The Impact of Corporate Governance on Discretionary Accrual Changes Around the Sarbanes-Oxley Act*

Abstract

Previous research such as Cohen, Dey and Lys (2005) and Lobo and Zhou (2006) document that there is a decrease in discretionary accruals following the Sarbanes-Oxley Act (hereafter SOX). More specifically, Cohen et al. (2005) document that firms' management of accounting earnings increased steadily from 1987 until the passage of the Sarbanes Oxley Act (SOX) in 2002, with a significant increase in the two years before SOX when major scandals occurred, and a significant decline after passage of SOX. Lobo and Zhou (2006) find that firms report lower discretionary accruals after SOX than in the period preceding SOX and firms incorporate losses more quickly into their earnings in the post-SOX period. In this paper we posit that corporate governance plays an important role in the behavior of discretionary accruals. We present evidence that firms with stronger corporate governance engage in less earnings management in the post-SOX period. More importantly, firms with stronger governance experience a lower reduction in discretionary accruals in the post-SOX period. This study provides further evidence of the impact of corporate governance on managers' discretionary accounting decisions. More importantly this study shows that the decrease in discretionary accruals behavior in the post-SOX period is not homogeneous across sample firms; it is inversely related to the quality of corporate governance.