SOX 404 and debt contracting value of accounting information

• Pages: 384-412
• DOI: https://doi.org/10.1108/IJAIM-03-2017-0042
• Date: 06 August 2018
• Published date: 06 August 2018
• Author: Shihong Li
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

SOX 404 and debt contracting

value of accounting information

Shihong Li

University of New Mexico, Albuquerque, New Mexico, USA

Abstract

Purpose –This paper aims to investigate whether the Section 404 of Sarbanes–Oxley Act (SOX 404)

changed theway banks use accounting information to price corporateloans.

Design/methodology/approach –The study uses a sample of 1,173 US-listed firms that issued

syndicated loansboth before and after their compliance with SOX 404 to analyze the changes in loan spread’s

sensitivityto some key accounting metrics such as ROA, interestcoverage, leverage and net worth.

Findings –The study finds that the interestspread’s sensitivity to key accounting metrics, most noticeably

for ROA, declined following the borrower’s compliance with the requirements of SOX 404.The decline was

not explainable by borrowers thatdisclosed internal control weaknesses but concentrated among borrowers

suspectedof real earnings management (REM).

Originality/value –By examining the effects of SOX 404 on banks’pricingprocess, this study augments

the literature on SOX’s economic consequences. The findings suggest that lenders perceive little new

information from SOX 404 disclosuresof internal control deficiencies and are cautious about the accounting

informationprovided by REM borrowers. It also extends the research on the useof accounting information in

debt contracting. By examining loan interest’s sensitivity to accounting metrics, it broadens the conceptof

debt contracting value of accountinginformation to include accounting’s usefulness for assessingcredit risk

at loan inception.

Keywords Bank loans, Real earnings management, Debt contracting, Internal control weakness,

Sarbanes-Oxley Act

Paper type Research paper

1. Introduction

Considerable research has investigated the effects of the Sarbanes–Oxley Act (SOX) on

shareholders, managers,auditors and bond holders. Little research, however, has addressed

the effect, if any, of SOX on private lenders, such as bankers. In particular, the question of

whether SOX altered the manner in which private lenders use accounting metrics to

evaluate credit risk has been largely overlooked by accounting researchers. The SOX

mandate that speaks directlyto financial reporting is Section 404 (SOX 404). It requires both

a management certification of and an auditor attestation to the effectiveness of the issuer’s

internal control over financial reporting. This study examines whether and how the

borrower’s compliance with SOX 404 has affected the weight that private lenders place on

its accounting metricswhen pricing corporate loans.

Corporate executives manage accounting earnings for compensation, reputation and

other career benefits (Healy,1985;Dichev et al., 2012). To “have teeth”in curbing accounting

malpractices, SOX specifies a clawbackprovision and criminal penalties in connection with

management certification of financial reporting. If a company restates its financials as a

result of misconduct, the company’s CEO and CFO must return any incentive-based

compensation and trading profits. They are also subject to a prison term of up to ten years

Data availability: All data are available from public sources identified in the paper.

IJAIM

26,3

384

Received27 March 2017

Revised18 July 2017

Accepted18 August 2017

InternationalJournal of

Accounting& Information

Management

Vol.26 No. 3, 2018

pp. 384-412

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-03-2017-0042

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

and a fine of up to $1 million if they knowingly sign off on a false financial report. As

“(auditors) cannot readily challenge real economic actions to meet earnings targets that are

taken in the ordinary course of business”,[1] companies appear to have shifted away from

primarily accrual-basedearnings management (AEM) to more of real earnings management

(REM) in the post-SOX era (Graham et al., 2005;Cohenet al., 2008;Zang, 2012). Did this shift

in the borrower’s method of earnings management affect the lender’s use of its accounting

metrics? I attempt to answer this questionby studying a sample of syndicated loans issued

by US-listed companiesbefore and after their SOX 404 compliance.

I use a before-and-after design to investigate whether SOX 404 altered the weight that

private lenders place on the borrower’skey accounting metrics when assessing credit risk of

corporate loans. For the ease of exposition, I refer to an accounting metric’s ability to

indicate the level of credit risk as its debt contracting value (DCV). As loan interest spread

contains a borrower-specificrisk premium, I use its association with key accountingmetrics

such as ROA, interest coverage, leverage and net worth, as the primary proxy for

accounting DCV. As a robustness check, I also use these metrics’explanatory power with

respect to the loan interest spreadto measure their collective ability to inform on credit risk.

The results indicate that the DCV of examined accounting metrics declined after the

borrower’s implementationof SOX 404, and that this decline was most noticeablefor ROA.

I then investigate two potential explanations for the post-SOX404 decline in accounting

DCV: internal control weaknesses (ICW) and real earnings management. SOX 404 requires

that the registrant assess the effectiveness of its internal control structure and procedures

for financial reporting. The auditor must provide an opinion on the management

assessment; any identified weaknesses in the registrant’s internal control system must be

disclosed. If ICW disclosures reveal previously unknown problems in the borrower’s

reporting system, then the accounting information produced by such a system naturally

loses credibility in predictingthe borrower’s credit risk. The lender will have to rely moreon

other information than accounting metrics to price the credit risk of a loan. To test this

possibility, I examine whether the post-SOX 404 decline in accounting DCV concentrated

among firms that haddisclosed ICWs. The empirical results do not supportthis conjecture.

Another explanation, givenfirms’post-SOX shift from AEM to REM, is that banks view

REM as impairing key accounting metrics’ability to predict credit risk. AEM temporarily

alters the appearance of firm performancewith no direct impact on the stream of cash flows;

REM, however, often changes the timing or structure of business transactions and,

consequentially, can affect both the expected valueand the variability in future cash flows,

which are more important than book earnings to the lender. If lenders believe that REM-

contaminated financialreports lose value in predicting the borrower’s ability to meet itsdebt

obligations, they would rely less on the accountingnumbers provided by an REM borrower

when pricing the loan. Consistentwith this prediction, I find that REM borrowers had lower

post-SOX DCV of ROA than non-REM borrowers.

This study contributes to two streamsof literature. By examining the effects of SOX 404

on banks’pricing process, it augments the literature on SOX’s economic consequences.

Multiple studies examine the effects of SOX 404 on private lenders with somewhat

conflicting results. Kim et al. (2011) provide convincing evidence that banks charge ICW

firms higher interest rate than they do non-ICW firms to compensate for information risk.

They also claim that ICW disclosures under SOX 404 contain new information for private

lenders. However, Dhaliwal et al. (2011) find no bond market response to SOX 404 ICW

reports for firms with private debt in place, implying that the SOX 404 disclosure, though

informative to bond investors, may not be informative to banks[2].Kim et al. (2011) within-

firm analysis, which is pertinentto the question whether ICW disclosures are informative to

SOX 404

and debt

contracting

value

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