Discuss the purpose of AICPA Code of Professional Conducts Under what circumstances may ethical conflicts in the public practice arise? What steps does AICPA Code of Professional

PERCEPTIONS OF THE EFFECT OF

SARBANES-OXLEY ON EARNINGS

MANAGEMENT PRACTICES

John E. McEnroe

ABSTRACT

A key objective of the Sarbanes-Oxley Act (SOA) was the restoration of

public confidence in the integrity of audited financial statements. One sec-

tion of SOA (Section 302) requires the chief executive officer(s) and the

principal financial officer(s) to certify in each quarterly or annual report

filed with the Securities Exchange Commission (SEC) that the financial

statements fairly present the financial condition and results of operations

for the periods presented in the reports. An important distinction is that the

SEC explicitly states that fair presentation is not limited to a reference that

the statements have been presented in accordance with generally accepted

accounting principles (GAAP). As such, it would follow that this aspect of

SOA would place a higher standard of quality on the financial information

than in the past and that GAAP can no longer be used as a safe harbor

defense for earnings management practices. I surveyed CFOs of the For-

tune 500 firms and audit partners for the 33 largest audit firms by revenue

as to whether they perceived that SOA significantly reduced various earn-

ings management practices in audited financial statements in general. The

results suggest that the respondents perceived that SOA reduced earnings

management in only 4 of 15 cases, and as such, contribute to the body of

survey research involving earnings management.

Research in Accounting Regulation, Volume 19, 137–157

Copyright r 2007 by Elsevier Ltd.

All rights of reproduction in any form reserved

ISSN: 1052-0457/doi:10.1016/S1052-0457(06)19007-4

137

JOHN E. MCENROE138

The Sarbanes-Oxley Act (SOA) of 2002 (P.L. No. 107–204, 2002) primarily addresses corporate governance and oversight of the accounting profession. President George W. Bush signed the legislation on July 30, 2002. Congress passed the SOA in large measure as a response to Enron and other cor- porate scandals. Several prominent individuals involved with government oversight of capital markets have cited SOA as the most far-reaching federal securities regulation since the Securities Acts of the 1930s.1

An important provision of SOA is Section 302(a), which requires the principal executive officer(s) and the principal financial officers(s) to certify in each quarterly or annual report submitted to the SEC, among other things, that (P.L. No. 107–204, 2002, p. 65):

y based on the officer’s knowledge, the financial statements and other financial infor-

mation included in the report fairly present in all material respects the financial condition

and results of operations of the issuer as of, and for, the periods presented in the report.2

The language contrasts with that contained in the standard United States audit report, which states that the financial statements present fairly, in all material respects, the financial information of the entity in conformity with generally accepted accounting principles (GAAP).

As a result, it would follow that this aspect of SOA would place a higher standard on the quality of the financial information than in the past, and concomitantly, GAAP can no longer be used as a safe harbor defense against charges of creative accounting practices. In fact, as will be explained in more detail in a later section, the SEC (2002, p. 7) specifically states that fair presentation is not limited to GAAP. This requirement engenders a certain tension that is designed and expected to result in reduced earnings management practices.

Dechow and Skinner (2000, p. 236) state that academic research has not demonstrated that earnings management has had a large impact, on aver- age, on reported earnings. As a result, they assert that academics perceive that investors should not be concerned with its existence. The authors state that the reason for this belief is, as the research of Healy and Wahlen (1999) and others indicate, academic research is limited in its ability to identify earnings management in large samples due to measurement issues. However, they state that in contrast, practitioners and regulators observe earnings management on a regular basis because they have different objectives than earnings management researchers.

Given this background, this research examines the perceptions of Chief Financial Officers (CFOs) and audit partners of the impact of SOA on earnings management in audited financial statements. Nelson, Elliot, and

Perceptions of the Effect of Sarbanes-Oxley 139

Tarply (2003, p. 18) state that very little systematic research exists concern- ing specific attempts of earnings management. Furthermore, they cite the benefits of a better understanding of extant earnings management practices to several parties, including regulators and standard setters, auditors, CEOs, CFOs, audit committees, investors, managers, and educators. As such, this study extends such research by identifying specific areas of earnings man- agement perceived to be affected by SOA. At this point, the work of Buckmaster (2001) should be cited for it is related to the contribution of this study. His work represents the most comprehensive analysis of the earnings management literature, which he refers to as ‘‘income smoothing.’’ Buckmaster studied three taxonomies of earnings management literature over the period from 1893 to 1998. His work indicates that there will always be a debate over the best approach to study the subject. With that point made, the contribution of the results of this study involve the literature involving perceptions of earnings management versus a study attempting to measure actual observations. The paper begins with a discussion of the quality of earnings, especially within a GAAP framework, followed by the research question, the research method, discussion of results, and the sum- mary and conclusions.

BACKGROUND AND RESEARCH QUESTION

Earnings Management and GAAP

The quality of financial information, especially as it relates to the quality of earnings, has attracted much attention in both academic and business jour- nals.3 Perhaps the most often cited reference is then SEC chairman Arthur Levitt’s 1998 speech (Levitt, 1998). Levitt described what he referred to as five popular accounting ‘‘illusions’’: ‘‘big bath’’ restructuring charges, cre- ative accounting acquisitions, ‘‘cookie jar’’ reserves, immaterial misappli- cation of accounting principles, and premature revenue recognition.

Although some of the above practices appear to be in violation of GAAP, other creative accounting practices fall within the letter of GAAP. As Nelson (2003, p. 101) states, precise accounting standards may offer safe harbors through accounting transaction engineering, which in turn, con- strains accounting regulators’ ability to address earnings management which reflects aggressive financial reporting.

As such, GAAP is often referred to as a ‘‘rule dominated’’ financial re- porting system, and as in Nelson’s observation, has been blamed in large

JOHN E. MCENROE140

measure for a number of creative accounting practices. For example, past SEC Chairman Harvey Pitt stated, ‘‘The development of rule-based ac- counting standards has resulted in the employment of financial engineering techniques designed solely to achieve accounting objectives rather than economic objectives’’ (FASB, 2002, p. 2).

The FASB also concedes that there is a widely held perception that rule dominated standards allow for a manipulation of the financial information contained in an entity’s financial statements.4

Many also assert that because much of the detail and complexity in accounting stand-

ards results from rule-driven implementation guidance, the standards allow financial and

accounting engineering to structure transactions ‘‘around’’ the rules, thereby circum-

venting the intent and the spirit of the standards. (FASB, 2002, p. 2)

Given the corporate scandals and attention to earnings management in both academic research and media publications, there is a movement toward a principle-based approach to accounting standard setting. This, in the view of many, would lead to more transparency in financial statements and a reduction in earnings management.

For example, the American Accounting Association Financial Account- ing Standards Committee ‘‘strongly supported’’ the FASB’s effort to eval- uate the feasibility of concept-based standards.5 The Committee stated the reason for its position is that the associated accounting standards applicable to the transaction, in conjunction with its economic substance, should be the reference points for the manner in which it is reported. The Committee concluded that a concept-based system provides the best approach toward that objective (AAA, 2003, pp. 73–74). The Committee acknowledges, however, that the implementation and enforcement of concept-based stand- ards will be difficult, because it will take the joint efforts of management, the board of directors, and the auditors to apply professional expertise and judgment to achieve unbiased financial statements.

Katherine Schipper (2003), a current member of the FASB, on the other hand, argues that extant U.S. GAAP are, in fact, principles-based, however, they contain elements such as scope, treatment, and detailed implementation guidance that make them appear to be rules-based. Sir David Tweedle, Chairman of the International Accounting Standards Board (IASB) offered an international perspective that, in part, shares Schipper’s point of view. Tweedle states that although International Financial Reporting Standards (IFRS) and U.S. GAAP strive to be principles-based since they are derived from a body of concepts, U.S. GAAP is more specific in its requirements and implementation guidance; hence, more rule-based than the IFRS.

Perceptions of the Effect of Sarbanes-Oxley 141

Tweedle asserts that a key difference is that the international approach requires both the firm and the auditor to ‘‘take a step back’’ to determine if the proposed accounting for the transaction is consistent with the under- lying principle (FASB, 2002, p. 7).

The SEC, in its explanation of the SOA Section 302(a) requirement, also expressed its concerns with the limitations of GAAP. The SEC explicitly states in the certification statement that fair presentation is not limited to an assertion that the financial statements and other financial information have been presented in accordance with GAAP. The SEC explained its position in the ensuing paragraph:

We believe that Congress intended this statement to provide assurances that the financial

information disclosed in a report, viewed in its entirety, meets a standard of overall

material accuracy and completeness that is broader than financial reporting require-

ments under generally accepted accounting principles. In our view, a ‘‘fair presentation’’

of an issuer’s financial condition, results of operations and cash flows encompasses the

selection of appropriate accounting policies, proper application of appropriate account-

ing policies, disclosure of financial information that is informative and reasonably re-

flects the underlying transactions and events and the inclusion of any additional

disclosure necessary to provide investors with a materially accurate and complete picture

of an issuer’s financial condition, results of operations and cash flows. (SEC, 2002, p. 7)6

In essence, this position constitutes a principles-based reporting system, es- pecially given the SEC’s authority over the reporting practices of publicly traded entities. As stated earlier, this requirement creates a certain tension and pressure on the certifying officers to reduce earnings management practices. This is, this aspect of SOA is designed then to eliminate clear violation of GAAP (i.e., fraud) as well as earnings management through the application of GAAP, as described in Dechow and Skinner’s earnings management framework (Dechow and Skinner, 2000, p. 239).

Another important body that issued guidance on the application of GAAP is the Auditing Standards Board (ASB) of the AICPA. Although the Public Company Accounting Oversight Board (PCAOB) has since replaced the ASB as the promulgator of auditing standards, the ASB’s Statement on Auditing Standards (SASs) have been adopted as interim standards by the PCAOB and are in effect until modified or superceded. In 1992, the ASB issued Statement on Auditing Standards No. 69 (SAS 69), The Meaning of

Present Fairly In Conformity With Generally Accepted Accounting Principles

In The Independent Auditors’ Report (AICPA, 1992). In contrast to the SEC and the FASB, SAS 69 states that the implementation of GAAP ‘‘almost always’’ results in the fair presentation of the financial statements. However, it goes on to state that the ‘‘literal application’’ of GAAP might, in unusual

JOHN E. MCENROE142

circumstances, result in misleading financial statements. In this case the auditors should provide a qualified or adverse rather than an unqualified audit opinion (AICPA, 1992, par. 5).

The preceding discussion indicates that there is an official difference of opinion on the efficacy of GAAP to insure fair reporting. The SEC and FASB concede that there is the ability to ‘‘engineer’’ GAAP, while the ASB is more confident that the use of GAAP insures fair presentation.

It appears that the financial media sides with the SEC and FASB. Besides such derisive articles involving GAAP and earnings management, consider the following quote (Eichenwald, 2002).7

Can accounting that follows the stated rules still be unreliable? In other words, is there a

gap in GAAP? After a year of corporate scandals in which some of the most outrageous

financial reporting appears to have complied with generally accepted accounting prin-

ciples, or GAAP, the answer appears to be yes.

The author then mentioned the cases of Tyco and WorldCom in which both entities set up large reserves after an acquisition to account for anticipated costs. The reserves were later reversed, increasing future income. A review of the Wall Street Journal indicates that there continues to be concern about the use of GAAP to effect earnings management.8

Although some question the merits of academic research in identifying earnings management due to measurement issues (Healy & Wahlen, 1999; Dechow & Skinner, 2000), some recent survey research has been conducted, which overcomes these problems to some extent.

Nelson et al. (2003) surveyed audit partners from a Big Five audit firm as to the earnings management practices that they had encountered. The re- sults were that revenues and other gains represented 22 percent of the ex- amples, expenses and other losses totaled 42 percent, business combinations, 13 percent, and other approaches, 13 percent. As to the income effect in the current period, 53 percent of the practices increased income, 31 percent decreased income, and 16 percent had no clear effect.

Hodge (2003) surveyed investors regarding earnings quality, auditor in- dependence, and the relevance of audited financial information. The re- spondents believed that, on average, managers of publicly traded firms engaged in earnings management approximately 50 percent of the time. Hodge states that his findings support the validity of the SEC’s concerns involving a deterioration of earnings quality and auditor independence. Furthermore, investors perceived a decline in the reliability and the quality of earnings of publicly traded companies, as well as auditor independence.

Perceptions of the Effect of Sarbanes-Oxley 143

Cohen, Dey, and Lys (2005) studied earnings management practices over the pre-SOA and the post-SOA period. They further divided the pre-SOA period into a pre-scandal period and a scandal period. The pre-scandal period was from the first quarter of 1987 through the second quarter of 2001, and the scandal period from the third quarter of 2001 through the second quarter of 2002. This scandal period included the reporting of a number of corporate scandals, including Enron, Global-Crossing, and WorldCom, among others. The post-SOA period included the period from the third quarter of 2002 through the fourth quarter of 2003. They found that earnings management increased in a steady manner from the start of 1987 until the passage of SOA. They further discovered that it decreased after SOA was enacted.

Lobo and Zhou (2005) investigated whether the SOA officer certification requirement for SEC financial statements resulted in increased conservatism in financial reporting. They found less income increasing earnings in the initial year of certification by the CEOs and CFOs than in the previous, non- certification year and faster incorporation of losses than gains in the cer- tification years. They interpreted their findings as evidence that the SEC officer certification requirement has increased the quality of earnings through increased conservatism. Although the preceding two studies have similar findings, Cohen et al. (2005, p. 10) state that beyond these, studies on the effects of SOA on earnings management have produced inconsistent results. They state that this might be a result of the rather limited time period subsequent to the passage of SOA.

Research Question

As explained earlier, it is expected that the SOA expanded definition of ‘‘fair presentation’’ without ‘‘conformity to generally accepted accounting princi- ples’’ as a safe harbor will create a certain atmosphere of tension and result in fewer incidents of earnings management. Joseph Floyd of Huron Consulting Group LLC, a firm that specializes in forensic accounting, cited SOA in part for the 13 percent increase in error driven restatements of annual reports in 2003 over 2002. Floyd asserted that SOA engendered heightened scrutiny of annual reports by various parties, including management, audit committees, auditors and regulators (Bryan-Law, 2004). Floyd again listed SOA as the reason for the subsequent 28 percent restatement increase in 2004, caused by ‘‘an unprecedented level of scrutiny’’ (Countryman, 2005, p. 1).

Norris (2004) observed that many corporate executives used to perceive that there was a gray area between flexible accounting and fraud. If SOA is

JOHN E. MCENROE144

effective, it should concomitantly reduce the amount of aggressive accounting practices in audited financial statements, besides increasing such restatements due to errors. This, in turn, should increase the perceptions of individuals involved in financial reporting that earnings management has decreased. I use the perceptions of those involved in the financial reporting process to assess the impact of SOA on earnings management. This expectation of a higher reporting standard leads to the following research question:

Do independent auditors and CFOs perceive that the Sarbanes-Oxley Act has been

effective in reducing earnings management practices in audited financial statements?

For the purpose of this research I adopt Healy and Wahlen’s (1999, p. 368) definition of earnings management:

Earnings management occurs when managers use judgment in financial reporting and in

structuring transactions to alter financial reports to either mislead some stakeholders

about the underlying economic performance of the company or to influence contractual

outcomes that depend on reported accounting numbers.

In accordance with the scope of Nelson et al. (2003, p. 17) this definition includes earnings management practices that are in accordance with GAAP, those that are difficult to distinguish from GAAP, and clear violations of GAAP.

Research Method

The research instrument contains 15 statements related to earnings man- agement practices and are listed in Table 1. Some of the transactions are in conformity with GAAP, while others are not. I developed the earnings management practices from a review of academic and popular business literature, including Levitt (1998), Brown (2002), Nelson (2003), Kieso, Weygandt, and Warfield (2004) and numerous other sources, especially the Wall Street Journal and Business Week. I also had several individuals review the research instrument prior to the mailing, including a former member of the Auditing Standards Board.

I mailed the research instrument in June, 2004 to the CFOs of the Fortune 500 firms and 500 audit partners from the 33 largest audit firms in the U.S. by revenue. The audit partners represent a random sample obtained from a list provided by the American Institute of Certified Public Accountants (AICPA). These individuals also belong to the SEC interest section of the AICPA and therefore should be very familiar with the officer certification requirements of SOA. I included the SEC interest criterion to ensure that the

Table 1. Earnings Management Practices.

Please mark the extent to which you agree or disagree with the following statements. Your responses should be in reference to material amounts (with the

exception of Statement No. 6) in audited financial statements

The Sarbanes-Oxley Act has

been Effective in Significantly

Reducing the Following

Events in Audited Financial

Statements

n Mean

Score

Significance

of t-Test

Very

Strongly

Disagree

Strongly

Disagree

Disagree Neither

Agree

nor

Disagree

Agree Strongly

Agree

Very

Strongly

Agree

(1) (2) (3) (4) (5) (6) (7)

1. Earnings management

practices that are

accomplished through

the employment of

GAAP

CFO 88 3.56 % 5.7 15.9 33 15.9 22.7 5.7 1.1

(1.36) NS

CPA 104 3.63 % 4.8 10.6 29.8 29.8 21.2 3.8 0

(1.18)

2. Earnings management

practices that are

accomplished through

the violation of GAAP

CFO 88 4.32 % 3.4 9.1 18.2 12.5 40.9 10.2 5.7

(1.45) NS

CPA 104 4.42 % 3.8 6.7 12.6 18.3 39.4 17.3 1.9

(1.35)

3. The overstatement of one

time ‘‘Big Bath’’

restructuring charges

in order to provide a

reserve to increase

future earnings

CFO 88 3.84 % 3.4 14.8 20.5 26.1 27.3 6.8 1.1

(1.32) NS

CPA 104 3.84 % 6.7 4.8 27.9 27.9 25 6.7 1

(1.29)

4. The establishment of

‘‘cookie jar reserves’’

through the

overstatement of such

items as sales returns,

loans, losses, or

warranty costs, etc. in

order to increase future

earnings

CFO 88 3.95 % 5.7 10.2 21.6 20.5 30.7 10.2 1.1

(1.41) NS

CPA 104 3.74 % 5.8 7.7 30.8 25 24 6.7 0

(1.26)

P ercep

tio n s o f th e E ffect

o f S a rb a n es-O

x ley

1 4 5

Table 1. (Continued )

Please mark the extent to which you agree or disagree with the following statements. Your responses should be in reference to material amounts (with the

exception of Statement No. 6) in audited financial statements

The Sarbanes-Oxley Act has

been Effective in Significantly

Reducing the Following

Events in Audited Financial

Statements

n Mean

Score

Significance

of t-Test

Very

Strongly

Disagree

Strongly

Disagree

Disagree Neither

Agree

nor

Disagree

Agree Strongly

Agree

Very

Strongly

Agree

(1) (2) (3) (4) (5) (6) (7)

5. The premature

recognition of revenue,

before a sale is

complete, or when the

customer has options

to terminate, void or

delay the sale

CFO 88 4.03 % 3.4 10.2 20.5 22.7 34.1 6.8 2.3

(1.33) NS

CPA 104 4.17 % 4.8 6.7 16.3 22.2 39.4 9.6 1

(1.31)

6. The violation of GAAP if

the belief is that the

independent auditors

will not find the effects

to the material

CFO 88 4.14 % 3.4 8 18.2 20.4 42 8 0

(1.24) NS

CPA 104 4.17 % 2.9 6.7 22.1 19.2 37.5 10.6 1

(1.27)

7. The parking of equity

securities in the

‘‘available for sale’’

category in order to

‘‘cherry pick’’ gains

and increase future

earnings when the

stock is sold

CFO 87 3.59 % 3.4 9.2 26.4 48.3 11.5 1.2 0

(0.971) NS

CPA 104 3.52 % 7.7 6.7 24 50 10.6 1 0

(1.06)

8. The retirement of old

debt with low interest

at a deep discount in

order to record gain,

even though the

CFO 87 3.24 % 6.9 12.6 36.8 37.9 4.6 1.2 0

(1.01) NS

CPA 104 3.53 % 6.7 7.7 23.1 52.9 7.7 1.9 0

(1.04)

JO H N

E . M

C E N R O E

1 4 6

transaction is

accomplished by

issuing new debt with

larger after tax interest

9. The classification as an

otherwise capital lease

as an operating lease

by having a third-party

guarantee the residual

value

CFO 87 3.74 % 2.3 11.5 25.3 36.8 21.8 0 2.3

(1.13) NS

CPA 104 3.61 % 5.8 2.9 34.6 43.2 8.7 4.8 0

(1.05)

10. The overstatement of the

amount of the

purchase price of an

acquired company

allocated to ‘‘in

process research and

development’’ in order

to reduce the amount

of recorded goodwill

CFO 87 3.64 % 2.3 15 24.1 37.9 18.4 0 2.3

(1.15) NS

CPA 104 3.65 % 6.7 3.8 30.8 35.6 22.1 1 0

(1.10)

11. The overstatement of the

assumed rates used to

discount pension and

post-retirement benefit

obligations in order to

improve the

appearance of the

Company’s funded

status of its plans

CFO 86 3.48 % 5.8 15.1 30.2 29.1 14 5.8 0

(1.24) NS

CPA 104 3.65 % 6.7 6.7 24 41.3 19.2 1.9 0

(1.13)

12. The deferral of expenses

in order to improve

earnings

CFO 86 3.98 % 2.3 12.8 27.9 10.5 37.2 7 2.3

(1.37) NS

CPA 104 3.92 % 7.7 4.8 27.9 20.2 26.9 11.5 1

(1.41)

13. The use of special

purpose entities (SPEs)

in order to secure off

balance sheet financing

CFO 86 4.48 % 2.3 9.3 18.6 12.8 29.1 20.9 7

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