The effect of audit committee financial expertise on earnings management tactics in the post-SOX era

Abstract

To restore investor confidence and promote the integrity of financial accounting information provided to investors, following the passage of the Sarbanes-Oxley Act (SOX), the SEC adopted two new rules for public firms in early 2003, requiring the disclosure of audit committee financial expertise (ACFE) per SOX 407 and the reconciliation of non-GAAP financial measures to those most comparable in GAAP (Regulation G) per SOX 401(b). Using quarterly filing data in the post-SOX era from March 2003 to December 2016, this study examines the impact of these requirements, with a focus on the effect of ACFE on the main earnings manipulation tactics used to just meet or beat analyst expectations (JUSTMBE). Our study investigates the effects of overall ACFE and its components on three key earnings management tactics, namely, discretionary accruals, real activities management, and non-GAAP financial disclosures. We observe that firms with a higher level of ACFE, particularly accounting and finance expertise, exhibit a lower propensity to JUSTMBE. Furthermore, we posit that two upward earnings manipulations, accrual-based and real activities management, are significantly mitigated by ACFE through a complementary effect of its accounting and supervisory expertise components. However, we identify a clear strategic shift in which non-GAAP financial disclosures with unexpected exclusions become a popular alternative tactic for managers to JUSTMBE under the increasing presence of ACFE. This study provides empirical evidence with implications for regulators to consider more rigorous intervention and regulation on non-GAAP disclosures and to refine the requirement of audit committee financial experts with an emphasis on the complement of accounting and non-accounting financial expertise to effectively curtail earnings manipulation.