Electronic copy available at: http://ssrn.com/abstract=1791766

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Sarbanes Oxley Effectiveness on the Earning Management

by

Rachel Ang

3/5/2011

ABSTRACT

The study examined the degree to which the enactment of Sarbanes-Oxley Act (SOX), specifically Section 404, has impacted earnings management practices among Fortune 500 companies. Companies practice earnings management to (a) be selective about the information on financial performance investors receive, and (b) hide or misrepresent the corporation’s true earnings. By examining the impact of regulatory intervention, accounting standard-setting organizations will have the opportunity to measure the strength of statutory oversight. Findings suggested that regulatory intervention through the implementation of SOX reduced the practice of earnings management. The findings enabled leadership to better understand the insight and to offer transformation to the companies’ ethical paradigms. As corporate leaders have a fiduciary responsibility to behave ethically and responsibly to provide investors, employees, stakeholders, and the public with the ethically based financial reports.

Electronic copy available at: http://ssrn.com/abstract=1791766

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Introduction

In 2000 to 2005, based on the way earnings were reported Green (2004) noted a

loss of $8 trillion dollars to investors, and Fortune 500 companies started to collapse.

Investigations of the financial reports uncovered (a) accounting irregularities (i.e.,

problems with the way accounting principles were applied), (b) fraud, and (c) unethical

forms of earnings management (Chang et al., 2006; Geiger & North, 2006). In August

2002, 12 companies were investigated for accounting irregularities. Senior chief

executive officers (CEOs) and chief financial officers (CFOs) from more than 10 leading

corporations were arrested for financial misconduct (Chang et al.).

These well-publicized investigations and arrests of prominent corporate leaders

lead to increased concerns about the integrity of internal management control systems for

financial statement reporting (Geiger & Taylor, 2003; Geiger & North). Corporate

leaders’ decisions to deviate from generally accepted accounting principles (GAAP)

(Rockness & Rockness, 2005). Since the 1930s, reputable accountants have followed

generally acceptable accounting principles (GAAP) in the preparation of financial reports

to disclose relevant, reliable information investors can use to make informed decisions

about firm performance (Xiong, 2006).

Earnings management has became a part of the financial reporting process in the

1900s, and in 2002 the U.S. Congress enacted Sarbanes-Oxley Act (SOX) to regulate the

use of earnings management by corporate leaders (SOX, 2002). Earnings management

involves corporate leaders’ strategic handling of earnings information in financial reports,

and allows corporate leaders to (a) be selective about the information investors receive on

Electronic copy available at: http://ssrn.com/abstract=1791766

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financial performance, and (b) hide or misrepresent the corporation’s true earnings

(Akers, Giacomino, & Bellovary, 2007; Financial Accounting Standards Board, 1980).

The effectiveness of Section 404 legislation on earnings management is not

known (Scarborough & Taylor, 2007) as the widespread use of earnings management has

been cited as one reason for the decrease in investor confidence in corporate America

(Chang, Chen, Liao, & Mishra, 2006). To address these concerns, the U.S. General

Accounting Office (U.S. GAO, 2002) conducted a study in which financial statement

restatements were examined. Accounting fraud was the result of company failure to apply

GAAP correctly (Lobo & Zhou, 2006).

Companies did not follow GAAP to record revenue-producing transactions. For

example, Enron created temporary, special-purpose companies to hide liabilities and

report higher earnings (Duchac, 2004). U.S. GAO (2002) found 39% of the 919 financial

restatements made between 1997 and 2002 occurred as 238 publicly traded companies

reported revenue before it was earned, a form of aggressive earnings management.

Accounting fraud had a negative effect on investor confidence (Giroux, 2003). To

restore confidence, the U.S. Congress enacted the Sarbanes-Oxley Act of 2002 to

“protect investors by improving the accuracy and reliability of corporate disclosures”

(SOX, 2002, p. 1). Section 404 of the Act requires companies to establish, document, and

maintain an internal control system for managing earnings in financial reports, and to

disclose their earnings practices (Bedohazi, 2007).

Data Description

A total of 217 domestic U.S. public companies were retrieved from the publicly

available financial reports, Mergent Online database. The specific population included

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Fortune 500 companies required to file internal control financial reports between the

period 2000 and 2006 (i.e., from two years immediately before to four years immediately

after the enactment of SOX). The study excluded utility industry firms with a 2-digit

Standard Industrial Classification (SIC) between 40 and 49 and financial institutions with

a 2-digit SIC between 60 and 69. It also excluded missing key data, with the exclusions,

66 companies were analyzed.

Data Findings

Table 1 provides the descriptive statistics for the Discretionary Accruals and

Market Value for the four years.

Table 1

Descriptive Statistics for the Discretionary Accruals and Market Value (N=63)

Year Median M SD Range

Discretionary accruals

2000 -631.98 -1132.18 1340.69 -6026.16–148.43

2001 -463.60 -952.90 1156.12 -4806.77–347.19

2003 -526.40 -1064.08 1427.95 -6514.71–1773.64

2004 -687.08 -1195.86 1470.11 -6740.29–892.80

Market value

2000 7.00 18.98 34.45 0–194

2001 9.00 21.78 40.29 0–243

2003 8.00 17.02 30.72 0–178

2004 10.00 23.49 43.42 0–282

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Discussion to Hypotheses 1, and 2

Hypothesis 1 addressed the effectiveness of SOX.

Ha1: Earnings management by measures of discretionary accruals will decrease

from before the establishment of internal control procedures required by SOX Section

404 to after the implementation of the controls.

H01: Earnings management by measures of discretionary accruals will not

decrease from before the establishment of internal control procedures required by SOX

Section 404 to after the implementation of the controls.

Before SOX implementation, not all 63 corporations had a certified internal

control system in 2000 and 2001. The implementation of SOX in 2002 shows 60 of the

corporations with a certified internal control system. Only three corporations did not have

a certified system. Figure 1 displayed the findings.

Figure 1. Discretionary accrual mean for the four years.

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In Figure 1, illustrated the above, and t-tests supported the findings (Mean

increase = 179.28, SD = 486.77, t(62) = 2.92, p < .01), and the values decreased

significantly from 2001 to 2004 (Mean decrease = -242.96, SD = 642.43, t(62) = 3.00, p

< .01). The findings supported the alternative hypothesis (Ha1).

Hypothesis 2 addressed the impact that regulatory intervention had on earnings

management.

Ha2: There will be a relationship between earnings management (discretionary

accruals) and corporate governance (market value).

H02: There will not be a relationship between earnings management (discretionary

accruals) and corporate governance (market value).

Table 2 presents the correlations between the discretionary accrual and market

value for the four years.

Table2

Spearman Correlations between Discretionary Accrual and Market Value (N = 63)

Year DA 00 DA 01 DA 03 DA 04 MV00 MV01 MV03 MV04

DA 2000 --

DA 2001 .93 --

DA 2003 .92 .93 --

DA 2004 .86 .86 .97 --

MV 2000 -.59 -.56 -.56 -.52 --

MV 2001 -.60 -.60 -.60 -.57 .96 --

MV 2003 -.44 -.51 -.52 -.50 .85 .92 --

MV 2004 -.44 -.50 -.52 -.51 .86 .91 .98 --

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Note. All ps < .001. DA = Discretionary Accrual; MV = Market Value.

The correlations in bold font from Table 2 suggested the range of -.51 to -.60.

Each correlation showed a highly significant (p < .001), moderately strong, negative or

inverse relationship between discretionary accrual and market value. The findings thus

supported the alternative hypothesis for Hypothesis 2.

Implication

Perhaps the most important significance impact of this study is the improved

understanding of the results. The study discloses information about the impact on

corporate leaders’ financial reporting decisions have on investors’ ability to evaluate a

firm’s performance management (Dogan, Coskun, & Çelik, 2007; Bedohazi, 2007). The

study demonstrated how leadership could offer insight to change the companies’ ethical

paradigms. Corporate leaders have a fiduciary responsibility to behave ethically (Staubus,

2005). They have the responsibility to provide investors with ethically based financial

reports where current financial performance is presented (Entwistle, Feltham, &

Mbagwu, 2006; Gore, Pope, & Singh, 2007; Lee, Li, & Yue, 2006). The study also serves

as a benchmark for the impact of legislative intervention on corporate accounting

methods.

Conclusion and Future Research

With pressure to achieve earnings projections, leaders used earnings management

approaches to enhance their company’s financial performance and image of the company

(Giroux, 2003). The study explored new insights on the percentage of companies required

to restate their financial statements as accounting irregularities grew 145% from January

1997 to June 2002. The number of companies restating financial information doubled

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from 92 in 1997 to 225 in 2001. In a 2006 follow-up study, GAO found a 67% increase in

restatements between July 2002 and September 2005.

These activities became so significant that Fortune 500 companies began filing

for bankruptcy protection, the U.S. Securities and Exchange Commission (SEC, 2003)

filed 515 enforcement actions against companies who restated financial statements from

July 1997 to July 2002. Enforcement actions were based on improper financial reporting

and fraud. Federal civil suits were brought against 186 of the 515 companies against

which with enforcement actions had been filed. To improve the financial reporting

process and increase investor confidence, Congress enacted SOX.

Future study may consider a longer time series, and conduct a survey to evaluate

characteristics such as cost of review, number of years conducting internal control

compliance audits, number of times fraud was detected, training of auditors, and changes

in organizational leadership. These characteristics could potentially affect the

effectiveness of SOX, and the requirements for how companies are required to comply

with SOX Section 404.

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APPENDIX A: SAMPLE CHARACTERISTICS

TABLE A-1

STANDARD INDUSTRIAL CLASSIFICATIONS OF SAMPLE COMPANIES

Code Standard Industrial Classification Total

13 Oil and gas extraction 3

20 Food and kindred products 3

21 Tobacco products 1

23 Apparel and other textile products 1

24 Lumber and wood products 2

25 Furniture and fixtures 1

26 Papers and allied products 1

27 Printing and publishing 2

28 Chemical and allied products 9

29 Petroleum and coal refining 3

30 Rubber and miscellaneous plastics products 1

32 Stone, clay, and glass products 1

33 Primary metal industries 1

34 Fabricated metal products 2

35 Industrial machinery and equipment 4

36 Electronic and other electrical equipment 2

37 Transportation equipment 10

12

Code Standard Industrial Classification Total

38 Instruments and related products 2

39 Miscellaneous manufacturing industries 1

50 Wholesale trade durable goods 2

51 Wholesale trade nondurable goods 2

55 Automotive dealers and service stations 1

58 Eating and drinking places 1

59 Miscellaneous retail 3

70 Hotels and other lodging places 1

73 Business services 4

80 Health services 2