Investor Perceptions of Government Deregulation: Evidence from the Sarbanes-Oxley Act’s Section 404
52 Pages Posted: 21 Sep 2017 Last revised: 21 Jul 2018
Date Written: June 21, 2018
We investigate the stock market’s reaction to events leading up to the Securities and Exchange Commission’s (SEC) and Public Company Accounting Oversight Board’s (PCAOB) 2007 regulatory changes that reduced the scope of and documentation requirements for assessments of firms’ internal controls over financial reporting (ICFR), as required by Section 404 of the Sarbanes-Oxley Act. The stated goal of these regulations was to reduce firms’ and auditors’ compliance costs with mandatory ICFR assessments, while maintaining the effectiveness of these assessments. We examine abnormal returns surrounding key dates leading to the passage of these regulations and offer two main findings. First, investors reacted negatively to key event dates, suggesting that investors viewed the regulations as likely to reduce financial reporting quality rather than to drive firm and audit efficiencies. Second, the negative market reaction is larger when ICFR effectiveness should matter most – when firms have higher litigation and fraud risk, and to a lesser extent, when firms are more complex. In additional analysis, we find that restatements increase in the post-regulation time period, consistent with investors’ concerns that the effect of the legislation would be a reduction in ICFR effectiveness. Overall, our results suggest that investors appear to prefer stronger government regulation when it comes to the assessments of a firm’s internal controls over financial reporting.
Keywords: regulation; internal control quality; financial reporting quality; audit quality
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