Sarbanes-Oxley may be discouraging earnings manipulation

Posted: Friday, August 06, 2004

NEW YORK (AP) Are investors better off than they were two years ago?

Since the Sarbanes-Oxley Act became law in late July 2002, setting a new standard of conduct for business, the market has rewarded those with the stamina to keep their money in stocks.

But any boost to investor morale produced by those sweeping reforms was likely secondary to other factors, especially the recovery in the economy and corporate profits.

The more crucial debate is whether the new rules of the game will serve as a hedge against future jolts to investor confidence. Here the early results appear somewhat promising.

There are signs, for example, that two notorious aspects of corporate behavior have taken a turn for the better, though it's too soon to conclude how much credit should go to Sarbanes-Oxley.

''Earnings management,'' the polite way to describe how accounting rules can be used to tweak a profit report, fell off sharply following the passage of Sarbanes-Oxley after rising to unprecedented levels during the scandal years, according to a new study by researchers from the Kellogg School of Management at Northwestern University.

Because business is rarely conducted on an all-cash basis, companies need to make a wide range of estimates in calculating their revenues and expenses during any given quarter.

Sometimes money is paid up front before a product is manufactured or a service is rendered. Sometimes it isn't paid until well after delivery. Sometimes a finished product goes into inventory with no buyer. As equipment ages, a company estimates how wear and tear is caused by each widget made by the machine.

The list of potential estimates or ''accruals'' goes on, providing ample wiggle room for management in calculating the profit reported to investors. No matter how earnest or innocent the estimate, the larger the accruals are, the bigger the difference between profits and the actual cash a business generates and the more questionable a company's reports become.

After rising steadily from the late 1980's through most of the 1990's, accruals as a percentage of revenues jumped sevenfold between 1999 and 2002, according to the study of more than 6,000 public companies by Kellogg professors Thomas Z. Lys, Daniel Cohen and Aiyesha Dey. But immediately after Sarbanes-Oxley became law, the ratio of accruals to sales fell by roughly half.

As that was happening, another leading culprit of the scandal years was tracing a similar pattern.

The value of stock options as a percentage of the total compensation paid to chief executives jumped from about a third in the early 1990's to about 60 percent in 1999 before peaking at almost 90 percent of pay in 2000, the researchers found. But here, the ratio of options pay began dropping off even before Sarbanes-Oxley, totaling about 60 percent again by 2003.

Although the swings were not identical, the researchers concluded that there was a definitive link between options pay and earnings management. However, whether the decline in both can be linked to Sarbanes-Oxley remains unclear.

Still, many of the reforms enacted under the law help clamp down on both earnings management and options abuse by bolstering the internal and external oversight of a company's accounting and compensation practices.

For example, the likelihood of vigilance by the board, the audit committee and the executive compensation committee has been enhanced by tightening the definition of which members have no major links to management or the company that constitute a conflict of interest. Similarly, the diligence of outside auditors was addressed with the creation of a new accounting oversight board, limits on the amount of non-audit work such firms can perform, and a more independent audit committee given the power of hire and fire.

Taken together, it seems likely that these new constraints on managerial discretion have played some role in the decline of earnings manipulation.

''You can infer one of two things. One is that Sarbanes-Oxley works. The other one is that there is an unobservable factor,'' said Lys, a professor of accounting and information management. ''You had these highly public arrests on the 6 o'clock news, CEOs being led away in handcuffs. That has a chilling effect too. But the data points are a little more toward Sarbanes-Oxley because it does line up well with passage of the act.''

Even if one argues that management's fear of arrest or investor backlash deserves the most responsibility for the decline in earnings management and stock options, there's plenty of reason to see the new safeguards from Sarbanes-Oxley as a wise backup plan rather than an pointless inconvenience for companies, as many powerful business lobbies assert.

A recent survey of 401 financial executives found that more than three-quarters of them would willingly sacrifice economic value for their companies to avoid a zig or zag in earnings that might cause them to miss a near-term target, according to research conducted by John R. Graham and Campbell R Havery of Duke University and Shiva Rajgopal at the University of Washington.

While the response to a survey may not translate into action, it's clear that executives will always have other motivations which don't necessarily serve shareholders. Thanks to Sarbanes-Oxley, there will be more people looking over their shoulders as post-scandal inhibitions fade.

Bruce Meyerson can be contacted at bmeyerson(at)

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