The Pendulum Effects of Legislation on the Probity of Financial Statements

Abstract

Extant theories in sociology, criminal justice, economics, and even political science posit the existence of periodicity in human affairs similar to a pendulum which swings from one extreme to the other. We examine in this study whether such a phenomenon exists in financial reporting, with periods of lax financial reporting followed by legislation which corrects the pendulum swing to the other direction, and eventually a reversal back to laxity. Focusing on the period from 1973 to 2017, we examine the effects of the four successive major laws intended to address internal controls and ensure greater probity in financial reporting, namely the Foreign Corrupt Practices Act (FCPA, 1977), the Omnibus Trade and Competitiveness Act of 1988 (OTCA, 1988), the Sarbanes-Oxley Act (SOX, 2002), and the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (DFA, 2010). Using an industry-level aggregate measure of innate and discretionary accruals as the measures of probity in financial statements, we find evidence of a long-cycle pendulum effect, with the period from 1973 to 2000 forming the downward swing (from the innate accruals standpoint), and an upswing from 2001 to 2017. Validation tests for the industry-level aggregate measures of innate and discretionary accruals find support for them as capturing creditor and equity investor perceptions of changes in information risk over the period examined.