The Securities and Exchange Commission (SEC) has long been concerned that earnings management practices result in adverse consequences for investors, including masking the true nature of economic transactions, and has often called for increased regulatory oversight of the financial reporting process. In our paper, The Switch Up: An Examination of Changes in Earnings Management after Receiving SEC Comment Letters, which was recently made publicly available on SSRN, we examine the influence of firm-specific regulatory oversight, in the form of SEC comment letters, on firms’ earnings management practices.
Firms can manage earnings using two primary methods: accrual-based earnings management (AEM), such as using “cookie jar” reserves, and real activities-based earnings management (REM), such as the opportunistic timing of discretionary expenses. Prior research provides evidence of a cost-benefit trade-off between these two methods (e.g., Cohen, Dey, and Lys 2008; Zang 2012). As the cost of one earnings management practice increases, companies shift to other, less costly, forms of earnings management. Cohen et al. (2008) document a decreasing trend in AEM and an increasing trend in REM in the years following the passage of the Sarbanes-Oxley Act of 2002 (SOX), suggesting that SOX imposes increased regulatory scrutiny on AEM, and thus increases the cost of AEM. Companies then offset the constrained AEM by engaging in additional REM. Survey results confirm that, post-SOX, managers likely switched to REM because it is more difficult to detect (Graham, Harvey, and Rajgopal 2005), but it is still unclear which provisions of SOX (or other concurrent factors) resulted in this shift from AEM to REM.
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. The SEC review process underwent substantial changes post-SOX, including improved transparency (i.e., comment letter correspondence is now available to the public) and increased frequency of reviews (i.e., higher probability of being reviewed). We expect that these regulatory changes of the SEC review process induce companies to reduce their AEM because accounting issues (e.g., accruals) are often the focus of the SEC’s reviews. We expect that companies will increase their REM because the SEC is less likely to scrutinize real business transactions as long as they are properly disclosed.
It is not clear whether the general threat of review, post-SOX, is enough to change firms’ earnings management behavior or whether it is the receipt of an actual comment letter. Firms do not know the exact timing of the review process unless they actually receive a comment letter, but they do know that they will be reviewed by the SEC at least once every three years. Thus, it is possible that the threat of the review process alone may constrain AEM. However, the receipt of a comment letter serves as a salient cue that the company is being monitored by the SEC and suggests that management may react specifically to the receipt of a comment letter. SEC comment letters are a top priority item and are given immediate attention by senior company management including the Chief Executive Officer and Chief Financial Officer (Johnson 2010). Therefore, we expect that, in addition to any behavior modifications accompanying the general threat of SEC review in the post-SOX period, companies will react to the receipt of an actual comment letter by reducing AEM and increasing REM.
Using augmented models from Zang (2012), which focus on suspect firms that meet or just beat specific earnings benchmarks, we find that AEM significantly decreases and REM significantly increases in the two years after the receipt of an SEC comment letter. These results are consistent with our hypothesis that, after receiving a comment letter, companies reduce their AEM, due to higher cost of regulatory scrutiny, and shift to more REM, which is less likely to be the SEC’s focus. Additionally, when considering the timing of the comment letters in relation to the changes in earnings management, we find that comment letters have an immediate impact in the subsequent year, and the impact has lasting effects for at least two years after the receipt of the letters.
To better understand whether our results are driven by general scrutiny from the SEC or accounting-specific scrutiny, we also perform cross-sectional analysis based on the type of SEC reviewer and the type of comments in the letter. Specifically, we divide the sample of comment letters into attorney and accountant reviews based on the titles of the reviewers referenced in the letters and then further divide the accountant reviews into accounting-related and non-accounting-related comments. Cross-sectional results suggest that our main results are driven by comment letters that come from an accountant review and contain at least one accounting-related comment. We find no significant change in AEM or REM when the comment letter stems from an attorney review or contains only non-accounting-related comments. Thus, it appears that general scrutiny from the SEC (i.e., commenting on non-accounting issues such as risk factors, internal control disclosures, etc.) is not sufficient to induce management to reevaluate the cost of accrual-based earnings management behavior. Alternatively, companies only change their earnings management behavior when the comment letters specifically address accounting-related issues.
The results of our study provide important implications for regulators. Although we find that SEC comment letters have the positive outcome of constraining questionable accrual-based earnings management practices, they also have the potentially unintended negative outcome of increasing the manipulation of real activities, which may be even more costly to investors in the long run. Therefore, regulators should be mindful of a more complete picture of the earnings management consequences of the comment letter process.
The full paper is available for download here.
An Examination of Changes in Earnings Management after Receiving SEC Comment Letters
More from: Bret Johnson, Lauren Cunningham, Ling Lei Lisic, Scott Johnson
Scott Johnson is Assistant Professor of Accounting at Virginia Tech. This post is based on an discussion paper authored by Professor Johnson; Lauren Cunningham, Assistant Professor of Accounting at the University of Tennessee; Bret Johnson, Assistant Professor of Accounting at George Mason University; and Ling Lei Lisic, Associate Professor of Accounting at George Mason University.
The Securities and Exchange Commission (SEC) has long been concerned that earnings management practices result in adverse consequences for investors, including masking the true nature of economic transactions, and has often called for increased regulatory oversight of the financial reporting process. In our paper, The Switch Up: An Examination of Changes in Earnings Management after Receiving SEC Comment Letters, which was recently made publicly available on SSRN, we examine the influence of firm-specific regulatory oversight, in the form of SEC comment letters, on firms’ earnings management practices.
Firms can manage earnings using two primary methods: accrual-based earnings management (AEM), such as using “cookie jar” reserves, and real activities-based earnings management (REM), such as the opportunistic timing of discretionary expenses. Prior research provides evidence of a cost-benefit trade-off between these two methods (e.g., Cohen, Dey, and Lys 2008; Zang 2012). As the cost of one earnings management practice increases, companies shift to other, less costly, forms of earnings management. Cohen et al. (2008) document a decreasing trend in AEM and an increasing trend in REM in the years following the passage of the Sarbanes-Oxley Act of 2002 (SOX), suggesting that SOX imposes increased regulatory scrutiny on AEM, and thus increases the cost of AEM. Companies then offset the constrained AEM by engaging in additional REM. Survey results confirm that, post-SOX, managers likely switched to REM because it is more difficult to detect (Graham, Harvey, and Rajgopal 2005), but it is still unclear which provisions of SOX (or other concurrent factors) resulted in this shift from AEM to REM.
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. The SEC review process underwent substantial changes post-SOX, including improved transparency (i.e., comment letter correspondence is now available to the public) and increased frequency of reviews (i.e., higher probability of being reviewed). We expect that these regulatory changes of the SEC review process induce companies to reduce their AEM because accounting issues (e.g., accruals) are often the focus of the SEC’s reviews. We expect that companies will increase their REM because the SEC is less likely to scrutinize real business transactions as long as they are properly disclosed.
It is not clear whether the general threat of review, post-SOX, is enough to change firms’ earnings management behavior or whether it is the receipt of an actual comment letter. Firms do not know the exact timing of the review process unless they actually receive a comment letter, but they do know that they will be reviewed by the SEC at least once every three years. Thus, it is possible that the threat of the review process alone may constrain AEM. However, the receipt of a comment letter serves as a salient cue that the company is being monitored by the SEC and suggests that management may react specifically to the receipt of a comment letter. SEC comment letters are a top priority item and are given immediate attention by senior company management including the Chief Executive Officer and Chief Financial Officer (Johnson 2010). Therefore, we expect that, in addition to any behavior modifications accompanying the general threat of SEC review in the post-SOX period, companies will react to the receipt of an actual comment letter by reducing AEM and increasing REM.
Using augmented models from Zang (2012), which focus on suspect firms that meet or just beat specific earnings benchmarks, we find that AEM significantly decreases and REM significantly increases in the two years after the receipt of an SEC comment letter. These results are consistent with our hypothesis that, after receiving a comment letter, companies reduce their AEM, due to higher cost of regulatory scrutiny, and shift to more REM, which is less likely to be the SEC’s focus. Additionally, when considering the timing of the comment letters in relation to the changes in earnings management, we find that comment letters have an immediate impact in the subsequent year, and the impact has lasting effects for at least two years after the receipt of the letters.
To better understand whether our results are driven by general scrutiny from the SEC or accounting-specific scrutiny, we also perform cross-sectional analysis based on the type of SEC reviewer and the type of comments in the letter. Specifically, we divide the sample of comment letters into attorney and accountant reviews based on the titles of the reviewers referenced in the letters and then further divide the accountant reviews into accounting-related and non-accounting-related comments. Cross-sectional results suggest that our main results are driven by comment letters that come from an accountant review and contain at least one accounting-related comment. We find no significant change in AEM or REM when the comment letter stems from an attorney review or contains only non-accounting-related comments. Thus, it appears that general scrutiny from the SEC (i.e., commenting on non-accounting issues such as risk factors, internal control disclosures, etc.) is not sufficient to induce management to reevaluate the cost of accrual-based earnings management behavior. Alternatively, companies only change their earnings management behavior when the comment letters specifically address accounting-related issues.
The results of our study provide important implications for regulators. Although we find that SEC comment letters have the positive outcome of constraining questionable accrual-based earnings management practices, they also have the potentially unintended negative outcome of increasing the manipulation of real activities, which may be even more costly to investors in the long run. Therefore, regulators should be mindful of a more complete picture of the earnings management consequences of the comment letter process.
The full paper is available for download here.