The Switch Up: An Examination of Changes in Earnings Management after Receiving SEC Comment Letters

Abstract

Earnings management practices result in adverse consequences for investors and have led to increased attention from the Securities and Exchange Commission (SEC). To carry out the SEC’s oversight role, the Division of Corporation Finance periodically reviews companies’ filings and issues comment letters to monitor and enhance compliance with regulatory disclosure and accounting requirements. We examine whether the SEC’s oversight role affects firms’ earnings management behavior. We expect that increased firm-specific scrutiny from the SEC, in the form of a comment letter, will increase the cost of accrual-based earnings management (AEM) and induce management to decrease its usage. Because prior literature finds that firms substitute different forms of earnings management as other forms become more costly, we expect that companies will switch to real activities-based earnings management (REM), which is less likely to be scrutinized in the SEC’s review process. Consistent with our predictions, we find that AEM decreases and REM increases following the receipt of a comment letter. These results suggest that the comment letter process is effective in constraining AEM but may have the unintended consequence of encouraging companies to switch to REM.