The effects of the The effects of the Sarbanes/Oxley Act, Sarbanes/Oxley Act,

Specifically Section 404, on Specifically Section 404, on Innovation in America’s Innovation in America’s

Publicly Held CorporationsPublicly Held Corporations

By Wendy Vidlak

BackgroundBackground

Accounting + Creativity =Accounting + Creativity =

Accounting Scandals Made Accounting Scandals Made Headlines In the Early 2000’s Headlines In the Early 2000’s And Forced the Government And Forced the Government

to Actto ActEnron

General Re

Tyco

Xerox

Arthur Anderson

Sunbeam

Freddie Mac

WorldCom

Key Points of Sarbanes/Oxley Key Points of Sarbanes/Oxley (SOX) Legislation(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)

What is Needed for Innovation What is Needed for Innovation at Companies?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)

Purpose of the ProjectPurpose of the Project

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

Thesis StatementsThesis Statements

The costs of Implementing The costs of Implementing Section 404 are Quite High Section 404 are Quite High and Many Corporations are and Many Corporations are

Funding the Increased Funding the Increased Accounting Costs by Accounting Costs by

Reducing Research and Reducing Research and DevelopmentDevelopment

Section 404’s Emphasis on Section 404’s Emphasis on Measuring Corporate Risk is Measuring Corporate Risk is

Creating a Culture of Risk Creating a Culture of Risk Aversion Among Top Aversion Among Top

Executives and Stifling Executives and Stifling Innovation in Areas of New Innovation in Areas of New

Product DevelopmentProduct Development

That Section 404 is Creating That Section 404 is Creating Some Innovations in the Some Innovations in the

Areas of Financial Reporting Areas of Financial Reporting and Procedures as and Procedures as

Companies Attempt to Companies Attempt to Reduce Costs of Compliance Reduce Costs of Compliance

and Open Their and Open Their Financial Processes to Public Financial Processes to Public

ScrutinyScrutiny

Data Gathering TechniquesData Gathering TechniquesCompiled 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

Data Gathering Techniques 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

Results So Far. . . Results So Far. . .

Trademark SearchTrademark 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 12.4Russell 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

Possible Implications of Possible Implications of Trademark SearchTrademark Search

Increased risk and processes increases trademark applications

Many companies had no trademark applications, especially smaller companies

Patent Search ResultsPatent 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 21.6Patents 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

Patent Search Patent Search Implications/ProblemsImplications/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

Financial Analysis 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 2004Administrative expenses increased 15.91%

Financial Analysis ResultsFinancial 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

Literature ReviewLiterature 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)

Literature ReviewLiterature 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)

Other Major Regulatory Other Major Regulatory Changes’ Effects on Changes’ Effects on

InnovationInnovation 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

Where Do I Go From Here?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

Things I LearnedThings 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

ReferencesReferences

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.

References (Cont.)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.

References (Cont.)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.

References (Cont.)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.

References (Cont.)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

References (Cont.)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.

References (Cont.)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