MIT Sloan professor challenges congressional criticism of corporate reform law

Far from hurting thm, Sabanes-Oxley can financially benefits firms

Cambridge, Mass. — Despite current calls in Congress to ease the Sarbanes-Oxley corporate reform law, an MIT Sloan School of Management professor and co-authors finds that the act's reporting and disclosure standards have meant significant financial benefits for businesses, including smaller firms that some in Washington now seek to exempt from the law.

Far from just adding to corporate costs, says MIT Sloan Assistant Professor Ryan LaFond, “our findings tell a very different but consistent story about Sarbanes-Oxley. Firms with strong internal controls already in place and firms that remediate prior control weaknesses are rewarded with a significantly lower cost of capital,“ which falls by as much as 150 basis points for firms that can demonstrate such compliance.

LaFond, whose study is among the first to document potential benefits rather than costs from Sarbanes-Oxley (SOX), compared unaudited financial disclosures by companies prior to SOX to audit opinions issued after the law was enacted.

“Our results indicate that the market was adding higher costs of capital borrowing even before the formal internal control reporting required by SOX,” he says. “Companies with poor internal controls tend to have poorer quality financial information, which indicates problems to investors, which causes the market to assess a higher cost of capital.“

But that market penalty is reversed — and capital costs are lower — after SOX enables companies to prove to investors they have maintained or established solid financial systems.

“A subset of the firms that we reviewed had poor internal controls,” says LaFond. “The real test of our study is whether their cost of capital goes down once the SOX audit demonstrates to the market that the internal control problems are fixed. And those costs do consistently go down.”

LaFond agrees that SOX does add costs for businesses, but he says that burden will most likely ease over time. “Most audit firms will tell you that there was a large, one-time cost to get companies up to speed to meet SOX requirements, but going forward, things won't be so costly. There is already some evidence that audit fees are going down.”

While data on smaller firms is harder to track, LaFond suggests that smaller firms may see financial benefits from SOX.

“Our results suggest that some smaller firms may find the potential benefits in terms of cost of capital reduction well worth the cost of a SOX audit of internal controls,” he says.

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