientsa
Mcap
Mcap
MB
Q
DTC
σ
1
0.05
0.021
2124
-0.043
0.066
1788
0.034
0.122
2124
0.022
0.302
2128
2128
MB
Q
DTC
σ
restate
AuditAA
Opn
EP
-0.069
0.001
2128
0.068
0.002
2108
0.014
0.117
0.51 <.0001
2136
2136
0.038
0.08
2116
-0.081
2E-04
2128
-0.043
0.066
1788
-0.031
0.186
1796
1800
0.034
0.129
0.122 <.0001
2124
2132
-0.013
0.594
1800
2136
0.001
0.104
0.948 <.0001
2136
1800
-0.004
0.867
2136
2140
0.014
0.529
2136
0.025
0.24
2140
2140
0.015
-0.097
0.5 <.0001
2136
2140
-0.059
0.006
2140
2140
0.018
0.457
1800
-0.069
0.098
-0.132
0.001 <.0001
<.0001
2136
2140
2140
0.003
0.88
2140
2140
-0.04
0.093
1780
0.013
-0.325
-0.13
0.553 <.0001
<.0001
2116
2120
2120
0.025
0.249
2120
0.03
0.168
2120
-0.081
2E-04
2128
0.006
0.791
1800
0.014
-0.109
0.51 <.0001
2136
1800
-0.069
0.117
0.001 <.0001
2128
2136
0.068
0.002
2108
1
0.038
0.08
2116
0.001
-0.148
0.948 <.0001
2136
2136
EP
2136
-0.032
-0.148
0.14 <.0001
2128
2136
-0.031
0.129
0.186 <.0001
1796
2132
-0.032
0.14
2128
Opn
0.05
0.021
2124
0.022
0.302
2128
1
restate AuditAA
-0.013
0.104
0.594 <.0001
1800
1800
1
-0.004
0.867
2136
1
0.006
-0.109
0.791 <.0001
1800
1800
0.014
0.529
2136
0.015
0.5
2136
0.018
0.457
1800
-0.04
0.093
1780
-0.069
0.001
2136
0.013
0.553
2116
0.025
-0.097
0.098
-0.325
0.24 <.0001
<.0001
<.0001
2140
2140
2140
2120
1
-0.059
-0.132
-0.13
0.006 <.0001
<.0001
2140
2140
2120
1
0.003
0.88
2140
0.025
0.249
2120
1
0.03
0.168
2120
1
2120
a The correlation for each pair of variables is presented in the first row. The second row is the p- value and the third
row is the number of observation for which data is available for both variables.
34
TABLE 4
MARKET REACTION TO THE EVENTS LEADING TO THE PASSAGE OF THE
SARBANES-OXLEY ACT OF 2002
S&P 500 Index b
Event
Daily
Abnormal
Return
3-day
CARd
Value-line Index c
Event
Day
Abnormal
Return
Event
Number
Event
Date
Predictiona
3-day
CARd
1
Feb-14-02
U
-0.13%
-0.13%
-0.76%
-0.39%
2
Jun-25-02
U
-1.62%
-1.42%
-1.66%
-2.30%
3
Jul-15-02
D
-0.32%
-2.72%*
-0.85%
-2.27%
4
Jul-16-02
D
-1.80%
-1.50%
-0.88%
-1.34%
5
Jul-19-02
D
-3.78%**
-9.67%**
-3.11%*
-8.19%**
6
Jul-24-02
I
5.78%**
2.62%*
4.34%**
-0.20%
7
Jul-25-02
I
-0.51%
7.01%**
-0.80%
4.21%**
8
Jul-26-02
I
1.74%
6.69%**
0.67%
5.34%**
9
Jul-30-02
I
0.48%
6.97%**
0.28%
4.63%**
Notes: ** and * indicate statistical significance at 1% and 5% levels respectively
a. Predictions: Increase (I), decrease (D), or uncertainty (U) in the likelihood of the
passage of the Sarbanes-Oxley Act of 2002
b. Abnormal returns are calculated using the return on the S&P 500 value weighted index
in a constant-mean return model.
c. Abnormal returns are calculated using the return on the Value-Line equally weighted
index in a constant-mean return model.
d. CARs are sum of ARs on days -1, 0, and +1. Results for 2-day CARs for days (-1, 0)
and (0, +1) are not statistically different from those of 3-day CARs.
35
TABLE 5
CROSS SECTIONAL ANALYSIS OF ABNORMAL RETURNS SURROUNDING THE
KEY EVENTS LEADING TO THE PASSAGE OF THE
SARBANES-OXLEY ACT OF 2002 a
CARit    1 MCapi   2 MBi   3 EPi   4 Qi   5 DTC   6 AuditAA   7 Opn   8   9 Restate  
Dependent Variable
AR
N=
1668
Explanatory Variables
Intercept
Market capitalization
Market to book ratio
Earnings to price ratio
Earnings retention ratio
Debt to capital ratio
Auditor is Andersen
Qualified audit
Stock price volatility
Earnings Restatement
Adjusted R-square
Coefficient
0.0024
0.0740*
0.0052
0.0187**
0.0030
0.0020
0.0034
0.0004
-0.0010**
0.0019
3.89%
Standard
error
0.0034
0.0321
0.0093
0.0053
0.0016
0.0022
0.0033
0.0026
0.0002
0.0062
CAR
Standard
Coefficient error
0.0276**
0.1444*
0.0226
0.0673**
0.0034
0.0057
0.0093
-0.0014
-0.0043**
-0.0234
0.0070
0.0666
0.0193
0.0111
0.0034
0.0046
0.0069
0.0054
0.0003
0.0128
15.01%
Notes: ** and * indicate statistical significance at 1% and 5% levels respectively
a. This table estimates two regressions with abnormal return (AR) and cumulative abnormal
returns (CAR) respectively. The equation for CAR is shown above and AR equation is similar.
36
TABLE 6
STOCK RETURN REGRESSIONS FOR THE SELECTED INDUSTRIES a
R pt    1 RMt   2 e De  
Industry
First-five digits of
NAICS
Event Description
Passed by Congress
Adjusted R-Square
Independent
Variable/
Event Date
Intercept
Market
7/25/2002
Electric Power
Generation
Natural Gas
Distribution
Pharmaceutical
Preparation
Manufacturing
22111
22121
32541
Coefficient
Coefficient
Coefficient
Petroleum and
Petroleum
Products
Wholesalers
Wired
Telecommunications
Carriers
42272
Coefficient
51331
Coefficient
0.0072**
0.8262**
0.0150
0.0000
0.7427**
0.0132
-0.0002
0.9283**
0.0161*
-0.0023
2.7520**
-0.1046*
0.0016
1.1751**
-0.0355**
0.3454
0.473
0.6997
0.2748
0.4755
Notes: Coefficients are marked with ** and * if they are significant at 1% and 5% levels respectively.
a.
OLS estimates reported in this Table are based on CARs for each industry portfolio as dependent variable and the
market return and the passage of the Act as explanatory variables. We run the OLS regressions for AR for each of the
event dates and observed statistically similar results.
37
APPENDIX
Summary of Some Provisions of the Sarbanes-Oxley Act of 2002
1. Public Company Accounting Oversight Board (PCAOB)
The Act creates a new public company accounting oversight board (PCAOB)
which is empowered to set auditing, quality control, and independence and ethics
standards as rules. The PCAOB is an independent not-for-profit organization
subject to SEC oversight, made up of five members of which no more than two
may hold the CPA credential. The PCAOB registers public accounting firms that
conduct audits of publicly traded companies, conducts inspection of the registered
public accounting firms and performs investigations and discipline proceedings.
2. Auditor Independence
The registered public accounting firms will be prohibited from providing several
non-audit services to their clients contemporaneously with the audit and the lead
audit or coordinating partner and the reviewing partner must rotate off of the audit
every five years.
3. Corporate Responsibility
The Act requires that each member of the audit committee be independent
members of the board of directors, have the authority to engage independent
counsel and other advisors, and be directly responsible for the appointment,
compensation, and oversight of the work of any registered public accounting
firms.
4. Enhanced Financial Disclosure
The Act creates significant reporting responsibilities for top executives of publicly
traded companies to improve financial disclosures including certification of
financial reports by the CEOs and CFOs and establishment of adequate and
effective disclosure controls and procedures.
5. Trading, Disclosure, and Conflicts of Interest
The Act prohibits insider trades during pension fund blackout periods, requires
disclosure of all off-balance sheet transactions, and prevents investment banking
staff from supervising research analysts.
6. Corporate Misconduct and Crime
The Act contains several provisions to prevent wrongdoing and establishes a new
crime of securities fraud with a tough 25-year jail sentence
7. Further Studies
The Act directs the SEC and Comptroller General to conduct nine studies on
various aspects of corporate governance, the financial reporting process, audit
functions, investment banking, and enforcement actions of corporate laws.
38