Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley Periods

Abstract

We document that accrual-based earnings management increased steadily from 1987 until the passage of the Sarbanes-Oxley Act (SOX) in 2002, followed by a significant decline after the passage of SOX. Conversely, the level of real earnings management activities declined prior to SOX and increased signicantly after the passage of SOX, suggesting that  rms switched from accrual-based to real earnings management methods after the passage of SOX. We also document that the accrual-based earnings management activities were particularly high in the period immediately preceding SOX. Consistent with these results, we nd that rms that just achieved important earnings benchmarks used less accruals and more real earnings management after SOX when compared to similar rms before SOX.

In addition, our analysis provides evidence that the increases in accrual-based earnings management in the period preceding SOX were concurrent with increases in equity-based compensation. Our results suggest that stock-option components provide a differential set of incentives with regard to accrual-based earnings management. We document that while new options granted during the current period are negatively associated with incomeincreasing accrual-based earnings management, unexercised options are positively associated with income-increasing accrual-based earnings management.

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Introduction

The recent wave of corporate governance failures has raised concerns about the integrity of the accounting information provided to investors and resulted in a drop in investor con? dence (Jain et al. 2003; Jain and Rezaee 2006; Rezaee 2004). These failures were highly publicized and ultimately led to the passage of the Sarbanes-Oxley Act (SOX, July 30, 2002). The changes mandated by SOX were extensive, with President George W. Bush commenting that this Act constitutes ‘‘the most far-reaching reforms of American business practices since the time of Franklin D.Roosevelt. ’’Similarly, the head of the AICPA commented that SOX ‘‘contains some of the most far-reaching changes that Congress has ever introduced to the business world’’ including an unprecedented shift in the regulation of corporate governance from the states to the federal government. Although SOX proposed sweeping changes, the scope of the events that led to the passage of the Act and the consequences of the resulting regulatory changes have yet to be systematically studied. Specifically, it is unclear whether there really was a widespread breakdown of the reliability of financial reporting prior to the passage of SOX or whether the highly publicized scandals were isolated instances of individuals engaging in blatant financial manipulations. If it were the former, then how did the passage of SOX affect financial reporting practices? Moreover, some argue that these frauds occurred after 70 years of ever-increasing securities regulation, suggesting that more regulation may not be the answer (Ribstein 2002). We investigate the prevalence of both accrual-based and real earnings management activities in the period leading to the passage of SOX and in the period following the passage of SOX.

Our primary motivation for conducting this analysis is to investigate whether the period leading to the passage of SOX was characterized by a widespread increase in earnings management rather than by a few highly publicized events, and whether the passage of SOX resulted in a reduction in earnings management. We carry out our investigation by dividing the sample period into two time periods: the period prior to the passage of SOX (the pre-SOX period: 1987 through 2001), and the period after the passage of SOX (the post-SOX period: 2002 through 2005).

We further subdivide the pre-SOX period into two subperiods: the period prior to the major corporate scandals (the pre-SCA period: 1987 through 1999) and the period immediately preceding the passage of SOX when the major scandals occurred (the SCA period: 2000 and 2001). We document that the pre-SOX period was characterized by increasing accrual-based earnings management, culminating in even larger increases in the SCA period, but declining real earnings management. We also document that the increase in accrual-based earnings management in the SCA period was associated with a contemporaneous increase in optionbased compensation.

However, option-based compensation exhibits two opposing incentives with respect to current stock prices (and thus earnings management). On the one hand, managers have an incentive to lower the current stock price around stock option award (e. g. , Yermack 1997; Aboody and Kasznik 2000). On the other hand, for unexercised options (excluding new option grants), managers have an incentive to increase current stock prices and, hence, to manage earnings upward. To capture these two effects, we partition overall options held at the end of the year into unexercised options (excluding new options

T 1 2 3 Bumiller (2002). Melancon (2002). Traditionally, the federal government has focused on regulating disclosure, public trading, and antitrust, while regulating corporate governance has been the focus of the states. The Accounting Review, May 2008 Real and Accrual-Based Earnings Management 759 grants), new options granted in the current period, and exercisable vested options. Consistent with the notion that these components provide a differential set of incentives, that while new options granted during the current period are negatively associated with income-increasing discretionary accruals, unexercised options are positively associated with income-increasing discretionary accruals. Furthermore, we document that the relation between income-increasing discretionary accruals and unexercised options (excluding new option grants) declined in the post-SOX period. To the best of our knowledge, we are to document this evidence empirically. Following the passage of SOX accrual-based earnings management declined signi? cantly, while real earnings management increased significantly. At the same time, optionbased compensation decreased. Consistent with the results of a recent survey by Graham et al. (2005), this suggests that firms switched to managing earnings using real methods, possibly because these techniques, while more costly, are likely to be harder to detect. In additional analyses, we examine both the pre-SOX and post-SOX accrual-based and real earnings management activities for a subset of  that are more likely to have managed earnings (we refer to these firms as the SUSPECT firms). Specifically, we examine three incentives for managing earnings, namely, meeting or beating last year’s earnings, meeting or beating the consensus analysts’ forecast and avoiding reporting losses. We focus on these incentives because Graham et al. (2005) document that these specific motives are among the most important reasons for earnings management behavior.

Our results contribute to the current debate on the pervasiveness of earnings management prior to the passage of SOX, and the impact of SOX on such behavior. While we find an increase in accrual-based earnings management prior to SOX, our evidence suggests that firms are likely to have switched to earnings-management techniques that, while likely to be more costly to shareholders, are harder to detect. This evidence forms an important consideration in the debate on the costs and benefits of the new regulation. The remainder of the paper proceeds as follows.

Motivation, Research Questions, and Hypotheses

In a recent commentary, U. S. Treasury Secretary Henry Paulson emphasized the importance of strong capital markets, and pointed out that capital markets rely on trust and that trust is based on financial information presumed to be accurate and to reflect economic reality. The series of corporate scandals occurring in 2000–2001 eroded that trust in ? ancial reports. Indeed, one of the main objectives of SOX was to restore the integrity of 4 Paulson (2007). The Accounting Review, May 2008 760 Cohen, Dey, and Lys financial statements by curbing earnings management and accounting fraud. Therefore, the extent of earnings management prior to SOX and the effect of SOX on earnings management is an important research topic. The primary purpose of this paper is to examine the extent of earnings management in the period leading to the scandals and prior to SOX, and the changes in such activities after the passage of SOX.  Our examination of changes in firms’ arnings management activities is motivated in part by the literature documenting that managerial propensity to manage earnings and to avoid negative earnings surprises has increased significantly over time . Our main objective is to examine whether the degree of earnings management increased over time and reached a zenith in the period surrounding the corporate accounting scandals, and declined after the passage of SOX. Consistent with the literature, we examine earnings management activities using discretionary accruals.

However, in addition to using accrual-based accounting estimates and methods, firms are likely to employ real operational activities to manipulate earnings numbers as well. In fact, in their survey Graham et al. (2005) report the following: strong evidence that managers take real economic actions to maintain accounting appearances. In particular, 80% of survey participants report that they would decrease discretionary spending on R&D, advertising, and maintenance to meet an earnings target. More than half (55 %) state that they would delay starting a new project to meet an earnings target, even if such a delay entailed a small sacri? ce in value. Thus, to provide a more complete study of the trends in earnings management activities in the periods before and after SOX, we also examine real earnings management activities over the sample period. Next, we examine possible explanations for any changes in earnings management activities over the sample period. We focus on the hypothesis that managers’ choices of accounting practices are influenced by the impact of these accounting methods on their compensation.

In a recent working paper, Zang (2006) investigates whether managers use real and accrual manipulations in managing earnings as substitutes. Based on a model she develops, she provides evidence consistent with managers using real and accrual manipulations as substitutes. For instance, Coffee (2003) asserts that the increase in stock-based executive compensation created an environment where managers became very sensitive to short-term stock performance. Greenp (2002) opines that ‘‘the highly desirable spread of shareholding and options among business managers perversely created incentives to arti? ially in? ate earnings to keep stock prices high and rising. ’’ Fuller and Jensen (2002, 42) also state that ‘‘[a]s stock options became an increasing part of executive compensation, and managers who made great fortunes on options became the stuff of legends, the preservation or enhancement of short-term stock prices became a personal (and damaging) priority for many CEOs and CFOs. High share prices and earnings multiples stoked already amply endowed managerial egos, and management teams proved reluctant to undermine their own stature by surrendering hard won records of quarter-over-quarter earnings growth.

The Accounting Review, May 2008 Real and Accrual-Based Earnings Management 761 Prior studies (e. g. , Cheng and War? eld 2005; Bergstresser and Philippon 2006) provide evidence suggesting that equity incentives derived from stock-option compensation are positively associated with managements’ likelihood to engage in accrual-based earnings management activities. However, Johnson et al. (2005) conclude that only unrestricted stock holdings are associated with the occurrence of accounting fraud; the stock option grants are not. Further, Erickson et al. (2006) ? d no consistent evidence that executive equity incentives are associated with fraud. In addition to equity-based compensation, executives are also rewarded based on explicit bonus-linked targets for reported income. Healy (1985) presents evidence that the accruals policies of managers are related to the nonlinear incentives inherent in their bonus contracts. Therefore, we investigate whether earnings-based compensation contracts are associated with earnings management. Our focus on the compensation structure is motivated by the current debate whether option-based compensation and bonus grants are associated with earnings management.

Further, there has been a signi? cant increase in the grant of stock options in the past decade. We examine whether those increases (prior to SOX) and decreases (after SOX) are related to the level of earnings management during that period. Specifically, our hypothesis that managers behave opportunistically due to compensation-related incentives has two empirical predictions. First, changes in reported earnings are affected by changes in the compensation and incentives of managers.

Second, even after controlling for managerial incentives, earnings management would decline after the passage of SOX, either because of the sanctions imposed on managers by SOX or because of the adverse publicity and legal costs imposed on executives and firms who were accused of questionable or even fraudulent reporting practices. We based this expectation on the premise that after the passage of SOX accrual manipulations were more likely to draw auditors’ or regulators’ scrutiny than real earnings management. If firms were more wary after the passage of SOX, then they would be more likely to substitute real earnings management for accrual-based earnings management after SOX. This conjecture is also suggested by Graham et al. (2005): [W]e acknowledge that the aftermath of accounting scandals at Enron and WorldCom and the certifiation requirements imposed by the Sarbanes-Oxley Act may have changed managers’ preferences for the mix between taking accounting versus real actions to manage earnings. Given the above argument, investigating the trends in both real and accrual-based earnings management after SOX is important. Evidence of a decline in one type of earnings management may lead one to conclude that such activities have decreased in response to regulators or other events, when in fact a substitution of one earnings management method for another has occurred.

We thus hypothesize and test whether the level of real earnings management increased after the passage of SOX, i. e. , whether firms substituted between 8 In their survey, Graham et al. (2005, 66) report: ‘‘Managers candidly admit that they would take real economic actions such as delaying maintenance or advertising expenditure, and would even give up positive NPV projects, to meet short-term earnings benchmarks. ’’ The Accounting Review, May 2008 762 Cohen, Dey, and Lys real and accrual-based methods after SOX. The next section discusses the empirical methodology employed in the study. III.

Empirical Methodology

To test the compensation hypothesis, we use data from ExecuComp, which is available only from 1992 onward. Thus, merging the full sample with ExecuComp results in a second (and smaller) sample consisting of 2,018 rms and 31,668 ? rm-year observations (the ExecuComp sample) for the 1992 through 2005 period. Event Periods We focus in our analysis on earnings management across two main time periods—the pre-SOX period (further classi? ed into the pre-SCA and the SCA periods), and the postSOX period. The pre-SOX period extends from 1987 through 2001, and the post-SOX period extends from 2002 through the end of 2005.

Within the pre-SOX period, we classify the period from 1987 through 1999 as the pre-SCA period, and the period from 2000 through 2001 as the SCA period (i. e. , the period that purportedly lead to the passage of SOX). 10 Figure 1 depicts these different time periods analyzed. 11 9 10 11 SFAS No. 95 requires rms to present a statement of cash flows for fiscal years ending after July 15, 1988. Some  rms early-adopted SFAS No. 95, so our sample begins in 1987. We acknowledge that the subdivision into the pre-SCA and SCA periods may induce hindsight bias into the analysis.

We thus repeat our analysis by only dividing the entire sample period into the pre-SOX and the postSOX periods. Our conclusions on earnings management activities before and after SOX are unchanged and become stronger. We do not report these results in the paper for the sake of brevity, but will provide them upon request. The use of annual data determines how we subdivide the sample period to some extent. Although some scandals took place in the beginning of 2002, we include 2002 in the post-SOX period, since SOX was passed in 2002.

Also, even though the most public phase of the scandals began with Enron in 2001, we include year 2000 in the SCA period since some frauds also occurred in 2000 (e. g. , Xerox). Further, as a robustness check, we also repeat our analysis using quarterly data and subdivide the sample period using the ‘‘Corporate Scandal Sheet’’ developed by Forbes (2002). Specifically, we define the SCA period as extending from Q3, 2001 through Q2, 2002, and the post-SOX period as extending from Q3, 2002 onward. Our main conclusions remain unchanged, which provides added con? dence in the results obtained using annual data.

• Caveat - Various studies in the literature raise the concern that discretionary accruals measured using the Jones model might be capturing nondiscretionary components and these errors in discretionary accruals are likely to be correlated with stock prices and performance measures in general. While this concern is valid and we acknowledge this limitation in measuring discretionary accruals, note that we use discretionary accruals as a dependent variable and not as an explanatory variable. If indeed discretionary accruals are measured with error, then the only consequence in our case will be a lower explanatory power of the model, we will obtain lower R2s. Otherwise, using discretionary accruals measured using the Jones model as a dependent variable is not likely to introduce any bias in our results.

Following the methodology used in the literature, we estimate the industry-specific regressions using the change in reported revenues, implicitly assuming no discretionary choices with respect to revenue recognition. However, while computing the normal accruals, we adjust the reported revenues of the sample rms for the change in accounts receivable to capture any potential accounting discretion arising from credit sales. Our measure of discretionary accruals is the difference between total accruals and the fitted normal accruals, defined as DAit (TAit /Assetsit 1) NAit. In contrast to studies that focus on a  corporate event, our analysis using the full sample is conducted in calendar time. Consequently, because accruals reverse over time and we cannot condition the analysis on events that are hypothesized to provide managers with incentives to manage reported earnings in any given direction (e. g. , in ate reported earnings) we compute the absolute value of discretionary accruals to proxy for earnings management and refer to it as ABS DA throughout the analysis. In contrast, our test of the SUSPECT firms (that is, firms that were just able to meet or beat earnings benchmarks) is based on a directional test.

Subsequent studies, such as Zang (2006) and Gunny (2005), provide evidence of the We repeat our analysis using the square of discretionary accruals and the results are somewhat stronger. Although the squared discretionary accruals have more desirable distributional properties, we report the results using the absolute values of discretionary accruals to allow comparison with other research. We also carry out performance matching based on two-digit SIC code, year, and ROA (both current ROA and lagged ROA) and obtain results similar to those reported in the paper.

Real and Accrual-Based Earnings Management construct validity of these proxies. We focus on three manipulation methods and their impact on the above three variables:

1. Acceleration of the timing of sales through increased price discounts or more lenient credit terms. Such discounts and lenient credit terms will temporarily increase sales volumes, but these are likely to disappear once the rm reverts to old prices. The additional sales will boost current period earnings, assuming the margins are positive. However, both price discounts and more lenient credit terms will result in lower cash ws in the current period.
2. Reporting of lower cost of goods sold through increased production. Managers can increase production more than necessary in order to increase earnings. When managers produce more units, they can spread the  xed overhead costs over a larger number of units, thus lowering  xed costs per unit. As long as the reduction in xed costs per unit is not offset by any increase in marginal cost per unit, total cost per unit declines. This decreases reported cost of goods sold (COGS) and the rm can report higher operating margins. However, will still incur other production and holding costs that will lead to higher annual production costs relative to sales, and lower cash  ows from operations given sales levels.
3. We use these three variables as proxies for real earnings management. Given sales levels, ? rms that manage earnings upward are likely to have one or all of these: unusually low cash ow from operations, and/or unusually low discretionary expenses, and/or unusually high production costs. In order to capture the effects of real earnings management through all these three variables in a comprehensive measure, we compute a single variable by combining the three individual real earnings management variables. Specifically, we compute RM PROXY as the sum of the standardized variables, R CFO, R PROD, and R DISX.

However, we acknowledge that the three individual variables have different implications for earnings that may dilute any results using RM PROXY alone. We thus report results corresponding to the single real earnings management proxy (RM PROXY) as well as the three individual real earnings management proxies (R CFO, R PROD, and R DISX).

Tests and Results

Whenever possible, we perform the tests on both the full and the ExecuComp samples to assess the impact of the ExecuComp selection on our results. The Accounting Review, May 2008 Real and Accrual-Based Earnings Management 769 rm size does not seem to have a signi? cant impact on fundamental measures such as leverage, growth of sales, or market-to-book ratios. As expected, TA (total accruals de? ated by prior-year total assets) is negative at 0. 10 ( 0. 07 for the ExecuComp subsample) with a standard deviation of 0. 25 (0. 12 for the for the ExecuComp subsample). In contrast the average DA (discretionary accruals) is 0. 0 (standard deviation of 0. 20) for the full sample and 0. 01 (0. 11) for the ExecuComp subsample. 18 While the average DA is zero, we nd that positive discretionary accruals (Positive DA) are, on average, larger in magnitude than negative discretionary accruals (Negative DA). This is not only true for the mean, but also for the median and the 75th percentiles. This is however not true for the ExecuComp sample (except at the 75th percentile). Thus, for the full sample, it appears that larger earnings increasing DAs are followed by smaller but more frequent reversals.

The last three rows of Panels A and B of Table 1 report our proxies for real earnings management. Comparing the 25th and 75th percentiles of the real earnings management proxies to DA suggests that accrual-based earnings management takes larger values. This observation is consistent with Graham et al. ’s (2005) survey, which suggests that real earnings management is more costly than accrual based earnings management.

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