The Internal Control Provisions Of Sarbanes-Oxley Act And Quality Of Interim Earnings
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This study examines the change in the quality of interim earnings around the enactment of Sarbanes-Oxley Act (SOX) and whether the change differs between interim and annual earnings by focusing on the impact of internal control provisions. In particular, two hypotheses are tested in this study. First, the quality of interim earnings improves after the SOX. Second, the gap in earnings quality between annual and interim reporting decreases after the SOX. Prior research indicates that the quality of interim earnings is lower because managers have more discretion in interim reporting and interim earnings are only subject to review which involves limited auditors' work. This study is motivated by the argument that the internal control provisions of SOX (SOX 302 and SOX 404) are expected to dampen the major causes that have led to the lower quality of interim earnings. Specifically, (1) SOX 302 mandates the management's certification of internal controls on a quarterly basis, and (2) SOX 404 increases the extent and amount of audit work during interim quarters. In the empirical analysis, earnings quality is measured under two approaches: the earnings-management approach and the earnings-attribute approach. Under the earnings-management approach, discretionary accruals are used to measure earnings quality. Under the earnings-attribute approach, both accrual quality and the value-relevance of earnings are used to measure earnings quality. The results of earnings management provide strong support to both hypotheses. Specifically, earnings management with interim quarters decreases after the passage of SOX, suggesting the improvement of interim earnings quality. Moreover, such improvement for interim earnings is higher than that for annual earnings. Both SOX 302 and SOX 404 appear to play a role in decreasing earnings management with interim quarters and in reducing the gap in earnings quality between interim quarters and annual periods. The results of earnings attributes provide little support to both hypotheses. The tests based on accrual quality fail to support either hypothesis. The tests based on value relevance provide some evidence that the value relevance of interim earnings improves after SOX. However, the improvement with interim earnings is not different from that with annual earnings. In addition, only SOX 302 appears to play a role in improving the value relevance of interim earnings and in reducing the gap in value relevance between interim quarters and annual periods.