Using Malmquist Indexes to measure changes in the productivity and efficiency of US accounting firms before and after the Sarbanes–Oxley Act

Abstract

There have been many criticisms of the Sarbanes–Oxley (SOX) Act passed in July of 2002 to correct business accountability and performance practices. The act has a major emphasis on accounting and its practices. This paper attempts a response to these criticisms by investigating changes in productive efficiency for 62 of the largest US public accounting firms between the periods (2000–2001) and (2003–2004)—the periods before and after enactment of SOX in July of 2002. DEA is used to calculate Malmquist indexes of productivity and efficiency changes. This index is used because it can distinguish between changes in technical efficiency, which limit the possibilities, and changes in the performance efficiencies for each firm. Contrary to many of the criticisms, results indicate that accounting firms have exhibited significant post SOX growth in productive efficiency which is better than pre-SOX performances.

Introduction

There has been a large and very vocal outburst of criticisms of the Sarbanes–Oxley (SOX) act passed by Congress in July of 2002 and signed by President Bush. This act is aimed at correcting practices believed to be associated with the recent parade of business and accounting scandals. See Prentice and Spence [1] for a comprehensive survey of these criticisms and possible responses. See also Prentice [2].

Many of these criticisms are reminiscent of the similar criticisms evoked by the Securities and Securities Exchange acts of the 1930s which represented responses to similar deficiencies in business accounting and financial practices that were believed to have led to the 1929 stock market crash and the subsequent “great depression.” These 1930s criticisms have long since abated, however, and, as noted in Prentice [2], the regulatory activities—especially the accountability and full disclosure requirements associated with these laws—have now become models for other countries to follow.

See also Ijiri [3] who describes the reaction to the legislation directed to accounting reform in the 1930s as well as to SOX—which Ijiri refers to as the “reform bill,” that was in process at the time of his writing. This is all preparatory to his discussion of the need to focus on “procedural fairness” instead of the “fairness” concepts that have been a guide to FASB and its predecessors going back to the 1930s.

Comment 1

The prospect of prohibiting simultaneous provision of accounting-audit services and the more profitable MAS (management advisory services) was of particular concern to the accounting industry which mounted a campaign against this legislation. However, a veritable flood of scandals, some involving accounting firms, swept aside these objections. See Asare et al. [4] who used a designed experiment to test these conflicting claims and found that their results were consistent with the claim of the accounting industry that this practice was not associated with higher risks.

Other papers also appearing in JAPP that deal with effects of SOX on accounting include Zhang et al. [5], which deals with internal control weaknesses and finds that recent auditor changes are more likely to be associated internal control weaknesses. See also Krishnan [6]. Gordon et al. [7] find strong evidence that corporation information security activities are receiving more focus since the passage of SOX, and Cullinan et al. [8] who find a significant association between executive loans and financial misstatements. Thus, these studies as well as others we examined, deal with propriety whereas we deal with performance efficiencies.

In this paper we report on an inquiry directed to ascertaining performance effects of SOX (if any) on 62 of the largest US public accounting firms. We selected accounting firms partly because of data availability (at the early stage, 2005, when the data for this study were collected) but also because accounting firms and practices constitute a center piece of this legislation.

For this study we divided the data into two groups: post-SOX (2003–2004) and pre-SOX (2000–2001). We then employed a relatively new version of the Malmquist Index to evaluate the changes, if any, in performance efficiencies of these 62 firms. We chose the “Malmquist index” to study these changes because this index makes it possible to distinguish between effects that reflect changes in efficiency that are due to the firm performances and the effects that are associated with changes in the productive possibilities associated with legislations, etc. (The latter effects can be regarded as externalities that affect the productive possibilities for accounting performances—e.g., effects on financial markets, where critics claim that expenses arising from the need for complying with the information requirements imposed by SOX result in diversions of IPOs from US to foreign financial markets.) See Prentice [2].