Another unintended consequence of SOX: preliminary earnings

Larry Ribstein —  16 October 2010

We know that Sarbanes-Oxley imposed significant costs on firms in the interests of more accurate disclosures.  Maybe this is a cost worth bearing.  But what if one of these costs is actually less accurate disclosures?

Scott N. Bronson, Chris Hogan and Marilyn Johnson of Michigan State have written The Unintended Consequences of PCAOB Auditing Standards Nos. 2 and 3 on the Reliability of Preliminary Earnings Releases.  Here’s an excerpt from their discussion of the paper on the Harvard Blog:

Historically, the vast majority of publicly-traded companies wait until after the audit report date (i.e., after the completion of audit fieldwork) to release preliminary earnings information. However, the implementation of Public Company Accounting Oversight Board Auditing Standards No. 2 (“AS2”) on internal control and No. 3 (“AS3”) on audit documentation resulted in delaying completion of the audit for a large number of public companies.

Using a large sample of annual earnings releases over the period 2000-2005, we find a dramatic increase in the length of time between the fiscal year-end and the audit report date (“audit report lag”) that is concurrent with the implementation of PCAOB AS2 and AS3. * * * However, due to market demand for timely disclosures, most firms maintain the same preliminary earnings release date even though the audit may not be complete as of that date. Consequently, the incidence of firms announcing earnings after the audit report date declined from close to 70% in the 2000-2001 period to around 20% in 2005. This change is due predominantly to accelerated filers that had to comply with both AS2 and AS3. * * *

Consistent with the increase in the proportion of firms whose preliminary releases contain pre-audit report date numbers, we show that the number of PEA revisions in our sample has increased over time from 12 in 2000 to 186 in 2005. After controlling for characteristics of firms with PEA revisions, we find that this unintended regulatory effect is economically significant in that PEA revisions would have been 35% lower during 2005 if the historical frequency of issuing earnings releases after the audit report date had not changed due to the new regulations.

* * * Consistent with prior evidence of a negative market reaction to announcements that previously-filed earnings numbers will be restated, we find a significantly negative market reaction to the announcement of a forthcoming PEA revision for 35% of PEA revision firms that announce the revision in a press release and/or 8-K. However, we find no significant market reaction when the initial disclosure of a PEA revision is the 10-K filing containing the revised numbers (which occurs in 46% of our sample revisions). This result is consistent with our finding that revisions disclosed in 10-K filings are generally smaller in absolute magnitude than revisions disclosed in press releases and/or 8-K filings. In addition, for firms that foreshadow impending PEA revisions in the earnings press release (19% of our sample), we find that the market reaction around the release of preliminary earnings reflects the market’s reliability concerns, as evidenced by the fact that the market reaction to unexpected earnings is less (more) pronounced for good (bad) news.

So SOX’s requirements do increase the reliability of audited earnings, but also result in increased release of less reliable pre-audit information.  Any assessment of the benefits of SOX must take both of these effects into account.

This is one of many papers on the unintended consequences of SOX.  We await the papers on the unintended consequences of Dodd-Frank.

Larry Ribstein


Professor of Law, University of Illinois College of Law

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