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    Capital Structure, Earnings Management, and Sarbanes-Oxley:...
    research summary posted November 17, 2014 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.01 Earnings Management 
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    Title:
    Capital Structure, Earnings Management, and Sarbanes-Oxley: Evidence from Canadian and U.S. Firms
    Practical Implications:

    This study is important because an increase in a firm’s debt level also increases the probability that the firm goes bankrupt.  Thus, it behooves managers and auditors to understand the way that SOX and earnings management impact the percentage of one component of debt (here, long-term debt) in a firm.

    The result contained in the first bullet of the “Findings” section suggests that, even though SOX spurs managers to report more accurate financials, which tend to lower the cost of equity financing, managers still find it cheaper to use debt.  The result in the second bullet of the “Findings” section suggests that managers anticipate a higher cost of debt after SOX and acquire debt while it is relatively cheap.  This result is consistent with research papers that find that market participants rationally expect Congress to pass legislation (e.g., SOX) that protect investors and improves firm behavior in the aftermath of financial or accounting scandals.  Thus, managers rationally expect long-term debt to be more expensive after SOX and, accordingly, take on more of it before SOX. 

    The result contained in the third bullet of the “Findings” section suggests that SOX requires managers who reported less transparent financial statements before SOX to report more transparent financials after SOX.  Since the more transparent financials are likely to be more volatile than and weaker than earlier financials, many managers will not be able to issue bonds to fund projects.  Thus, if those managers wish to take on projects, they will need to finance those projects by issuing equity, leading to lower long-term debt ratios.  Oppositely, SOX’s disclosure requirements will prompt managers who reported transparent earnings before SOX to continue to do so after SOX.  Thus, lenders will reward those managers by allowing them to take on additional long-term debt to finance the projects that the managers wish to undertake.

    For more information on this study, please contact Kelly E. Carter.

    Citation:

    Carter, K. 2013. Capital structure, earnings management, and Sarbanes-Oxley:  Evidence from Canadian and U.S. firms. Accounting Horizons 27 (2): 301-318.

    Keywords:
    Capital structure; earnings management; debt ratio; Sarbanes-Oxley.
    Purpose of the Study:

    The effect of the Sarbanes-Oxley Act (SOX) on earnings quality has been documented in the academic literature.  However, SOX’s effect on other aspects of firms is not known.  The purpose of this study is to document the effect of SOX and earnings quality on the capital structure of firms.  I measure earnings quality via accrual-based earnings management.  I measure capital structure via the ratio of long-term debt to assets (i.e., the long-term debt ratio).

    Design/Method/ Approach:

    This study uses quarterly data from 2000 to 2004, providing a relatively narrow window within which to investigate the effects of SOX’s announcement on capital structure.  Since SOX applies to firms that are listed on a U.S. exchange, the author segments firms by listing location.  Test firms include U.S. firms that are listed on a U.S. exchange as well as Canadian firms that are cross-listed in the U.S.  Control firms are Canadian firms that are listed in Canada.  The pre- versus post-SOX differences in the long-term debt ratios of test firms are compared to those of control firms.

    Findings:
    • SOX is associated with higher long-term debt ratios, as firms listed in the U.S. raise their long-term debt ratios by two to three percentage points.
    • The increase in long-term debt ratios occurs in the two quarters prior to SOX.
    • Firms that heavily manage earnings prior to SOX use less debt after SOX, while firms that lightly manage earnings prior to SOX use more debt after SOX. 
    Category:
    Corporate Matters
    Sub-category:
    Earnings Management