Earnings Management After Receiving SEC Comment Letters

The Switch Up: An Examination Of Changes In Earnings Management After Receiving SEC Comment Letters

Lauren M. Cunningham
University of Tennessee

Bret A. Johnson
George Mason University

E Scott Johnson
Virginia Polytechnic Institute & State University – Pamplin College of Business

Ling Lei Lisic
George Mason University

April 1, 2016
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. We examine whether the SEC’s oversight role affects firms’ earnings management behavior. We expect that increased firm-specific scrutiny from the SEC, in the form of a comment letter, will increase the cost of accrual-based earnings management (AEM) and induce management to decrease its usage. Because prior literature finds that firms substitute different forms of earnings management as other forms become more costly, we expect that companies will switch to real activities-based earnings management (REM), which is less likely to be scrutinized in the SEC’s review process. Consistent with our predictions, we find that AEM decreases and REM increases following the receipt of a comment letter. These results suggest that the comment letter process is effective in constraining AEM but may have the unintended consequence of encouraging companies to switch to REM.

The Switch Up: An Examination Of Changes In Earnings Management After Receiving SEC Comment Letters – Introduction

The Securities and Exchange Commission (SEC) has long been concerned that earnings management practices result in adverse consequences for investors, including masking “the true consequences of management’s decisions,” and has often called for increased regulatory oversight of the financial reporting process.1 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. Specifically, under Section 408 of the Sarbanes-Oxley Act of 2002 (SOX), the SEC is required to review the periodic filings of all registrants at least once every three years. If the SEC identifies a potential deficiency in an accounting treatment or a disclosure that requires clarification, the SEC issues a comment letter to the company. 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),2 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 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.

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 “does not evaluate the merits of any transaction…,”3 and thus is less likely to comment on whether real business transactions appear to mislead investors by distorting financial outcomes (i.e., REM).

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.4 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.

To test whether SEC comment letters are associated with reduced AEM and increased REM, we augment the models in Zang (2012) by including an indicator variable for whether a firm has received a comment letter in the prior two years. Similar to Zang (2012), we test our hypotheses using suspect firms. Suspect firms are those that report earnings that meet or just beat specific benchmarks and are thus the most likely to have engaged in earnings management. 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 (i.e., whether the letter was received one or two years prior), 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.