The Sarbanes-Oxley Act and Small Public Companies

Transcription

1 The Sarbanes-Oxley Ac and Small Publc Companes Smry Prakash Randhawa * June 5 h 2009 ABSTRACT Ths sudy consrucs measures of coss as well as benefs of mplemenng Secon 404 for small publc companes. In hs paper I provde a comprehensve measure of Secon 404 coss by developng models of drec and ndrec coss based on fnancal saemen nformaon. The resuls hus far ndcae ha mplemenng Secon 404 of was very cosly for smaller publc companes and herefore he non-acceleraed flers ha wll become Secon 404 complan n he nex few years need o be ready o pay a much hgher cos for beng publc n he US. I furher develop models o es he benefs of Sarbanes-Oxley. In parcular I consruc ess o measure ncrease n qualy and relevance of fnancal saemens. The es resuls for earnngs qualy ndcae ha mplemenng Secon 404 has ncreased he qualy of earnngs for small publc companes. * I would lke o hank Maureen McNchols for her consan help and gudance. I would also lke o hank Ana Adma Bll Beaver Rober Danes George Foser Charles Horngren Alan Jagolnzer Madhav Rajan Ken Shos and workshop parcpans a Sanford Unversy for helpful commens and suggesons..

2 INTRODUCTION The Sarbanes-Oxley () bll sgned no law on July 30 h 2002 s consdered one of he mos far-reachng reforms of Amercan busness pracces snce he Secures Ac of 933. The Ac was passed n response o a number of major accounng scandals dscovered durng ncludng Enron Tyco Inernaonal and WorldCom. Even fve years afer he passage of he Ac here s consderable debae over wheher smaller ssuers 2 should be subjeced o Secon 404 of he Ac. Noably research o dae has no focused on smaller companes and herefore provdes lmed gudance on he coss and benefs of he ac for small frms. Therefore o shed some lgh on hs debae I develop a comprehensve measure of coss as well as benefs of n parcular Secon 404 n hs paper. A major am of hs paper s o consruc measures of coss as well as benefs of mplemenng Secon 404 for small publc companes. There are hree dfferen perspecves on wheher smaller publc companes should be subjec o Secon 404 of. The frs perspecve advanced by Small Busness Advocacy and he Advsory commee on Smaller Publc Companes 3 s ha he coss of Secon 404 complance are oo hgh for smaller frms and herefore hese frms should be exemped 4 from becomng Secon 404 complan. A a mnmum s argued ha hs requremen should be deferred unl can be proven ha hese companes can become 404 complan n a cos-effecve manner. 5 Ths vew was also expressed n he recen arcle by Rober Grady n he Wall Sree Journal. 6 The second perspecve advanced by he Publc Company Accounng Oversgh Board (PCAOB) s ha Secon 404 s an effecve way of denfyng companes wh nernal conrol Elsabeh Bumller: "Bush Sgns Bll Amed a Fraud n Corporaons" The New York Tmes July page A 2 Small ssuers refers o non-acceleraed flers 3 hp:// 4 hp:// 5 hp:// 6 hp://

3 problems and s herefore benefcal for shareholders. Therefore s mporan ha all companes should be subjec o Secon 404 regardless of sze. 7 Many penson funds have also suppored hs vew. The hrd perspecve s ha smaller frms should be subjec o Secon 404 bu he requremens should be made less srngen for hese frms. 8 For now based on he SEC s May 24 h 2007 flng seems ha he SEC has acceped hs vew. The frs group of non-acceleraed flers has o become Secon 404 complan on December 5 h In hs paper I develop measures o provde evdence on he mer of hese vews usng he experence of smaller acceleraed flers. 0 In addon hs paper can help answer quesons abou he coss and benefs of non-acceleraed flers once hey become Secon 404 complan. As menoned earler accounng research on drec coss of o dae has focused on larger companes. For example Grffn and Lon (2006) focus on he companes ha were clens of bg four aud frms whle Elderdge and Keeley (2005) look a Forune 500 companes. Mos of he subsanal fndngs abou benefs of lke Cohen e al. (2006) agan focus on bgger companes and snce hey use Execucomp daa her sample s comprsed of very large frms. On he oher hand as dscussed n Secon 2. sudes lke Doyle e al. (2005) Engel e al. (2005) Hosak e al. (2007) and Porosk and Srnvasan (2006) have clearly demonsraed ha small companes were he ones who were mos affeced by he Ac. Therefore s very mporan o sudy he coss and benefs of Sarbanes-Oxley on smaller publc companes. 7 hp:// 8 hp:// rner=rssuserland&emc=rss 9 hp://accounng.smarpros.com/x60067.xml 0 Of course due o he new aud sandard for nernal conrol over fnancal reporng he coss esmaes provded n hs paper should be hough of as an upper bound for he coss ha non-acceleraed flers wll have o pay. hp://

4 The conrbuons of hs paper are hreefold. Frs of all my research provdes a more comprehensve measure of Secon 404 coss by developng models of drec and ndrec coss based on fnancal saemen nformaon. Second hs s he frs paper o es he benefs of Secon 404; n hs paper I hypohesze ha wll ncrease he qualy and relevance of fnancal saemens. Thrd hs paper makes wo mporan mehodologcal conrbuons o curren research. My sudy denfes an mporan conrol group for Secon 404 sudes namely he non-acceleraed flers whch are small publc companes ha have no ye adoped Secon 404. My sudy also documens ha he year of Secon 404 complance s no always 2004 as pror sudes assume. I show ha he year of complance can be correcly denfed by usng he exsng daa sources. The res of he paper s organzed as follows: Secon 2 revews he exsng leraure on Sarbanes-Oxley as well as oher relevan leraure on small busnesses. Secon 3 develops he hypoheses whle Secon 4 develops he relevan ess. Secon 5 dscusses he resuls and Secon 6 concludes he paper and dscusses he remanng work. 2. LITERATURE REVIEW 2. Sarbanes-Oxley Research A number of papers have red o measure he ne benef of ndrecly by lookng a marke reacons o mporan evens ha led o he passage of. The fndngs of hese papers have vared dependng on he dae ranges hey nclude n he analyss. For example Razaee and Jan (2003) and L e al. (2004) repor ha s benefcal o frms whle Zhang (2005) concludes ha he coss of surpass he benefs. Please refer o Appendx A for a bref overvew of he relevan leraure on

5 Grffn and Lon (2006) Elderdge and Keeley (2005) and Lnck e al. (2007) are he frs papers o look a he drec coss of. Grffn and Lon (2006) have demonsraed ha led o an ncrease n aud coss for he publc frms auded by Bg Four audors. They also show ha durng 2004 whch hey assume s he year of Secon 404 complance for all frms he ncrease n aud fees s larger han ha of he pror year. Smlarly Eldrdge and Kealey (2005) show ha he aud fees of Forune 000 frms sgnfcanly ncreased n 2004 f he frm had mplemened Secon 404 n ha year. Lnck e al. (2007) demonsrae ha he cos of mananng corporae boards ncreased sgnfcanly afer came no effec n 2002 due o ncreased D&O nsurance premum and drecor fees. Though hese sudes are que relevan o hs paper a major dfference s ha hese sudes have focused on large publc companes where he magnude of coss and benefs can be less sgnfcan whle n hs paper I focus on smaller busnesses. I s clear from pror research ha small frms have faced hgh coss o reman publc. Carney e al. (2005) and Engel e al. (2006) show ha a number of smaller frms chose o eher ermnae reporng under he secures laws or go prvae. Smlarly Porosk and Srnvasan (2006) provde evdence ha he passage of has affeced he flow of nernaonal lsngs n he US. They show ha he frms choosng o ls on he LSE Alernave Invesmen Marke (AIM) over US markes are smaller and less profable han he frms lsed on US exchanges afer was passed. Also Hosak e al. (2007) demonsrae ha foregn frms ha delsed her Amercan Deposary Receps (ADRs) n he US were smaller han he frms ha dd no dels her ADRs. A few papers have also demonsraed he effec of Sarbanes-Oxley on acual busness pracces of frms. Cohen e al. (2006) fnd ha accrual earnngs managemen decreased sgnfcanly afer

6 he passage of whle real earnngs managemen ncreased afer he passage of he Ac. In anoher paper Cohen e al. (2004) fnd a sgnfcan declne n he rao of ncenve compensaon o salary afer he passage of. Accordng o he auhors hs fndng was a resul of frms ryng o compensae he managemen for he addonal lably mposed by. DeFond e al. (2004) fnd ha companes volunarly apponed fnancal expers o her aud commees. However he marke reaced posvely o hese announcemens only f he fnancal exper was an accounng fnancal exper and he reacon was hgher for companes ha had beer corporae governance. Also Wagner and Dmar (2006) n a recen Harvard Busness Revew summarze he benefs of Sarbanes-Oxley ha a few companes experenced. For example hey provde evdence ha Secon 404 helped n srenghenng he conrol envronmen sandardzng processes mnmzng human error and explong convergence opporunes across dfferen deparmens whn he same frm. These sudes along wh he legslaure s belef ha here are benefs o lead me o hypohesze ha here have been benefs from. Therefore o gan a more complee pcure of he consequences of s mporan o undersand he cos and benefs of. 2.2 Imporance of Small Busnesses Pror leraure has esablshed ha smaller busnesses are an mporan drver of growh n he US economy. Accordng o Acs and Audresch (987 and 988) Baldwn and Johnson (99) as well as Acs Audresch and Feldman (994) small frms 2 are an mporan source of nnovaon n he economy. Also accordng o Brch (98) and Blackford (99) small frms 2 These sudes defne small frms as frms ha have less han 500 employees.

7 are an mporan source of employmen for he economy and generaed almos 40% of he new jobs durng 970s and 980s. Snce nnovaon and job creaon are wo very mporan facors ha lead o growh of any economy small busnesses are an mporan par of he US economy. Therefore legslaon ha leads o a declne n he growh of small busnesses can serously hamper he growh of he economy. 2.3 Small Busnesses and Accounng Problems Pror research has shown ha reporng and conrol problems are greaer n smaller frms. For example Wells (2004) fnds a dsproporonae number of occupaonal frauds were commed agans small busnesses. Knney and McDanel (989) fnd ha frms resang earnngs are normally smaller n sze. Doyle e al. (2005) have shown ha he frms reporng serous frmwde conrol ssues normally are smaller n sze. As a resul esablshng beer nernal conrols as a resul of Sarbanes-Oxley wll mprove reporng and herefore benef he fnancal saemen users of hese frms. However snce hey do no have good conrols n place already esablshng conrols wll be cosly for hese frms. 3. HYPOTHESIS DEVELOPMENT Snce small publc companes are an mporan par of fnancal markes I focus on he effec of on hese companes n my dsseraon. Accordng o he repor by he Advsory Commee for Smaller Publc Companes companes below 25 mllon USD n marke capalzaon form % of oal US marke capalzaon and conss of 50% of oal publc companes. Gven ha he Dow Jones Wlshre ndex had a marke capalzaon of 6683 bllon USD 4 as of 3 The Dow Jones Wlshre 5000 Compose Index s a broad-based sock marke ndex more han 6700 publclyraded companes and s ofen used o represen he enre Uned Saes sock marke. 4 hp://

8 November 2006 hs mples ha he smaller companes are worh 66 bllon USD. Ths s a szable amoun of marke capalzaon n absolue erms. Ths absolue magnude mples ha collecvely small companes form a bg group wh subsanal marke share. I can also be argued ha small companes have a dfferen nsuonal srucure as compared o larger companes. For example smaller publc companes are more lkely o be auded by non- Bg Four audng frms and as a resul he qualy of her auded repors mgh be lower han ha of larger companes. Also smaller companes end o focus on one ndusry and echnology whch makes easer for nvesors who wan o be on one echnology o nves n one company. Thus f he company ceases o be publc hey wll have o nves n a greaer number of companes n order o creae a porfolo wh he same rsk and reurn characerscs or he exposure o a ceran busness and s reurns mgh be unavalable. In hs paper I develop measures of coss as well as benefs of. I expec ha he secons of ha are descrbed below wll have he greaes effec on coss and benefs of he Ac. I s also mporan o recognze ha he Ac has been phased n over me as shown n Appendx B:. Secon 302 Ths secon mandaes ha dsclosure conrols and procedures mus be mananed n a company and he effecveness of her desgn and operaon mus be evaluaed. Ths secon wen no effec on Augus 29 h I requres ha all Forms 0-K and 0-Q mus:. Conan CEO/CFO cerfcaons under 302 (revew of repor no known maeral mssaemen or omsson no known falure o farly presen fnancal condon n all maeral respecs responsbly for dsclosure conrols and procedures

9 nernal dsclosure of defcences n nernal conrols or fraud dsclosure n repor of sgnfcan changes n nernal conrols); and. Conan CEO s/cfo s conclusons regardng he effecveness of he operaon and desgn of he company s dsclosure conrols and procedures. 2. Secon 404 Ths secon has 2 componens:. Managemen should manan and assess Inernal Conrols 5 over fnancal reporng.. Audors have o assess wheher he nernal conrols are effecve or no. Ths secon wen no effec on November 5 h 2004 for acceleraed flers and nonacceleraed flers are requred o mplemen by December 5 h (Noe acceleraed flers who were no large acceleraed flers go 45 exra days for her frs 404 complance repor/aud). Secon 404 s vewed as he mos cosly secon of he and has led o a lo of debae abou wheher he requremens of hs secon should be made less srngen o decrease he coss of he Ac. 3. Secon 409 Ths secon has wo man componens: a. Dsclosure of Elecronc Avalably of Flngs (effecve Dec 5 h 2002) 5 Accordng o COSO nernal conrol as defned by s a process effeced by an eny's board of drecors managemen and oher personnel desgned o provde reasonable assurance regardng he relably of fnancal reporng. Broader defnon of nernal conrols can be found a COSO s webse. 6 Non-acceleraed flers are defned as companes wh less han 75 mllon n publc floa. Acceleraed flers have more han 75 mllon and less han 700 mllon n publc floa. Large Acceleraed flers have 700 mllon or more n publc floa. Appendx D gves a more precse descrpon of acceleraed and large acceleraed flers.

10 b. Acceleraed Flng of Perodc Repors ( s Sep: Acceleraed flng for acceleraed flers reducng 0K flng me o 75 days and 0Q flng me o 40 days was mplemened on Dec 5 h nd Sep: Reducng 0K flng me o 60 days for large acceleraed flers was mplemened on Dec 5 h 2006) Apar from hese 3 secons oher mporan secons of he Ac are Secons and Coss of In hs paper I dvde he coss ha companes face as a resul of becomng complan no drec and ndrec coss. The descrpon of he wo caegores s as follows: Drec Coss: Drec coss are he addonal moneary expenses ncurred as a resul of becomng complan. Aud coss are one of he major drec coss. Grffn and Lon (2006) as well as Eldrdge and Kealey (2005) provde evdence ha and n parcular Secon 404 led o a bg ncrease n aud coss. In hs paper I compare he average ncrease n aud coss for acceleraed versus non-acceleraed flers I expec here s a fxed cos assocaed wh procurng sofware manpower ec. for becomng complan and an addonal varable cos assocaed wh monorng he hgher level of sales so overall cos s ncreasng n sales. Oher drec coss nclude he coss borne by he company o acqure and manan nernal conrol sofware ncreased employee hours o comply wh ncreased D&O nsurance premums due o ncrease n lably as a resul of and ncreased drecors fees as a resul of greaer me commmen and responsbly. I revewed a number of 0-K repors o analyze whch lne ems would be mos affeced by an ncrease n coss due o Sarbanes-Oxley. I found ha hese

11 coss were generally ncluded n Sellng General &Admnsrave (SG&A) expenses 7 and as a resul I desgn ess o deec ncreases n SG&A. Furhermore I conjecure ha he ncrease n SG&A s greaer for frms ha dsclose a maeral weakness n her Secon 404 repors as compared o frms ha do no dsclose a maeral weakness. 8 I predc ha a maeral weakness wll subsanally ncrease he cos of Secon 404 complance because n order o remedae hese weaknesses he frm wll have o esablsh more conrols whch wll requre addonal documenaon sofware and manpower. I s possble ha some of hese coss are refleced n he Cos of Goods Sold (COGS) 9. For example he salary of he employee hred o oversee conrols a he process level would be refleced n he process overhead and can be allocaed o he gven produc. Ths dscusson of drec coss suggess my frs wo hypoheses: H: Drec coss of acceleraed flers ncrease n he year he fler became Secon 404 complan. H2: Coss of flers ncrease n he year he fler fnds a maeral weakness. Indrec Coss: 20 Indrec coss are ncurred because apar from moneary expenses complance requres resources such as managemen me and may have ncreased he rsk averson of he managemen. These resources nclude he me spen by execuves of he company workng on complance problems and no on he long erm sraeges whch can affec 7 Please refer o Appendx C where I have ncluded excerps from hree dfferen 0-K flngs whch show ha Secon 404 coss were mosly ncluded n SG&A expenses. 8 Accordng o Sandard 2 an nernal conrol defcency exss when he desgn or operaon of a conrol does no allow for he mely prevenon or deecon of mssaemens. A maeral weakness s sad o exs f a sgnfcan defcency or a combnaon of sgnfcan defcences can resul n more han a remoe lkelhood ha a maeral mssaemen of he fnancal saemens wll no be prevened or deeced. 9 I also ran regressons smlar o SG&A expenses for COGS and dd no fnd any evdence ha Secon 404 coss are ncluded n COGS n hs sample. 20 Indrec cos of refers o opporuny cos of

12 he long erm as well as shor erm growh of he company. Cohen e al. (2004a) clam ha ncreased rsk averson n managers leadng o a decrease n R&D expendures as well as CAPEX and hs could furher affec he long erm growh of he company. Also here s some evdence ha mplemenaon of Secon 404 led o cubacks n R&D because he companes had o spend her lmed funds on auds raher han on R&D 2. For example hs excerp from a newspaper arcle descrbes he experence of a small publc boech company when mplemened Secon 404: A small publc boech company spen over $ on exernal subsanaon of nernal conrols. Ths onerous exercse forced he company o reassgn laboraory researchers o perform nernal conrol work dcaed by pospone he hrng of 5 o 0 addonal researchers and delay promsng research and developmen programs. 22 In hs paper I focus on esng wheher here was a decrease n Capal Expendure and R&D Expendures n he year he company became Secon 404 complan. The reason for hs predcon s ha managemen me whch s a lmed resource would have been dvered owards complance wh Secon 404. As a resul managemen would have less me o analyze and approve nvesmen projecs. In order o undersand hs argumen consder a small company A wh he followng cos and benef analyss. Before : A any gven me : NPV(Inernal Conrol Pre- ) = A = Toal fuure Benef of mplemenng IC Toal Cos of mplemenng IC 2 hp:// 22 hp://hehll.com/op-eds/scale-back-sarbanes-oxley hml

13 Now f managemen a any gven me can only mplemen n projecs n order o gve requred aenon o all he projecs and NPV(Inernal Conrol Pre- ) >0 hen he managemen mgh sll no choose o mplemen nernal conrols f: If NPV(IC) < NPV(n) < NPV(n-) < < NPV() Or n words f he NPV of nernal conrols s lower han ha of n oher projecs hen managemen wll choose no o mplemen nernal conrols. Afer : NPV(Inernal Conrol Pos- ) = A Benef of beng Publc So NPV(Inernal Conrol Pos- ) > NPV(Inernal Conrol Pre- ) As a resul he probably of mplemenaon of Inernal Conrols ncreased afer and as a resul he company would no underake a leas one of he projecs ha would have nvesed n whou he mplemenaon of. Also managemen would need o be more nvolved n desgnng conrols n case he company has a maeral weakness. As a resul ndrec coss would also be hgher. Ths dscusson leads o my second hypohess: H3: Indrec coss of acceleraed flers would ncrease n he year he fler became Secon 404 complan.

14 3.2 Benefs of Sarbanes-Oxley I beleve ha n order o undersand he benefs of Sarbanes-Oxley s mporan o assess wheher ncreased he qualy of fnancal reporng and he nformaon conen of fnancal saemens. In hs secon I explan why I expec Secon 404 o ncrease he qualy of fnancal reporng. I also descrbe how dfferen secons of n parcular Secons and 409 ncreased he nformaon conen of fnancal saemens. I hypohesze ha Sarbanes-Oxley n parcular Secon 404 ncreased he qualy of fnancal reporng by requrng frms o manan and assess nernal conrol over fnancal reporng. I expec ha mananng and assessng nernal conrol over fnancal reporng wll mprove he qualy of fnancal reporng due o ncrease n manageral nvolvemen mprovemen n he fnancal reporng process and decrease n earnngs managemen. Frs of all I expec ha Secon 404 wll ncrease n manageral nvolvemen and responsbly n he fnancal reporng process. has ncreased he nvolvemen of managers n he fnancal reporng process by requrng hem o manan and assess nernal conrols as well as by requrng CEOs and CFOs o cerfy he fnancal saemens fled wh SEC. All hese provsons of he Ac have ncreased awareness abou fnancal reporng processes 23 and ncreased he nvolvemen of managemen n he fnancal reporng process. Managers now cerfy ha hey are responsble for esablshng and mananng dsclosure conrols and procedures o provde reasonable assurance ha maeral nformaon relang o he ssuer s made known o he nvesors. I expec hs ncrease n responsbly and nvolvemen of CEO 23 hp://

15 and CFO wll ncrease he relably of fnancal saemens because wll dssuade employees lower down he herarchy from makng msakes or commng occupaonal frauds. Secondly here s evdence ha Secon 404 mproved he fnancal reporng process. The Glass Lews sudy on maeral dsclosures fnds ha he number of maeral weaknesses dsclosed by companes beween $75 mllon o $749 mllon n marke capal ha have mplemened Secon 404 decreased by 45% (from 699 maeral weakness dsclosures n 2005 o 379 dsclosures n 2006). On he oher hand maeral weakness dsclosures by non-acceleraed flers ncreased by 8% (from 573 dsclosures n 2005 o 677 dsclosures n 2006). The decrease n maeral weakness dsclosures by Secon 404 complan frms suggess ha Secon 404 requremens are effecve n mprovng nernal conrols over fnancal reporng. Also mos of he maeral weaknesses n Secon 404 complan frms were due o sysems and procedures relaed ssues. These fndngs sugges acklng hese ssues ncreases he relably of he process of fnancal reporng. Lasly I expec ha wll lead o a decrease n earnngs managemen. Esablshng nernal conrols over reporng process wll make sure ha he nformaon provded by he companes n fnancal repors s correc and wll make harder for managers o manage repored earnngs n order o mee or bea analys forecass and as a resul he qualy of ncome would ncrease. For example Cohen e al. (2006) shows ha Sarbanes-Oxley led o a decrease n accrual earnngs managemen. These reasons movae my fourh hypohess: H4: Earnngs qualy of acceleraed flers wll ncrease afer he fler becomes Secon 404 complan.

16 I plan o es for ncrease n fnancal reporng qualy by lookng a he qualy of earnngs as defned n Dechow and Dchev (2002). Anoher way of esng fnancal qualy would be o look a he ncrease n earnngs perssence afer Secon 404 came no effec 24. I furher predc ha wll ncrease nformaveness of fnancal saemens. There are hree reasons for hs predcon. Frs I expec ha wll ncrease he nformaon conen of he 0-K flng. Accounng research has shown ha adverse opnons/fndngs under Secon 302 and Secon 404 are value relevan for nvesors. Hammersley e al. (2005) show ha dsclosure of a weakness under Secon 302 leads o a negave prce reacon and ncrease n radng volume on average. Smlarly Cheng e al. (2006) fnds ha frms announcng maeral weaknesses show negave cumulave abnormal reurns n he 3 day perod surroundng he announcemen day. Also Ashbaugh-Skafe e al. (2006) shows ha he cos of capal s hgher for frms reporng defcences n nernal conrol. Secondly has ncreased he melness of he nformaon provded n nformaon saemens. Informaon s provded n a more mely manner o nvesors n he 0-K repors. Whle adopng acceleraed reporng n 2002 he SEC saed ha hey expeced ha perodc repors fled under he Exchange Ac conan valuable nformaon for nvesors and expressed concern ha an undue delay n makng avalable he perodc repor nformaon may cause he nformaon o be less valuable. As a resul accelerang he flng of 0-Ks s a way of makng hese repors more valuable o nvesors. Bryan-Kucher e al. (2005) shows ha frms ha me 24 Tesng f ERC ncreased afer mplemenaon of Secon 404 would be one of he mehods of measurng ncreased nvesor confdence n earnngs qualy.

17 he shorened deadlne were able o provde hgher qualy nformaon n a more mely manner. Ther measure of qualy was absolue dscreonary accruals measured usng Jones modfed model 25. So f frms are provdng beer qualy nformaon n a mely manner because of Secon 409 should ncrease he value of he nformaon o he marke. Lasly as dscussed before ncreased he qualy of fnancal saemens. I expec ha hgher qualy fnancal saemens are more nformave. I plan o measure hs benef by nvesor response durng 0-K flng daes. A prelmnary model for measurng hs benef s developed n hs paper. H5: Informaveness of fnancal saemens of acceleraed flers wll ncrease afer he fler becomes Secon 404 complan. 4. EMPIRICAL MODELS FOR TESTING HYPOTHESES 4. Measurng Coss of Secon 404 Complance 4.. Drec Coss There are wo prmary ess n hs paper o measure he drec coss of Sarbanes-Oxley. The frs es looks a he ncrease n SG&A expenses when he frm becomes Secon 404 complan whle he second examnes he ncrease n aud coss when he frm becomes Secon 404 complan. 25 Noe I am no really convnced ha lower dscreonary accruals acually mply beer nformaon qualy

18 4... SG&A Cos The model for SG&A coss s as follows: SGA ln( ) = j ln( ) 2 ln( ) Decrease _ Dummy SGA Aud 3 ln( ) 4 ln( ) Decrease _ Dummy 5 ln( ) 2 2 Aud MW 0 * MW 2 * MW 3 * MW ε () where for each frm and year = Revenue (Compusa: Daa 2) 2 Decrease_Dummy = Indcaor equal o f he sales decreased n hs year Aud = Aud Fees Aud Relaed Fees (Aud Analycs: Aud_Fees and Aud_Relaed_Fees) = Indcaor equal o f he frm became Secon 404 complan n year (Aud Analycs: Frs year wh 404 Inernal Repor) 2 = Indcaor equal o f he frm became Secon 404 complan n year - (Aud Analycs: Second year wh 404 Inernal Repor) 3 = Indcaor equal o f he frm became Secon 404 complan n year -2 (Aud Analycs: Second year wh 404 Inernal Repor) MW = Indcaor equal o f he frm reveals a maeral weakness n Inernal Conrol n he Secon 302/404 repor (Aud Analycs: IC_IS_EFFECTIVE) Ths es s based on he model of SG&A coss proposed by Anderson e al. (2003) who show ha SG&A coss are scky. Specfcally hey show ha SG&A coss ncrease more when revenues ncrease han hey decrease when revenues decrease by he same amoun. The reason for hs fndng s ha managers mgh delay he reducons o commed resources unl hey are more ceran ha demand has declned permanenly and as a resul a decrease n revenues s no accompaned by a decrease n coss. In hs model he coeffcen on represens he ncrease n SG&A expenses ncurred n becomng Secon 404 complan. Smlarly he

19 coeffcen on 2 represens he ncrease n SG&A expenses ncurred by flers durng he second year of becomng Secon 404 complan whle he aud varable s a conrol for he ncrease n audng coss. Hypohess predcs ha he coeffcen on should be posve. If a componen of coss when frms became 404 complan s fxed and wll no recur n he followng year hen he coeffcen on 2 wll be negave. Snce audng akes place afer he end of he fnancal year s lkely ha coss of Secon 404 coss are carred no he year afer he frm becomes 404 complan. Also based on hypohess 2 f he ncrease n SG&A s greaer for frms ha dsclose a maeral weakness n her Secon 404 repors as compared o frms ha do no dsclose maeral weaknesses hen he coeffcen on MW* should be posve Aud Cos The second es s for an ncrease n Aud coss when he frm becomes Secon 404 complan. Aud ln( Aud 3 ln( 3 ε 7 ) = j ln( 2 ) 4 ln( MW ) Decrease _ Dummy * MW ) 2 ln( 2 0 ) Decrease _ Dummy * MW * MW (2) where for each frm and year Aud = Aud Fees Aud Relaed Fees (Aud Analycs: Aud_Fees and Aud_Relaed_Fees) = Revenue (Compusa: Daa 2) Decrease_Dummy = Indcaor equal o f he sales decreased n hs year = Indcaor equal o f he frm became Secon 404 complan n year (Aud Analycs: Frs year wh 404 Inernal Repor)

20 2 = Indcaor equal o f he frm became Secon 404 complan n year - (Aud Analycs: Second year wh 404 Inernal Repor) 3 = Indcaor equal o f he frm became Secon 404 complan n year -2 (Aud Analycs: Second year wh 404 Inernal Repor) MW = Indcaor equal o f he frm reveals a maeral weakness n Inernal Conrol n he Secon 302/404 repor (Aud Analycs: IC_IS_EFFECTIVE) Ths es s smlar o he es for SG&A coss. In hs model he coeffcen on represens he ncrease n Aud coss ncurred as a resul of becomng Secon 404 complan. Smlarly 2 denoes he ncrease n Aud Coss ncurred by flers durng he second year of becomng Secon 404 complan. The coeffcen on MW* corresponds o addonal ncrease n aud coss for companes ha dsclose a maeral weakness n her Secon 404 repors. Based on Hypohess he coeffcen on should be posve. If a componen of aud coss n he year frms became 404 complan s fxed and wll no recur n he nex year hen he coeffcen on 2 should be negave. Also he coeffcen on MW* should be posve f he aud coss of companes ha dsclose maeral weakness s hgher based on hypohess Indrec Coss In order o measure he ndrec coss of Sarbanes-Oxley I plan o es wheher a frm decreased nvesmen n a year n whch becomes Secon 404 complan. I es for hs by lookng a changes n capal expendures and R&D expendures separaely. All hese expendures are mporan for he fuure growh of he company and a decrease n hem due o dverson of managemen me can negavely affec he fuure growh of he company.

21 4..2. Research and Developmen Expenses Addonal models are used o examne Research & Developmen expenses and Capal Expendure. The model for Research and Developmen Expenses s as follows: R & D j VP 2Lev 3Cash MW 2 * MW 3 * MW ε = where for every frm n gven year and ndusry j: RD = Research and Developmen expense (Daa 46: Compusa) V/P = Measure of growh opporunes rao of he value of frm and he marke value of equy smlar o Tobn s Q V= (-αr) BVE α (r) OI -α r*dv where r=2% and α= (ω/ (ω-r)) where BVE s he Book Value of Equy OI s operang ncome and Dv s dvdend pad P = Marke Value of Equy 2 Lev = Leverage Book Value of Toal Deb/Toal Asses ((Daa 9 Daa 34)/ (Daa 9 Daa 34 Daa 60): Compusa) Sze = log of oal asses n begnnng of he year (lag (Daa 6): Compusa) Cash= Cash and Shor erm nvesmens (Daa : Compusa) = Indcaor equal o f he frm became Secon 404 complan n year (Aud Analycs: Frs year wh 404 Inernal Repor) 2 = Indcaor equal o f he frm became Secon 404 complan n year - (Aud Analycs: Second year wh 404 Inernal Repor) 3 = Indcaor equal o f he frm became Secon 404 complan n year -2 (Aud Analycs: Second year wh 404 Inernal Repor) MW = Indcaor equal o f he frm reveals a maeral weakness n Inernal Conrol n he Secon 302/404 repor (Aud Analycs: IC_IS_EFFECTIVE) RD = Research and Developmen expense (Daa 46: Compusa) 4Sze 5RD 0 * MW (3)

22 Ths model measures he change n R&D n he year a frm becomes Secon 404 complan. V/P 26 s a measure of growh opporunes where he value of he frm s calculaed usng Ohlson (995) framework whch assumes ha prce s equal o dscouned expeced dvdends cleansurplus relaon hold and abnormal earnngs follow an auo-regressve process and have a perssence parameer equal o ω. Ths measure of book value of equy ncludes book value of equy earnngs and dvdends and as a resul akes no accoun nangble asses and hence s a beer measure of he value of exsng asses I use V/P as a varable n hs model nsead of Tobn s Q because I ancpae ha he value of a frm calculaed usng Ohlson (995) framework akes he value of unrecognzed nangble asses no accoun. As a resul V/P would be a beer predcor of R&D expendure whch n effec s an expendure on an unrecognzed nangble asse. Please refer o he descrpon of model 3 n secon for a dealed dscusson of V/P. Oher conrol varables lke cash level leverage and sze are ncluded because pror sudes such as Hall (992) Hall and Reenen(999) Hmmelberg and Peersen (994) and Hubbard (998) have shown ha hese are mporan conrols. 27 In hs model he coeffcen on represens he change n R&D expendure as a resul of becomng Secon 404 complan. The coeffcen on MW* corresponds o addonal change n R&D expendure ncurred by companes ha dsclose a maeral weakness n her nernal conrol repor. Hypohess 3 predcs ha he coeffcen on should be negave. Smlarly can be assumed ha wll harder for frms wh maeral weaknesses o become 404 complan and as a 26 V/P was used n Rchardson (2006). 27 Noe I dd no nclude operang ncome whch s one of he common varables used n R&D regressons no he equaon because V/P s composed of operang ncome.

23 resul her R&D expendure could decrease even more n he year hey become Secon 404 complan as predced by Hypohess 2. I also consder he neracon of wh cash because as dscussed earler here s evdence ha some frms had o cu back on R&D expendures due o cash consrans. As a resul I would expec ha he cash consran would become even more mporan n he year n whch he frm becomes Secon 404 complan and herefore he coeffcen on hs erm would be posve Capal Expendure I also run separae ess for capal expendures. The model used o es Capal Expendure s as follows: CAPEX = Inv _ Q CAPEX j 3 6 * MW ε 7 MW 2 8 CF 3 * MW * MW (4) where for every frm n gven year and ndusry j: CAPEX = Capal Expendure (Daa 28: Compusa) Inv_Q = Inverse of Tobn s Q = (Book Value of Asses/Marke Value of Asses) s a measure of growh opporunes of a frm ((Daa 25 * Daa 99 Daa 6 Daa 60)/Daa 6: Compusa) CF = Cash from operaons (Daa 308: Compusa) In hs model Inv_Q conrols for he growh opporunes avalable o he frm 28. Tobn (969) and Hayash (982) show ha under ceran condons Tobn s Q capures all nvesmen opporunes. I nclude cash flows n he model because Fazzar Hubbard and Bruce (988) show ha cash flow conrols for fnancng consrans n he model. I also conrol for leverage n hs model because frms wh hgh leverage mgh have deb covenans whch mgh resrc 28 McNchols and Subben use nverse of Tobn s Q because he dsrbuon of he recprocal s less skewed leadng o more desrable properes for he regresson analyss.

24 hem from nvesng n some projecs and as a resul I would expec ha capal expendure would decrease wh ncrease n leverage. In hs model he coeffcen on represens he change n capal expendure as a resul of becomng Secon 404 complan. The coeffcen on MW* corresponds o addonal change n capal expendure ncurred by companes ha dsclose a maeral weakness n her nernal conrol repor. Hypohess 3 predcs ha he coeffcen on should be negave. Smlarly can be expeced ha wll be harder for frms wh maeral weaknesses o become Secon 404 complan and as a resul her capal expendure could decrease even more n he year hey become Secon 404 complan. On he oher hand s possble ha becomng Secon 404 complan reduces he cos of capal for hese frms because now her earnngs are of hgher qualy and also because here s more nformaon abou frms n he fnancal saemen whch reduces nformaon asymmery. As a resul hese frms would be able o underake more capal expendure projecs. In hs case I would expec ha he coeffcen on would be posve Measurng Benefs of 4.2. Earnngs Qualy The measure of accounng qualy n hs paper s he accrual qualy from he modfed Dechow and Dchev (2002) model dscussed n McNchols (2002). The model whch wll be esmaed for each 2 dg SIC code based on quarerly daa s as follows 29 : ΔWC 5 j = PPE j 3 j n= CFO 6n j QTR n 2 j ε CFO 3 j CFO 4 j Δ (5) 29 Dhalwal e al. (2007) have used he model n quarerly specfcaon wh a seasonaly facor

25 Where for every frm quarer and ndusry j ΔWC= Changes n workng capal accouns CFO= Cash from operaons Δ= Changes n sales PPE= Propery plan and equpmen QTR = Indcaor varable equal o f he fscal quarer equal o n Ths model s smlar o he quarerly model presened n Dhalwal e al. (2007). Accordng o hs model he qualy of accruals depends on how closely he accruals are relaed o he pas presen and fuure cash flow realzaons. The error erm from he model represens he earnngs qualy of he frm. The furher s from zero he lower s he qualy. I also calculae he model esmaed for each 2 dg SIC code based on quarerly daa whle allowng he coeffcens o ake dfferen values n case hey have a loss n he gven year. In ha case he esmaon equaon looks lke: ΔWC 5 j 3 n= CFO = 9n j j QTR * Loss n j Where for every frm quarer and ndusry j ε Loss 6 j 2 j CFO CFO * Loss 3 j CFO 7 j Δ * Loss 8 j 4 j PPE CFO (6) Loss = Indcaor varable equal o f he Earnngs before exraordnary ems n a gven quarer s less han 0.

26 My measure of earnngs qualy s he sandard devaon of resduals before and afer company becomes Secon 404 complan 30. The effec of on earnngs qualy would be measured by he followng model whch s based on Dhalwal e al. (2007): Qualy = α α BgFour α AvgSze α σ ( ) 6 α MW * 0 α Loss 7 ε 8 2 α α MW 9 α OpCycle 3 α MW * 0 α In 4 α σ ( CFO) 5 (7) where for every frm n ndusry j Qualy = Earnngs qualy BgFour = Indcaor equal o n year f he audor was Bg Four n all he quarers Average Sze = Average of oal asses across all quarers OpCycle = average of log(operang Cycle) across all quarers In = Average of R&D nvesmen across all quarers σ(cfo) = Sandard devaon of cash from operaons across all quarers σ() = Sandard devaon of sales across all quarers Loss = Indcaor equal o f number of quarers of loss s greaer han quarers of prof = Indcaor equal o afer he company becomes Secon 404 complan MW = Indcaor equal o f he company dsclosed a maeral weakness In hs model he coeffcen on represens he ncrease n earnngs qualy as a resul of becomng Secon 404 complan. The coeffcen on MW* corresponds o he change n earnng qualy of companes ha dsclose a maeral weakness n her nernal conrol repor. Hypohess 4 predcs ha he coeffcen on should be negave. However s no clear how he earnngs qualy would change for a frm ha dscloses maeral weakness hough s 30 I requre a company o have nformaon for a leas 4 quarers before and afer becomng Secon 404 complan o calculae he sandard devaon. I repeaed he analyss by ncreasng he requremen o 5 and 6 quarers and he resuls were comparable o he resuls presened n hs paper.

27 clear ha earnngs qualy would ncrease for hese frms once her nernal conrols become effecve. Ths model ncludes conrols for operang cycle sandard devaon of cash flow sandard devaon of sales followng Dechow and Dchev (2002) and conrols for nvesmen n nangbles because Francs Lafond Olsson and Schpper (2004) fnd ha ncreased nvesmen n nangbles decreases earnngs qualy Informaveness of Fnancal Saemens In order o es wheher nformaveness of fnancal saemens ncreases afer I wll examne he relaon beween he sock prce response around he 0-K flng dae and varables relaed o. Specfcally I wll es he followng model: ER = 0 NT 2MW 3ICD 4Secon302 5 AccFlng 6Secon404 ε where for every frm n gven year : (8) ER = 2-day mean sandardzed sgned/unsgned excess reurn measured usng Sharpe and Lnner model around he 0-K flng day NT = f here s a pror Form NT-0K flng for he same perod MW = Indcaor equal o f he frm reveals a maeral weakness n Inernal Conrol n he Secon 302/404 repor (Aud Analycs: IC_IS_EFFECTIVE) ICD= Indcaor equal o f he frm reveals a nernal conrol defcency n Inernal Conrol n he Secon 302/404 repor (Aud Analycs: SIG_DEFICIENCY) Secon302 = Indcaor varable equal o f he flng s afer Augus 29 h 2002 and as a resul was Secon 302 complan AccFlng = Indcaor varable equal o f he flng was an acceleraed flng afer December 5 h 2003 Secon404 = Indcaor varable equal o f he flng was made by Secon 404 complan frm (Aud Analycs: Year wh 404 Inernal Repor)

28 In hs model he dependen varable ER s smlar o Beaver (968) U-Sasc and capures he unusual prce movemen n he flng perod. The coeffcen on Secon302 capures he ncrease n 0-K nformaveness as a resul of Secon 302 complance. Smlarly he coeffcen on AccFlng reflecs he ncrease n 0-K nformaveness due o acceleraed flng and he coeffcen on Secon404 capures he ncrease n nformaveness because of Secon 404 complance. Ths model assumes ha nvesors beleve ha all he nformaon n he flng s relevan for frm valuaon and hence respond o hs nformaon. Even hough I have presened hs model for 0-K flngs smlar analyses can be done for earnngs announcemens because I expec ha annual/quarerly earnngs mgh be announced earler because of acceleraon of fnancal saemen flng daes. Also ncrease n qualy of earnngs wll ncrease he nformaveness of earnngs dsclosure. 5. SAMPLE AND RESULTS 5. Sample: In hs sudy I use 2 dfferen samples o undersand he effec of Sarbanes-Oxley on small publc companes. Frs I use he daa from Aud Analycs and Compusa of companes ha are secon 404 complan and dvde no 3 dfferen caegores namely small medum and large flers based on asse sze n he year of complance. There are 753 companes wh asses beween mllon and 50 mllon USD n 2007 n hs sample. Also here are 70 companes beween 50 mllon o bllon USD and 38 companes above bllon USD n asses. Then I run regressons ndvdually on every group o fnd f here s a dfferen effec of beween hese groups. One dsadvanage of usng daa only from acceleraed flers s ha s hard o conrol for macro-economc facors n parcular for he cos sudes. Therefore I use a second

29 daase where usng Aud Analycs I mach he 753 companes wh asses beween mllon and 50 mllon USD n 2007 whch are Secon 404 complan wh 000 companes beween mllon o 50 mllon USD n asses durng 2007 whch are no Secon 404 complan. An mporan advanage of he second sample s ha I explo he defnon of acceleraed and non-acceleraed flers o conrol for oher macro-economc facors n he sudy. Snce acceleraed and non-acceleraed flers dffer on he dmenson of publc floa 3 here are nonacceleraed flers ha mach an acceleraed fler on all dmensons oher han publc floa. These non-acceleraed flers provde a good conrol group for hs sudy because by machng smaller acceleraed flers wh non-acceleraed flers based on ndusry and sze I can conrol for ndusry-relaed and macro-economc facors affecng frms n he perod hey mplemened. I choose companes based on oal asse sze because he sze of a company s a beer ndcaor of s resources compared o marke value of equy and hus he dffculy mgh encouner n complyng wh Secon 404. I chose he lm of 50 mllon because gven he cos range of 900 housand o 2.5 mllon as esmaed by he Advsory Commee for Smaller Publc Companes for becomng complan; 32 coss would have been a more sgnfcan fnancal burden for hese companes. I colleced a machng sample of 428 frms ha are acceleraed flers afer combnng daa from Aud Analycs and Compusa. Table 2 Panel A explans he sample dervaon for he second daase n deal. I deermne he frs year of Secon 404 complance by he fnancal year n whch he frs Secon 404 repor s 3 Publc floa s he number of freely raded shares n he hands of he publc. Floa s calculaed as Shares Ousandng mnus Shares Owned by Insders 5% Owners and Rule 44 Shares. Acceleraed flers have publc floa beween mllon whle non-acceleraed flers have publc floa less han 75 mllon. 32 Advsory commee repor on Smaller Publc Companes

30 fled by he acceleraed fler. Ths mehodology dffers from he prevous leraure whch assumes ha all flers become Secon 404 complan n fnancal year As Table 2 panel C shows almos 42% of he frs year of he complance would have been msclassfed for small frms f I had assumed ha all he acceleraed flers became complan n 2004 smlarly 3% and 26% of he frs year of complance for medum and large frms would have been msclassfed. Also n case of he mached sample almos 33% of frs year of complance would have been msclassfed. I mach each acceleraed fler wh a non-acceleraed fler wh he same 3 dg SIC code and he closes asse sze. The mean (medan) dfference n asse sze beween acceleraed flers and nonacceleraed flers s mllon (.4 mllon) and he mean (medan) dfference n marke value of equy s almos 35 mllon (00 mllon) n he year of complance. The mean marke capal for non-acceleraed flers s 43 mllon and for acceleraed flers s 78 mllon. I obaned SG&A sales and nvesmen from Compusa. The daa on aud fees and aud relaed fees was obaned from Aud Analycs. Table provdes he descrpon and source for all he varables used n he analyss. Table 3 panel A presens he descrpve sascs for small frms medum and large frms. Accordng o hs able he average small medum and large companes have 84 mllon 430 mllon and 7 bllon n sales and 88 mllon 496 mllon 9 bllon n asses respecvely. The mean marke value of equy for hese frms s 95 mllon 608 mllon 9.6 bllon respecvely. Also small frms pay 370 housand n aud fees whle medum and large frms pay 690 housand and 3.4 mllon respecvely.

31 Accordng o he descrpve sascs n Table 3 Panel B for he mached sample he average acceleraed fler n he sample has 8. mllon n asses and 98. mllon n sales whle he average non-acceleraed fler has 08.9 mllon n asses and 43.5 mllon n sales. The average marke value of equy of he acceleraed fler s 93 mllon and on average he aud fee of hese flers s 380 housand whle non-acceleraed flers have marke value of equy of 58.4 mllon and pay 20 housand n aud fees. In boh he samples I deleed all he observaons for he year n whch he companes wen hrough merger acquson or any accounng change 33. In order o examne he daa for oulers I compared Pearson and Spearman correlaon beween all he varables and found hey were conssen. Also n order o make sure ha flers were no acvely choosng o say below 75 USD mllon n marke floa n he mached sample I looked a he dsrbuon of marke floa of frms no flng Secon 404 repors whch s presened n Appendx D and I found ha he dsrbuon seems prey connuous and here does no seem o be any dsconnuy around 75 mllon dollar mark. In furher analyss no presened n hs paper I also looked a dfferences n paerns of repurchase of socks by he non-acceleraed and acceleraed flers and dd no fnd any dfference ha would sugges ha he non-acceleraed flers are acvely ryng o manan her saus. Table 4 presens he descrpve sascs of maeral weakness dsclosures by he small medum and large frms. Accordng o he daa more han 32% of all he small frms had a maeral weakness dsclosure whle 30% of he medum frms and 7% of he large frms dsclosed a maeral weakness. Also almos 0 o 20% of he frms wh maeral weakness dscovered he 33 I s really mporan o delee observaons from hese years oherwse hese observaons can lead o ncorrec fndngs. For example when I looked a COGS regressons wh hese observaons seemed ha hose coss were also ncreasng bu once I deleed hose observaons hen all he coeffcens became nsgnfcan.

32 weakness before he frs year of Secon 404 flng. Ths mples ha Secon 404 audng s acually a very mporan sep n analyzng nernal conrols of he frm. 5.2 Resuls 5.2. Drec Coss Tables 5 and 6 presen he esmaon resuls for he drec coss. Table 5 Panel A presens he resuls from esmang model wh ndusry fxed effecs for SG&A expenses for all 3 groups. Conssen wh Hypohess he coeffcen on s posve and sgnfcan. The coeffcen on around for small frms and s sascally sgnfcan a 0.0 level whle s around for medum frms and large frms. Ths mples ha Secon 404 was cosler o mplemen for small frms compared o medum or large frms. Also he fndng for large frms mples ha hey n general had nernal conrols n place before hey underwen Secon audng under. Afer akng no accoun he ncrease n aud fees and all he oher varables he coeffcen of for small flers s whch mples ha here s a 5.2% ncrease n SG&A n he year he acceleraed flers became Secon 404 complan and he coeffcen on 2 s sgnfcan whch mples here an ncrease n SG&A n he second year of Secon 404 complance as well. Ths mples ha we need o conrol for macro-economc effecs n order o fnd he acual ncrease n SG&A coss due o Secon 404 for small fler. Also he coeffcen on MW s no sascally sgnfcan whch mples ha jus dsclosng maeral weakness does no ncrease SG&A for a frm. In addon he coeffcen on MW* s around 2% and s margnally sgnfcan a 0.0 level mplyng companes wh maeral weaknesses mgh have pad more n 34 I should be noed ha companes are requred o manan nernal conrol over fnancal reporng under he Foregn Corrup Pracces Ac of 977.

33 he year of Secon 404 complance han companes wh no defcences bu hs paper does no enough evdence o suppor hs fndng. Smlarly MW*2 s posve and sascally sgnfcan a 0.0 level mplyng ha frms ha dsclosed maeral weakness n he second year of Secon 404 ncurred addonal expenses. Table 5 Panel B presens he resuls for model wh year and fxed effecs for he mached sample. Accordng o hs able ncrease n cos for small frms was around 5% of SG&A for small frms n frs year of Secon 404 mplemenaon and here was no ncrease n coss n he second year of Secon 404 mplemenaon. Ths mples ha he ncrease n second year of Secon 404 ha was found n Panel A was due o macro-economc facors. Accordng o hs able he acual ncrease n coss of small flers due o Secon 404 afer accounng for audng coss s around 3.94%. Because SG&A expenses average around 3 mllon dollars hs mples average Secon 404 complance cos s approxmaely.2 mllon dollars every year. Table 6 Panel A presens he esmaon resuls for model 2 wh ndusry fxed effecs for audng coss of small medum and large flers. The coeffcen on small flers s 0.5 and s sascally sgnfcan a 0.0 level. Ths ndcaes ha here s an ncrease of a leas 5% n audng coss n he frs year n whch he small fler became Secon 404 complan. Smlarly he coeffcen for medum and large flers s 0.48 and 0.36 respecvely. Ths mples ha ncrease n audng coss for he small frms due o mplemenaon of Secon 404 was much greaer han he larger frms. Also he coeffcen on 2 s negave and sascally sgnfcan a 0.0 level. The coeffcen on 2 ndcaes almos a 9% decrease n audng coss n he second year for small flers wh no maeral weakness n nernal conrols whle here was a 22% decrease n aud coss for boh medum and large flers.

34 The coeffcen on MW s posve and sascally nsgnfcan a 0.0 level. Ths mples ha frms dsclosng a maeral weakness mgh have hgher coss bu here s no enough evdence o suppor hs n our daa. In addon he coeffcen on *MW s 0.30 and on 2*MW s 0.28 for small frms and hey are sascally sgnfcan. Ths mples ha frms dsclosng a maeral weakness n he frs year or second year of Secon 404 complance ncur addonal audng coss. These fndngs ndcae ha aud coss ncreased by almos 50 housand for small flers when hey became Secon 404 complan f hey do no have any maeral weakness. Also he coeffcen of MW n he frs year ndcaes ha he frm s audng coss ncrease by an addonal 00 housand dollars f hey have a maeral weakness n he frs or second year of Secon 404 complance. Also he fndngs n Panel B suppor he fndngs n Panel A of he able. Snce audng coss are less han 2% of he oal SG&A expenses he esmaes of 5% ncrease n audng coss explans only.02 % ncrease n SG&A expenses. Therefore a large poron of he ncrease n SG&A expenses can be arbued o non-audng coss ncurred whn he frm due o Secon 404. My fndngs are slghly lower han he 2 o 3 mllon dollar esmae of Secon 404 coss noed by Grady (2007). However gven he average marke capal of he small companes s less han 200 mllon he fac ha relaed coss mgh no be a oneme expense bu a recurrng expense mgh be a bg cause of concern for hese companes Indrec Coss Table 7 Panel A presens he resuls from he R&D model wh fxed ndusry effecs for small medum and large flers. The fndngs n Table 7 ndcae ha R&D expenses for small flers 35 Noe ha more years of daa s needed o analyze how he coss for Secon 404 mplemenaon decreased for he small companes.

35 declned n he year of complance and are sgnfcan a 0.0 level conssen wh my predcons. The coeffcen of for medum fler s negave and no sascally sgnfcan whle he coeffcen for large fler s posve and no sascally sgnfcan. Ths mples ha he ndrec cos of Secon 404 was hgher for small flers compared o large flers. The average rao of R&D expenses o Toal Asses s around % and coeffcens on s around -0. whch mples ha R&D declned around % of oal asses n he year of Secon 404 complance. Ths fndng s suppored by he mached sample resuls n Panel B of able 7 hough afer akng no macro-economc facors hs decrease seems o be around 0.5% of oal asses. Pror research by Grlches (98) Pakes (985) Jaffe (986) and Salnger (984) fnds ha R&D expendures are an mporan drver of fuure growh. Consequenly a decrease n R&D can adversely affec he fuure growh of a frm and s value 36. Ths s n lne wh he dscusson ha companes ha faced consrans because of Secon 404 coss reduced on R&D expendures. Even hough hs resul can be explaned by lack of manageral aenon here are several alernave explanaons for hs fndng. For example earnngs managemen o mee earnngs arge can explan hs fndng snce pror research lke Bushee (998) has shown ha managers can cu R&D o mee earnngs arge. From he earler resuls n hs paper we know ha SG&A ncreased n he year he small frms became Secon 404 complan herefore s possble ha managemen cu her R&D budge n order o mee earnngs arges. Table 8 Panel A presens he esmaed resuls for he capal expendure model for small medum and large flers. The fndngs for hs model mply ha capal expendure ncreased 36 Also n furher analyss he coeffcen of he neracon of cash wh was found o be posve mplyng ha change n cash became a bgger consran for hese companes when hey become Secon 404 complan.

36 once he companes became Secon 404 complan. The coeffcens of and 2 for CAPEX are posve and sascally sgnfcan for all flers ndcang an ncrease n CAPEX n he frs and second year of Secon 404 complance. The coeffcen on ranges beween 0.00 and for small o large flers and he coeffcen s beween 0.02 and for 2 for small o large flers also he coeffcens are sascally sgnfcan a 0.0 level. Ths mples ha capal expendure ncreased by 2 o 3% n he frs year of Secon 404 mplemenaon for all flers. There was a smlar ncrease n capal expendure n he second year. Ths s no conssen wh hypohess 3 bu s conssen wh he dscusson ha cos of equy mgh have reduced for hese companes as a resul of Secon 404 complance due o ncrease n earnngs qualy 37. The fndngs n Panel A for small flers are suppored by smlar fndngs n Panel B for he mached sample of flers. These fndngs need o be explored furher because I beleve ha cos of equy would decrease only afer he frm comples wh Secon 404 and as a resul he ncrease n capal expendure n frs year of Secon 404 complance canno be arbued o reduced cos of equy Earnngs Qualy 38 Table 9 presens he descrpve sascs of he earnngs qualy varables. The mean of sandard devaon of resduals of he sample s 0.0 and for small flers whle s around for large flers. Ths mples ha earnngs qualy of frms decrease wh decrease n sze. Ths resul s expeced because dfferen sze frms are probably n dfferen sages of produc lfe cycle and as a resul hey focus on dfferen aspecs of busness o maxmze shareholder value. 37 We know from Francs Lafond Olsson and Schpper (2004) ha cos of equy for a frm wh hgh accrual qualy s lower han a frm wh low accrual qualy. 38 There are only 324 companes n he fnal sample for earnngs qualy because he oher 6 companes were mssng cash flow daa.

37 Also s neresng o noe ha he probably of beng auded by a Bg Four audor ncreases wh ncrease n frm sze. The correlaon marx ndcaes ha here s a decrease n sandard devaon of resduals or an ncrease n earnngs qualy for all frms afer Secon 404 came no effec. Also accordng o he resuls of regresson of earnngs qualy n Table 0 seems ha earnngs qualy ncreased afer he frms became Secon 404 complan. The coeffcen of s around for small flers and s sascally sgnfcan a 0.0 level whch mples almos a 20% decrease n sandard devaon based on he mean of 0.0 for he sample. Ths fndng s n lne wh hypohess Also here seems o be an ncrease n earnngs qualy for medum and large flers as mpled by coeffcens around and respecvely all coeffcens are sascally sgnfcan a 0.0 level. Also small flers have he hghes ncrease n absolue qualy bu he relave mprovemen n qualy for medum flers (6%) and large (7%) flers s prey smlar o small flers. 5.3 Sensvy Analyss and Addonal Tess I repeaed he analyss n hs paper by machng he non-acceleraed sample based on marke value of equy nsead of asse sze and found smlar resuls. I have also looked a he changes regressons for nvesmen nsead of levels regresson and my fndngs were conssen wh he fndngs n hs paper. All he resuls presened n hs paper excep he earnngs qualy regressons are based on robus regresson analyss 40. Accordng o Huber (98) and Rousseeuw and Leroy (986) robus regresson s robus wh respec o oulers and does no assume normaly of errors. Ths regresson comprses of hree seps. In he frs sep he algorhm selecs an nal esmae of coeffcens based on Ordnary Leas Squares (OLS). In 39 I also repeaed hs analyss on frm level and found smlar resuls. 40 M-mehod s used n he resuls.

38 second sep resdual and assocaed wegh from prevous eraon s calculaed. In he hrd sep he algorhm solves for he new weghed leas square esmae. The second and hrd seps are repeaed ll he esmaed coeffcens converge. The coeffcens from he model can be nerpreed n he same way as OLS esmaes. I also ran regressons for change n SG&A audng coss and nvesmen whle allowng for cross-seconal correlaon and he resuls remaned unchanged. 6. CONCLUSION In hs paper I es he coss and benefs of on smaller publc companes. The resuls so far ndcae ha mplemenng Secon 404 of was very cosly for smaller publc companes and herefore he non-acceleraed flers ha wll become Secon 404 complan n he nex few years need o be ready o pay a much hgher cos for beng publc n he US. The hgher coss requred o mplemen Secon 404 are boh drec and ndrec. In addon he ess for earnngs qualy ndcae ha mplemenng Secon 404 n fac ncreased he qualy of earnngs for all publc companes. Ths mples ha even hough coss of mplemenng Secon 404 are really hgh here are some benefs as well and n order o compleely undersand he mplcaons of he Ac s mporan o sudy he benefs n more deal. Some of he fuure work ha remans o be done s as follows: ) Develop a beer undersandng of he fndng ha capal expendure ncreased n he year of Secon 404 complance. I would lke o undersand f hs ncrease s a resul of decrease n cos of capal due o beer fnancal qualy or f here are oher reasons for hs fndng.

39 ) The new Audng Sandard 5 (AS5) whch became effecve n Augus 2007 mgh change he cos and benef srucure of Secon 404. I would be neresng o es how he coss and benefs of Secon 404 are dfferen under AS2 and AS5. ) v) Add nformaon abou corporae governance o he ess n hs paper. I wll be neresng o sudy f here s a decrease n coss of n parcular audng coss as audng frms learn more abou Secon 404 over me and herefore mgh become more effcen n esng conrols n new frms n 2006 han n 2005.

40 References: Acs Zolan and Audresch Davd 987 Innovaon Marke Srucure and Frm Sze The Revew of Economcs and Sascs 69: Acs Zolan and Audresch Davd 988 Innovaon n Large and Small Frms: An Emprcal Analyss The Amercan Economc Revew 78: Acs Zolan Audresch Davd and Maryann Feldman 994 R&D Spllovers and Recpen Frm Sze The Revew of Economcs and Sascs 76: Anderson M. Banker R.D. and Janakraman S.N 2003 Are Sellng General and Admnsrave coss scky? Journal of Accounng Research 4 : Ashbaugh-Skafe Holls Collns Danel W. Knney Jr. Wllam R. and LaFond Ryan 2006 "The Effec of Inernal Conrol Defcences on Frm Rsk and Cos of Equy Capal" hp://ssrn.com/absrac= Baldwn John and Johnson Joanne 99 Enry Innovaon and Frm Growh Are Small Frms Imporan Ther Role and Impac W. Beaver 968 The nformaon conen of annual earnngs announcemens Journal of Accounng Research 6: Bhaacharya U. P. Groznk and B. Haslem 2002 Is CEO Cerfcaon Credble? Regulaon 26: 8-0. Davd Brch 98 Who Creaes Jobs? The Publc Ineres 65: 3-4. Mansel G. Blackford 99 A Hsory of Small Busness n Amerca Frederck A. Praeger Publshers Boosan C. 997 Dsclosure Level and he Cos of Equy Capal. The Accounng Revew 72: Bran J. Bushee 998 The Influence of Insuonal Invesors on Myopc R&D Invesmen Behavor The Accounng Revew 73: Bryan-Kucher Lsa Peng Emma Yan and Zvnaks Krsna 2005 "Tmelness and Qualy of 0-K Flngs: The Impac of he Acceleraed Flng Deadlne" hp://ssrn.com/absrac= Carney W. "The Coss of Beng Publc Afer Sarbanes-Oxley: The Irony of 'Gong Prvae'" (February 2005). Emory Law and Economcs Research Paper No ChambersA E. and PenmanS J. 984 Tmelness of Reporng and he Sock Prce Reacon o Earnngs Announcemens Journal of Accounng Research 22: 2-47.

41 Cheng C.S. Agnes Ho Joanna L.Y. and Tan Feng 2006 An Emprcal Analyss of Valuerelevance of Dsclosure of Maeral Weaknesses under Secon 404 hp://ssrn.com/absrac= Cohen D. A. Dey and T. Lys 2006 Real and Accrual-based Earnngs Managemen n he Preand Pos-Sarbanes Oxley Perods Workng paper Norhwesern Unversy and Unversy of Souhern Calforna. Cohen D A. Dey and T. Lys 2004 The Sarbanes Oxley Ac of 2002: Implcaons for Compensaon Srucure and Rsk-Takng Incenves of CEOs Workng paper Norhwesern Unversy and Unversy of Souhern Calforna. COSO Webse: hp:// Dechow P. M. and I. D. Dchev 2002 The Qualy of Accruals and Earnngs: The Role of Accrual Esmaon Errors The Accounng Revew 77: DeFond M R. Hann and X. Hu 2004 Does he Marke Value Fnancal Experse on Aud Commees of Boards of Drecors? Workng paper Unversy of Souhern Calforna. Dhalwal D.S. V. Naker and F. Navss 2007 "Aud Commee Fnancal Experse Corporae Governance and Accruals Qualy: An Emprcal Analyss" Unversy of Arzona Workng Paper Damond D. and R. 99 Verreccha Dsclosure Lqudy and he Cos of Capal The Journal of Fnance 46: Doyle J. W. Ge and S. McVay 2005 Deermnans of weaknesses n nernal conrol over fnancal reporng Workng paper Unversy of Mchgan. Eldrdge S. W. and B. T. Kealey 2005 " Coss: Audor Aesaon under Secon 404" hp://ssrn.com/absrac= Engel E. R.M. Hayes and X. Wang 2005 The Sarbanes-Oxley Ac and Frms Gong-Prvae Decsons Workng paper Unversy of Chcago. Fazzar S. R.G. Hubbard and B.C. Peersen 998 "Fnancng Consrans and Corporae Invesmen" Brookngs Paper on Economc Acvy :4-95. Francs J. R. LaFond P. Olsson and K. Schpper 2004 Coss of Equy and Earnngs Arbues Accounng Revew 79: Ghosh A Z. Gu and P.C. Jan2005 Susaned Earnngs and Revenue Growh Earnngs Qualy and Earnngs Response Coeffcens Revew of Accounng Sudes 0: Grffn Paul A Go Informaon? Invesor Response o Form 0-K and Form 0-Q EDGAR Flngs. Revew of Accounng Sudes 8:

42 Grffn Paul A and D. Lon 2006 An Analyss of Aud Fees Followng he Passage of Sarbanes-Oxley Workng paper Unversy of Calforna Davs. Zv Grlches 98 Marke Value R&D and Paens Economc Leers 7: Mark Grohe 2007 The Maerally Weak Glass Lews & Co. Repor. Bronmyn Hall 992 "Invesmen and Research and Developmen a he Frm Level: Does he Source of Fnancng Maer?" NBER workng paper Hall B.H.. and J. van Reenen 999 How effecve are fscal ncenves for R&D? A revew of he evdence NBER workng paper. Hammersley Jacquelne S. Myers Lnda A. and Shakespeare Caherne2005 "Marke Reacons o he Dsclosure of Inernal Conrol Weaknesses and o he Characerscs of hose Weaknesses under Secon 302 of he Sarbanes Oxley Ac of 2002" hp://ssrn.com/absrac= Handa P and S. C. Lnn 993 Arbrage Prcng wh Esmaon Rsk The Journal of Fnancal and Quanave Analyss 28: F. Hayash 982 Tobn s margnal q and average q: a neoclasscal nerpreaon Economerca 50: Hmmelberg C.P. and BC Peersen 994 "R&D and Inernal Fnance: A Panel Sudy of Small Frms n Hgh-Tech Indusres" The Revew of Economcs and Sascs 76: 38-5 Hosak Peer Karaoglu Emre Emre Lys Thomas and Yang Yong George 2007 "An Examnaon of he Impac of he Sarbanes-Oxley Ac on he Aracveness of US Capal Markes for Foregn Frms" hp://ssrn.com/absrac= R.G.Hubbard 998 Capal-marke mperfecons and nvesmen Journal of Economc Leraure 36: P.J. Huber 98 Robus Sascs John Wley & Sons New York. Adam B. Jaffe 986 Technologcal Opporuny and Spllovers of R&D: Evdence from frms paens profs and marke value Amercan Economc Revew 76: Knney W. R. Jr. and L. S. McDanel 989 Characerscs of Frms Correcng Prevously Repored Quarerly Earnngs Journal of Accounng & Economcs : Koh K. D. Masumoo and S. Rajgopal 2006 "Meeng Analys Forecass n he Pos-Scandals World: Early Evdence on Sock Marke Rewards and Manageral Acons hp://ssrn.com/absrac=87983 L H. M. Pncus and S. Rego 2004 Marke reacon o evens surroundng he Sarbanes- Oxley Ac of 2002 Workng paper Unversy of Iowa.

43 Lnck James S. Neer Jeffry M. and Yang Tna 2007"The Effecs and Unnended Consequences of he Sarbanes-Oxley Ac and s Era on he Supply and Demand for Drecors" hp://ssrn.com/absrac= Leuz C. and R. Verrecha 2000 The Economc Consequences of Increased Dsclosure Journal of Accounng Research pp Maureen F. McNchols 2002 Dscusson of he Qualy of Accruals and Earnngs: The Role of Accrual Esmaon Errors The Accounng Revew 77: McNchols M. and Manegold J The Effec of he Informaon Envronmen on he Relaonshp beween Fnancal Dsclosure and Secury Prce Varably Journal of Accounng and Economcs 5: McNchols M. and Subben S Does Earnngs Managemen Affec Frms Invesmen Decsons? Sanford Unversy Workng Paper. Ogneva Mara Raghunandan Kannan and Subramanyam K.R "Inernal Conrol Weakness and Cos of Equy: Evdence from Secon 404 Dsclosures" hp://ssrn.com/absrac= James A. Ohlson 995 Earnngs Book Values and Dvdends n Equy Valuaon Conemporary Accounng Research : Arel Pakes 985 On Paens R & D and he Sock Marke Rae of Reurn The Journal of Polcal Economy 93: James M. Paell 976 Corporae Forecass of Earnngs Per Share and Sock Prce Behavor: Emprcal Tes Journal of Accounng Research 4: Porosk Joseph D. and Srnvasan Suraj 2007 "The Sarbanes-Oxley Ac and he Flow of Inernaonal Lsngs hp://ssrn.com/absrac= Rezaee Z. and P. Jan 2003 The Sarbanes-Oxley Ac of 2002 and secury marke behavor: early evdence Workng paper Unversy of Memphs. Glenn Rfkn February 9h 2006 Corporae Boards Call On he Experse of Rered Execuves The New York Tmes. S. Rchardson 2006 Over-nvesmen of free cash flow Revew of Accounng Sudes : Rousseeuw P.J. and A.M. Leroy 986 Robus Regresson and Ouler Deecon John Wley & Sons New York. Mchael A. Salnger 984 Tobn s Q Unonzaon and he Concenraon-Profs Relaonshp Rand Journal of Economcs 5:59-70.

44 Gerald F Sussy 2007 Pavng he Way for Non-Acceleraed Flers Pennsylvana CPA Journal pages J. Tobn 969 A General Equlbrum Approach o Moneary Theory Journal of Money Cred and Bankng : Wagner S. and L. Dmar 2006 The Unexpeced Benefs of Sarbanes-Oxley Harvard Busness Revew 84: Joseph T. Wells 2004 Small Busness Bg Losses Journal of Accounancy hp:// Zhang I Economc Consequences of he Sarbanes-Oxley Ac of 2002 Workng paper Unversy of Rocheser.

45 Appendx A Sudes on Sarbanes-Oxley Topc Major Fndng Sample Ne Benef of Even Sudes Razaee and Jan (2003) Posve Reacon o S&P 500 L e al. (2004) Posve Reacon o All frms Zhang (2005) Negave Reacon o All frms Coss Aud Coss Grffn and Lon (2006) Increase n Aud Coss Clens of Bg Four Elderdge and Keeley (2005) Increase n Aud Coss Forune 000 D&O premum & Board Characerscs Lnck e al. (2007) Increase n board member compensaon D&O nsurance Execucomp IRRC Deregsraon and Foregn Lsng Gong Prvae Carney (2005) Frms ha wen prvae afer Frms ha wen prvae Engel e al. (2005) Increase n frms gong prvae Frms ha wen prvae Foregn Lsng Porosk and Srnvasan (2006) Inernal Conrol Defcency Dsclosure Maeral Weakness under Secon 302 Doyle e al. (2005) Ge and McVay (2005) Hammersley e al. (2005) Maeral Weakness under Secon 404 Cheng e al. (2006) Ogneva e al. (2006) ICD and Cos of Capal Ashbaugh-Skafe e al. (2006) Busness Pracces Decrease n frequency of foregn lsngs on US exchange Analyses dfferen knds of maeral weaknesses Company wde problems vs. accoun relaed problems Frms dsclosng maeral weakness under Wha are maeral weaknesses relaed o Negave reacon o maeral weakness dsclosure under secon 302 Negave reacon o maeral weakness dsclosure under secon 404 Cos of equy for frms dsclosng maeral weakness undrer secon 404 s hgher Cos of equy for frms dsclosng ICD s hgher han oher frms Frms regserng on NASDAQ & NYSE vs. LSE andaim Frms dsclosng maeral weakness Frms dsclosng maeral weakness Frms dsclosng maeral weakness Frms dsclosng maeral weakness Frms dsclosng maeral weakness and frms wh clean repors Frms dsclosng maeral weakness and frms no dsclosng ICD Earnngs Managemen Cohen e al. (2006) CEO compensaon srucure afer Cohen e al. (2004) Exper on Aud Commee DeFond e al. (2004) Benefs of Wagner and Dmar (2006) Decrease n Accrual Based earnngs managemen and Increase n Real earnngs managemen All frms wh daa Sgnfcan declne n he rao of ncenve compensaon o salary afer he passage of Execucomp Volunarly apponng fnancal expers on aud commee s valued by marke only f boh he exper and apponng frm possess characerscs ha faclae he effecve use of he accounng 72 companes apponng new ousde experse drecors o aud commee Summarzes some of he benefs of Sarbanes Oxley Sudes 2 companes

46 Appendx B Ocober 2000 Regulaon FD Oc- Nov 200 Enron Scandal June 5h 2002 Arhur Andersen Convced dfor s Role n Enron Scandal June 25h July 30h Jan 26h 2003 June 27h 2003 Sarbanes-Oxley Bll Secon 306 came Secon 303 came s passed and no effec no effec sgned no law Augus 29h 2002 Secons 403 and 302 go no effec May 6h 2003 Secons and 206 came no effec Oc 3s 2003 Secon 802 came no effec January s 2004 More dsclosure abou nomnaon process of board requred Augus 23rd 2004 Secon 409 came no effec. Acceleraed 8- Kreporng Dec 2000 SAB 0 Jan 2002 Arhur Andersen adms o s role n Enron Scandal and s ndced June 25h 2002 WorldCom Scandal Oc 2002 PCAOB Charman Eleced Dec 5h 2002 Secon 409 July 30h 2002 Secons and 50 of came no effec Elecronc Reporng March 28h 2003 Secon 40 came no effec June 5h 2003 Secon 40 came no effec Dec 5h 2003 Secon 409 (Acc. Flng) 202 came no effec June-Oc 2003 NYSE NASDAQ and AMEX pass Rules regardng sockholder approval of equy compensaon plans and broker vong 2004 Nov 5h 2004 Secon 404 came no effec for acceleraed flers Jan 5h 2004 Secon came no effec

47 Appendx C Excerps of evdence of Secon 404 coss from 0-K repors PETROLEUM DEVELOPMENT CORPORATION (Excerp from 0-K fled on 5/23/2007) General and Admnsrave Coss General and admnsrave expenses for he year ended December ncreased o $7 mllon compared o $4.5 mllon for he year ended December an ncrease of approxmaely $2.5 mllon or 55.6%. The ncrease was prmarly due o ncreased coss of complyng wh he varous provsons of Sarbanes-Oxley n parcular Secon 404 (Inernal Conrols) he cos of he Company's fnancal saemen resaemens and ncreased personnel coss for he ncreased number of employees. RAINDANCE COMM (Excerp from 0-K fled on 3/5/2005) General and Admnsrave Coss Accounng expense ncreased $0.4 mllon for he year ended December as compared o he year ended December due o an ncrease n aud fees assocaed wh he aud of nernal conrols over fnancal reporng requred by Sarbanes-Oxley. Ousde servces expense ncreased $0.7 mllon for he year ended December as compared o he year ended December as a resul of consulans we engaged o asss us wh our Sarbanes-Oxley complance effor and ceran sraegc naves. PAINCARE HOLDINGS (0-K fled on 6/30/2006) General and Admnsrave Coss General and admnsrave expenses a corporae ncreased o $ from $ represenng an ncrease of 64.7%. Ths ncrease s prmarly comprsed of he followng expenses: $ for salares and payroll axes $ for Sarbanes-Oxley consulng and ravel expenses $ for EDX and IAJP servcng fees $42204 for consulng fees $48799 for legal fees and $49346 for accounng and aud fees.

48 Appendx D 40 Marke Floa Dsrbuon of Secon 404 Complan and Non Complan Flers Frequn ncy (n Percen) Complan Non-complan >200 Marke Floa (n Mllons)

49 Table Varable Defnon and Source Varable Defnon Calculaon Drec Cos SG&A Sellng General and Admnsrave Expenses ncurred Daa 89 (Compusa) Aud Fee Audng fees pad n a gven year Aud Fees Aud Relaed Fees (Aud Analycs) Toal Daa 2 (Compusa) sga Change n SG&A expenses log(sg&a/lag (SG&A)) rev Change n log(/lag()) ca Change n Audng Fees log(toal Aud Fees/lag(Toal Aud Fees)) Dec_Dummy Indcaor equal o f sales declned n he curren year Equal o f rev < 0 else equal o 0 Indrec Cos Cash Cash on Company's Balance Shee a year end Daa (Compusa) Asses Toal Asses on Company's Balance Shee a end of year Daa 6 (Compusa) CAPEX Toal Capal Expendure Daa 28 (Compusa) R&D Research and Developmen coss Daa 46 (Compusa) MVE Marke Value of Equy a he end of year Daa 25 * Daa 99 (Compusa) BVE Book Value of Equy a he end of year Daa 60 (Compusa) Toal Deb Toal Deb Ousandng a he end of year Daa 9 Daa 34 (Compusa) Ne PPE Toal Plan Propery and Equpmen ne of Deprecaon a he end of year Daa 8 (Compusa) Cash Flow Cash Flows from operang acves Daa 308 (Compusa) OI Operang Income afer Deprecaon Daa 78 (Compusa) Dv Dvdends pad Daa 2 (Compusa) Tobn's Q Rao of Marke Value of Asses o Toal Asses (MVE Asses BVE)/Asses Sze Proxy for sze of he company log(lag(asses)) Leverage Rao of Deb o Toal Asse Toal Deb/(Toal Deb BVE) ω Abnormal earnngs perssence parameer from Ohlson (995) framework 0.62 (Assumpon) V AIP Value of he frm (-αr)bve α(r) OI -α r*dv where r=2% and α=(ω/(ω-r)) vp Rao of value of frm and he marke value of equy V AIP /MVE nv_q Inverse of Tobn's Q as defned n McNchols and Subben (2005) Asses/(MVE Asses BVE) nv Capal Expendure deflaed by Asses CAPEX/lag(Asses) cf Cash Flows from operang acves deflaed by Asses Cash Flow/lag(Asses)

50 Varable Defnon Calculaon Earnngs Qualy ΔWC Change n workng capal accoun n a gven quarer deflaed by lagged asse Increase n accouns recevable (Daa 03) ncrease n nvenory (Daa 04) decrease n accouns payable and accrued lables (daa 05) plus decreases n axes accrued (Daa 06) Increase (Decrease) n oher asses (lables) (Daa 07) deflaed by lagged asse (Daa 44) (Compusa Quaerly) CFO Cash flow from operaons n a gven quarer Daa 08/Daa 44 (Compusa Quarerly) Δ Change n n gven quarer (Daa 2 -lag(daa 2))/Daa 44 (Compusa Quarerly) PPE Plan propery and Equpmen n a gven quarer Daa 43/Daa 44 (Compusa Quarerly) QTR Indcaor varable for quarer QTR (Compusa Quarerly) BgFour Indcaor equal o f frm had a BgFour audor n all quarers Audor_fKey (Aud Analycs) AvgSze Average of log of oal asses across all quarers log(daa 44) (Compusa Quarerly) OpCycle Average of log of Operang Cycle across all quarers log((365/daa2)*daa37)((365/daa30)*daa38)) (Compusa Quarerly) Inangble Average of R&D nvesmen acoss all quarers Daa 4/Daa 44 (Compusa Quarerly) σ(cfo) Sandard devaon of cash from operaons σ(daa 2/Daa44) (Compusa Quarerly) σ() Sandard devaon of sales σ(daa 08/Daa44) (Compusa Quarerly) Indcaor equal o afer he company becomes secon 404 complan 404 repor n Aud Analycs Common Varables Indcaor equal o f a maeral weakness was presen n 302/404 MW dsclosure Maeral_Weakness (Aud Analycs) 2 Indcaor varable equal o f s he frs year of Secon 404 complance Frs year wh 404 Inernal Repor (Aud Analycs) Indcaor varable equal o f s he second year of Secon 404 complance Second year wh 404 Inernal Repor (Aud Analycs) 3 Indcaor varable equal o f s he hrd year of Secon 404 complancethrd year wh 404 Inernal Repor (Aud Analycs) Year Indcaor for Calendar Year ( ) Indusry Indcaor for SIC Indusry Codes

51 Table 2 Panel A: Sample Dervaon (Mached Sample) Orgnal sample of Acceleraed flers obaned from Aud Analycs Less Acceleraed flers wh more han 50 mllon n Asses n he frs year of Secon 404 complance Frms Less Acceleraed flers whch could no be mached wh a nonacceleraed fler whn he same 3 dg SIC code Fnal Sample of Acceleraed flers (mached wh a nonacceleraed fler) Toal No. of frms n he sample 770 Panel B:Top Ten Indusres (Mached Sample) Indusry Frequency Percen Busness Servces Measurng Insrumens Elecrcal oher elecc equpmen 86.7 Chemcals and alled producs Compuer equpmen Ol & Gas Healh Servces Engneerng Accounng servces Transporaon Equpmen Holdng & Oher Inves Offces

52 Table 2 Panel C: Year of Secon 404 Complance Small Frms Based on Compusa Year Based on Calendar Year Year Frequency Perceage Year Frequency Perceage Toal Toal Medum Frms Based on Compusa Year Based on Calendar Year Year Frequency Perceage Year Frequency Perceage Toal Toal Large Frms Based on Compusa Year Based on Calendar Year Year Frequency Perceage Year Frequency Perceage Toal Toal Mached Sample Based on Compusa Year Based on Calendar Year Year Frequency Perceage Year Frequency Perceage Toal Toal

53 Table 3 Panel A Descrpve Sascs for Small Large and Medum Acceleraed Flers Varable Small Mean Medum Mean Large Mean Asses - Toal (MM$) (Ne) (MM$) Prce - Calendar Year - Close Common Shares Ousandng (MM) SG&A Expenses (MM$) R&D Expenses (MM $) CAPEX (MM $) Marke Value of Equy (MM$) sox sox sox sox sga (Change n SG&A) ca (Change n Aud Cos) Rev (Change n Revenue) leverage sze cash vp (Measure of growh opporunes roa cf Invq (Inverse Tobn s Q) nv rd sales Aud Fees (mllons) Ths able conans descrpve sascs of small medum and large Secon 404 flers from For defnon of varables please refer o Table.

54 Panel B Descrpve Sascs for Mached Sample Table 3 Secon 404 Flers Secon 404 Non-Flers Varable Mean Sandard Dev Mean Sandard Dev T-Sa Asses - Toal (MM$) (Ne) (MM$) Prce - Calendar Year - Close Common Shares Ousandng (MM) SG&A Expenses (MM$) R&D Expenses (MM $) CAPEX (MM $) Marke Value of Equy (MM$) sox sox sox sox sga (Change n SG&A) ca (Change n Aud Cos) Rev (Change n Revenue) leverage sze cash vp (Measure of growh opporunes) roa cf Invq (Inverse Tobn s Q) nv rd sales Aud Fees (mllons) ca Ths able conans descrpve sascs of 770 Secon 404 fler and Secon 404 non-flers from years For defnon of varables please refer o Table.

55 Table 4 Small Frms Maeral Weakness Dscovery Year No. of mes Maeral Weakness Year relave o Secon 404 No. of frms Percen No. of mes Frequency Percen Toal Toal Medum Frms Maeral Weakness Dscovery Year No. of mes Maeral Weakness Year relave o Secon 404 No. of frms Percen No. of mes Frequency Percen Toal Toal Large Frms Maeral Weakness Dscovery Year No. of mes Maeral Weakness Year relave o Secon 404 No. of frms Percen No. of mes Frequency Percen Toal Toal

56 Table 5 Regresson of Change n Sellng General and Admnsrave Coss Model Panel A: Regresson for Small Medum and Large Frms Dependen Varable = ln(sga /SGA - ) Robus Regresson Varable Esmae Esmae Esmae Esmae Esmae Esmae Predced Sgn (S.E.) (S.E.) (S.E.) (S.E.) (S.E.) (S.E.) Small Small Medum Medum Large Large Inercep? rev rev*dec_dummy ca ?? MW *MW *MW? *MW? Indusry Indcaor Yes Yes Yes Yes Yes Yes N Adjused R % 2.0% 20.86% 2.00% 28.45% 9.2% Model: SGA ln( SGA 3 ln( 6 2 ) = j ln( 2 ) 4 ln( 2 2 ) 2 ln( ) Decrease _ Dummy MW * MW 3 * MW ε ) Decrease _ Dummy 0 Aud 5 ln( Aud * MW ) () Ths able conans regressons for small medum and large flers from years s an ndcaor varable equal o f s he frs year of Secon 404 complance smlarly 2 and 3 are ndcaor varabled equal o f s he second or hrd year of Secon 404 complance. MW s an ndcaor equal o f he frm dsclosed a Maeral Weakness n Inernal Conrol n s Secon 302/404 repor for he gven year. For defnon of all oher varables please refer o Table.

57 Table 5 Panel B: Regresson for mached sample Dependen Varable = ln(sga /SGA - ) Robus Regresson Varable Predced Esmae Esmae Esmae Esmae Esmae Esmae Esmae Sgn (S.E.) (S.E.) (S.E.) (S.E.) (S.E.) (S.E.) (S.E.) Inercep rev? rev*dec_dum my lag(rev) lag(rev)*lag(de c_dummy) ca 2 3 MW * MW 2*MW 3*MW???? Indusry Indcaor Yes Yes Yes Yes Yes Yes Yes Year Indcaor Yes Yes Yes Yes Yes Yes Yes N Adjused R 2 2.0% 2.5% 4.33% 4.74% 2.20% 5.30% 5.49% Model: SGA ln( SGA 3 ln( 6 2 ) = j ln( * MW ) 4 ln( ) Decrease_ Dummy * MW ) 2 ln( MW 9 ε 0 ) Decrease_ Dummy Aud 5 ln( Aud * MW ) () Ths able conans mached sample of 770 Secon 404 flers and non- flers from years s an ndcaor varable equal o f s he frs year of Secon 404 complance smlarly 2 and 3 are ndcaor varabled equal o f s he second or hrd year of Secon 404 complance. MW s an ndcaor equal o f he frm dsclosed a Maeral Weakness n Inernal Conrol n s Secon 302/404 repor for he gven year. For defnon of all oher varables please refer o Table.

58 Table 6 Regresson of Change n Audng Coss Model Panel A: Regresson for Small Medum and Large Frms Dependen Varable = ln(aud Cos /Aud Cos - ) Robus Regresson Varable Esmae Esmae Esmae Predced Sgn (S.E.) (S.E.) (S.E.) Small Medum Large Inercep? rev rev*dec_dummy ? MW * MW *MW *MW Indusry Indcaor Yes Yes Yes N Adjused R % 6.28% 6.93% Model: Aud ln( Aud 3 ln( 3 ε 7 ) = j ln( 2 ) 4 ln( MW ) 2 ln( ) Decrease * MW _ Dummy 2 0 ) Decrease * MW _ Dummy * MW (2) Ths able conans regressons for small medum and large flers from years s an ndcaor varable equal o f s he frs year of Secon 404 complance smlarly 2 and 3 are ndcaor varabled equal o f s he second or hrd year of Secon 404 complance. MW s an ndcaor equal o f he frm dsclosed a Maeral Weakness n Inernal Conrol n s Secon 302/404 repor for he gven year. For defnon of all oher varables please refer o Table.

59 Table 6 Panel B: Regresson for mached sample Dependen Varable = ln(aud Cos /Aud Cos - ) Robus Regresson Varable Predced Esmae Esmae Esmae Esmae Sgn (S.E.) (S.E.) (S.E.) (S.E.) Inercep rev? rev*dec_dummy lag(rev) lag(rev)*lag(dec_dummy)?? MW * MW? *MW *MW Indusry Indcaor Yes Yes Yes Yes Year Indcaor Yes Yes Yes Yes N Adjused R % 9.08% 0.55% 0.66% Model: Aud ln( Aud 3 ln( 3 ε 7 ) = j ln( 2 ) 4 ln( MW ) Decrease * MW ) 2 ln( _ Dummy 2 0 ) Decrease * MW 5 _ Dummy * MW (2) Ths able conans mached sample of 770 Secon 404 flers and non- flers from years s an ndcaor varable equal o f s he frs year of Secon 404 complance smlarly 2 and 3 are ndcaor varabled equal o f s he second or hrd year of Secon 404 complance. MW s an ndcaor equal o f he frm dsclosed a Maeral Weakness n Inernal Conrol n s Secon 302/404 repor for he gven year. For defnon of all oher varables please refer o Table.

60 Table 7 Regresson of R&D model Panel A: Regresson for Small Medum and Large Frms Dependen Varable = R&D Robus Regresson Varable Esmae Esmae Esmae Predced Sgn (S.E.) (S.E.) (S.E.) Small Medum Large vp lev cash sze lag_rd ? ? MW *MW *MW? *MW? Indusry Indcaor Yes Yes Yes N Adjused R % 62.47% 6.55% Model: R & D = VP j 2 6 * MW Lev Cash 3 * MW 8 MW Sze ε 4 9 * MW (3) Ths able conans regressons for small medum and large flers from years s an ndcaor varable equal o f s he frs year of Secon 404 complance smlarly 2 and 3 are ndcaor varabled equal o f s he second or hrd year of Secon 404 complance. MW s an ndcaor equal o f he frm dsclosed a Maeral Weakness n Inernal Conrol n s Secon 302/404 repor for he gven year. For defnon of all oher varables please refer o Table.

61 Table 7 Panel B: Regresson for mached sample Dependen Varable = R&D Robus Regresson Varable Esmae Esmae Esmae Predced Sgn (S.E.) (S.E.) (S.E.) vp lev cash Model: R & D cash*negcf sze lag_rd 2 3 MW *MW 2*MW 3*MW -?? - -?? Indusry Yes Yes Yes Year Indcaor Yes Yes Yes N Adjused R % 60.4% 60.50% = VP j 2 6 * MW 3 3 Lev 7 2 Cash * MW 3 MW 8 ε Sze 4 9 * MW (3) Ths able conans mached sample of 770 Secon 404 flers and non- flers from years s an ndcaor varable equal o f s he frs year of Secon 404 complance smlarly 2 and 3 are ndcaor varabled equal o f s he second or hrd year of Secon 404 complance MW s an ndcaor equal o f he frm dsclosed a Maeral Weakness n Inernal Conrol n s Secon 302/404 repor for he gven year. For defnon of all oher varables please refer o Table.

62 Table 8 Regresson of CAPEX Model Panel A: Regresson for Small Medum and Large Frms Dependen Varable = CAPEX Robus Regresson Varable Esmae Esmae Esmae Predced Sgn (S.E.) (S.E.) (S.E.) Small Medum Large nv_q cf cf*negcf lag_capex ? ? MW *MW *MW? *MW? Indusry Indcaor Yes Yes Yes N Adjused R % 37.53% 2.09% Model: CAPEX = Inv _ Q j 7 * MW MW ε 8 CF 2 * MW * MW (4) Ths able conans regressons for small medum and large flers from years s an ndcaor varable equal o f s he frs year of Secon 404 complance smlarly 2 and 3 are ndcaor varabled equal o f s he second or hrd year of Secon 404 complance. MW s an ndcaor equal o f he frm dsclosed a Maeral Weakness n Inernal Conrol n s Secon 302/404 repor for he gven year. For defnon of all oher varables please refer o Table.

63 Table 8 Panel B: Regresson for mached sample Dependen Varable = CAPEX Robus Regresson Varable Predced Esmae Esmae Esmae Sgn (S.E.) (S.E.) (S.E.) nv_q cf cf*negcf lag_nv 2 3 MW *MW - -?? *MW? *MW? Indusry Indcaor Yes Yes Yes Year Indcaor Yes Yes Yes N Adjused R % 7.05% 7.07% Model: CAPEX = Inv _ Q j 7 * MW MW ε 8 CF 2 * MW * MW (4) Ths able conans mached sample of 770 Secon 404 flers and non- flers from years s an ndcaor varable equal o f s he frs year of Secon 404 complance smlarly 2 and 3 are ndcaor varabled equal o f s he second or hrd year of Secon 404 complance. MW s an ndcaor equal o f he frm dsclosed a Maeral Weakness n Inernal Conrol n s Secon 302/404 repor for he gven year. For defnon of all oher varables please refer o Table.

64 Table 9 Earnngs Qualy Small Medum Large Varable N Mean Sd Dev N Mean Sd Dev N Mean Sd Dev σ(resd) σ(resd_loss) Bg AvgSze OpCycle Inangble σ(cfo) σ() MW Panel B: Correlaon Marx ( Spearman - Below Dagonal) Small Frms σ(resd) Bg4 AvgSze OpCycle Inangble σ(cfo) σ() MW σ(resd).0000 Bg AvgSze OpCycle Inangble <.000 <.000 <.000 < < < σ(cfo) < < <.000 <.000 σ() < < <.000 <.000 MW

65 Medum Frm σ(resd) Bg4 AvgSze OpCycle Inangble σ(cfo) σ() MW σ(resd) Bg AvgSze <.000 <.000 OpCycle Inangble < <.000 < <.000 <.000 < σ(cfo) < < σ() <.000 <.000 < <.000 <.000 <.000 MW Large Frm σ(resd) Bg4 AvgSze OpCycle Inangble σ(cfo) σ() MW σ(resd) Bg AvgSze OpCycle Inangble < <.000 <.000 < σ(cfo) σ() < < <.000 <.000 MW

66 Table 0 Regresson of Earnngs Qualy Dependen Varable = Qualy σ(resd) σ(resd_loss) Small Medum Large Small Medum Large Varable Predced Esmae Esmae Esmae Esmae Esmae Esmae Sgn (S.E.) (S.E.) (S.E.) (S.E.) (S.E.) (S.E.) Bg Four Avg Sze OpCycle Inangble σ(cfo) σ() Loss MW? MW*? Indusry Indcaor Yes Yes Yes Yes Yes Yes N Adjused R 2 6.3% 3.4% 9.59% 6.3% 0.63% 9.28% Model: Qualy = α 0 α BgFour α 2 AvgSze α 3 OpCycle α 4 In α 5 σ ( CFO ) α 6 σ ( ) α 7 Loss α 8 α 9 MW α MW * α MW * ε (7 ) 0 g g y s an ndcaor varable equal o f s he frs year of Secon 404 complance smlarly 2 and 3 are ndcaor varabled equal o f s he second or hrd year of Secon 404 complance. MW s an ndcaor equal o f he frm dsclosed a Maeral Weakness n Inernal Conrol n s Secon 302/404 repor for he gven year. For defnon of all oher varables please refer o Table.