The disciplining role of the market versus government regulation: The case of Sarbanes-Oxley and the earnings quality of M&A targets

This study examines whether and how the passage of the Sarbanes-Oxley Act (SOX) affected earnings quality, proxied by accrual measures, prior to mergers and acquisitions (M&A). Given that the capital markets underwent unusual vicissitudes in the period leading up to the passage of SOX, we subdivide the pre-SOX period into four sub-periods: (1) the pre-technology bubble (1992-1997); (2) the technology bubble (1998-3/2000); (3) the bubble collapse (4/2000-9/2001); and (4) the pre-SOX scandal period (10/2001-7/2002). We document that abnormal accruals moved from significantly positive to significantly negative during the period of the major corporate scandals immediately preceding SOX, and remained negative in the post-SOX period. However, abnormal accruals in the post-SOX period were significantly less negative than during the scandals. Thus, a reduction (increase) in abnormal accruals (earnings quality) seems to have occurred concomitantly with the scandals, not as a result of the passage of SOX.We also document that investors' awareness of earnings manipulation by sellers consistently grew after the bursting of the technology bubble, as reflected in an increase in the discount applied to transaction prices throughout the sub-periods. Hence, concomitantly with the decrease (increase) in the levels of abnormal accrual (earnings quality) occurring during the scandals, the discount to transaction price due to suspected earnings manipulation also increased. Furthermore, the higher discount applied after SOX, relative to that immediately prior to SOX, implies that investors do not rely on SOX to prevent management from manipulating their earnings prior to a sale transaction. We conclude that changes in earnings quality prior to M&A transactions cannot be attributed to SOX. Rather, other events such as the bursting of the technology bubble and revelations of major accounting scandals seem to have affected managers' propensity to manipulate earnings. It seems that market response has a greater effect on managers' behavior than government regulation.