Section 404 of the Sarbanes-Oxley act and its capital market effects

Abstract

Starting with November 15, 2004, Section 404 of the Sarbanes-Oxley Act of 2002 (SOX 404) requires all accelerated firms (with at least $75 million in public equity) to report on the effectiveness of their internal controls over financial reporting. There has been some controversy regarding the burden that it casts on companies and whether the benefits outweigh the costs of compliance. Reporting under SOX is meant to improve investor confidence concerning the stock of a specific company by adding credibility to its financial statements. An increase in the quality of financial information should determine a narrowing of the bid-ask spread. I identify the cost components of the market makers bid-ask spread for a sample of stocks surrounding the implementation of SOX 404. The expectation is that market makers react to the implementation of Section 404 as if information asymmetry has diminished. The study uses the model developed by Bollen et al.(2004) to separate the cost components of the bid-ask spread for a sample of compliant firms in the period surrounding the implementation of SOX 404. Key words: Bid-ask spread, informed trading, information asymmetry, internal controls, adverse selection cost.