The Switch Up: An Examination of Changes in Earnings Management after Receiving SEC Comment Letters

51 Pages Posted: 10 Apr 2016 Last revised: 25 May 2019

See all articles by Lauren M. Cunningham

Lauren M. Cunningham

University of Tennessee - Haslam College of Business

Bret A. Johnson

George Mason University - Department of Accounting

E. Scott Johnson

Virginia Tech - Pamplin College of Business

Ling Lei Lisic

Virginia Polytechnic Institute & State University - Pamplin College of Business

Date Written: May 2019

Abstract

The Securities and Exchange Commission (SEC) has long asserted that earnings management practices result in adverse consequences for investors. We examine whether SEC oversight affects firms’ accounting quality in terms of earnings management trade-offs. We expect that increased firm-specific regulatory scrutiny, in the form of an SEC comment letter, will induce management to switch from accrual-based earnings management (AEM), which is a main focus of the SEC, to real-activities-based earnings management (REM), which is not likely to be commented on in the SEC’s review process. Consistent with our predictions, we find that AEM is lower and REM is higher following the receipt of a comment letter, relative to non-comment-letter years and a propensity-score-matched sample of non-comment-letter firms. However, we do not find a significant difference in total earnings management (i.e., the sum of AEM and REM), suggesting that the higher REM acts as a substitute for lower AEM activity. We further find that our results are driven by accounting comments relating to estimates and accruals and not by classification-only comments, which suggests that a comment letter that does not question specific issues associated with estimates and accruals is not a strong enough signal to induce the firm to change earnings management behavior. Additionally, the shift to REM is attenuated for firms with high institutional ownership. These results collectively suggest that the comment letter process effectively constrains AEM but has the unintended consequence of firms, on average, switching to REM.

Keywords: accruals-based earnings management; comment letter; filing review process; real earnings management; SEC

JEL Classification: M41, M48

Suggested Citation

Cunningham, Lauren M. and Johnson, Bret A. and Johnson, E. Scott and Lisic, Ling Lei, The Switch Up: An Examination of Changes in Earnings Management after Receiving SEC Comment Letters (May 2019). Available at SSRN: https://ssrn.com/abstract=2760638 or http://dx.doi.org/10.2139/ssrn.2760638

Lauren M. Cunningham

University of Tennessee - Haslam College of Business ( email )

Accounting and Information Management
603 Stokely Management Center
Knoxville, TN 37996
United States

Bret A. Johnson (Contact Author)

George Mason University - Department of Accounting ( email )

Fairfax, VA
United States
703-993-8185 (Phone)

E. Scott Johnson

Virginia Tech - Pamplin College of Business ( email )

3114 Pamplin Hall
Blacksburg, VA 24060
United States
2394102250 (Phone)

Ling Lei Lisic

Virginia Polytechnic Institute & State University - Pamplin College of Business ( email )

1016 Pamplin Hall
Blacksburg, VA 24061
United States

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