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This note was prepared by Professors Kenneth A. Merchant (University of Southern California) and Wim A. Van der Stede (London
School of Economics) for the sole purpose of aiding classroom instructors in the use of the Pacific Sunwear of California, Inc. case.
I
t provides analysis and questions that are intended to present alternative approaches to deepening students comprehension o
f
business issues and energizing classroom discussion.
Marshall School of Business
University of Southern California
Pacific Sunwear of California, Inc.
Teaching Note
Purpose of Case
This case illustrates one companys efforts to comply with the Sarbanes-Oxley Act of 2002
(SOX) and, in particular, Section 404 of the Act requiring elaborate tests and certifications of
the effectiveness of the companys internal control system. In this case, the companys
Suggested Assignment Questions
As mentioned above, Pacific Sunwear of California, Inc.s (PacSun) executives are negative
about most of the SOX 404 compliance experience. Instructors who want to present students
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
372
Suggested questions
1. Evaluate the process that PacSun went through to comply with SOX, and particularly
Section 404. Was that process as effective and efficient as it could have been?
2. Are the significant deficiencies that were identified in each of the 2 years of the audit
Case Analysis
SOX
SOX is an important backdrop to this case. Before discussing the case, instructors need to
ensure that students are at least aware of the basic requirements imposed by this legislation.
Textbook Chapter 13 provides a summary of the SOX provisions, as does the case. It is
The Year One 404 Process
The first year for SOX compliance was uncomfortable for all companies and all auditors. The
law had been passed over a year earlier, but the understanding of the implications of the law was
unfolding throughout the first year in which the companies had to comply with it. Note that at
PacSun the compliance process for the first year (ending January 2004) did not begin until mid-
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
373
case, PacSun had some advantages in that they have a single, simple business model, and all of
their major operations are in one location.
Each of the processes and controls had to be documented. The documentation part of the
compliance process created a lot of work. Examples are shown in case Exhibits 3 and 4.
Particularly burdensome for many companies was the documentation of old (legacy) systems
The Year Two 404 Process
Like most companies, PacSun found SOX 404 compliance much easier in year two. Both
company and audit personnel understood the legal requirements better, The SEC and PCAOB
Costs vs. Benefits
PacSuns costs of complying with SOX Section 404 are shown in Case Exhibit 9. The costs
were about 2.5% of net income in FY 2004. This dropped to a little over 1% in FY 2005.
Were the benefits to the company greater than the costs? PacSuns CFO admits that the
documentation and testing processes provided some benefits in helping the company identify
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
and fix some control weaknesses. But he argues that the benefits to the company were much
smaller than the costs of complying.
Some articles, such as that mentioned in the suggested assignment, claim that other companies
have benefited more from their SOX 404-related efforts, which have been particularly valuable
in providing an understanding of, for example:
Incomplete integration of systems stemming from mergers and reorganizations
Beyond the 404 requirement, SOX also provided benefits to many companies in changing the
control environment, such as by passing the responsibility for maintaining effective internal
controls throughout the organization and by strengthening the role of the audit committee of the
board of directors.
Research Findings
Time allowing, it is useful for instructors to bring some of the SOX-related academic research
findings into the classroom. At the time of the writing of this teaching note, academic tests of
the market reactions to SOX-related disclosures were just beginning to appear. This teaching
note is not the proper forum for a thorough review of this literature, but a few suggestive
findings will be mentioned.45
Merchant & Van der Stede, Management Control Systems, 3rd edition, Instructors Manual
375
But does it matter if a company gets a clean or adverse 404 opinion? The early evidence
suggests that it does. On average, firms with adverse opinions had negative abnormal returns in
the forthcoming period. But not all did, which suggests that investors look at the reasons for the
Pedagogy
This case is intended to give students a feel for what companies went through in complying with
SOX, and particularly Section 404 of the Act. It also motivates a discussion of whether SOX
merely imposed compliance costs on firms, for the purpose of improving financial reporting, or
whether firms control systems were improved because of the additional requirements. The
answer is both but, of course, some companies benefited more than others.
Instructors can deliver these messages by lecturing. But letting students get involved in a
The ordering presented in this teaching note is a logical way to organize a class. Here is a
reasonable time budget:
Clarification of SOX requirements 20 minutes
