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Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley PeriodsAuthor(s): Daniel A. Cohen, Aiyesha Dey and Thomas Z. Lys

Source: The Accounting Review, Vol. 83, No. 3 (May, 2008), pp. 757-787

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

Real and Accrual-Based Earnings in thePre-and Management Periods Post-Sarbanes-Oxley New York University University of Chicago Northwestern University ABSTRACT: Wedocument that accrual-based increased steadearnings management from 1987until thepassageoftheSarbanes-Oxley Act(SOX) in2002,followed ily by a significant decline after thepassageofSOX.Conversely, thelevel ofreal earnings activities declined toSOXandincreased after thepasprior management significantly of that from firms switched accrual-based to manreal sage SOX, suggesting earnings the methods after of SOX. We also that document the accrual-based agement passage were intheperiod activities earnings management particularly prehigh immediately with imSOX.Consistent we find that firms that theseresults, justachieved ceding benchmarks usedlessaccruals andmore real portant earnings earnings management after SOXwhen to similar firms before SOX.Inaddition, ouranalysis compared prothat theincreases inaccrual-based vides evidence intheperiod earnings management SOX wereconcurrent with inequity-based increases Our compensation. preceding results that a differential setofincentives provide stock-option components suggest with to accrual-based We document that while new regard earnings management. thecurrent are negatively with associated incomeoptions period granted during accrual-based unexercised arepositively asoptions increasing earnings management, with sociated accrual-based income-increasing management. earnings

DanielA. Cohen Aiyesha Dey

Thomas Z. Lys

Weacknowledge the financial from the Center atthe Research School andhelpful support Accounting Kellogg from Dan Dhaliwal, comments Krishna EddieRiedl, IraWeiss, Klein, Kumar, April SurajSrinivasan, Jerry two atthe and HBSAccounting Control the 2006 FARS Zimmermann, reviewers, seminar, ano

nymous participants 2004AAAAnnual the the 2004Corporate Governance Conference atthe ofWashMeeting, Meeting, University inSt.Louis, and the 2004LBS Accounting Allremaining errors areour own. ington Symposium. Editor's Thispaper note: was accepted byDan Dhaliwal.

Submitted 2006 February October 2007 Accepted

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Cohen, Dey,and Lys

oftheaccounting information to investors andresulted in a dropin tegrity provided investor confidence et al. and Rezaee Rezaee 2003; Jain 2006; (Jain 2004). These failures werehighly and led to thepassageof theSarbanes-Oxley publicized ultimately Act (SOX, July mandated with President 30, 2002). The changes by SOX wereextensive, that thisAct constitutes"themostfar-reaching reforms of GeorgeW. Bush commenting American business sincethetime of Franklin D. Roosevelt."' the head practices Similarly, of theAICPA commented that SOX"contains someof themostfar-reaching that changes has ever introduced to the world"2 business an shift Congress including unprecedented in theregulation of corporate from states to thefederal the governance government.3 SOX proposed the scope of theevents thatled to the Although sweeping changes, of theresulting haveyetto passageof theAct and theconsequences regulatory changes be systematically studied. it is unclear whether there was a widespread Specifically, really breakdown of thereliability of financial to thepassageof SOX or whether reporting prior thehighly scandals were isolated instances of individuals inblatant fipublicized engaging If nancial it were the how then did the of SOX affect firms' former, manipulations. passage financial some arguethatthesefrauds occurred after 70 Moreover, reporting practices? securities that moreregulation yearsof ever-increasing regulation, suggesting maynotbe theanswer (Ribstein 2002). We investigate theprevalence of bothaccrual-based and real earnings management in the periodleadingto thepassage of SOX and in theperiodfollowing activities the of SOX. Our motivation for this is to passage primary conducting analysis investigate whether the periodleadingto the passage of SOX was characterized by a widespread inearnings increase rather than andwhether events, management bya fewhighly publicized in a thepassageof SOX resulted reduction in earnings management. We carry out our investigation thesampleperiodintotwotimeperiods: by dividing to thepassageof SOX (thepre-SOX theperiod 2001), andthe prior period:1987 through thepassageof SOX (thepost-SOXperiod:2002 through 2005). We further periodafter thepre-SOX to themajor subdivide intotwosubperiods: theperiod period corporate prior scandals(thepre-SCAperiod:1987 through 1999) and theperiod immediately preceding thepassageof SOX whenthemajorscandals occurred 2000 and 2001). (theSCA period: that We document thepre-SOX accrual-based periodwas characterized by increasing in even in SCA incr

eases the butdeclining earnings management, culminating period, larger in real earnings We also that document the increase accrual-based management. earnings in theSCA period in optionwas associated with a contemporaneous increase management basedcompensation. twoopposing exhibits incentives However, option-based compensation withrespect to current stockprices(and thusearnings On theone hand, management). have an incentive to lowerthecurrent stockpricearound stockoptionaward managers forunexercised 1997; Aboodyand Kasznik2000). On theother hand, (e.g.,Yermack opnewoption tions(excluding have an incentive to increase current stock grants), managers to manage To capture thesetwoeffects, we partition pricesand,hence, earnings upward. overall heldat theendoftheyearintounexercised newoptions options options (excluding

he

waveofcorporate recent failures hasraised concerns about theingovernance

I. INTRODUCTION

2

Bumiller (2002). Melancon (2002). 3 Traditionally, has focused thefederal on regulating andantitrust, while disclosure, government trading, public hasbeenthefocus ofthestates. regulating corporate governance

TheAccounting Review, May2008

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RealandAccrual-Based Management Earnings

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in thecurrent and exercisable vested Consisnewoptions granted period, options. grants), a differential set of we find with thenotion that these tent incentives, components provide current with thatwhilenew options the are associated granted during period negatively unexercised are associated accruals, discretionary income-increasing options positively with Cheng and with income-increasing accruals.However,consistent discretionary Warfield a significant association between accrual-based (2005), we do notfind earnings and exercisable vestedoptions. we document that therelation Furthermore, management accruals and unexercised new between income-increasing discretionary options (excluding in of declined the To the best our we the are grants) post-SOX period. option knowledge, first thisevidence to document empirically. thepassageof SOX accrual-based declined Following earnings management signifiwhilereal earnings increased At thesametime, management significantly. optioncantly, with theresults of a recent based compensation decreased. Consistent survey by Graham firms et al. (2005), thissuggests that switched to managing earnings usingrealmethods, to be harder becausethese whilemorecostly, arelikely to detect. techniques, possibly both the and and In additional we examine accrual-based analyses, pre-SOX post-SOX of firms that more to real earnings activities for a subset are have management likely tothese firms as theSUSPECT firms). we examine (we refer Specifically, managed earnings incentives formanaging or beating last year'searnings, three earnings, namely, meeting andavoiding orbeating forecast losses.We focus theconsensus analysts' meeti

ng reporting becauseGraham that thesespecific motives are on theseincentives et al. (2005) document forearnings behavior. reasons management amongthemostimportant with we find ourfullsample that both before and after Consistent results, SOX, SUSwhen to PECT firms had significantly accruals that discretionary compared firms higher or firms not close to either or misseither missed those benchmarks that were making just used significantly less incometheseSUSPECT firms However, ing thosebenchmarks. in similar after to firms SOX when circumstances increasing accrual-management compared behavior ofthese SOX. An analysis oftherealearnings firms indicates before management after had significantly realearnings activities that theSUSPECT firms management higher in similar to SOX. to thefirms circumstances SOX whencompared prior of earnings to thecurrent contribute debateon thepervasiveness Ourresults manageofSOX on suchbehavior. Whilewe find ment to thepassageofSOX, andtheimpact prior in accrual-based an increase toSOX, ourevidence that prior earnings management suggests while firms are likely to haveswitched to earnings-management to that, likely techniques This evidence forms an important be morecostlyto shareholders, are harder to detect. in thedebate of thenewregulation. consideration on thecostsandbenefits The remainder of thepaperproceeds as follows. of SectionII provides a discussion III theresearch and hypotheses. Section discussestheempirical questions methodology, thedataand sampleselection measures ofearnings andthevarious including management usedinthestudy. Thetests andresults arediscussed inSection V concludes. IV,andSection II. MOTIVATION,RESEARCH QUESTIONS, AND HYPOTHESES In a recent U.S. Treasury Paulsonemphasized theimcommentary, Secretary Henry out that markets on trust of and and portance strong capitalmarkets, pointed capital rely is basedon financial information to be and to reflect economic that trust accurate presumed in fiThe seriesof corporate scandalsoccurring in 2000-2001 erodedthat trust reality.4 of nancialreports. one of themainobjectives of SOX was to restore theintegrity Indeed, 4

Paulson (2007).

TheAccounting Review, May2008

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statements financial andaccounting fraud. the Therefore, management bycurbing earnings extent of earnings to SOX and the effect of on SOX management prior earnings manageresearch is an important ment topic. The primary of thispaperis to examine theextent of earnings purpose management in theperiod to in suchactivities and prior to SOX, and thechanges leading thescandals thepassage of SOX.5 Our examination after of changesin firms' earnings management in partby theliterature activities is motivated that to documenting managerial propensity to and avoid has increased over manageearnings negative earnings surprises significantly et.al. 2002;Lopez andRees2001

;Matsumoto time 2001;Bartov 2002;Brown (e.g.,Brown thedegree of earnings and Caylor2005). Ourmainobjective is to examine whether manin increased over time and reached a zenith the the surrounding corporate agement period anddeclined after thepassageof SOX. scandals, accounting withtheliterature, we examine Consistent activities usingdismanagement earnings in addition accruals. to usingaccrual-based estimates and However, cretionary accounting firms are likelyto employreal operational activities to manipulate methods, earnings in their numbers as well(e.g.,HealyandWahlen 1999;DechowandSkinner 2000). In fact, al. the Graham et (2005) report following:6 survey evidence that takereal economic actions to maintain ac[W]e findstrong managers In 80% of that would counting survey participants report they appearances. particular, to meetan on R&D, advertising, and maintenance decreasediscretionary spending half that would a new More than state (55.3%) delaystarting they earnings target. if in meet even a entailed a small sacrifice to an such delay earnings target, project value. in earnings in a more of thetrends activities Thus,to provide complete management study and after also examine real activities theperiods before we SOX, earnings management overthesampleperiod. foranychanges in earnings acNext,we examine management possibleexplanations thatmanagers' choicesof over the sampleperiod.We focuson the hypothesis tivities methods on their of theseaccounting are influenced by theimpact accounting practices aremoresenwith stockand option-based compensation Managers higher compensation. if to affect andcan use their discretion to short-term stock sitive earnings reported prices, havedifficulty (see Fieldset al.[2001]for earnings management detecting capitalmarkets of earnings a discussion on thepricing management.)7 Lobo and Zhou (2006) investigate that financial statements whether theSOX mandate be study, 5 In a related in financial in an increase in theconservatism andfind CEOs andCFOs resulted certified reporting, by firms' in reported evidence ofgreater conservatism earnings. use realandaccrual in whether 6 In a recent working paper, Zang (2006) investigates managers manipulations as substitutes. with Based on a modelshedevelops, sheprovides evidence consistent manmanaging earnings realandaccrual as substitutes. agersusing manipulations theincrease executive created an environFor instance, Coffee that in stock-based (2003) asserts compensation to short-term ment where becamevery sensitive stock (2002) opinesthat managers performance. Greenspan ofshareholding andoptions incentives desirable business created"thehighly among perversely spread managers Fuller that andrising." andJensen to artificially inflate to keepstock (2002,42) also state earnings prices high whomade fortunes andmanagers ofexecutive anincreasing became"[a]s stock great part compensation, options stock became a thepreservation or enhancement of short-term becamethestuff of legends, on

options prices andearnings stoked formany CEOs andCFOs. Highshare (anddamaging) multiples prices personal priority toundermine their own stature teams reluctant endowed proved managerial egos,andmanagement already amply of quarter-over-quarter hard wonrecords earnings growth." by surrendering

TheAccounting Review, May2008

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