Effect of the Sarbanes Oxley Act on audit quality

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Effect of the Sarbanes Oxley Act on audit quality

Final version Ciska Taal (10595961) June 2016 Words count:7273 Supervisor: dr. S.R. Arping

BSc Economics & Business, specialization Economics and Finance Faculty of Economics and Business, University of Amsterdam

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Statement of Originality

This document is written by student Ciska Taal who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

In 2002 it was publicly announced that Enron, one of the largest US companies at the time, had overstated its profits by nearly 600 million dollars. Enron’s auditor Arthur Andersen had failed to report these overstatements. This led to a large discussion about the overall quality of audits in the US. As a consequence in July 2002 the Sarbanes – Oxley Act was introduced. This Act was meant to restore investor confidence by improving audit quality. The Act was carried out by the Public company accounting oversight board which intended to improve audit quality by means of inspections. This research examines the consequences of SOX based on three variables: number of restatements, the magnitude of non – audit fees and the choice for a Big 4 audit firm. It shows a large spike in the number of restatements observed in 2002 after which the restatements again decreased. Moreover, the Act was followed was by a large decrease in the use of non – audit services by public firms. A significant negative connection was found between the magnitude of the non – audit fees and the number of restatements, consistent with proponents of SOX arguing the combination of audit and non – audit services affects audit quality negatively. The sample firms nonetheless did not massively switch to the Big 4 audit firms, however this is mainly caused by the fact that most sample firms were already audited by Big 4 audit firms. Finally these results are compared between top 50 Fortune 500 firms and firms between places 400 – 500. It shows the results vary for the different types regarding mainly non – audit fees.

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1. Introduction

In December of 2001 Enron, the seventh – biggest company in America at the time, declared bankruptcy. Enron had overstated its profits by almost $600 million over the period of 1997 – 2000. This bankruptcy raised many questions about the skill of the company’s auditor, Arthur Andersen. As a consequence the company admitted “error of judgement” and fired the partner in charge of the Enron audit. A striking factor in this bankruptcy was the fact that in excess of providing auditing services, Andersen had also earned a considerable amount of money providing consulting services to Enron.

Before the occurrence of the scandal regulators had already argued there was a possible conflict of interest when a company provided audit and non – audit services to a company (Liu, Carol, 2006, pp. 948). The first person who tried to introduce a law to prevent these situations was Democratic senator Paul Sarbanes, however he did not receive support from the Senate. Republican Michael Oxley tried to introduce a similar but milder version of this law but also failed. However after the Enron – Andersen scandal the two men could count on much more support from the Senate. They combined their plans which then formed the basis for the Sarbanes – Oxley Act (SOX) which was eventually introduced on 30th of July 2002.

The two most important articles of SOX are as following. According to Article 302, a company is obliged to periodically report about the effectiveness of its internal controls. In Article 404 it is stated that the company must annually provide a statement about the reliability of internal

controls. On top of that the act bars auditors from providing non – audit services to their audit clients (Ashbaugh – skaife et al., 2008, pp. 8).

The goal of the act is to protect investors and to restore their confidence in the stock market by improving the accuracy and reliability of corporate disclosure (Singer, You, 2011, pp. 557). When investors trust the accuracy of financial statements the stock market is more efficient and the cost of equity for firms goes down.

After the introduction of the act there was a lot of critique coming from the business world (Singer, You, 2011, pp. 556). The act obliged firms to confirm to multiple new principles which costed the audit firms and the public firms large amounts of money (Defond, Lennox, 2011, pp. 22). Difficult for regulators was the fact that the costs of the act were easily measurable, the benefits not so. Considering that there was so much discussion about the act indicated it had the power to significantly change the dynamics in the audit and overall US market, influencing public firms to change auditor and their use of non – audit services. This research will examine how these variables were affected after the introduction of SOX to see if the introduction of the Act has had the desired effect on audit quality. The research question is thus: “To what extent did the Sarbanes – Oxley act of July 2002 affect the functioning of the audit market in the period 2001 - 2006?”

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First a general overview will be provided of the effects of SOX on the different players in the audit market. Following a data analysis will be performed to examine the effect of non – audit fees and the choice of audit firm on the audit quality of public firms’ financial statements. Following the observed effects will also be compared for small and large firms. Finally a conclusion will be drawn and a recommendation for further research provided.

2. Literature Review

The Sarbanes – Oxley Act (SOX) was introduced in July 2002. The main aim of the act was to protect investors and restore their confidence in the stock market by improving the accuracy and reliability of corporate disclosure (DeFond, Francis, 2005, pp. 5 - 6). The two most important articles are Article 302 and 404. The first mentioned obliges the board of a company to periodically report about the effectivity of its internal controls. Section 404 requires both management and an external auditor to assess the effectiveness of the firm’s internal controls.

The reliability of an annual statement can be increased by decreasing unintentional estimation errors and intentional fraudulent reporting. These non – random misstatements typically

overstate earnings for the current period. (Ashbaugh – Skaife et al., 2009, pp. 9). This practice is called earnings management. Due to this practice investors are misled when choosing in which public firm they want to invest. It is the external auditors’ responsibility to detect and report these misstatements.

First the Public company accounting oversight board will be introduced, this newly set up quasi - public institution was responsible for carrying out the Act. Following the consequences of the Act for the three parties in the audit market who were influenced by the Act will be discussed: the audit firms, investors and public firms. Following the measurability of audit quality will be discussed.

2.1 Role of PCAOB

The controlling institution of the Sarbanes – Oxley Act is the Public company accounting oversight board (PCAOB) (Gunny, Zhang, 2013, pp. 136 - 137). The role of the PCAOB is to protect investors and to further the public interest by overseeing the work of accounting firms that audit publicly traded companies (Berger, 2010, pp. 28 – 29). The PCAOB’s budget and regulations have to be approved by the Securities and Exchange Commission (SEC), however they do have the independence to directly tax public and audit firms (Coates & Srinivasan, 2014, pp. 4). Their primary vehicle for improving the quality of the auditing practice is their inspection process (Carcello, Hollingsworth & Mastrolia, 2011, pp. 85).Registered public accounting firms that issue audit reports for more than 100 public companies are subject to annual inspections by the PCAOB, and those with 100 or less are subject to triennial inspections (Gunny, Zhang, 2014, pp. 137). The PCAOB proposes the following definition of audit quality: “Auditors ability to discover and report misstatements, meet legal and professional requirements and to meet the needs of investors”. (Dickins, Fay, & Reisch, 2014, pp. 16 - 17).

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The importance of auditing can best be observed in the following definition of auditing: “reducing information asymmetries that exist between managers and firm stakeholders by allowing outsiders to verify the validity of financial statements” (Becker et al. 1998, pp. 6). According to Dickins, Fay, & Reisch (2014, pp. 16), investors heavily rely on analysts, regulators and external auditors to detect and report fraud. If auditors thus do not report any restatement they will believe the accounting numbers fairly reflect the economic reality of the reporting entity and thus their information risk is near zero. (DeFond, Francis, 2005, pp. 15 - 16). The benefit of information risk being low is that this translates into lower cost of equity

(Ashbaugh – Skaife et al., 2009, pp. 4).

Before the introduction of SOX the audit market was self – regulated by the American Institute of Certified Public Accountants (AICPA). All accounting companies that audited SEC reporting companies had to first register at the Securities and Exchange Practice Section (SECPS) to become a member of the AICPA. When registering the accounting firm needed to agree to a peer review every three years. The perceived advantages of the PCAOB in comparison to the till then in place self – regulation of the market include that the inspectors of the PCAOB are more likely to be independent and objective than peer reviewers. (Carcello, Hollingsworth & Mastrolia, 2011, pp. 86). On top of that they will have a greater inspection expertise and their scope will be greater than that of an AICPA – sponsored peer review. Moreover the PCAOB inspection results can provide a stimulus for audit firms to pursue high quality thereby improving the public

perception of audit quality (Gunny, Zhang, 2013, pp. 138).

However there are also criticisms concerning the overseeing board. Firstly, although the PCAOB inspectors come from public practice, their expertise could become dated very quickly.

Moreover, in the past there has been a significant delay between the PCAOB’s inspection fieldwork and the delivery of their final reports. On top of that concerns were also raised about the information available to the public under the PCAOB inspection process.

2.2 Consequences of SOX for Audit firms

The most evident beneficiary group of the introduction of SOX would on first glance be the audit firms. Due to the new legislation public issuers had no choice but to be audited by an external auditor. (Langevoort, 2007, pp. 1829). The profession was thus plainly promoted in regulatory importance. Due to the fall of Arthur Andersen (Blouin et al., 2007, pp. 621) the already concentrated market narrowed even further, expanding the client lists of the remaining audit firms.

However, the introduction of the new requirements for auditing practices also affected audit firms negatively financially. The act demanded stricter compliance with auditing standards and raised the penalties for auditor misconduct (DeFond & Lennox, 2011, pp. 22). To be able to comply with these new standards audit firms had to invest, and these investments had to be covered by the audit fees of the firms. The consequences of the changes were very different for

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small audit firms than for the Big 4, this is why these two types of firms will be separated in the following section of the literature review. First incentives for firms to not report errors in financial statements will be introduced. Following the relevance of these incentives for small audit firms and Big 4 firms are explained.

2.2.1. Factors influencing whether or not to report errors in financial statements

Managers of firms have incentives to “adjust” earnings to maximize firm and/or manager wealth, thereby misleading investors and engaging in earnings management. Multiple studies assume the skills of auditors to be equal and thus assume an equal probability of an auditor to discover such an error in a financial statement. The determining factor of audit quality is thus whether the auditor reports this error. If the auditor does, the reliability of that firm’s financial statements will be affected. There are three factors that audit firms needed to weigh against each other when finding an error in financial statements of a client firm.

First is the percentage of audit fees paid by the public firm to the audit firm in consideration to the audit firm’s total revenue. When this percentage is large the audit firm will be more willing to adjust to the wishes of the client firm because they want to continue the collaboration, thus decreasing auditor independence. When a conflict with the client would arise there is a large chance a client will change audit firm thus decreasing revenues of the current audit firm significantly. If the percentage is small, the audit firm can easily survive when they would lose the firm as client, thus positively affecting auditor independence. This factor will generally weigh heavier for a small audit firm.

The second factor that needs to be considered is the reputation of the audit firm. A large, well – known firm will have a lot to lose and will do anything to maintain a trustworthy reputation (Hribar, Kravet, & Wilson, 2014, pp. 507). Most logical example is the fall of Arthur Andersen. One error of judgement at one client firm (Enron), although rather large, led to the downfall of the entire firm. Current remaining large scale audit firms will be extra careful not to make the same error.

The third, and maybe most important factor, is the risk of getting caught. Next to the indirect financial consequences of loss of reputation there are also direct financial consequences in the form of fines involved, mostly imposed by the SEC. After the introduction of SOX the

probability of getting caught increased significantly due to the change from peer reviews to inspection by the PCAOB. If the PCAOB detects an error, the firm usually has 12 months to correct after which the error will be publicly published resulting in possible reputation loss.

2.2.2 Consequences of SOX for small audit firms

Following the introduction of the Sarbanes – Oxley Act there was a large decrease in the number of small audit firms operating in the market from 1233 to 626 (DeFond, Lennox, 2011, pp. 21). As mentioned before the Act demanded stricter compliance with auditing standards, increased regulatory scrutiny and raised the penalties for auditor misconduct. These smaller auditors have a

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smaller audit fee base and thus will find it difficult to remain competitive while enduring these higher costs. This is the main reason for low quality small auditors to exit the market.

Consequence of this large exit flow was a doubling of the average number of clients for the small non – exiting audit firms. Analysis shows that the successor auditors were more likely than the exiting auditors to issues going – concern opinions to the exiting auditors, thus indicating the exiting firms had been of lower quality (DeFond & Lennox, 2011, pp. 22). These low quality auditors are more likely to find it cost beneficial, at the margin, to exit the market for public company audits in response to the new regulatory environment implemented after SOX (2011, pp. 22). Their exit can thus be seen as beneficial for the audit quality. However, men thus have to take into account the possibility that the quality of the remaining higher quality small audit firms will decrease because they are overwhelmed by the increase in the client base. Moreover the new audit firm will know less about the client than the exiting audit firm.

2.2.3. Consequences of SOX for the Big 4

Before the fall of Arthur Andersen the Big 5 of the auditing industry were Deloitte,

PricewaterhouseCoopers, Ernst & Young, KPMG and thus Arthur Andersen. After the fall of Arthur Andersen the Big 4 remained. They dominate the major part of the market. Multiple studies have used the variable Big4 in their regressions and have found a positive relationship between the quality of auditing and the auditor of a public firm being one of the Big 4 companies (Dickins, 2014, pp. 17).

Due to the introduction of the SOX these firms had to discontinue their non – auditing practices. Ernst & Young for example sold their consulting unit to Cap Gemini during this period. Other audit firms spun off their consulting departments as separate entities. PriceWaterhouseCoopers consulting unit continued under the name PwC consulting and BearingPoint is the successor of KPMG consulting. Deloitte however did not do so. The argument of regulators was that

proliferation of non – audit services and the substantial fees realized for such services had created incentives for auditors to maintain relationships with their clients (Liu, Nabar, 2006, pp. 948). However, Abbott et al (2003, pp. 29) find no significant association between non-audit fees and audit opinions. There still remains discussion about the effect of non – auditing practices on audit quality. In the data analysis it will be examined if there is a trend in the magnitude of non – audit fees and subsequently if there is a connection to the development of audit quality.

These large audit firms were subject to PCAOB inspections annually. To measure if these

inspections had a significant effect on the audit quality of these firms, Carcello, Hollingsworth & Mastrolia, (2011, pp. 87) took as a proxy reduced earnings management which they measured by abnormal accruals. Investors expect SOX to constrain earnings management. In the year

following a PCAOB inspection abnormal accruals exhibit a broad – based decline , regardless of whether abnormal accruals were positive or negative in the pre – period. This reduction seems to

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be driven by PCAOB inspections, as abnormal accruals do not decline until the beginning of the PCAOB inspection process.

2.3. Consequences of SOX for investors

Since the passage of the Sarbanes – Oxley Act there has been a sharp increase in the number of accounting restatements. Becker et al. (1998, pp. 2) researched if these restatements had led to confusion for investors, this could have led to the trading volume being independent of price movements. However, this was not case. On top of that they found post – SOX restatements have significantly less drift than do pre – SOX restatements. These pricing and volume tests thus do not support the notion that the increase in restatements after SOX produced confusion.

On the contrary, DeFond & Francis (2005, pp. 22 – 23) show increased reliability of the reported earnings over their used control group. Moreover intentional misstatements had decreased and the predictive power of current earnings over future earnings had increased. From an investor point of view last mentioned is the most important, this ensures higher investor confidence. Thus from an investor position, considering the fact they do not directly have to pay for the stricter guidelines, the introduction of SOX and its positive effects on the quality of financial statements has been highly beneficial.

2.4. Consequences of SOX for firms

According to the Act, public companies need to have their financial statements audited annually by independent external auditors. In the case of larger public companies, the auditor must also express an opinion on whether the company maintained, in all material respects, effective internal control over its financial reporting, as of a specified date. On top of that the firms are required to report their internal control deficiencies. Firm’s that did so exhibited greater noise in accruals and their abnormal accruals were relatively larger. This led to them experiencing a higher cost of equity (Ashbaugh – skaife et al., 2008, pp. 2). However, research also shows that the firms who remediated their previously reported internal controls benefited through a lowered cost of equity.

After the introduction of SOX the audit committees of public companies were required to consist of solely independent members according to section 301 (Bargeron, Lehn, & Zutter, 2009, pp. 53). This has been emphasized by the Securities and Exchange Commission who sees the audit committee in the role of providing active oversight of the financing reporting and as a key player in the relationship between a firm’s management and its audit firm (Abbott et al, 2003, pp. 17). Moreover the auditing committee of each public company needed to include at least one financial expert (DeFond et al, 2005). Link et al (2008, pp. 310) found that boards of publicly traded US corporations are larger and consist of more outside directors after SOX. However, Smith and Watts (1992, pp. 264) argue it is more costly for outside directors to obtain information about the quality of investment in projects in risky, high growth firms. Thus by expanding the role played by independent directors in corporate governance, SOX may have

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imposed a suboptimal board structure on firms that previously relied less on independent directors.

Moreover due to the Sarbanes – Oxley Act firms were no longer allowed to purchase audit and non – audit services from the same firm. As mentioned earlier the economic incentives for auditors to maintain relationships with their clients would have a negative effect on audit quality. (Dickins et al., 2014, pp. 16).

Critics have argued non – audit services could have a positive effect on audit effectiveness because of the “knowledge spillovers” (Ribstein 2002). They also argue there is no evidence that supports the hypothesis of Dickins et al. However stock price reactions of Ernst & Young’s audit clients around the announcement and the actual happening of the sale of Ernst & Young’s

consulting unit to Cap Gemini showed to be positive. This according to Liu & Carol suggests that investors in these audit clients favorably viewed EY’s divestiture of its consulting unit, which confirms the SEC’s belief that auditors’ provision of non – audit services to audit clients adversely affects investor confidence in the independence of the auditors (2006, pp. 955).

The above mentioned conclusion is in line with the evidence found by Causholli, Chambers and Payne (2015, pp. 1 – 6). They find that an accountant who hopes to obtain a large non – audit engagement to receive for example more partnership shares, is in greater jeopardy of impaired objectivity. Following they find a significant association between abnormal accruals and increases in non - audit fees in the subsequent year.

Lastly Ribstein (2002) argues CEO’s allegedly will take less risky actions due to the higher regulated market. Risky projects tend to lead to having to report special financial accounts, it is difficult to find an internal control system that can insure the reliability of these figures. Due to this the firm might have to report internal control deficiencies. They will want to avoid doing so and will thus not engage in the risky, however potentially financially rewarding, project. This is confirmed by a survey among CEO’s performed by PricewaterhouseCooper showing the finding that 59% of the respondents view the risk of overregulation as one of the biggest threats to the growth of firms (Norris, 2004). Wallison (2003) also expects the change in management’s risk – taking behavior to reduce the growth of firms and even deter economic growth.

2.5 Measuring audit quality

In previous studies many different variables have been used to measure audit quality. Gunny & Zhang (2013, pp. 136) for example use the following three measures: abnormal accruals, number of restatements and the propensity to issue a going concern opinion. In this research the measure used will be the number of restatements of financial statements.

Restatements capture a particularly severe form of earnings management. The financial

statements of the company in this case were not presented in accordance with GAAP. Assumed will be that the number of restatements will be more closely linked to the Sarbanes – Oxley Act

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than abnormal accruals. As Gunny & Zhang already showed, inspected auditors with seriously deficient reports have a greater propensity to restate (2013, pp. 138). In the case of abnormal accruals there are many other factors that could influence the magnitude of the accruals. There is a clearer connection between the number of restatements and the introduction of SOX. SOX is considered to be one of the largest legislation introductions. It would thus be logical that after the introduction of the Act there would be a large increase in the number of restatements by firms needing to apply with the new guidelines.

3. Research Method

As mentioned above the measure of restatements will be used to examine if there has been an increase in audit quality. The time period examined is 2001 - 2006. SOX was signed in July 2002. However, the act was introduced in different stages for different types of firms. The firms with a public float above 75 million in either 2002, 2003, 2004 were indicated as accelerated filers. These firms were the first issuers required to comply with the internal control reporting requirements for fiscal years ending after November 15, 2004. All firms in this sample are accelerated filers. Being an accelerated firm means the firm has to publish its annual report within 75 days instead of 90. On top of that from 2004 onwards the firm has to publish a management report which is then reviewed by an external auditor. Since all the firms in the sample have had to deal with the new law in the same time period no time lags need to be expected in the sample regarding the consequences of the act.

For the data analysis the variable “sox” has been created which is “1” for the observations after the introduction of the Sarbanes Oxley Act and “0” for the observations before in the years 2001 and 2002. The reason for the fact that this separation is made instead of the division 2001 – 2004 and 2005 – 2006, taking into account that this was the first fiscal year the accelerated filer needed to comply with SOX, is that firms were already qualified as accelerated filer in 2002. Thus they could already respond to the changes that needed to be made in their financial statements and internal control systems, affecting the number of restatements and the choice of audit firm. Regarding the non – audit fees this prohibition did go into working in 2002.

The significance level used is 5 percent. The sample consists of 48 firms, 24 are in the top 50 of the Fortune 500, the other 24 are in also in the same list between places 400 - 500. These firms have been chosen from these two different sections of the Fortune 500 to see if the effects researched differ between large and relatively smaller firms. The Fortune 500 is ranked by total revenue of the current fiscal year. The ranking used is that of 2002. The reason these particular firms are used for the performed data analysis is the fact that all the necessary data needed was retrievable for these firms in the Audit Analytics database. For all the 48 public firms annual data has been retrieved.

To answer the research question: “To what extent did the Sarbanes – Oxley act of July 2002 affect the functioning of the audit market in the period 2001 - 2006?,” the question will be

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divided into four sub - hypothesis. Firstly the number of restatements before and after the introduction of the act will be examined. Even though a restatement means the financial statements were incorrect in the first place, more restatements in the short term after the introduction of the act could also indicate the quality of the financial statements is being improved. In the long term the number of restatements should decrease again since the public firms should then have their internal control systems at SOX quality level. There thus should be a positive relation between the number of restatements and the introduction of the act in the short term and a negative relation in the long term. We would thus expect a strong increase right after the Act and a slow decrease in the years following.

𝐻𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑠 1: 𝑇ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑟𝑒𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡𝑠 ℎ𝑎𝑠 𝑠𝑖𝑔𝑛𝑖𝑓𝑖𝑐𝑎𝑛𝑡𝑙𝑦 𝑐ℎ𝑎𝑛𝑔𝑒𝑑 𝑖𝑛 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟𝑠 (2003 − 2006) 𝑓𝑜𝑙𝑙𝑜𝑤𝑖𝑛𝑔 𝑡ℎ𝑒 𝑖𝑛𝑡𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑡ℎ𝑒 𝑆𝑎𝑟𝑏𝑎𝑛𝑒𝑠 𝑂𝑥𝑙𝑒𝑦 𝐴𝑐𝑡 𝑖𝑛 𝑐𝑜𝑚𝑝𝑎𝑟𝑖𝑠𝑜𝑛 𝑤𝑖𝑡ℎ 𝑡ℎ𝑒 𝑦𝑒𝑎𝑟𝑠 𝑏𝑒𝑓𝑜𝑟𝑒 𝑡ℎ𝑒 𝐴𝑐𝑡

The second variable examined is non – audit fees. As indicated before in the literature review there is still discussion about the impact of the combination of audit and non – audit services is for the quality of audit. Firstly the effect of the introduction of the act on the magnitude of non – audit fees will be examined. Following there will be an analysis performed to see if there is a significant correlation between the number of restatements and the magnitude of the non – audit fees.

𝐻𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑠 2: 𝐴𝑢𝑑𝑖𝑡 𝑞𝑢𝑎𝑙𝑖𝑡𝑦, 𝑚𝑒𝑎𝑠𝑢𝑟𝑒𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑟𝑒𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡𝑠, ℎ𝑎𝑠 𝑠𝑖𝑔𝑛𝑖𝑓𝑖𝑐𝑎𝑛𝑡𝑙𝑦 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑑 𝑠𝑖𝑛𝑐𝑒 𝑆𝑂𝑋 𝑑𝑢𝑒 𝑡𝑜 𝑡ℎ𝑒 𝑠𝑒𝑝𝑎𝑟𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑎𝑢𝑑𝑖𝑡 𝑎𝑛𝑑 𝑛𝑜𝑛𝑎𝑢𝑑𝑖𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠 𝑡𝑜 𝑝𝑢𝑏𝑙𝑖𝑐 𝑓𝑖𝑟𝑚𝑠 𝑏𝑦 𝑎𝑛 𝑎𝑢𝑑𝑖𝑡 𝑓𝑖𝑟𝑚

Finally the last variable used will be ‘Big4’. This variable has value “1” if the firm in the observed year is audited by either KPMG, E&Y, Deloitte or PricewaterhouseCoopers. Previous research has indicated this variable has a significant impact on audit quality, thus by means of this hypothesis the effect of this variable in this regression will be researched.

𝐻𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑠 3: 𝑊ℎ𝑒𝑛 𝑎 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 𝑖𝑠 𝑎𝑢𝑑𝑖𝑡𝑒𝑑 𝑏𝑦 𝑎 𝐵𝑖𝑔 4 𝑎𝑢𝑑𝑖𝑡 𝑓𝑖𝑟𝑚 𝑖𝑡′_{𝑠 𝑎𝑢𝑑𝑖𝑡 𝑞𝑢𝑎𝑙𝑖𝑡𝑦,} 𝑚𝑒𝑎𝑠𝑢𝑟𝑒𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑟𝑒𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡𝑠, 𝑖𝑠 ℎ𝑖𝑔ℎ𝑒𝑟

Earlier it has been mentioned that the effect of SOX was different for small audit firms than for the Big 4. Unknown is if the same is true for audit quality of the financial statements of small and large public firms. Thus for each variable there will also be an analysis to observe if there is a connection between the ranking of the company on the Fortune 500 and the variable affecting audit quality.

𝐻𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑠 4: 𝑇ℎ𝑒 𝑖𝑛𝑡𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑆𝑂𝑋 ℎ𝑎𝑠 ℎ𝑎𝑑 𝑎 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡 𝑒𝑓𝑓𝑒𝑐𝑡 𝑜𝑛 𝑓𝑖𝑟𝑚𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑡𝑜𝑝 50 𝑜𝑓 𝑡ℎ𝑒 𝐹𝑜𝑟𝑡𝑢𝑛𝑒 500 𝑡ℎ𝑎𝑛 𝑜𝑛 𝑓𝑖𝑟𝑚𝑠 𝑖𝑛 𝑝𝑙𝑎𝑐𝑒𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 400 − 500

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In the data analysis first the development of the three variables mentioned in the first three hypothesis - number of restatements, non – audit fees, choice for a Big 4 – audit firm – over the period 2001 – 2006 will be examined. Subsequently the following OLS – regression will be run:

𝑅𝑒𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡_𝑡 = 𝛽₀+ 𝛽₁× 𝑠𝑜𝑥_𝑡+ 𝛽₂× log(𝑛𝑜𝑛 − 𝑎𝑢𝑑𝑖𝑡 𝑓𝑒𝑒𝑠)_𝑡+ 𝛽₃× 𝐵𝑖𝑔4_𝑡+ 𝛽₄

× 𝑅𝑒𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡𝑠 𝑝𝑒𝑟 𝑓𝑖𝑟𝑚 + 𝛽5× log(𝑎𝑢𝑑𝑖𝑡 𝑓𝑒𝑒𝑠)𝑡+ 𝛽6× 𝑆𝑖𝑧𝑒 𝑓𝑖𝑟𝑚 + 𝛽7× 𝑡𝑜𝑝50

+ 𝜀_𝑡

Multiple control variables have been added to the regression. All three of these variables have a theoretical connection with the variable “restatement”. Not including them would thus lead to a biased result.

Firstly “restatements per firm”, in the data it can be observed that some firms report relatively more restatements than others. To avoid the chance of a small group of firms influencing the total regression, this control variable is added.

The control variable “log audit fees” has been added to correct for the difference in size of the sample firms. The more complicated the financial statements of a firm, the higher the risk of missing an error. Thus in the case of the introduction of SOX a more complex firm would have to bear higher compliance costs. According to Iliev these additional costs can be measured by audit fees (2010, pp. 1166).

Lastly, the variable “size firm” has been included. This ranking is based on the magnitude of the revenue of the public year in the fiscal year 2002. As mentioned before a larger firm will

probably have more complex financial statements thus increasing the chance of a restatement. To control for this the variable has been added.

Important to mention is the fact that a before – after analysis in this time period is difficult because of the many economic and political developments. In section 7 there will be a further explanation of the limitations of this research method.

4. Data analysis

4.1 Change in variables

4.1.1. Number of restatements

As can be observed in the graph below the total number of restatements spiked in the year the Sarbanes – Oxley Act was introduced. The magnitude of the restatements decreased again sharply in 2003. However the number of restatements per year in the following years remains above the original level observed in 2001 when restatements were relatively rare for the sample firms.

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A possible explanation for this trend in the development of the number of restatements could be the fact that the Fortune 500 companies, all being accelerated filers, needed to comply with the new SOX guidelines concerning internal control systems directly after its introduction. Wanting to avoid high fines and reputation loss they immediately did so, explaining the high number of restatements in 2002. Being large companies, these Fortune 500 companies would have had the resources to set up a team to make sure the firm’s future financial statements rapidly meet the SOX guidelines. This would be a possible cause for the sharp decrease in the number of restatements in the years following.

4.1.2. Non – audit fees

Considering non – audit fees, the graph below shows there has been a clear decrease in the expenditure of public firms on non – audit fees. The red dots show the decrease of the average non – audit fees paid per public firm, the blue dots indicate the ratio of non – audit fees over total fees of public firms. SOX prohibited firms to receive audit and non – audit services from the same firm, however a public firm could switch to a different consultancy firm and remain at the same non – audit fee volume.

The graph however shows this has not happened on a large scale. Reason could be the fact that the public firms need to build a new trust relationship with the new consultancy firm and this firm has to get to know the new firm and industry the firm is active in. They will thus still make use of non – audit services but on a smaller scale.

Public firms can also have chosen to use the new free budget to improve internal controls to comply with the new SOX guidelines. This could lead to a negative relation between non – audit fees and audit quality, when non – audit fees decreases audit quality increase. If this is the case will be researched in the following section by performing a regression.

0 5 10 15 20 25 2000 2001 2002 2003 2004 2005 2006 2007 n u m b e r o f r e stat e m e n ts Years

Number of restatements per year

non - top 50 firm top 50 firm total

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Figure 2 Development of non - audit fees in the period 2001 - 2006 4.1.3. Choice for a Big 4 audit firm

As shown in the graphs below no change has occurred in the percentage of public firms that are audited by a Big 4 audit firm. Although this variable has shown a positive relationship with audit quality in previous literature, these graphs indicate there will most likely be no significant effect of the variable on the number of restatements in this research. This is largely due to the fact that nearly all firms in the sample were already audited by a Big 4 audit firm.

£2.000.000,00 £4.000.000,00 £6.000.000,00 £8.000.000,00 £10.000.000,00 £12.000.000,00 £14.000.000,00 -5 0 5 10 15 20 25 30 2000 2001 2002 2003 2004 2005 2006 2007 A ve rag e n o n au d it fee s R atio N o n au d it fee s/To tal Fee s Fiscal year

Ratio Non audit fees Lineair (Ratio) Lineair (Non audit fees)

Figure 3 The development of the choice of audit firm in the period 2001 - 2006 0% 20% 40% 60% 80% 100% Top 50 (before SOX) Top 50 (after SOX) Not top 50 (before Sox)

Not top 50 (after Sox)

Total Total

Public firms choice for a Big 4 audit firm

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4.2 Regression Dependent variable: Restatement Coefficient Standard error t - value P > |𝒕| Sox*** -0.1955152 0.0622582 -3.14 0.002

log non audit fees** -0.0513731 0.0216966 -2.37 0.019

Big 4 -0.0542987 0.1765681 -0.31 0.759

Restatements per firm*** 0.0505327 0.0150478 3.36 0.001

log audit fees** 0.0648801 0.0313026 2.07 0.039

size firm 0.004363 0.0031912 1.37 0.173

top 50 0.0897032 0.0983761 0.91 0.363

constant -0.0820214 0.3880946 -0.21 0.833

R2 0.0827

Number of observations 288

Note: *** 1% significance, ** 5% significance, * 10% significance

Figure 4 Regression of multiple variables on the dependent variable "Restatement"

With the above shown regression it is possible to draw conclusions about all earlier described hypothesis. First the significance of the regression will be discussed.

The R- squared of the regression is 0,0827 which means the independent variables explain the dependent variable 8,27%. This can be explained by the fact that the reporting of a restatement can be caused by many more factors that are difficult to measure. For example, the auditor himself can make an error or the assigned auditor does not have the required level of

specialization. In this research we have assumed all auditors have the same skill and it is their tendency to report an error that determines audit quality. However if this assumption were to be wrong, which could be logical in practice, this could also influence the results of this regression.

4.3 Hypothesis

The first hypothesis stated in the research method was:

𝐻𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑠 1:The number of restatements has significantly changed in the years (2003 – 2006) following the introduction of the Sarbanes Oxley Act in comparison to the years before the Act

From the significant coefficient – 0,1955152 of the variable “sox” it can be concluded that the number of restatements has decreased since the introduction of the Act. The consequences of the Act regarding restatements were already directly noticeable in 2002. There was a huge spike in the number of restatements in the introduction year of the Act. The large decrease in the numbers of restatements that followed could indicate the financial statements of companies already

complied with the new principles directly after the introduction of the act to avoid unnecessary fines. The decreasing number of restatements in the period 2003 – 2006 thus indicates an

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increase in audit quality since more firms have their internal controls in order and no longer need their financial statements to be restated.

The second hypothesis was as following:

𝐻𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑠 2: 𝐴𝑢𝑑𝑖𝑡 𝑞𝑢𝑎𝑙𝑖𝑡𝑦, 𝑚𝑒𝑎𝑠𝑢𝑟𝑒𝑑 𝑏𝑦 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑟𝑒𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡𝑠, ℎ𝑎𝑠 𝑠𝑖𝑔𝑛𝑖𝑓𝑖𝑐𝑎𝑛𝑡𝑙𝑦 𝑖𝑛𝑐𝑟𝑒𝑎𝑠𝑒𝑑 𝑠𝑖𝑛𝑐𝑒 𝑆𝑂𝑋 𝑑𝑢𝑒 𝑡𝑜 𝑡ℎ𝑒 𝑠𝑒𝑝𝑎𝑟𝑎𝑡𝑖𝑜𝑛 𝑜𝑓 𝑎𝑢𝑑𝑖𝑡 𝑎𝑛𝑑 𝑛𝑜𝑛𝑎𝑢𝑑𝑖𝑡 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠 𝑡𝑜 𝑝𝑢𝑏𝑙𝑖𝑐 𝑓𝑖𝑟𝑚𝑠 𝑏𝑦 𝑎𝑛 𝑎𝑢𝑑𝑖𝑡 𝑓𝑖𝑟𝑚

This hypothesis was examined by first analyzing the development of non-audit fees over the period. This showed a clear downward trend. Following a regression was run to see if this downward trend in non-audit fees has led to an increase or decrease of the number of

restatements. The regression shows a significant negative relationship of -0.0513731. This means that when the non – audit fees increase by 1 percent, the change in the number of restatements is:

∆𝑅𝑒𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡 = −0,051371 × log(1,01) = −0,0002219932

The effect of non – audit fees on the number of restatements is thus negative. The cause of this relationship could lay in the fact that due to the fact that the Fortune 500 firms spend less on non – audit services they have more budget to spend on internal auditors that can better insure there are no errors in the firm’s financial statements which would otherwise need to be restated. This conclusion is in line with the view of proponents of the Sarbanes Oxley Act who state the decrease in non – audit fees indicates higher auditor independence because the audit firm is no longer playing a double role.

Stated in the third hypothesis:

𝐻𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑠 3: 𝑊ℎ𝑒𝑛 𝑎 𝑐𝑜𝑚𝑝𝑎𝑛𝑦 𝑖𝑠 𝑎𝑢𝑑𝑖𝑡𝑒𝑑 𝑏𝑦 𝑎 𝐵𝑖𝑔 4 𝑎𝑢𝑑𝑖𝑡 𝑓𝑖𝑟𝑚 𝑖𝑡′_{𝑠 𝑎𝑢𝑑𝑖𝑡 𝑞𝑢𝑎𝑙𝑖𝑡𝑦, 𝑚𝑒𝑎𝑠𝑢𝑟𝑒𝑑} 𝑏𝑦 𝑡ℎ𝑒 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑟𝑒𝑠𝑡𝑎𝑡𝑒𝑚𝑒𝑛𝑡𝑠, 𝑖𝑠 ℎ𝑖𝑔ℎ𝑒𝑟

The coefficient of the variable “Big4” is not significant. As mentioned earlier this is due to the fact that all firms, also the smaller ones in places 400 – 500, were already audited by Big 4 audit firms before the introduction of SOX, there was thus no significant change in the number of firms audited by Big 4 firm. A “flight to quality” can thus not be observed or tested.

Finally, the last hypothesis was:

𝐻𝑦𝑝𝑜𝑡ℎ𝑒𝑠𝑖𝑠 4: 𝑇ℎ𝑒 𝑖𝑛𝑡𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑜𝑛 𝑜𝑓 𝑆𝑂𝑋 ℎ𝑎𝑠 ℎ𝑎𝑑 𝑎 𝑑𝑖𝑓𝑓𝑒𝑟𝑒𝑛𝑡 𝑒𝑓𝑓𝑒𝑐𝑡 𝑜𝑛 𝑓𝑖𝑟𝑚𝑠 𝑖𝑛 𝑡ℎ𝑒 𝑡𝑜𝑝 50 𝑜𝑓 𝑡ℎ𝑒 𝐹𝑜𝑟𝑡𝑢𝑛𝑒 500 𝑡ℎ𝑎𝑛 𝑜𝑛 𝑓𝑖𝑟𝑚𝑠 𝑖𝑛 𝑝𝑙𝑎𝑐𝑒𝑠 𝑏𝑒𝑡𝑤𝑒𝑒𝑛 400 − 500

The coefficient “top50” also shows to be non-significant, thus indicating the introduction of the Act has had the same effect on both firms in the top 50 of the Fortune 500 as on firms in place 400 – 500.

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However when splitting up the effects:

Dependent variable: Top50

Independent variable Coefficient Standard error

t - value P > |𝑡| 𝑅2

Restatement -0.0208333 0.0483049 -0.43 0.667 0.0006

Log non audit fees*** 2.399372 0.1742424 13.77 0 0.3987

Big 4** 0.0416667 0.0167103 2.49 0.013 0.0213

Note: *** 1% significance, ** 5% significance, * 10% significance

Figure 5 The effect of independent variable on the dependent variable "top50"

From the table can be observed that the effect of SOX on the number of restatements reported does not differ between large and small firms. Regarding the non – audit fees however there is a significant difference between the different ranks of the Fortune 500. This can possibly be explained by the fact that larger firms have more budget to spend on non – audit fees and thus were also more severely hit by the prohibition of combining audit and non – audit services.

Lastly, the variable “Big 4” also shows a significant coefficient that would indicate larger firms more often have a big 4 audit firm. However the coefficient is nearly zero so this result does not indicate a large difference in the choice of audit firm by the different Fortune 500 companies.

5. Conclusion

The fact that the Sarbanes Oxley Act has changed the dynamics of the audit market became very clear in the literature review. The change from peer review to PCAOB inspection and the stricter guidelines led to higher costs for both audit and public firms. Multiple low quality small audit firms even left the public audit market due to the legislation. Questions were raised by the business world if the Act had had its projected benefits. This led to the following research

question: “To what extent did the Sarbanes – Oxley act of July 2002 affect the functioning of the audit market in the period 2001 - 2006?”. This research question was made easier measurable by dividing it in four sub – hypotheses.

The intention of the data analysis was to research what the effect was of the Act on the

magnitude of non – audit fees and the choice of audit firm. Following the effect of the change in these variables was examined in relation to audit quality, measured by the number of

restatements. Following large and small public firms were compared to see if the results of this research could be generalized to all public firms.

It can be concluded that the number of restatements have significantly decreased since the introduction of SOX when dividing the time period in the periods 2001 – 2002 and 2003 - 2006. However, there was a large spike in the number of restatements in 2002. This could indicate a fast increase in audit quality right after the introduction of the Act. The decrease in restatements that follows is then caused by the fact that the financial statements of the sample firms were

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already according to the SOX guidelines and needed no further adjustment. The analysis however did show the number of restatements per year remained above the level of 2001, indicating audit quality continued to slowly increase.

Moreover the magnitude of non – audit fees has significantly decreased due to the Act. There is a small negative connection between non – audit fees and the number of restatements. This would be in line with the view of proponents of the Sarbanes Oxley Act stating that providing non – audit and audit services to the same company can decrease auditor independence and thus audit quality.

In the past multiple researchers had found that being audited by a Big 4 audit firm increased audit quality. However this research showed a non – significant relation. Nonetheless when comparing the top 50 public firms with the firms on places 400 – 500 the relation between the choice for a Big 4 audit firm and the public firms’ position on the Fortune 500 was significant. However the coefficient of this relation was near zero. This is due to the fact that nearly all firms in the dataset were already audited by a Big 4 firm before the introduction of the Act.

In summary, when measuring audit quality by the total number of restatements, audit quality increased very quickly after the introduction of the act and continued to slowly increase in the following years. The significant decrease in non – audit fees is significantly linked through the number of restatements to an increase in audit quality. However there was no significant shift from or to Big 4 audit firms after SOX. Small public firms experienced a smaller decrease in non –audit fees, however their results regarding the number of restatements and the shift to Big 4 firms were nearly equal to that of larger public firms.

6. Review

An important limitation of this research is the fact that it is based on a before – after analysis. The conclusions drawn from these type of analysis are always disputable because it can never be said with certainty that the change in a variable is caused by the described event. In the case of the Sarbanes – Oxley Act the introduction of the law fell together with multiple political and economic developments. For example, even if the act would not have been introduced the market would still have had to deal with the consequences of the fall of Arthur Andersen and the

changed business perspective on audit quality due to the multiple scandals of large, seemingly trustworthy, companies. In this research the choice of restatements as measure has tried to minimize this risk. They have a clearer connection to the introduction of the legislation than abnormal accruals. However this of course does not eliminate the uncertainty. Iliev (2010) in his research tried to isolate the effect of SOX. He did so by examining small firms and comparing groups of firms which had different dates of having to comply with SOX. However in this research this was not possible since all the Fortune 500 companies, also the companies in places 400 – 500, were accelerated filers and thus had the same compliance date.

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Another important limitation of my research is the fact that only the number of restatements has been used to measure the quality of audit. If the subject would be further researched other

measures, as for example the probability of a going concern opinion, should also be used to see if audit quality has increased.

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Effect of the Sarbanes Oxley Act on audit quality