How Costly is Sox 404? Evidence from Real Operations

Abstract

This study investigates the impact of SOX 404 compliance on firm real operations. We focus on a sample of firms that report internal control deficiencies under SOX 404. We hypothesize that this group of firms had likely chosen relatively weak internal controls pre-SOX 404 based on cost-benefit tradeoff but were forced to increase spending on internal control under SOX 404. Using a difference-in-difference research design, we show that these firms not only experience difficulty in liquidity management, but also cut back on investment including capital spending, R&D spending and employment growth. The observed patterns are more pronounced for firms facing more severe financial constraint. Lastly, we show that firms with higher SOX 404 compliance costs are less likely to remediate control deficiencies in the following year and more likely to stop financial reporting altogether. This study suggests that SOX 404 compliance imposes real costs on compliant firms that outweigh potential benefits.