The Economic Effects of Earnings Management Pre- and Post-SOX

Research suggests that following several high-profile accounting scandals and the passage of SOX legislation in 2002, firms substituted real earnings management strategies for accrual manipulation. However, the broader implications of this tradeoff from a public policy and financial oversight perspective are not well understood. Consistent with our expectations, we find that abnormal operating decisions are less informative about future ROA in the post-SOX period. We also find that the increase in real earnings management negatively impacts firm value, but investors appear slow to recognize and price the myopic behavior. We do not observe a corresponding increase in the quality of discretionary accruals after SOX, but market mispricing of abnormal accruals essentially disappears, consistent with greater investor scrutiny. Although the shift away from accrual manipulation to real earnings management should result in less distortion of underlying economic events, the net effect appears to be value destroying for the average firm. Data Availability: Data are publicly available from sources identified in the paper. JEL Classifications: G32; G38; M41; M48.