The Sarbanes-Oxley act and mitigation of earnings management

Abstract

The Sarbanes-Oxley Act (hereafter, SOA) and the Securities and Exchange Commission (hereafter SEC) certification order are expected to improve financial reporting quality. Prior studies have demonstrated that earnings management significantly influences financial reporting quality. This study examines whether SOA or the SEC certification order mitigates earnings management and therefore improves financial reporting quality. This study addresses the following questions: (1) Does SOA mitigate earnings management? (2) Does the SEC certification order mitigate earnings management? (3) Are firms that certify financial statements late more likely to manage earnings relative to firms that certify early or on time? Using the performance matched discretionary accrual model (Kothari et al. 2002) to estimate discretionary accruals, this study examines the effect of SOA on earnings management by investigating the change in discretionary accruals. This study finds evidence that SOA significantly mitigates earnings management. This study also finds that SOA mitigates income-increasing earnings management more than income-decreasing earnings management and affects high-discretionary accrual firms more than low-discretionary accrual firms. These results hold when using the modified Jones model to estimate discretionary accruals under balance sheet approach and cash flow approach, respectively. This study documents significant evidence regarding the effect of the SEC certification order on earnings management. By examining the level of discretionary accruals estimated following Kothari et al. (2002), this study finds that the change in discretionary accruals between the pre-certification period and the certification period is usually statistically significant, but not after the SEC certification order. This study also finds that the SEC certification order mitigates income-increasing earnings management more significantly than income-decreasing earnings management and affects high-discretionary accrual firms more than low-discretionary accrual firms. The results are robust using the modified Jones model under cash flow approach, but not under balance sheet approach. However, this study documents no consistent or significant evidence that late-certifying firms engaged in income-increasing earnings management during the certification period.The Sarbanes-Oxley Act (hereafter, SOA) and the Securities and Exchange Commission (hereafter SEC) certification order are expected to improve financial reporting quality. Prior studies have demonstrated that earnings management significantly influences financial reporting quality. This study examines whether SOA or the SEC certification order mitigates earnings management and therefore improves financial reporting quality. This study addresses the following questions: (1) Does SOA mitigate earnings management? (2) Does the SEC certification order mitigate earnings management? (3) Are firms that certify financial statements late more likely to manage earnings relative to firms that certify early or on time? Using the performance matched discretionary accrual model (Kothari et al. 2002) to estimate discretionary accruals, this study examines the effect of SOA on earnings management by investigating the change in discretionary accruals. This study finds evidence that SOA significantly mitigates earnings management. This study also finds that SOA mitigates income-increasing earnings management more than income-decreasing earnings management and affects high-discretionary accrual firms more than low-discretionary accrual firms. These results hold when using the modified Jones model to estimate discretionary accruals under balance sheet approach and cash flow approach, respectively. This study documents significant evidence regarding the effect of the SEC certification order on earnings management. By examining the level of discretionary accruals estimated following Kothari et al. (2002), this study finds that the change in discretionary accruals between the pre-certification period and the certification period is usually statistically significant, but not after the SEC certification order. This study also finds that the SEC certification order mitigates income-increasing earnings management more significantly than income-decreasing earnings management and affects high-discretionary accrual firms more than low-discretionary accrual firms. The results are robust using the modified Jones model under cash flow approach, but not under balance sheet approach. However, this study documents no consistent or significant evidence that late-certifying firms engaged in income-increasing earnings management during the certification period.