Paper

Accounting Horizons Vol. 20, No. 1 March 2006 pp. 57–73

Did Conservatism in Financial Reporting Increase after the Sarbanes-Oxley Act? Initial Evidence

Gerald J. Lobo and Jian Zhou

SYNOPSIS: In this paper, we investigate the change in managerial discretion over financial reporting following the Sarbanes-Oxley Act (hereafter SOX). We document an increase in conservatism in financial reporting following SOX and the resulting requirement by the SEC that financial statements be certified by firms’ CEOs and CFOs. First, we find that firms report lower discretionary accruals after SOX than in the period preceding SOX. Second, based on the Basu (1997) measure of conservatism, we find that firms incorporate losses more quickly than gains when they report income in the post-SOX period. These results are obtained with alternative estimation and measurement approaches and after controlling for potentially confounding variables. This empirical evidence suggests that SOX and the resultant SEC certification requirement may have altered management’s discretionary reporting behavior to make it more conservative.

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INTRODUCTION he decreased investor confidence in financial statement information resulting from corporate scandals at companies such as Enron and WorldCom served as a catalyst for the passage of the Sarbanes-Oxley Act of 2002 (U.S. House of Representatives 2002) (hereafter SOX). The majority of these corporate scandals involved firms that aggressively applied generally accepted accounting principles. For example, Enron shifted its liabilities and losses to nonconsolidated special purpose entities. This led to an unexpected nonrecurring charge of $1.01 billion in October 2001 when it recognized those amounts. Premature revenue recognition is a form of aggressive earnings management that occurred in 39 percent of the 919 financial restatements announced between 1997 and 2002 (United States General Accounting Office 2002). Coffee (2003, 21) observes that ‘‘while earlier in...