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The effects of the Sarbanes/Oxley Act, Specifically Section 404, on Innovation in America’s Publicly Held Corporations

The effects of the Sarbanes/Oxley Act, Specifically Section 404, on Innovation in America’s Publicly Held Corporations. By Wendy Vidlak. Background. Accounting + Creativity =. Accounting Scandals Made Headlines In the Early 2000’s And Forced the Government to Act. WorldCom. Enron.

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The effects of the Sarbanes/Oxley Act, Specifically Section 404, on Innovation in America’s Publicly Held Corporations

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  1. The effects of the Sarbanes/Oxley Act, Specifically Section 404, on Innovation in America’s Publicly Held Corporations By Wendy Vidlak

  2. Background

  3. Accounting + Creativity =

  4. Accounting Scandals Made Headlines In the Early 2000’s And Forced the Government to Act WorldCom Enron Arthur Anderson General Re Xerox Freddie Mac Sunbeam Tyco

  5. Key Points of Sarbanes/Oxley (SOX) Legislation • Does not add many extra protections for investors • CEOs of fraudulent companies’ such as Enron are being tried using the old rules and laws Lambert (2003), Adams (2004), Fisch (2004), Romano (2005) • Now a criminal offense for a CEO to sign a fraudulent Annual Report (http://www.aicpa.org/info/sarbanes_Oxley_summary.htm) • Section 404 requires a company to account for all financial risks and put processes in place to reduce those risks Cobb (2004)

  6. What is Needed for Innovation at Companies? • Embrace Risks Nickerson (1999), Farson and Keyes (2002), Blumentritt (2004), Green (2005), Thain (2004), Carroll (2004) • Capital • Organizational Flexibility Galunic and Rodan (1998), Seaden (2001)

  7. Purpose of the Project • To ascertain the effects of the Sarbane/Oxley Act, specifically section 404, on innovation in America’s publicly held corporations

  8. Thesis Statements

  9. The costs of Implementing Section 404 are Quite High and Many Corporations are Funding the Increased Accounting Costs by Reducing Research and Development

  10. Section 404’s Emphasis on Measuring Corporate Risk is Creating a Culture of Risk Aversion Among Top Executives and Stifling Innovation in Areas of New Product Development

  11. That Section 404 is Creating Some Innovations in the Areas of Financial Reporting and Procedures as Companies Attempt to Reduce Costs of Compliance and Open Their Financial Processes to Public Scrutiny

  12. Data Gathering Techniques • Compiled a random sampling of 50 companies from S&P 500 and 50 from the Russell 2000 Index • Looked at the number of new patents and trademarks each company had before and after SOX • Compared R&D costs with the Administration costs of the companies

  13. Data Gathering Techniques • Send a short e-mail survey to the 100 companies in the sample to help determine if there is a connection between the new law and innovation • Conduct several in-depth phone or e-mail (participant preference) interviews with several companies to try to indicate there is causation to the correlation of the quantitative findings

  14. Results So Far. . .

  15. Trademark Search • S&P 500 Companies trademarks increased from 15.42 per company in 2002 to an average of 18.6 in 2004 • The average from 1992-2002 was 12.4 • Russell 2000 companies trademarks increased from 1.52 per company in 2002 to an average of 1.63 in 2004 • The average from 1992-2002 being 1.16

  16. Possible Implications of Trademark Search • Increased risk and processes increases trademark applications • Many companies had no trademark applications, especially smaller companies

  17. Patent Search Results • Patents approved in 2002 for the S&P 500 sample averaged 25.74 per company in 2002 and 4.5 in 2004 • The average from 1992-2002 was 21.6 • Patents approved in 2002 for the Russell 2000 sample averaged 1.14 per company and in 2004 the average was .2 per company • The average from 1992-2002 is .74

  18. Patent Search Implications/Problems • Numbers taken at face value indicate thesis is true • Companies can keep patent applications secret until approved, which would artificially decrease 2004 numbers • Some industries do not file for patents

  19. Financial Analysis • S&P 500 companies increased R&D spending an average of 17.28% between 2002 and 2004 • Administrative expenses increased 23.4% • Russell 2000 companies decreased R&D spending by 1.3% between 2002 and 2004 • Administrative expenses increased 15.91%

  20. Financial Analysis Results • Significant difference between sample company spending at S&P 500 versus Russell 2000 • Russell 2000 supports the thesis well. S&P 500 numbers still support it but less convincingly • Many of the preliminary trade reports are showing similar issues where the law is hitting smaller companies harder

  21. Literature Review • New products are often used as formal measurements of innovation Thomas (1990), Schnee (1979) • Preliminary results in trade papers show the costs of 404 compliance run an average of $1.9 million for companies with less than $25 million of revenue, approximately 7.6% of revenue • Compliance costs run $4.7 million for companies with more than $5 billion revenue, approximately .09% of revenue (http://www.fei.org/files/spacer.cfm?file_id=788)

  22. Literature Review • Innovative firms take on more risk Farson and Keyes (2002), Guifford and Howe (2004), Blumentritt (2004), Green (2005) • Companies living with fear tend to respond with tests and measures and become more risk averse Meckler (2004), Pearson (2002) • SOX requires many tests and measures Verschoor (2005), Audit committee Brief, Deloitte Development • Organizations are less likely to take new risks for fear of running afoul of SOX Green (2005), Thain (2004), Carroll (2004)

  23. Other Major Regulatory Changes’ Effects on Innovation • 1979 FDA regulations caused new drug introductions to decline 50% Schnee (1979), Thomas (1990) • Large companies increased innovation • Small companies ceased to innovate • Nuclear Regulations after 3 Mile Island (TMI) Marcus (1988) • Companies that were rule bound before TMI became more rule bound • Companies that were autonomous before TMI used the regulations to innovate

  24. Where Do I Go From Here? • Send out surveys • Finish interviews and documentation • Hopefully the surveys and interviews will help strengthen the link between the numbers to the effects of SOX

  25. Things I Learned • Regulations have tremendous impacts on business • Measuring the direct effects of regulations is quite difficult • In a time of global economy, innovation is the key for the U.S. staying competitive, yet we are potentially regulating ourselves out of business

  26. References • Summary of the Sarbanes Oxley Act. AICPA Website. Retrieved November 10, 2005, from http://www.aicpa.org/info/sarbanes_oxley_summary.htm • Audit Committee Brief [Brochure]. (August 2004). Deloitte Development LLC. • Adams, R. B. (2004) Cost, Quality, and Sarbanes Oxley. AACE Internal Transaction, PM81, 3 pages.

  27. References (Cont.) • Blumentritt, T. (2004). Does Small and Mature Have to Mean Dull? Defying the Ho-hum at SMEs. The Journal of Business Strategy, 25 (1) 27-34. • Carroll, J. (2004, December). Could SOX Kill Innovation? CA Magazine. 137 (10) 14. • Cobb, C.G. (2004). Sarbanes-Oxley: Pain or Gain?. Quality Progress, 37 (11) 48-53. • Farson, R. And Keyes, R. (2002). The Failure-Tolerant Leader. Harvard Business Review, 80 (8), 64-72.

  28. References (Cont.) • Fisch, J. E. (2004, Fall). The New Federal Regulation of Corporate Governance. Harvard Journal of Law and Public Policy, 28(1), 39-49. • Galunic, D.C. and Rodan, S. (1998). Resource Recombinations in the Firm: Knowledge Structures and the Potential for Schumpeterian Innovation. Strategic Management Journal, 19, 1193-1201 • Green, S. (2005, March). The Limitations of the Sarbanes-Oxley Act. USA Today, 133 (2718) 66-68.

  29. References (Cont.) • Guifford, R.H. & Howe, H. (2004). Regulation and Unintended Consequences: Thought on Sarbanes-Oxley. The CPA Journal, 74 (6), 6-10. • Lambert, P. W. (2003) Worlds Are Colliding: A Critique of the Need for the Additional Criminal Securities Fraud Section in Sarbanes-Oxley. Case Western Reserve Law Review, 53 (3), p839, 17p • Marcus, A. (1988). Responses to Externally Induced Innovation: Their Effects on Organizational Performance. Strategic Management Journal, 9 (4) 387-403.

  30. References (Cont.) • Nickerson, R.S. (2002). Enhancing Creativity. In R.J. Sternberg (Ed.), Handbook of Creativity (pp. 392-430). United States: Cambridge University Press. • Pearson, A. E. (2002). Tough-Minded Ways to Get Innovative. Harvard Business Review, 80 (8), 117-125. • Romano, R. (2005, May). The Sarbanes-Oxley Act and the Making of Quack Corporate Governance. Yale Law Journal, 114 (7), p1521-1612, 92p

  31. References (Cont.) • Seaden, G. (2001). Public Policy and Construction Innovation. Building Research and Information. 29 (3) 182-197. • Schnee, J. (1979). Regulation and Innovation: U.S. Pharmaceutical Industry. California Management Review. 22 (1) 23-33.

  32. References (Cont.) • Thain, J. (2004, May 27), Sarbanes-Oxley: Is the Price Too High? Wall Street Journal, p. A20 • Thomas, L.G. (Winter 1990) Regulation and Firm Size: FDA Impacts on Innovation. RAND Journal of Economics, 21 (4) 497-518. • Verschoor, C. (2005) Sarbanes-Oxley Section 404 Implementation Needs Modification. Strategic Finance, 86 (9), 17-19

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