In Section 1.2, we noted a provision of the 2002 Sarbanes- Oxley Act ( SOX)— namely, the requirement for the CEO and Chief Financial Officer ( CFO) of public companies to certify the proper operation of their internal controls ( ICs) over financial reporting, with deficiencies and their remediation to be publicly reported. Wang (2010) pointed out that the CFO is the senior executive primarily responsible for the quality of the firm’s financial reporting, and thus that this reporting quality reflects the quality of the CFO’s effort.
Wang compared the compensation of CFOs for a large sample of public companies before (1998– 2001) and after (2002– 2005) SOX, separately analyzing firms with weak ICs ( one or more deficiencies reported post- SOX) and firms with strong ICs ( no deficiencies reported). He found significant differences in CFO compensation post- SOX relative to pre- SOX, with average compensation of CFOs of weak IC firms lower, and that of CFOs of strong IC firms higher, than before. He also found a significant increase in the probability of a weak IC CFO being fired, relative to that of a strong CFO.

a. Based on Wang’s findings, what was the effect of SOX on the reservation utilities of CFOs? Explain your answer.
b. Wang also found that, for weak IC firms, when return on assets ( ROA) increased post- SOX, executive bonuses, but not other compensation components, increased significantly. No such increase was found for strong IC firms. Does this imply an increase or decrease in the informativeness of net income (i. e., ROA) with respect to the quality of manager effort for weak IC firms? What does it imply about the sophistication of compensation committees in their use of accounting information?
c. Does the operation of the managerial labour market for CFOs appear to have improved post- SOX? Explain.
d. Why is the proper operation of the managerial labour market important for a market-oriented economy?

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