Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley Periods

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THE ACCOUNTING REVIEW Vol. 83, No. 3 2008 pp. 757–787

Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley Periods Daniel A. Cohen New York University Aiyesha Dey University of Chicago Thomas Z. Lys Northwestern University ABSTRACT: We document that accrual-based earnings management increased steadily from 1987 until the passage of the Sarbanes-Oxley Act (SOX) in 2002, followed by a significant decline after the passage of SOX. Conversely, the level of real earnings management activities declined prior to SOX and increased significantly after the passage of SOX, suggesting that firms switched from accrual-based to real earnings management methods after the passage of SOX. We also document that the accrual-based earnings management activities were particularly high in the period immediately preceding SOX. Consistent with these results, we find that firms that just achieved important earnings benchmarks used less accruals and more real earnings management after SOX when compared to similar firms before SOX. In addition, our analysis provides evidence that the increases in accrual-based earnings management in the period preceding SOX were concurrent with increases in equity-based compensation. Our results suggest that stock-option components provide a differential set of incentives with regard to accrual-based earnings management. We document that while new options granted during the current period are negatively associated with incomeincreasing accrual-based earnings management, unexercised options are positively associated with income-increasing accrual-based earnings management.

We acknowledge the financial support from the Accounting Research Center at the Kellogg School and helpful comments from Dan Dhaliwal, April Klein, Krishna Kumar, Eddie Riedl, Suraj Srinivasan, Ira Weiss, Jerry Zimmermann, two anonymous reviewers, participants at the HBS Accounting and Control seminar, the 2006 FARS Meeting, the 2004 AAA Annual Meeting, the 2004 Corporate Governance Conference at the University of Washington in St. Louis, and the 2004 LBS Accounting Symposium. All remaining errors are our own. Editor’s note: This paper was accepted by Dan Dhaliwal.

Submitted February 2006 Accepted October 2007



Cohen, Dey, and Lys

I. INTRODUCTION he recent wave of corporate governance failures has raised concerns about the integrity of the accounting information provided to investors and resulted in a drop in investor confidence (Jain et al. 2003; Jain and Rezaee 2006; Rezaee 2004). These failures were highly publicized and ultimately led to the passage of the Sarbanes-Oxley Act (SOX, July 30, 2002). The changes mandated by SOX were extensive, with President George W. Bush commenting that this Act constitutes ‘‘the most far-reaching reforms of American business practices since the time of Franklin D. Roosevelt.’’1 Similarly, the head of the AICPA commented that SOX ‘‘contains some of the most far-reaching changes that Congress has ever introduced to the business world’’2 including an unprecedented shift in the regulation of corporate governance from the states to the federal government.3 Although SOX proposed sweeping changes, the scope of the events that led to the passage of the Act and the consequences of the resulting regulatory changes have yet to be systematically studied. Specifically, it is unclear whether there really was a widespread breakdown of the reliability of financial reporting prior to the passage of SOX or whether the highly publicized scandals were isolated instances of individuals engaging in blatant financial manipulations. If it were the former, then how did the passage of SOX affect firms’ financial reporting practices? Moreover, some argue that these frauds occurred after 70 years of ever-increasing securities regulation, suggesting that more regulation may not be the answer (Ribstein 2002). We investigate the prevalence of both accrual-based and real earnings management activities...
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