The Economic Effects of Earnings Management Pre- and Post-SOX

Date
2017-08-01
Authors
Mason, Terry W
Morton, Richard M
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While prior research suggests that firms have primarily switched from accrual to real earnings management strategies since the passage of the Sarbanes-Oxley Act of 2002 (SOX) (Cohen, Dey, and Lys 2008), there has been limited research on the effects that this switch might have on future performance and firm value. Accrual earnings management shifts income recognition without directly affecting cash flows, whereas real earnings management implies suboptimal decisions that directly affect the underlying cash flows. Thus, this shift in earnings management techniques could have important consequences for investors. Consistent with increased real earnings management post-SOX, we find that abnormal operating decisions are less informative about future return on assets (ROA) and have a more negative effect on firm value relative to the pre-SOX period. Alternatively, consistent with less accrual earnings management post-SOX, we find that discretionary accruals are more informative about future ROA and there is less evidence of market mispricing relative to the pre-SOX period. Finally, we examine the net effect that SOX has had on earnings management and find that the lower future returns and firm performance associated with greater real earnings management outweigh the positive effects of improved accrual quality.
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Sarbanes-Oxley, Real Activities Manipulation, Accrual Earnings Management, Earnings Management
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