Corporate Governance and Earnings Management in the Pre– and Post–Sarbanes-Oxley Act Regimes

Abstract

Backdating stock options, a practice that retroactively adjusts stock option grant dates to lower the exercise price, has raised governance, legal, accounting, tax, and auditing concerns. The practice of backdating options generally is believed to be a result of both ineffective corporate governance and management opportunism. Both of these factors have been linked to a higher level of discretionary accruals adjustments. This study examines the accruals-based earnings management patterns for a group of firms that were implicated by the Securities and Exchange Commission (SEC) for backdating stock options with a matched control group of nonimplicated firms for a time period surrounding the enactment of the Sarbanes-Oxley Act (SOX) of 2002. Both the univariate and multivariate analyses show that in the pre-SOX years, the sample of implicated firms managed abnormal accruals at a significantly greater level than the matched group of nonimplicated firms. The differential pattern of accruals management across these two groups becomes insignificant in the post-SOX period. Our result also suggests that the effect of SOX on mitigating the level of accruals management is substantially greater for the implicated companies than for the nonimplicated companies. The difference in the effect of SOX on the two groups of firms persists even after controlling for the differences in their governance and internal control effectiveness. We, therefore, suggest that SOX had effects on management’s reporting choices beyond those resulting from improvements in governance and internal control over financial reporting.