Trends in Earnings Management and Informativeness of Earnings Announcements in the Pre- and Post-Sarbanes Oxley Periods

Abstract

We document that firms' management of accounting earnings increased steadily from 1987 until the passage of the Sarbanes Oxley Act (SOX), with a significant increase during the period prior to SOX, followed by a significant decline after passage of SOX. However, the increase in earnings management preceding SOX was primarily in poorly performing industries. We also show that the informativeness of earnings increased steadily over time, and there was no significant change in earnings informativeness following the passage of SOX. Further, we find that earnings management increased the absolute informativeness of earnings, but reduced the informativeness for a given earnings surprise, as well as reduced the abnormal return for a given amount of earnings surprise. Finally, the evidence supports the hypothesis that the opportunistic behavior of managers, primarily related to the fraction of compensation derived from options, was significantly associated with earnings management in the period preceding SOX.1

Audit Committee Financial Expertise, Competing Corporate Governance Mechanisms, and Earnings Management

“…Roychowdhury (2005) and Cohen et al (2005) use a firm's abnormal level of discretionary expenditures and abnormal level of production costs (using a similar technique to the modified-Jones model) as metrics of real earnings management.…”

“…Further, Cohen et al (2005) report a significant drop in earnings management following SOX, although they also find that managers increased "real" earnings management (e.g., a reduction in R&D or advertising expenses) during the same time period.…”

“…They report that the vast majority of CFOs consider EPS to be an important reported number and that CFOs are willing to engage in real earnings management to meet earnings expectations or to smooth earnings. Cohen et al (2005) provide evidence that since the enactment of SOX, GAAP earnings management has declined but real earnings management has increased. Since real earnings management is within the bounds of GAAP, we argue that it is not in the purview of the audit committee.…”

“…We also contribute to the growing literature on "real" vs. "GAAP" earnings management (Roychowdhury, 2005;Cohen et al, 2005;Graham et al, 2005;. SOX was enacted to improve the reliability of the financial reporting system.…”

“…There is a growing empirical literature documenting the effects that SOX and market regulations have had on earnings management (e.g., see Cohen et al, 2005;Klein, 2002a;Carver, 2005). 1 Further, within this body of research, there are papers examining the role that audit committee financial expertise has on auditor independence (Carcello and Neal, 2003), fraud and earnings restatements (Abbott et al, 2004;Agrawal and Chadha, 2005), financial reporting quality 1 See DeFond and Francis (2005) for an excellent summary of the audit research before and after the enactment of SOX.…”