The Sarbanes-Oxley Effect - Assignment Example

What is the research question presented by the article The research paper by Gerlad J Lobo and Jian Zhou closely studies the enhanced conservatism in financial reporting, post the Sarbanes-Oxley Act. Through various surveys and reports it has been found that the 2002 act and the resultant SEC certification requirements have essentially affected management's discretionary reporting of financial reports and have led to increased conservatism amongst the companies. This paper takes an acute look at the financial reports made before and after the act, what led to the passing of this act in the US assembly and has it really augmented conservatism in discretionary revelation of financial reports. The paper also investigates if there has been a decline in aggressive accounting due to this conservatism post the Act. Major financial scandals which involved big companies such as Enron and Worldcom gave a strong impetus towards bringing in SOX act. Most of these scandals took place in companies which aggressively pursued all the common principles of accounting, hence scandals in such places were also a big set back for the market investors. Therefore a strong need was felt to bring in a stringent law that would not only keep a tab on financial reporting but also help in rebuilding investor's confidence. The main aim of SOX is to improve the accuracy and reliability of financial disclosures by corporates and to ensure integrity in their financial reporting. The act also imposes severe penalties and punishments for the CEOs and CFOs of the firms which fail to adhere to its requirements. The paper focuses on changes in conservatism, a discretionary choice of reporting lower or decreased financial earnings after the implementation of SOX. (2) What does prior research say There have been numerous studies and researches on this subject. Keeping in lieu with SOX intention of increasing financial accuracy, Cohen report of 2005 suggests a steady increase in financial accruals before SOX and a reversal in this trend post SOX. Heflin and Hsu paper (2004) indicates a significant decline in the use of non GAAP earning measures and a probability that disclosed earnings either exceed or meet expectations post SOX. (3) What is the underlying theory used in the article SOX have been described as one of the most stringent and far reaching reforms for the US corporate sector. In response to implementation of SOX, the SEC required all the firms listed on exchange to certify material accuracy and completeness of their financial statements. Since SOX imposes severe penalties and punishments for firms failing to adhere to its norms, the firms have a greater motive to avoid overstating their financial earnings. The paper comprehensively examines if the American corporate firms have become more conservative in revelation of their financial statements after imposition of SOX and SEC certifications. (4) What is the methodology The paper has been divided into different sections. Each section deals with different aspects of SOX and its impacts, and is yet woven in a coherent manner. Beginning with a basic introduction and primary subject of the paper the paper is fragmented into sections on hypothesis, sample selection, research design, reports and results In the paper the researchers have implemented two approaches to measure conservatism before and after SOX. In the first approach, a detailed comparison of discretionary accruals pre and post the Act has been conducted. A decrease in discretionary accruals would be an indication towards enhanced conservatism. In the second approach the researchers have applied the Basu methodology to compare the discretionary accruals over the given time period. In this method conservatism in calculated by the obtaining difference between coefficient relating earnings to stock returns for firms with positive stock returns and the coefficient for firms with negative stock returns. An increase in the coefficient difference after SOX would be an indicator of increased conservatism. The paper suggests that in both approaches it has been found that there was an increase in conservatism immediately after introduction of SOX. The researchers also implied alternative estimation and measurement techniques to arrive at a comprehensive conclusion. Use of a short window to examine the effects of SOX also diminishes the impact of other regulatory procedures on the results of this paper. The findings reveal an initial increase in conservatism; however leave an open question on if this increase is still persistent. The research design in the paper compares accounting trend in a year after and before SOX. Within the time frame of two years only those firms have been taken into consideration, which have complete data for both the years. (5) What are the results, conclusions, implications The paper reveals evidence that on an average firms have become more conservationist while revealing financial accruals after SOX. The researchers found a significant decline in discretionary accruals post SOX as compared to pre SOX period. The use of Basu method also reveals increased conservatism in the post SOX years. The findings are consistent with the SOX and SEC requirements that the CEOs and CFOs certify their financial statements, avoiding any potential earning overstatements. The results are also in coherence with Watts' observation (2003) which states that litigation under Securities Act encourages conservatism because litigation is more likely to occur when earnings are overstated. The paper concludes that the increase in conservatism in immediate period after SOX may have arised due to management's awareness of and responses to changes in the environment rather than from SOX and its accompanying certifications. The paper implicates that though an increase in conservatism has been observed post SOX it cannot be stated if this shift is permanent owing to lack of data. Read More