A federal law requiring publicly traded firms to disclose whether they have adopted codes of ethics for their senior financial officers may be useful, but a Penn State researcher says its impact is often limited.

A firm's board of directors needs to be the driving force behind creating and implementing the program in most cases for it to truly be successful.

"According to my research, firms with ethics programs overseen by their boards of directors disclose more credible financial information—as perceived by financial analysts—than do firms having ethics programs not overseen by their boards, and firms not having ethics programs," said Andrew Felo, assistant professor of accounting at Penn State Great Valley graduate school in suburban Philadelphia.

"This is important because people tend to use this financial information to decide which companies to invest in, and this can help them make more informed choices," he adds.

In the wake of the Enron and WorldCom corporate fraud cases of the early 2000s, companies have been under increasing pressure to operate ethically. The Sarbanes-Oxley Act of 2002 contains a provision requiring publicly traded firms to disclose whether they have adopted codes of ethics for their senior financial officers and, if not, explain why they have chosen not to do so.

The Penn State researcher studied 71 firms with ethics programs across 14 industries. He analyzed these firms' proxy statements from 2001 and 2002 annual shareholder meetings to ascertain which had boards that oversee ethics programs, and which do not. Of these, 50 were characterized as "board oversight," while 21 were placed in the "no board oversight" category. This is a far cry from an analysis of the same firms based on data from 1995, which found only 19 out of 71 classified under "board oversight." Felo used information from Standard & Poor's on transparency and disclosure to measure financial reporting transparency. Felo also noted in the study that having board oversight of ethics programs is no longer a practice reserved for large firms.

"In today's market where investors examine financial information very closely before deciding how to invest, the reliability of credible financial reporting information is critical for firms of all sizes," he said. "Providing negative financial news on your company can serve two key purposes: it can temper speculation about bad news, and it can make the good financial news firms report seem more credible."

While Coca-Cola wasn't one of the firms in his study, Felo used a recent example of a financial disclosure by the soft drink giant as an example. Coca-Cola put out a forecast about disappointing sales in the United States in advance of its financial report for the first quarter of 2007. In the days following the forecast, the price of shares of Coke actually went up.

Felo said the relationship between firms and investors is closer than ever, which makes this type of preemptive truth-telling exceedingly important. However, he doesn't foresee the day when all companies will learn the lesson.

"It's human nature for some people to push the envelope, and if a company wants to commit fraud, they're going to do it," he said. "However, I anticipate that increasing board oversight of ethics programs, Sarbanes-Oxley, and other measures that enhance scrutiny of organizations will all make a difference."

His findings are published in an article, "Board Oversight of Corporate Ethics Programs and Changes in Financial Disclosure Credibility," in a recent issue of the Journal of Forensic Accounting.

Written from a news release by Penn State.