The Effect of Section 404 of the Sarbanes-Oxley Act on Financial Reporting Quality

Abstract

In this paper we study the effect of Section 404 of the Sarbanes-Oxley Act on earnings quality. Using a difference-in-differences method we find that firms that were required to comply with Section 404 during the first two years of its implementation improved the quality of their financial reporting more than control firms that were not required to comply. Our testing results also provide some evidence that the reduction in intentional misstatement contributes to the improvement in financial reporting quality of complying firms. Investor confidence appears to be restored, in that they react more strongly to earnings surprises of complying firms than to those of the control firms in the post-404 period. These results are robust to various sensitivity tests. Our results suggest that Section 404 helped to achieve the main goal of the Act: protecting investors and restoring their confidence in the stock market by improving the accuracy and reliability of corporate disclosure.

Keywords: Section 404 of the Sarbanes-Oxley Act, Earnings Quality, Internal Control, Investor Confidence

JEL Classification: G14, G30, G38, K22, M41