Erasmus University Rotterdam Netherlands
Erasmus School of Economics
Section Accounting Auditing and Control
22nd of August 2013
Economic consequences: The effectiveness of the Sarbanes Oxley Act 2002 regarding the occurrence of fraud scenarios”.
Written by: Aixa Ostiana
Student number: 302739
Supervised by: Lili Dai &
Drs. Rob van der Wal RA
I would like to take this opportunity to thank my supervisors Lili Dai and Mr. Rob van der Wal for all their efforts and help during the elaboration of this master thesis. I am also very grateful to my family and friends who supported me and helped me through this heavy but successful journey. Without their encouragement it would not be possible to perform and complete this study.
The financial scandals of Enron, WorldCom and some other large companies in the beginning of this century, encouraged Congress to introduce the Sarbanes Oxley Act (SOX) 2002 in order to fight the escalating commitment of financial statement fraud. The main objective of this legislation was to recover the investors’ trust in the American stock market, and enhancing the prevention and detection of corporate fraud. In this thesis I will be analyzing the effectiveness of SOX 2002 in preventing financial statement fraud, performing an empirical research based on restatement data from 1997 till 2006, corporate governance characteristics and effective internal control systems. The restatements data are originally from the GAO database, corporate governance characteristics were collected from the Risk Metrics database and internal controls information were obtained from the Audit analytics database. To perform this study a logistic regression model was used to examine whether the implementation of SOX have prevent fraudulent reporting through effective internal controls systems and some corporate governance components.
Finally, the results of the study showed that SOX has not been able to prevent or reduce the likelihood of financial statement fraud. The main changes in corporate governance characteristics, board structure and audit committee composition, did not show to have any influence on the probability of fraud scenarios after SOX’s implementation. However, the effectiveness of internal controls- a compliance requirement implemented by SOX- appeared to have a very significant impact on the prevention of corporate fraud. This means that some reforms are still needed on the level of corporate governance and other segments of SOX, in order to have a more efficient result from this law.
Keywords: Fraud, SOX, Corporate Governance and Internal Controls
Table of Contents
1. Introduction 4
1.1 Relevance and contribution of the topic 6
2. Fraudulent Financial statements 8
2.2 The Implications of Fraud 8
2.3 Motives to commit Fraud 10
2.4 Earnings Restatements 12
2.5 Summary 14
3. The implementation of the Sarbanes Oxley Act 16
3.1 Introduction 16
3.2 Prior to The Sarbanes Oxley Act 16
3.3 Implementing the Sarbanes Oxley Act 2002 20
3.4 A Review of Prior Researches 22
3.5 Compliance with SOX 404 and changes in Corporate Governance 26
3.6 Summary 30
4. Research Design 31
4.1 Introduction 31
4.2 Hypothesis development 31
4.3 Sample and Data collection 37
4.4 Methodology 38
5. Findings 47
5.1 Introduction 47
5.2 Findings 47
5.3 Limitations 51
5.4 Recommendations 52
5.5 Summary 53
6. Conclusion 55
Since the last 20 years the global economy has been facing a dramatic flow of accounting scandals committed by CEOs and managers of prestigious entities known all around the world. One of the most notorious fraud cases in the last decade was that of Enron where debts were hidden, revenues were inflated and the presence of corruption was uncovered. Other similar cases that also battered the accounting world were those of Adelphia Communications and Global, WorldCom, Parmalat, AIG and Tyco International. Most of these scandals took place during the latter years of the previous century and in the beginning of 2000. These actions obviously triggered a high level of uncertainty regarding the accuracy and reliability of financial statements by investors, creditors and other agents. Moreover, this also contributed to less confidence in the audit profession since one of the most well-known auditing and assurance firms, Arthur Andersen LLP, was involved in the Enron case. Consequently, this has put a lot of pressure and stress on the audit profession, because the whole world has dumped all the responsibility of the accurateness and completeness of financial statements on the auditors.
In order to combat and stop the harmful consequences caused by these fraudulent actions, the 26th chairman of the Securities and Exchange Commission (SEC), Harvey Pit, implemented the Act (SOX) in 2002 to restructure the lost confidence of the public in the accounting profession. As a supportive organ the quasi-public agency, Public Company Accounting Oversight Board (PCOAB), was created to regulate, observe, analyze and discipline the accounting firms in their duty as Certified Public Accountants. The requirements of this act contain regulations that enforce the structure of corporate governance, provide assessment of internal controls, emphasize the importance of the auditor’s independency, and aim for an enhanced disclosure of financial statements. As a reaction on fraudulent financial reporting, the senator Paul Sarbanes came up with the SOX act especially to prevent and detect intentional financial misstatements and reporting errors.
In 2002, the implementation of SOX seemed to give the accounting profession and the financial market hope to solve the fraud epidemic that was consuming and hitting the global economy. However, the costs of implementing the required information system by SOX was extremely high which made it extremely difficult, especially for small public firms, to introduce this legislation into all public companies. Several of these firms chose to go private in order to escape these high costs, since the benefits were totally unknown. According to the Financial Executives International survey, the amount of the initial compliance costs exceeded the amount of approximately four millions dollars for large companies. Nevertheless, these costs have decreased over time as companies gain more experience working with the implemented systems.
It has been already eleven years ago that SOX was introduced as an obligatory legislation which all publicly trading companies had to comply with. It was a tough struggle for many companies to fully comply with the comprehensive and costly requirements of this legislation. The main question now is whether the implementation of SOX has been effective after all these years and whether it achieved its goal of preventing financial statement fraud.
According to Patrick Taylor, CEO of the Oversight System, fraud has become more prevalent nowadays compared to 2002. He based his statement on surveys carried out by Oversight System in 2005 and 2007, where 76% of the respondents indicated that fraud was more widespread over the preceding five years. This includes the stock market bubble of 2000 and the scandals of 2002 (Oversight Systems, 2007). Moreover, only a minimum of 3% opinioned that fraud has diminished with the introduction of SOX, whilst 21% believe that the number of fraud events has not changed over these past years. On the other hand, there are some advocates of SOX that argue its implementation has improved and enhanced the quality and reliability of financial reporting, herein diminishing the amounts of fraud scenarios, because of the preventive controls established by SOX. The dramatic failures of Lehman Brothers in 2008 and Royal Ahold NV in 2010, made it apparent that the introduction of SOX may not have been useful after all. As a result of all these contradictory statements, this paper will performed a detailed analysis whether SOX has been able to accomplish its goal of preventing fraudulent financial reporting. The research question that will be leading this study is as follows, “Did the Sarbanes Oxley Act accomplish its goal of reducing fraudulent reporting of financial statements after its implementation in 2002?”
In order to answer this question we first start by analyzing several relevant publications relating to the effects of SOX in relation to fraud scenarios in the financial market. We provide the reader with sufficient relevant background information relating to the implications of SOX, by comparing different studies and different arguments. After this, we introduce some econometric estimation we use to analyse the impact of SOX. We discuss our results, as well as comparing our results with prior research. Any limitations encountered throughout our analysis will also be highlighted for future research. Finally, we also provide any concluding remarks in our last section.