The impact of Sarbanes-Oxley act on cosmetic earnings management

Abstract

ABSTRACT This study examines the mitigating effect of Sarbanes-Oxley Act on cosmetic earnings management, referred by Kinnunen and Koskela (2003) as earnings manipulative behavior to round earnings such that they result in an upward bias. This behavior reports income numbers to achieve key cognitive reference points represented by N×10k. Using Benford’s law, our analysis compares the distribution of second digits in reported annual net income for publicly listed US companies between a 2-year periods before and after the year 2002 when Sarbanes-Oxley Act went into effect. Our empirical results suggest that, in the 2-year period prior to the Act, there was evidence of cosmetic earnings management. However, such behavior in manipulating net income has noticeably decreased in the period after the Act. This finding is consistent with the notion that Sarbanes-Oxley Act has a deterring impact on corporate America’s manipulative behavior to report earnings that achieve certain key reference points.