Effects of Regulation and Internal Monitoring on Earnings Quality : Evidence from the 2002 SOX

In response to a string of highly publicized corporate scandals, the US Congress passed the Sarbanes-Oxley Act (SOX) on July 30, 2002, with the intention to restore investors' confidence in financial and public reporting. This study addresses the question of whether any improvement in earnings quality (proxied by unsigned discretionary accruals) following SOX depends on the strength of the reporting entity's internal monitoring (proxied by financial expertise or independence of an audit committee) surrounding SOX. We find that the reporting gap between Big4 clients with strong internal monitoring and non-Big4 clients with weak internal monitoring widens shortly after the introduction of SOX. Further analyses indicate that non-Big4 clients with strong internal monitoring can widen the reporting gap over non-Big4 clients with weak internal monitoring from the pre- to the post-SOX period. However, there is no change to the reporting gap between firms with strong versus weak monitoring when they retain a Big4 auditor. These findings highlight potential cross-sectional variations in the value of comprehensive regulations over internal monitoring, such as SOX