Are Earnings Strings Restrained after SOX?

Purpose – This paper aims to examine whether external monitors (auditors and analysts) constrain earnings strings, an indicator of earnings management, and whether this monitoring is more effective after the implementation of the Sarbanes-Oxley Act of 2002 (SOX), given the emphasis of SOX on improving auditing, financial reporting and the information environment. Design/methodology/approach – Agency theory establishes the premise between external monitoring and earnings strings. Auditor tenure and number of analysts following provide measures for external monitoring quality. Using prior research, empirical models explaining the presence of an earnings strings and earnings strings trend are developed to test the hypotheses. Findings – Pre-SOX, extreme auditor tenure, indicating lower quality external monitoring, is associated with greater earnings strings trend, and analyst coverage is associated with increased likelihood of earnings strings and greater earnings strings trend consistent with analyst pressure on management. More effective auditor and analyst monitoring occurs post-SOX in terms of reduced likelihood of earnings strings and earnings strings trend. Originality/value – The authors provide evidence on how elements of external monitoring are associated with increased earnings strings pre-SOX. Further, they contribute to the debate on the impact of SOX on external firm monitoring and the overall financial information environment. By focusing on earnings strings, the outcome of earnings management, the authors provide a unique understanding of external monitoring that also provides insight on the overvaluation of equity and ultimate destruction of firm value. The evidence demonstrates how regulation has contributed to an improved financial reporting environment and external monitoring.