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Abstract:
This paper examines discretionary financial reporting of three major accounting items, earnings, sales, and research and development expense, for a sample of 2,975 initial public offering (IPO) firms in the period 1988-2000. Four distinct groups of firms are analyzed: science-based, technology-based, assets-in-place, and Internet. I document significant variation in discretionary reporting across the groups in accordance with the importance that investors in each group attach to the items. I find that discretionary sales for the technology-based group and discretionary earnings for the assets-in-place group predict long-term stock returns; suggesting an opportunistic reporting behavior by firms and investors' unawareness that some reporting is discretionary. I demonstrate that my unique research design that examines manipulation of different accounting items by distinct groups of firms is essential for research on discretionary reporting by IPO firms; a more general model that only examines discretionary accruals by the entire sample generates much weaker results.

Over time, investors in the technology-based firms seem to learn of the use of discretion in reporting; in contrast, investors in the assets-in-place firms seem to remain fixated on the reported data. Despite the reduced benefit of data manipulation, companies do not change their practices either because of unawareness of investor learning or because the cost of discretionary reporting is too small to cause behavioral change.

earnings management, discretionary reporting, IPO

Abstract:
In this paper we study the effect of Section 404 of the Sarbanes-Oxley Act on earnings quality. Using a difference-in-differences method we find that firms that were required to comply with Section 404 during the first two years of its implementation improved the quality of their financial reporting more than control firms that were not required to comply. Our testing results also provide some evidence that the reduction in intentional misstatement contributes to the improvement in financial reporting quality of complying firms. Investor confidence appears to be restored, in that they react more strongly to earnings surprises of complying firms than to those of the control firms in the post-404 period. These results are robust to various sensitivity tests. Our results suggest that Section 404 helped to achieve the main goal of the Act: protecting investors and restoring their confidence in the stock market by improving the accuracy and reliability of corporate disclosure.

Section 404 of the Sarbanes-Oxley Act, Earnings Quality, Internal Control, Investor Confidence

Abstract:
This study examines firms surrounding the Sarbanes-Oxley Section 404 market value compliance threshold. We predict that management will behave opportunistically to affect their firm's market value in order to temporarily fall below the threshold. We find evidence that sample firms reduce their market value only during threshold measurement quarters, while control firms experience increasing market value. For threshold firms, dampened stock returns and insider trading function to reduce float. We consider this evidence of regulatory avoidance, confirming managers' beliefs regarding the net costs of the regulation. Additionally, we find that firms with the ability and incentives to avoid Section 404 do so.

Sarbanes-Oxley Section 404, Regulatory Avoidance, Small Firms