How Sarbanes-Oxley Changed Firms’ Responses to Announcements of Earnings Restatements

Among the many goals of the Sarbanes-Oxley legislation was to increase CEOs’ accountability for the veracity of financial statements by requiring that they personally certify financial disclosures. Although that provision has not led to  successful prosecutions of offending executives, our research finds that the act has had a related impact, although by way of an unexpected mechanism.

In our recent paper, Shine a Light: How Firm Responses to Announcing Earnings Restatements Changed After Sarbanes-Oxley, we find that firms forced to restate earnings are much more likely to replace their CEOs than they were before Sarbanes-Oxley was enacted. This is an informal consequence of the law rather than the result of legal enforcement. Our findings demonstrate that the law increased CEO accountability and changed expectations for the appropriate response to accounting failures. We further find that Sarbanes-Oxley amplified the effect of media coverage on firm responses to financial misconduct.

What accounts for this change in firms’ response to earnings restatements? In line with previous research, we argue that Sarbanes-Oxley generated several forms of pressure on companies that led to changes in organizational behavior. Some of these pressures are coercive, requiring that internal practice align with regulatory expectations. Others are normative, engendering change to signal compliance with the legislation, even if such changes are not specifically required by the law. Both coercive and normative pressures lead firms to proactively demonstrate compliance.

We propose that Sarbanes-Oxley generated an additional form of pressure – what we call reactive normative pressure – which governs how firms ought to react to evidence of non-compliance. That is, the new legislation generates an institutionally appropriate response to violations of the law. It is the consequences of reactive normative pressure that we explore in our research.

Our study finds that one such consequence is the replacement of CEOs, a costly, painful, and visible undertaking that nonetheless signals a credible commitment to change and is therefore often used as a tool for impression management. This effect is not the result of a legal requirement, but rather of stakeholder expectations. By holding the CEO responsible for the accuracy of financial statements, Sarbanes-Oxley generates normative pressure for firms to take remedial action that is both costlier and more visible than was expected before the legislation.

We also find a second explanation for increased CEO turnover, driven not by the legal system but by the media. Media scrutiny has always pushed firms to take significant remedial action, but the degree to which that is true changed around Sarbanes-Oxley. Before 2002, earnings restatements were relatively rare events, with which the public was largely unfamiliar and which the business press found difficult to explain. The raft of corporate accounting scandals between 2000 and 2002 increased public awareness and involved regulators, politicians, and the media in a very visible legislative process.

With so much attention focused on the reliability of financial statements, both the media and the public began to understand accounting failures in a more concrete and systematic way, leading to heightened media attention to and public scrutiny of restatements. In sum, the events that led to the Sarbanes-Oxley provided a new lens through which to make sense of organizational wrongdoing. This changed the meaning and the effect of media attention and amplified the effect of media scrutiny on the likelihood of firms firing their CEOs.

Our findings imply that sometimes the greatest impact of a legislative change comes not from legal enforcement but from changed expectations of appropriate firm behavior, which come about by focusing laypeople’s attention and sharpening their understanding of what they may have previously seen as an esoteric regulatory issue.

This post comes to us from Professor Jo-Ellen Pozner at Santa Clara University. It is based on a recent article, “Shine a light: How firm responses to announcing earnings restatements changed after Sarbanes–Oxley,” by her and professors Aharon Mohliver at London Business School and Celia Moore at Imperial College Business School. The article is available here.

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