The 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, Kim and Rezaee, 2003; Rezaee and Jain, 2003; Rezaee, 2002). 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.” Similarly, the head of the AICPA commented that SOX “contains some of the most farreaching changes that Congress has ever introduced to the business world” including an unprecedented shift in the regulation of corporate governance from the states to the federal government.
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. And if it were the former, 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 in the period leading to the passage of SOX and in the period following the passage of SOX. Our primary motivation for conducting this analysis is to investigate whether the period leading to the passage of SOX was characterized by widespread increase in earnings management rather than by a few highly publicized events, and whether the passage of SOX resulted in a reduction in earnings management.
We carry out our investigation by dividing the sample period into two time periods: the period prior to the passage of SOX (the pre-SOX period: 1987 through 2001), and the period after the passage of SOX (the post-SOX period: 2002 through 2005). We further subdivide the pre-SOX period into two sub-periods: the period prior to the major corporate scandals (the pre-SCA period: 1987 through 1999) and the period immediately preceding the passage of SOX when the major scandals occurred (the SCA period: 2000 and 2001).
We document that the pre-SOX period was characterized by increasing accrual-based earnings management culminating in even larger increases in the SCA period but declining real earnings management. We also document that the increase in accrual based earnings management in the SCA period was associated with a contemporaneous increase in equity based compensation, in particular, option-based compensation.
Following the passage of SOX accrual-based earnings management declined significantly, while real earnings management increased significantly. Consistent with the results of a recent survey by Graham, Harvey, and Rajgopal (2005), this suggests that firms switched to managing earnings using real methods, possibly because these techniques, while more costly, are likely to be harder to detect.
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