Regulatory Commitment to Auditing: The Impact of Sarbanes-Oxley on Pay-Performance Sensitivity and Managerial Effort

Abstract

The purpose of this paper is to investigate the impact on pay-performance sensitivity of a commitment by regulatory bodies to monitor the auditing of managers' financial reporting. We approach our investigation first by modeling the effects of an imposed mandatory audit of the auditor. We suggest that in a more rigorous audit environment, the reliability of performance measures increases. In motivating employees to work to their maximum potential, investors can rely on these performance measures to better effect. We then test our model in an empirical setting by comparing managers' pay-performance sensitivity before and after the passage of the Sarbanes-Oxley Act of 2002 (SOX). Our model reveals that both managerial effort levels and pay-performance sensitivity increase from a laissez-faire environment with the introduction of a regulatory commitment to auditing. Consistent with the model's prediction, our empirical tests of the impact on managerial incentive schemes after SOX reveal that pay-performance sensitivity did in fact increase.