The Effect of Section 404 of the Sarbanes-Oxley Act on Earnings Quality

Abstract

In this article, the authors study the effect of Section 404 of the Sarbanes-Oxley Act on two primary characteristics of earnings quality, reliability and relevance in combination. Using a difference-in-differences method, they find that firms that were required to comply with Section 404 during the first 2 years of its implementation improved the reliability of their reported earnings more than control firms that were not required to comply. The results also suggest that the regulation helped to reduce intentional misstatement, which may contribute to the improvement in earnings reliability. Furthermore, the improvement in reliability did not come at the expense of the relevance of earnings. On the contrary, the authors find a significantly larger improvement in the predictive power of current earnings over future earnings and future cash flows associated with complying firms. As earnings quality improved, investor confidence appears to be restored, in that they reacted more strongly to earnings surprises of complying firms than to those of the control firms in the post-404 period. The results of this study suggest that Section 404 helped to achieve the main goal of the Act: protecting investors and restoring their confidence in the stock market by improving the accuracy and reliability of corporate disclosure.