The Effect of Internal Control Certification Regulatory Changes on Real and Accrual-based Earnings Management

Abstract

ABSTRACTThis study examines the effect of changes in internal control certification requirements (ICCR) on the earnings management choices of Australian firms in the period 2007–2015. The Australian setting is unique as the certification requirements change from voluntary in 2004–2007 to mandatory in 2008–2014, before being abolished in 2015. Consistent with the notion that real earnings management (REM) is less susceptible to detection, the results suggest that firms place greater reliance on REM than on accrual-based earnings management (ABEM) when having to comply with certification requirements. In particular, I find voluntary certifiers have lower REM and ABEM relative to first-time certifiers in the mandatory period between 2008 and 2014, and there is an increase in REM activities among first-time mandatory period certifiers. Moreover, firms that discontinue certification, after the abolition of the requirement in 2015, switch from REM to ABEM. This suggests that regulatory ICCR changes affect firms’ earnings management choices.