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

• In Event: Earnings Management Issues

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. In this study, we examine whether the SEC’s oversight role affects firms’ earnings management behavior, particularly because of increased transparency and increased frequency of comment letters following the Sarbanes-Oxley Act of 2002 (SOX). Following attention bias theory, we expect that increased firm-specific scrutiny from the SEC, in the form of a comment letter, will cause management to reevaluate the cost of engaging in accruals-based earnings management and switch to real activities-based earnings management, that is less likely to be scrutinized in the SEC’s review process. Consistent with our predictions, we find that accruals-based forms of earnings management decrease and that real activities-based forms of earnings management increase in the two years following the receipt of a comment letter. These results suggest that the comment letter process is effective in constraining accounting-related methods of earnings management but may have the unintended consequence of encouraging companies to switch to real activities-based forms of earnings management.

Authors

• Lauren Cunningham (Dreher), University of Tennessee

• Bret Johnson, The Ohio State University

• E Scott Johnson, Virginia Tech University

• Ling Lisic, George Mason University