Capital Structure, Earnings Management, and Sarbanes-Oxley: Evidence from Canadian and U.S. Firms

Abstract

SYNOPSIS I examine Sarbanes-Oxley's (SOX) effect on capital structure. I find that SOX is associated with higher long-term debt ratios, as firms listed in the U.S. raise their long-term debt ratios by 2 to 3 percentage points. This finding is consistent with the idea that, although the reduction in information asymmetry associated with SOX could prompt managers to increase equity financing, debt is still safer and less costly than equity in the SOX era. Further analysis shows that the increase in debt occurs in the two quarters prior to SOX, suggesting that firms anticipate a higher cost of debt after SOX and acquire debt while it is relatively cheap. Also, firms that heavily (lightly) manage earnings prior to SOX use less (more) debt after SOX. This result is consistent with the view that firms that aggressively manage earnings before SOX reveal intrinsically weaker earnings after SOX, casting doubt on those firms' ability to repay debt and relegating those firms to issue equity for financing purposes. JEL Classifications: G32; G38. Data Availability: Data available upon request.

Corporate Governance and Credit Access in Brazil: The Sarbanes‐Oxley Act as a Natural Experiment

“…Notice that our results add to the understanding of a specific benefit of the Sarbanes‐Oxley Act. Like Carter () and Andrade et al (), we found a positive effect of SOX on terms of credit. Our model shows that the effect of SOX comes from a reduction in the information asymmetry between borrowers and lenders, mainly through three channels: disclosure, monitoring, and manager punishment.…”

“…For example, Litvak () compares returns to cross‐listed companies subject to SOX (cross‐listed at level 2 or 3) to returns of matching non‐cross‐listed companies from the same industry and country and similar in size. Carter () uses Canadian firms to examine the effect of SOX on long‐term debt ratios. Costello and Wittenberg‐Moerman () rely on SOX's internal control reports to measure financial reporting quality.…”

“…Our paper is closely related to Andrade et al (2014) and Carter (2013). In this study, we contribute to the literature by analyzing the existence of a specific benefit of SOX, isolated from other contemporaneous events, on the terms of debt finance.…”

“…The authors found a decrease in the cost of debt, provided by increased corporate transparency perceived by investors. Carter () argues that an increase in firms' financial reporting transparency induced by SOX promoted a reduction in the information asymmetry between managers and investors, increasing firms' debt financing. Costello and Wittenberg‐Moerman () study the trade‐off between financial reporting quality and the use of financial covenants.…”

Industry Peer Firms' Earnings Quality and IPO Underpricing

“…Prior research also finds that IPO underpricing generally decreases after SOX (e.g., Johnston & Madura, ). Carter () shows that information asymmetry decreases and long‐term debt ratio increases after SOX for mature firms. Johnston and Madura () find that the decreased information asymmetry after SOX is related with lower IPO underpricing for newly listed firms.…”