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    Real Earnings Management before and after Reporting SOX 404...
    research summary posted March 22, 2016 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.05 Impact of 404 on Fees and Financial Reporting Quality, 14.0 Corporate Matters, 14.01 Earnings Management 
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    Title:
    Real Earnings Management before and after Reporting SOX 404 Material Weaknesses.
    Practical Implications:

    The authors identify a setting where there is a greater risk of value reduction for stockholders. Specifically, they find that companies which have material weaknesses in internal controls are more likely to engage in real earnings management, through inventory management and reducing discretionary expenditures. While these activities are allowed by GAAP, the findings of this paper suggest management may take actions that are detrimental to firm value.

    Citation:

    Jarvinen, T. and E. Myllymaki. 2016. Read Earnings Management before and after Reporting SOX 404 Material Weaknesses. Accounting Horizons 30 (1): 119-141.

    Keywords:
    internal control, material weakness, real earnings management
    Purpose of the Study:

    This study investigates whether SOX Section 404 material weaknesses manifest in real earnings management behavior. The authors compare companies with effective internal controls to companies with existing material weaknesses, specifically looking at manipulation of real activities (particularly inventory overproduction). Such activity would suggest that companies strive to mitigate the expected negative reaction to disclosed material weaknesses by engagement in real earnings management.

    Design/Method/ Approach:

    The authors use company-year observations from public U.S. companies from 2004 to 2012. These company-years are split into three categories: 1) first year of internal control material weakness 2) years in which material weaknesses were disclosed as remediated 3) years in which material weaknesses were disclosed as nonremediated, and 4) company-years with effective internal controls. The authors observe differences in the extent of inventory management after controlling for various other predictors of real earnings management.

    Findings:

    The authors find:

    • Manipulation of real operational activities is associated with both the first-time existence of a material weakness and the subsequent disclosure of the material weakness.
    • Inventory overproduction is employed as an earnings management method before and after material weakness disclosure, and especially when the company has previously had poor financial performance.
    • Companies appear to cut discretionary expenditures when they have material weaknesses and when they have previously had poor financial performance.
    • Reduction in discretionary expenses is also used in the year when companies disclose and remediate material weaknesses.
    Category:
    Corporate Matters, Internal Control
    Sub-category:
    Earnings Management, Impact of 404 on Fees and Financial Reporting Quality