Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley Periods

THE ACCOUNTING REVIEW Vol. 83, No. 3 2008 pp. 757–787

Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley Periods
Daniel A. Cohen New York University Aiyesha Dey University of Chicago Thomas Z. Lys Northwestern University
ABSTRACT: We document that accrual-based earnings management increased steadily from 1987 until the passage of the Sarbanes-Oxley Act (SOX) in 2002, followed by a significant decline after the passage of SOX. Conversely, the level of real earnings management activities declined prior to SOX and increased significantly after the passage of SOX, suggesting that firms switched from accrual-based to real earnings management methods after the passage of SOX. We also document that the accrual-based earnings management activities were particularly high in the period immediately preceding SOX. Consistent with these results, we find that firms that just achieved important earnings benchmarks used less accruals and more real earnings management after SOX when compared to similar firms before SOX. In addition, our analysis provides evidence that the increases in accrual-based earnings management in the period preceding SOX were concurrent with increases in equity-based compensation. Our results suggest that stock-option components provide a differential set of incentives with regard to accrual-based earnings management. We document that while new options granted during the current period are negatively associated with incomeincreasing accrual-based earnings management, unexercised options are positively associated with income-increasing accrual-based earnings management.

We acknowledge the financial support from the Accounting Research Center at the Kellogg School and helpful comments from Dan Dhaliwal, April Klein, Krishna Kumar, Eddie Riedl, Suraj Srinivasan, Ira Weiss, Jerry Zimmermann, two anonymous reviewers, participants at the HBS Accounting and Control seminar, the 2006 FARS Meeting, the 2004 AAA Annual Meeting, the 2004

References: Aboody, D., and R. Kasznik. 2000. CEO stock option award and the timing of corporate voluntary disclosures. Journal of Accounting and Economics 29: 73–1000. Bartov, E., D. Givoly, and C. Hayn. 2002. The reward to meeting or beating analysts’ forecasts. Journal of Accounting and Economics 33: 173–204. Bergstresser, D., and T. Philippon. 2006. CEO incentives and earnings management. Journal of Financial Economics 80: 511–529. Brown, L. D. 2001. A temporal analysis of earnings surprises: Profits versus losses. Journal of Accounting Research 39: 221–241. ———, and M. L. Caylor. 2005. A temporal analysis of quarterly earnings thresholds: Propensities and valuation consequences. The Accounting Review 80: 423–440. Bumiller, E. 2002. Bush signs bill aimed at fraud in corporations. N.Y. Times (July 31). Cheng, Q., and T. D. Warfield. 2005. Equity incentives and earnings management. The Accounting Review 80: 441–476. Coffee, J. 2003. What causes Enron? A capsule social and economic history of the 1990s. Working paper, Columbia University. Collins, D., and P. Hribar. 2002. Errors in estimating accruals: Implications for empirical research. Journal of Accounting Research 40: 105–134. Dechow, P. M., R. G. Sloan, and A. P. Sweeney. 1995. Detecting earnings management. The Accounting Review 70: 193–225. ———, S. P. Kothari, and R. Watts. 1998. The relation between earnings and cash flows. Journal of Accounting and Economics 25: 133–168. ———, and D. J. Skinner. 2000. Earnings management: Reconciling the views of accounting academics, practitioners, and regulators. Accounting Horizons 14: 235–250. ———, and I. D. Dichev. 2002. The quality of accruals and earnings: The role of accrual estimation errors. The Accounting Review 77: 35–59. DeFond, M. L., and J. Jiambalvo. 1994. Debt covenant effects and the manipulation of accruals. Journal of Accounting and Economics 17: 145–176. Degeorge, F., J. Patel, and R. Zeckhauser. 1999. Earnings management to exceed thresholds. Journal of Business 72 (1): 1–33. Erickson, M., M. Hanlon, and E. L. Maydew. 2006. Is there a link between executive equity incentives and accounting fraud? Journal of Accounting Research 44: 113–144. Fields, T. D., T. Z. Lys, and L. Vincent. 2001. Empirical research on accounting choice. Journal of Accounting and Economics 31: 255–307. The Accounting Review, May 2008 Real and Accrual-Based Earnings Management 787 Financial Accounting Standards Board (FASB). 1997. Statement of Cash Flows. Statement of Financial Accounting Standards No. 95. Norwalk, CT: FASB. Forbes. 2002. The Corporate Scandal Sheet. Available at: http: / / www.forbes.com / home / 2002 / 07 / 25 / accountingtracker.html. Fuller, J., and M. C. Jensen. 2002. Just say no to Wall Street. Journal of Applied Corporate Finance 14: 41–46. Graham, J. R., C. R. Harvey, and S. Rajgopal. 2005. The economic implications of corporate financial reporting. Journal of Accounting and Economics 40: 3–73. Greenspan, A. 2002. Federal Reserve Board’s Semiannual Monetary Policy Report to the Congress. Testimony before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, July 16. Washington, D.C.: Government Printing Office. Gunny, K. 2005. What are the consequences of real earnings management? Working paper, University of Colorado. Healy, P. 1985. The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics 7: 85–107. ———, and J. M. Whalen. 1999. A review of the earnings management literature and its implications for standard setting. Accounting Horizons 13: 365–384. Jain, P. K., J. Kim, and Z. Rezaee. 2003. Have the Sarbanes-Oxley Act of 2002 and the CEO certifications made the market participants more informed? Working paper, University of Memphis. ———, and Z. Rezaee. 2006. The Sarbanes-Oxley Act of 2002 and capital-market behavior: Early evidence. Contemporary Accounting Research 23 (3): 629–654. Johnson, S. A., H. E. Ryan, Jr., and Y. S. Tian. 2005. Executive compensation and corporate fraud. Working paper, Texas A&M University. Jones, J. 1991. Earnings management during import relief investigations. Journal of Accounting Research 29: 193–228. Kasznik, R. 1999. On the association between voluntary disclosure and earnings management. Journal of Accounting Research 33: 353–367. Kothari, S. P., A. J. Leone, and C. Wasley. 2005. Performance matched discretionary accrual measures. Journal of Accounting and Economics 39: 163–197. Lobo, G., and J. Zhou. 2006. Did conservatism in financial reporting increase after the SarbanesOxley Act? Initial evidence. Accounting Horizons 20: 57–74. Lopez, T. J., and L. L. Rees. 2001. The effect of meeting analyst forecasts and systematic positive forecast errors on the information content of unexpected earnings. Working paper, Georgia State University. Matsumoto, D. 2002. Management incentives to avoid negative earnings surprises. The Accounting Review 77: 483–514. Melancon, B. C. 2002. A new accounting culture. September 4. Available at: http: / / www.aicpa.org. Paulson, H. 2007. The key test of accurate financial reporting is trust. Financial Times (May 17). Rezaee, Z. 2004. Corporate governance role in financial reporting. Research in Accounting Regulation 17: 107–149. Ribstein, L. E. 2002. Market vs. regulatory responses to corporate fraud: A critique of the SarbanesOxley Act of 2002. Journal of Corporation Law 28: 1–68. Roychowdhury, S. 2006. Earnings management through real activities manipulation. Journal of Accounting and Economics 42: 335–370. Yermack, D. 1997. Good timing: CEO stock option award and company news announcements. Journal of Finance 52 (2): 449–476. Zang, A. Z. 2006. Evidence on the tradeoff between real manipulation and accrual manipulation. Working paper, Duke University. The Accounting Review, May 2008