Do SOX Compliance Costs Affect IPO's??

The costs required to comply with Sarbanes-Oxley are currently a highly publicized topic in accounting. We decided to research the affect that Sarbanes-Oxley compliance costs are having on the number of IPO's in the U.S. and several foreign markets. Our research led us to adopt the hypothesis that Sarbanes-Oxley Costs are not directly affecting the number of IPO's around the world. We used number of IPO's in various markets as the dependent variable, and GDP percentage growth, exchange rate purchase power parity (PPP), percent changes in exchange rate purchase power parity (PPP), gross income from investment, percent changes in gross income from investment and gross income from investment divided by GDP in our analysis. The results of our analysis show that there is not a significant correlation between these factors and the dependent variable. We then did some research to determine if there are any other factors affecting the number of IPO's in the U.S. We found a multitude of other issues influencing where a company decides to list, including high underwriting fees, state-owned interests, and globalization to name a few. We found out that the reason that Sarbanes-Oxley compliance costs are so often blamed for the shift in IPO's is due to a push for a reform of section 404. We determined that if we had the appropriate data, we would test to see if there is a relationship with high underwriting fees, we would test other emerging markets, exclude companies with state-owned interests from the study, breakout SPO's and IPO's, examine companies trading on the U.S. markets under 144a, and check the companies with IPO's to see if they met the requirements to list on the NYSE or NASDAQ and if not, exclude them from the study.
Motivation

Since the creation of the Sarbanes Oxley Act of 2002 (SOX) there has been a great deal of controversy surrounding the soaring costs associated with implementation, especially section 404 the management's report on internal control's over financial reporting. This is a hot topic has been in the news a great deal lately. The interest in the subject came when we read an article in the CPA Journal entitled "Reducing Sarbanes-Oxley Compliance Costs" by Thomas A. Basilo in January 2007. The article explained some of the reasoning behind the high costs and alluded to the idea that the main reason for the high cost of compliance is due to section 404. This seemed like a very interesting topic that we wanted to explore further. Many questions arose:

Why were initial projected costs so grossly understated by the PCAOB?

How is this affecting the economy?

What does the future hold for SOX compliance costs?

How is this affecting organization's? We used these questions to further explore the subject through a literature review. Literature Review 1

We investigated a multitude of articles on this subject and below we are going to discuss each one we found that was relevant and how it helped to further define our topic. "Reducing Sarbanes Oxley Compliance Costs" - Thomas Basilo

This is an article that first struck our interest in the topic. The author explains that the costs of SOX have been very significant especially for non-accelerated filers (those with market capitalization of $75 million or less) and the PCAOB is currently working on a "top-down risk based approach" to help reduce these costs. The author believes that this approach is the reason for the high compliance costs and therefore does not agree that the PCAOB's new guidance will help to alleviate these costs. The author believes that the high initial costs of SOX compliance and how far out of line they are from the PCAOB's projection are due to three major factors:

The learning curve associated with implementing a new standard

Internal control documentation had not been updated due to the Risk based approach so now that is has it will be smoother in the future

Companies that waited until the last minute to comply placed a huge demand for qualified SOX compliant firms raised costsThis article was very insightful into possible reasons for the understatement of projected costs by the PCAOB. "Up's and Down's of Audit Fees since the Sarbanes-Oxley Act" - Jack Ciesielski

Since the inception of SOX and Section 404 the auditing profession has been under strict scrutiny for the increase in audit related fees. Between 2001 and 2004 audit fees have increased by 103% for 496 of the 500 companies on the S&P 500. The largest of this percentage is attributed to smaller companies. Combined audit and audit-related fees have increased 43% over the 2003 fees which was the first year that accelerated companies had to comply with Section 404. For smaller non-accelerated companies (market capitalization under $75 million) this is not until their first fiscal year ending after July 15, 2008. It will be interesting to view the change in their fees after this point.

It has also been stated in the article that in preliminary 2005 numbers the average audit fees for second year 404 implementation is expected to decline 39% for smaller companies and 42% for larger companies. It also shows that audit fees related to first-year Section 404 implementation accounted for 35% of SOX compliance for small companies and 26% for larger companies. Overall there are obvious trends in audit fees since the implementation of SOX which can be attributed to Section 404.

This article is the first article we found that give figures and trends in audit fees since Sarbanes-Oxley. It also supports the argument by Thomas Basilo that there was a learning curve to the compliance by the accounting profession and once it's over there will be a significant reduction in costs. However this article also shows that the affects of SOX are most significant on small companies that do not have the appropriate resources to properly comply and handle this magnitude of change. "Small Firms Face Big Bills to Come Clean" - Lisa Fickenscher

This article discusses the challenges facing small companies when it comes to Sarbanes-Oxley. The costs for a small company are so large relative to revenues, that many small private companies are deterred from going public. They do not want to take on the enormous cost and the risks involved. These small companies that have relatively few employees cannot afford to devote the time to complying with SOX. The CEOs and CFOs of these small companies are typically stretched thin as it is, so the likelihood of missing something is higher. This is quite stressful for these executives, with all of the personal risk on the line. This article suggests that fewer small companies have the opportunity to go public and raise the capital they need to grow, due to the high costs of SOX compliance.

"Selling to Escape Compliance Costs"- Mary Calegari and Howard Turetsky

This article talks about the costs of Sarbanes-Oxley being such a burden that it is more profitable for companies to look for alternatives than to take on the costs to comply with Sarbanes-Oxley. These high costs have a dramatic affect for smaller companies which do not have enough resources to comply. One alternative is to sell the company to a larger firm, which is beneficial when the buyer has its SOX strategies in place and working smoothly. Another alternative is to privatize, but this makes things hard if capital needs to be raised. Small to mid-sized companies face difficult decisions in planning a strategy for SOX compliance.

This article demonstrated to us that the costs of compliance can be such a burden on smaller to midsize companies that they may actually consider changing their business plan and structure to accommodate Sarbanes - Oxley. We asked ourselves is this affecting the number of IPO's in the market?

"Restatements Up, But Sarbox Work" - Stephen Taub

This article argues that SOX does work based on the finding by Glass Lewis that financial restatement among SOX compliant companies has dropped while financial restatement among non-SOX complaint companies have risen to record high. In 2006, there was 40 percent increase in the number of restatements from companies that are not required to comply with Section 404 while there was 14 percent decrease among companies that are required to comply with Section 404. The author asserts that such significant difference is a sign that "larger companies are making progress on cleaning up their books." The author also implies that the US market sees benefits from SOX by alluding to the finding by Glass Lewis: The median stock return of companies that filed restatement were 20% lower than the return for the Russell 3000 stock index in 2006.

"China becomes world's 2 biggest IPO destination"

This article points out that more and more companies are going overseas to avoid SOX compliance costs, particularly Section 404 costs. For instance, 24 of the 25 largest initial public offerings (IPO's) happened outside the United States in 2005 and only 3 of the 25 largest IPO's have been listed in the United States in 2006. UK remains the world's biggest market for IPO's, which handled $52.7 billion worth of IPO launches. China handled $45 billion worth of IPO's and took the second place as the world's capital source for corporate finance as of November 2006. The United States, which was overtaken by China for the first time, handled only $42.4 during the same period. The author asserts that such trends are due to SOX compliance costs. To support the point, the article contains a figure showing dollar amount of IPO's in the US, UK, and China from year 2000 to November 16 2006.

The data in the figure included two years prior to SOX went into effect and the initial look at the numbers seems to confirm the author's point. However, the biggest weakness of the study, in my opinion, is that comparison of IPO's among three nations in terms of dollar amount would not present an accurate picture due to IT bubbles during year 2000. The second weakness, in my opinion, is that the time-frame of the analysis is too short (only 6 years) to reveal true trend in the world IPO markets.

This is an excellent article which illuminated an interesting topic for further investigation. Have the SOX compliance costs really decreased the number of IPO's in the United States or are there other factors that may be affecting the IPO's? We are going to investigate this further with a more narrow second literature review. Hypothesis

We hypothesize that Sarbanes-Oxley Costs are not significantly affecting the number of IPO's around the world. We believe that there are other more prevailing factors that are affecting the number of IPO's which we are going to investigate further. Through our data collection and analysis we are going to either accept or reject this hypothesis.

Data Sources

One dependent variable and seven independent variables were included in the study. We are interested in finding out whether a relationship exists between the Sarbanes-Oxley Act and the changes in number of IPO's worldwide exist. The number of IPO's among various nations is designated as the dependent variable, and Sarbanes-Oxley Act was designated as an independent variable. In addition, to find out whether there were any other factors besides Sarbanes-Oxley that can better explain the changes in number of IPO's worldwide, six additional independent variables were added into the study. The six additional independent variables are GDP percentage growth, exchange rate purchase power parity (PPP), percent changes in exchange rate purchase power parity (PPP), gross income from investment, percent changes in gross income from investment, and gross income from investment divided by GDP. Dependent Variable

We gathered our data for the number of IPO's worldwide from the World Federation of Exchanges website (www.world-exchanges.org) . The number of IPO was labeled as "Number of Companies Newly Listed." Although we acknowledge that number of companies newly listed may also include second public offering (SPO), we assume that the number would be insignificant for the result of our study.

The data was broken down into two groups on the website: main markets and emerging markets. The website does not mention the criteria for dividing the counties into the two groups. However, we found the result of the breakdown fit the purpose of our study well since the data for all developed countries and most of developing countries were included in equity markets. We decided to use only the main markets data.

There were three reasons for excluding emerging markets from our data set. The first reason was the unavailability of IPO data among many countries classified as emerging markets. Secondly, except for two emerging markets in North America, IPO by foreign companies in emerging markets was very insignificant. To take 1997 and 1998 as an example, there were practically no IPO's by foreign companies except for Bermuda and Pacific in North America. Lastly, we believe that it is highly unlikely that both US domestic and foreign companies would go to emerging market for the IPO's to avoid high compliance costs due to the Sarbanes-Oxley Act. For example, when foreign companies consider an IPO in the US, they believe that it is easier to get financing in the US than their home countries despite the additional compliance costs. For many foreign companies from developed countries, it would be harder to get financing in the emerging markets.

Lastly, we were able to obtain two separate data sets for the number of IPO's on the same website: one data set included both domestic and foreign companies and another data set included the number of IPO's by foreign companies only. As a result, two sets of regression analyses were performed using the data.

Independent Variables

1. Sarbanes-Oxley Act

The SOX variable was divided into three groups and treated as a categorical variable: 1) all countries including the US prior to SOX, 2) all countries excluding the US after SOX, and 3) the US after SOX. To run the SOX variable into the regression model, SOX variables coded with three numbers: "0" for all countries including the US prior to SOX, "1" for all countries excluding the US after SOX, and "-1" for the US after SOX.

We decided to use year 2003 as a point that sets apart the pre-SOX years from the post-SOX years. Sarbanes-Oxley Act was finally approved by President Bush in July 30, 2002 and did not go into effect for the majority of publicly traded companies until year 2003 hence we feel the affect of SOX would not have been relevant in companies until 2003.

2. Gross Domestic Product

The data for the GDP variable was obtained from the Euromonitor International website (www.euromonitor.com). All of the data for every country in our dependent variable were available on the website. We decided to use GDP as one of our independent variables since GDP is the most common and widely used way to measure the size of nation's economy. We believe that bigger the size of the economy, the country will experience an increase in number of IPO's.

We decided to use annual percentage growth in GDP instead of using raw numbers because we did not want to have a big numerical discrepancy between our dependent variable and independent variables. For example, the largest number of total IPO's for the US was 382 in year 2005 while its GDP in the same year was over 12 million dollars.

3. Exchange Rate Purchasing Power Parity

The data for purchase power parity conversion factor variable was also obtained from the Euromonitor International website. Purchasing power parity (PPP) states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. For example, when a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must be depreciated in order to return to PPP.

We believe that the trend of weak US dollars against currencies of other developed countries would play an important role in the worldwide IPO markets. When US companies seek IPO's outside of US, they not only consider the availability of financing but they also consider the foreign exchange gain or loss. If US dollar continues to weaken against other currencies in the future, it may be beneficial for US companies to seek financing outside of the US.

There were three reasons for using exchange rate purchasing power parity conversion factor instead of using ordinary market exchange rate. First of all, by using exchange rate purchasing power parity, we were able to minimize the inflationary effect associated with exchange rates. Secondly, the introduction of Euro among Western European countries made the comparison with other countries difficult. Using the conversion factor, we were able to avoid the complication. Thirdly, since conversion factors are in small figures, we were able to avoid a big numerical discrepancy between our dependent variable and independent variables discussed earlier.

In addition to using the raw conversion factor figure, the annual percentage growth of exchange rate PPP conversion factor was added as an additional variable.
4. Gross Income from Investment

Our last variable is annual gross income from investment. This variable represents income from investment and consists of net property income, dividends, and income (less expenses) from rentals. We tried to find a data set that did not necessarily correlate positively with GDP growth.

By comparing percentage changes in GDP and gross income from investment, we found that there were 77 out of 296 cases that show more than 10% difference between the two variables. Furthermore, in some cases, two variables correlate negatively with each other. In fact, we found that there were 22 out of 296 cases that show strong negative correlation between the two variables. For example, percentage change of GDP for Taiwan in 1997 was 8% while percentage changes of gross income investment was minus 48% in the same year. Although it is intuitive to believe that higher the GDP will yield higher the number in gross income from investment, obviously it is not the case.

Our rationale behind using this data as an independent variable is that companies would prefer to seek financing from countries where more people are willing to take some risk when it comes to investment decisions rather than a country where people want to put all their money into risk free investment. More active investment market, more foreign companies want to do their IPO's in that country.

The data we found was expressed in local currency units so we had to convert it into US dollars. We decided to use fixed exchange rate instead of year-on-year exchange rate in the conversion process. We used the fixed exchange rate in an attempt to get rid of the effect of exchange rate fluctuations.

As with other independent variables mentioned earlier, the annual percentage growth of gross income from investment was added as an additional variable to the dollar volume. Furthermore, we created one more independent variable by dividing gross income from investment by GDP. Literature Review 2

After we completed the first literature review we narrowed our topic to decide does Sarbanes-Oxley really affect the number of IPO's and if not then what other factors may be major contributors? We chose many different factors that we feel are contributors to the decline in the number of IPO's which we explained above so we completed another literature review to investigate further how these factors may have affected the number of IPO's. "SarBull!!! The Truth Behind the IPO Imbalance; Those U.S. vs. Overseas Stats are More SarbOx Spin Than Substance" - Andrew Osterland

The article argues that the shift of IPO's to the foreign markets has very little to do with the stringent requirements imposed by Sarbanes-Oxley, and more to do with globalization of financial markets and the higher cost of raising capital in the U.S. One argument that the article makes is that many of these companies never wanted to list in the U.S. anyways, SOX or not. Many of the top 25 IPO's listed in 2005 such as Bank of China, The Industrial and Commercial Bank of China, Electricite de France, Telenet, and Vakifbank had state owned interests. This factor makes listing on their local exchanges the obvious choice due to political advantages. The article also points out that several of the largest IPO's in 2005 were stocks that the U.S. markets would not want to trade anyway. An example is PartyGaming who listed on the London Stock Exchange. The stock sharply declined when the United States Congress instituted legislation restricting on online gambling. Another argument this article makes is many of the IPO's were listed on the local exchanges due to lack of familiarity in the U.S. These companies will be able to raise more capital in a local market where they are well-known to investors versus the U.S. market where they aren't easy recognizable investors. High underwriting fees in the U.S. markets is another argument made for the lack of U.S. IPO's. The average underwriting fee in foreign markets is around half of fee in the United States. Those claiming that Sarbanes-Oxley is a cause of the flight of IPO's can point out the shift of small companies to foreign markets, however when examining these instances closer, many of these companies are too small to meet the lowest NASDAQ listing requirements. This article was very helpful in our research as it explains many other factors contributing to the shift of IPO's overseas, substantiating our deductions that SOX is at best a minimal factor in the trend. "Blaming SOX for Slump in IPO's Seen as Bum Rap; Law Advocates Claim U.S. Market Has Been Hurt by Globalization" - Andrew Osterland

The article gives the argument that the reason for the shift of IPO's is globalization. Foreign markets are growing and becoming more competitive with the U.S. markets. U.S. economic policy and regulations have promoted a more competitive global marketplace. The foreign markets are growing and able to compete with the U.S. exchanges. Even though the U.S. has missed out on many large IPO's, the U.S. is still in the number one spot, with a 20% dollar share of the IPO volume. It is becoming a natural choice to list on the local exchange now that there is more access to capital. This article quotes Barbara Roper as saying "You could repeal SOX, and (big foreign firms would) still list overseas."

This article supported our findings by giving us another explanation for the trend in IPOs by explaining that other markets are growing and evolving, and therefore better able to compete with the United States, so companies no longer have to list in the U.S. to raise capital, when it is easily accessible in the home market and accompanied by political advantages. "Globalization Gone Awry?"

The article explains looks at another aspect that is causing the IPO shift. The U.S. tort system is seen as a major factor for companies considering listing in the U.S. The legal system in the U.S. is overloaded with cases concerning compensation for injuries and, class action law suits in relation to pension plans. The excessive number of law suits in the U.S. causing trepidation for companies deciding where to list. However, the article then highlights the benefits to such rigid laws. By imposing such stringent regulations, investors have greater confidence in the market and companies are shielded from intellectual property theft. This article also argues that the shift of IPO's away from the U.S. may be overstated. The article identifies SEC rule 144a, which allows qualified institutional investors access to the U.S. capital market without registering on an exchange.

This article reveals another rationale for the burst of companies listing on foreign exchanges as opposed to the U.S, focusing on the U.S. legal system. "Adios, IPO's"

The article explains the costs associated with an IPO in the U.S. more in-depth and ascertains that these high costs are the reason for the IPO shift. This piece states that the average underwriting fees for companies going public on the NYSE and NASDAQ are about 6.5 percent and 7.0 percent, while fees for companies on the LSE's main market and the Alternative Investment Market were 3.25 percent and 4.0 percent. Another cost concern is that the "IPO discounts" are higher in the U.S. than in other markets. This is the amount that the IPO rises on the first day. This is not good for the companies selling their shares as it raises the cost of capital. Other costs mentioned are for lawyers, accountants, printers and investor relations professionals. This obviously includes Sarbanes-Oxley costs; however the perception of companies is that all of these costs are higher in the U.S. This article suggests that in the age of globalization, IPO's are becoming more of a commodity which requires a competitive price. Mayor Michael Bloomberg stated that New York City is a high-end product, but if a high-end product doesn't offer superior value, it could easily lose market share. This article provides further insight with respect to the costs linked to an IPO and how they are affecting a company's decision of what market to list on.

Data Analysis

The small difference (1%) between r² and adjusted r² indicates that we did not try to get a better fit by including too many predictors. In other words, it suggests that the model does not contain useless predictors.

Our model yields r² =0.683 for total IPO's and r² =0.308 for foreign IPO's. We could say that the predictors in the model explains 68.3% of the variation in number of total IPO's and 30.8% of the variation in the number of IPO's by foreign companies. Based on the high r² (0.683), the coefficient of determination, we concluded that our model using the Y₁ (number of total IPO's) as the response variable useful. On the other hand a much lower value of r² (0.308) in Y₂ (number of IPO's by foreign companies) suggests that the model was not so useful. In addition, the overall regression for Y₁ (F=48.59, p=.000) is much more significant than r² (F=5.83, p=.000). For those reasons, we would only discuss the outcome of the model using number of total IPO's as the response variable in the remainder of the paper.

For the investment income predictor, the very small value of coefficient indicates that the result is not useful to explain the changes in Y₁ although its p-value was the smallest (p=.000) among our predictors. The percentage changes in exchange rate PPP predictor, on the other hand, indicates that the variable is not only statistically significant (.019) but also there is a significant decrease in number of total worldwide IPO's when the percentage in exchange rate PPP increases (coefficient=-210.57). In addition, the small p-value (.006) and strong coefficient of the intercept (26.78) indicates that if we had more time and added additional predictors into the model, we would have found predictors that could better explain the changes in number of total worldwide IPO's. Lastly but most importantly, the positive value of the coefficient (9.97) and large p-value of SOX predictor (.42) suggest two important things: (1) There is no negative correlation between Sarbanes-Oxley Act and changes in number of total worldwide IPO's, and (2) the Sarbanes-Oxley Act does not have statistical significance for changes in number of total worldwide IPO's. Therefore, we would reject our null hypothesis and accept our hypothesis that Sarbanes-Oxley is not a major factor in the number of IPO's around the world. Conclusion

The results of our analysis show that there does not appear to be a significant relationship between Sarbanes-Oxley compliance costs and the number of IPO's in the U.S. Our additional research highlighted some other factors that could have a relationship with the number of IPO's in the U.S. If we had additional time and resources, we would have performed several other tests. We would test the relationship of IPO's with underwriting fees for each individual company. We would also like to include other emerging markets in our study to get a broader scope and perhaps identify a relationship with globalization. The information was not available on emerging markets when we preformed our research so this would take some more time and resources. If we could redo the model, we would like to exclude the companies with IPO's that have state-owned interests. In our model we were unable to differentiate between SPO's and IPO's, so both are included. If we had additional resources we would like to be able to distinguish the difference between the two. We would do additional research to see how many companies are trading in the U.S. markets under section 144a, which would show additional market activity in the U.S. without having to list publicly. Finally, we would examine the details about each foreign IPO to see if the companies actually meet NASDAQ requirements and if they do not, we would exclude them from the study.

Additionally, we found that the argument that Sarbanes-Oxley costs are affecting the number of U.S. IPO's is generally being made by parties with a political agenda to reform Sarbanes-Oxley, and more specifically section 404. Our research shows that this argument holds little water and there are not many facts to support it.
Appendix A - Analysis of Covariance - Total Number of IPO's

Appendix B - Analysis of Covariance - Number of IPO's Foreign Companies

Bibliography

Anonymous, "Globalization Gone Awry?" Chief Executive. New York: Jan/Feb 2007. p. 48

Basilo, Thomas. "Reducing Sarbanes-Oxley Compliance Costs. "The CPA Journal 77.1 (2007): 6,8-9. ABI/INFORM Global. ProQuest. Oakland University Library. Rochester, MI. 14 Mar. 2007 http://www.proquest.com/

Calegari, Mary, and Turetsky, Howard, "Selling to Escape Compliance Costs",Mergers & Acquisitions, 41 no9 p54-58, Sept. 2006.

"China becomes world's 2 biggest IPO destination". Xinhua Economic News Service. November 29 2006.

Ciesielski, Jack, Thomas R Weirich. "Ups and Downs of Audit Fees Since theSarbanes-Oxley Act. "The CPA Journal 76.10 (2006): 28-30,32,34- 35. ABI/INFORM Global. ProQuest. Oakland University Library. Rochester, MI. 14 Mar. 2007

Fickenscher, Lisa, "Small Firms Face Big Bills to Come Clean", Crain's New York Business, v18 no37 p1, 2002.

Gross, Daniel, "Adios IPOs", Slate Magazine, August 2, 2006.

Jamieson, Dan, "Blaming SOX for Slump in IPOs Seen as Bum Rap; Law's Advocates Claim U.S. Market Has Been Hurt by Globalization", Investment News, November 27, 2006

Osterland, Andrew, "SarBull!!! The Truth Behind the IPO Imbalance; Those U.S. vs. Overseas Stats are More SarbOx Spin Than Substance", Financial Week, November 13, 2006

Taub, Stephen. "Restatements Up, But Sarbox Works". Economist.com. February 28, 2007.

www.Euromonitor.com

www.world-exchanges.org

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