Accounting information is the basis for communicating financial performance to the market place. As such, it continues to be open to opportunistic behavior on the part of managers by means of earnings management. Typically, this opportunistic behavior involves using discretion allowed under Generally Accepted Accounting Principles (GAAP), managing earnings to obtain desirable outcomes, without breaking the law.
At the same time, some firms may choose (intentionally or not) to break GAAP rules in an effort to do the same. In either case, the lack of reliability in the financial statements makes it difficult for market participants to make fully-informed capital allocation decisions. This inherent information asymmetry between managers and owners (or potential owners) makes accounting information and earnings management the subject of much scrutiny, study, and regulation.
In an effort to reduce earnings management, regulators often take steps to curtail discretion in the way firms report financial information via rules, increased oversight of firm reporting processes, or increased disclosure requirements. The Sarbanes Oxley Act of 2002 is arguably the largest source of regulatory reform in the U.S. since the 1930's. Many studies examine whether Sarbanes Oxley has been effective in decreasing earnings management.
This study does not attempt to support or refute the specific provisions of Sarbanes Oxley, nor does it attribute any subsequent decrease in earnings management solely to Sarbanes Oxley. Instead, I assert that the reporting environment post-Sarbanes Oxley is stricter than the reporting environment prior to Sarbanes Oxley. As such, it provides an opportunity to compare firms between two different regulatory environments where earnings management was potentially affected.
