The Effect of Sarbanes-Oxley on Earnings Management Behavior

Abstract

This paper investigates the impact of Sarbanes-Oxley (SOX) on managers’ earnings management choices (i.e., accrual management and real earnings management). Specifically, I use a large sample of firms from 1987-2004 to investigate whether firms reduce their use of accrual management and increase their use of real earnings management post-SOX. SOX likely increases the cost of engaging in accrual management because of increased legal liability, greater auditor independence, and increased public awareness of aggressive accounting treatments. An increased cost of accrual management is likely to lead managers to use other methods to manage earnings (e.g., real earnings management through sales manipulation, reduction of discretionary expenditures, and overproduction). Consistent with this expectation, this paper finds an increased association between certain types of real earnings management (overproduction and sales manipulation) and the propensity to beat the profit and earnings change benchmarks. Results also indicate that the associations between abnormal accruals and beating the profit and earnings change benchmarks do not change post-SOX.