Advances in Accounting, incorporating Advances in International Accounting 27 (2011) 233–241

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Advances in Accounting, incorporating Advances inInternational Accounting

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An empirical examination of the impact of the Sarbanes Oxley Act in the reduction ofpension expense manipulation

Paula Diane Parker a,1, Nancy J. Swanson b,2, Michael T. Dugan a,⁎a School of Accountancy, University of Southern Mississippi, 118 College Drive #5178, Hattiesburg, MS 39406-0001, USAb Valdosta State University, Department of Accounting and Finance, Langdale College of Business, 1500 N. Patterson Street, Valdosta, GA 31698-0070, USA

⁎ Corresponding author. Tel.: +1 601 266 5028; fax:E-mail addresses: paula.d.parker@usm.edu (P.D. Par

(N.J. Swanson), Michael.Dugan@usm.edu (M.T. Dugan).1 Tel.: +1 601 266 5290; fax: +1 601 266 4642.2 Tel.: +1 229 561 5613.

0882-6110/$ – see front matter © 2011 Elsevier Ltd. Aldoi:10.1016/j.adiac.2011.05.007

a b s t r a c t

a r t i c l e i n f o

Keywords:

Sarbanes Oxley Act of 2002Managed earningsPension expense manipulationBenchmark earningsBenchmark behaviorSmoothing behavior

Since the Sarbanes Oxley Act of 2002 (SOX) attempts to make managers more accountable for the fairpresentation of reported earnings in their financial statements, we expect managers to manipulate pensionexpense less during the three years after the passage of SOX than during the three years preceding the passageof SOX. Our results reveal that for smoothing firms the magnitude of pension expense manipulation duringthe three years after the passage of SOX on average increases instead of decreases. On the other hand, forbenchmark firms the magnitude of pension expense manipulation during the three years after the passage ofSOX on average decreases as expected. This research provides mixed evidence concerning the effectiveness ofSOX in making financial statement reporting more transparent and representative of actual financial position, inthe area of pension expense.

+1 601 266 4642.ker), njswanson@valdosta.edu

l rights reserved.

© 2011 Elsevier Ltd. All rights reserved.

1. Introduction

This study addresses three main issues: (1) whether or notmanagers manipulate pension expense to avoid reporting a decreasein current year earnings during the seven year period 1999 through2005 (benchmark behavior); (2)whether or notmanagersmanipulatepension expense to store up hidden reserves to avoid reporting adecrease in future earnings during the seven year period 1999 through2005 (smoothing behavior); and (3) whether or not managers mani-pulate pension expense less on average, from both benchmark andsmoothing behaviors, in the three years following the passage of theSarbanes Oxley Act of 2002 than in the three years preceding thepassage of the Act.

This study is motivated by concerns regarding the integrity offinancial statement reporting and the impact of the Sarbanes OxleyAct of 2002 (SOX, U.S. House of Representatives, 2002) in reducingf inancial statement manipulation. By passing the Act, Congresssignals wide-ranging changes that indicate firms face a newheightened business environment. Key legislative changes include(1) f irm executives must certify the accuracy of f inancial reports, (2)firm executives and auditorsmust certify the effectiveness of internalcontrols, (3) firm executives and auditors face tightened account-ability and increased criminal penalties, and (4) corporate gover-

nance is more independent. As such, even before the effective date ofthe reporting upon internal controls from SOX, auditors shouldimmediately becomemore vigilant inmonitoring financial statementmanipulation. (He, El-Masry, & Wu, 2008).

The primary objective of SOX is to protect investors by improvingthe accuracy and reliability of f inancial reporting (SOXLAW).Therefore, if SOX is immediately effective in improving the qualityof f inancial reporting as intended, it is reasonable to expect firms tomanipulate pension expense less on average, from both benchmarkand smoothing behaviors, in the three years following the passage ofSOX than in the three years preceding the passage of SOX.

Prior pension accounting research provides some evidence thatfirms use pension expense to manipulate reported earnings (Ali &Kumar, 1993; Asthana, 2008; Bergstresser, Desai, & Rauh, 2006;Blankley, 1992; Brown, 2001; Cohen, Dey, & Lys, 2008; Kwon, 1989;VanDerhei & Joanette, 1988; and Weishar, 1997). Our study differsfrom this prior research by narrowing the event window to the sevenyear period 1999 through 2005 to first examine whether firms usepension expense to manipulate reported earnings during this timeperiod. The study then tests the immediate effectiveness of SOX inimproving the quality of f inancial statement reporting by focusingattention on firm behaviors three years following the passage of SOXas compared with the three years preceding the passage of SOX.

The pre–post research design provides relevant information neces-sary for corrective action to restrict future earnings managementthrough the identif ication of a specific discretionary accounting itemused by managers when managing earnings. By exposing pensionexpense as an item managers use to manipulate earnings, interestedparties are provided with relevant information to assure that monitor-ing occurs to prevent this type of manipulation in the future.

234 P.D. Parker et al. / Advances in Accounting, incorporating Advances in International Accounting 27 (2011) 233–241

Attempting to assess f inancial statement manipulation is alwayscomplicated by the determination of what a company's f inancialstatements would report absent the manipulation. Our study relies ontechniques in the Statement of Financial Accounting Standards No. 87,Employers'Accounting for Pensions (SFAS No. 87, Financial AccountingStandards Board, 1985). This approach allows us to reasonablyestimate pension expense absent manipulation. In this case, theprior year pension expense is assumed to be the most relevant andreliable expectation for current year pension expense.

Our research provides additional evidence that prior year earnings(i.e., benchmark earnings) create capital market incentives for firms inopposite directions depending on their economic status (measured bywhether or not firms will hypothetically miss or hypothetically beattheir benchmark earnings based upon their actual current year pre-managed earnings). Our research shows f irms use pension expense as adiscretionary accounting item in a predictable economic manner tomanipulate actual reported earnings during the seven year period 1999through 2005. In addition, f irm managers exhibit stronger smoothingbehavior in the three years immediately following the passage of SOX,whereas f irm managers exhibit stronger benchmark behavior in thethree years preceding the passage of SOX. Therefore, we find thatsmoothing f irms actually increase the magnitude of their pensionexpensemanipulation after the passage of SOX insteadof decreasing themagnitude of their pension expense manipulation as expected.

The remainder of our study is organized as follows. The firstsection provides a brief overview of the literature. The second sectionprovides the research design, hypotheses development, sampleselection, and other statistical considerations. The third section pro-vides the results, interpretations, and sensitivity analyses. The fourthsection provides a summary and conclusions.

2. Related literature

Prior research on pension-related f inancial statement manipula-tion consists of pre and post SFAS No. 87 research. Pre-SFAS 87research (VanDerhei & Joanette, 1988) indicates earnings manage-ment incentives are correlated with the actuarial cost method choicesof sponsors during this time period. This window of opportunity isclosed by the 1985 issuance of SFAS No. 87 that mandates all def inedbenefit pension plan sponsors use a single actuarial cost method. SFASNo. 87 also requires pension plan assets to be valued at fair value(Beaudoin et al., In Press).

The stream of research (Ali & Kumar, 1993; Blankley, 1992; Brown,2001; Kwon, 1989; and Weishar, 1997) that developed over the twodecades subsequent to the issuance of SFAS No. 87 focuses on theexplanation of pension rates rather than pension expense explicitly, asnot enough required f inancial information is disclosed for interestedparties to recalculate pension expense using the three pension rateassumptions (discount rate, compensation rate and expected rate-of-return on plan assets). In this stream of research, the funding ratio isthe only variable consistently signif icant in explaining pension rates.Pension rate explanation may no longer be the primary focus ofpension accounting research because of the improved disclosuresrequired by SFAS No. 132, Employers'Disclosures about Pensions andOther Postretirement Benefits (Financial Accounting Standards Board,1998), which became effective after December 1998.

Bergstresser et al. (2006) study the impact of manager aggres-siveness in the use of their assumed long-term rate of return whentheir assumptions have a greater impact on reported earnings. Theyconclude that firms use higher assumed rates of return when f irmsprepare to acquire other f irms, when firms are near critical earningsthresholds, and when managers exercise stock options.

Asthana (2008) also looks at how the assumed long-term rate ofreturn impacts the pension assets reported post SFAS No. 87 (FASB,1985), particularly as it relates to earnings benchmarks and to firmvalue. He determines thatmanipulation via the assumed rate of return

is used to increase earnings per share when the expected benchmarkwould not otherwise be reached.

The earnings-based benchmark literature (Barth, Elliott, & Finn,1999; Burgstahler & Dichev, 1997; DeGeorge, Patel, & Zeckhauser,1999; Moehrle, 2002; and Perols & Lougee, 2010) suggests that firmsmanage earnings to avoid an earnings decline, to avoid losses, and tomeet analysts' earnings forecasts. This stream of research suggestsactive efforts to exceed thresholds, to sustain recent performance, toreport positive earnings and/or to meet analysts' expectations, and toinduce particular patterns of earnings management that are not likelyby chance. This stream of literature indicates the presence of earningsmanagement without identifying the specific accounting item used bymanagers in managing earnings.

Nelson, Elliott, and Tarpley (2000) specifically examine earningsmanagement attempts rather than actual earnings managementreported in f inancial statements. Based on this research, pensionexpense is one of the identified areas where managers commonlyattempt earnings management.

Cohen et al. (2008) conduct research on the impact of SOX onearnings management. They find that earnings management usingaccruals increased over the period leading up to the passage of SOXand declined following the passage of SOX. However, they also findthat the use of earnings management via operational activities (i.e.,real earnings management) decreased in the period leading up to SOXand increased following the passage of SOX.

3. Research design and hypotheses development

The specif ic accruals method attempts to identify a specific ac-counting item used by managers to manipulate reported earnings.Once an accounting item is identif ied as used in the manipulationprocess, corrective action can be implemented to prevent managersfrom using the identified accounting item to manipulate future re-ported earnings. An advantage of this method is the ability for direc-tional hypotheses based on researcher knowledge, skill, and scrutinyof the accounting item under examination. The primary disadvantageof thismethod is the inability to simultaneously analyzemore thanoneaccounting item or a total aggregated effect of multiple accountingitems used by managers to manipulate reported earnings (Fields, Lys,& Vincent, 2001; Francis, 2001; McNichols, 2000).

Research using earnings-based distribution methods provides theability for predictions about the frequency of earnings realizationsthat are unlikely to be attributable to nondiscretionary components ofearnings (Burgstahler & Dichev, 1997). Other studies present evi-dence f irms that are managing earnings to continue a steady streamof earnings (Burgstahler & Dichev, 1997; DeGeorge et al., 1999;Moehrle, 2002), to avoid reporting a loss (Burgstahler & Dichev, 1997;DeGeorge et al., 1999), and/or to meet analysts' earnings forecasts(Brown, 2001; DeGeorge et al., 1999).

In the area of earnings management, future contributions to re-search are expected to come from documenting the extent and mag-nitude of the effects of specif ic accruals and from identifying factorsthat limit the ability ofmanagers tomanage earnings (Healy &Wahlen1999). Our research design is a mixture of designs used in priorresearch. Our study uses a specif ic accruals method with earnings-based benchmarks as the explanatory variables. We selected pensionexpense, an individual accounting item that is subject to substantialmanagerial judgment and generally able tomaterially impact reportedearnings, for examination.

This study distinguishes itself from prior research in twoways. Thefirst distinction from prior research is determining whether or not anassociation exists between the change in pension expense taken as awhole and the amount by which f irms would otherwise miss or beattheir benchmark earnings (i.e., prior year earnings) based upon pre-managed earnings for the seven year period 1999 through 2005. Priorresearch examines specific components in the calculation of pension

235P.D. Parker et al. / Advances in Accounting, incorporating Advances in International Accounting 27 (2011) 233–241

expense, suchas the assumed long-termrateof return, thediscount rate,and the salary rate (Bergstresser et al., 2006; Kwon, 1989; Weishar,1997). Using the rates has been considered problematic, particularly theassumed long-term rate of return, as it is set at the beginning of the yearand, thereby, should be subject to less manipulation. Looking at thepension expense as a whole should overcome this problem. The seconddistinction is determiningwhether or not an association exists betweenthe change in pension expense and the amount by which firms wouldotherwisemiss or beat their benchmark earnings relative to the passageof SOX. This study incrementally contributes to the research attributableto these distinctions.

Since one of the primary purposes of SOX is to make financialreporting more transparent, we expect f irms to manipulate reportedearnings less after the passage of SOX than before the passage of SOX.Thus, if SOX is effective in making financial reporting more trans-parent as intended, we can logically expect pension expense to bemanaged less in the three years following the passage of SOX than inthe three years preceding the passage of SOX.

Since firms generally engage actuaries (i.e., outside parties) tocompute the extremely complicated def ined benefit pension planmathematics necessary to record the pension expense amount inf inancial statements, a reasonable user of these f inancial statementsmight assume firms lack the ability to manipulate pension expense.However, f irmmanagers have the ability to retain the actuarieswhomthey choose. Obviously, firm managers have the opportunity to com-municate their desired pension expense amount to their actuaries,and actuaries have the ability to manipulate the various actuarialassumptions (i.e., mortality rates, employee turnover, interest andearnings rates, early retirement frequency, and future salaries basedon the compensation rate) used in the calculation of the pension ex-pense amount. Since these actuarial assumptions are highly subjec-tive, cover an extended length of time in the future, and the pensionplanmathematics are complicated, it is diff icult to monitor and detectmanipulation of these assumptions. As a result, firm managers havethe opportunity to manipulate pension expense.

In an attempt to determine whether or not firm managers aremanipulating pension expense in a predictable manner and whetheror not SOX is effective in making f inancial reporting more transpar-ent, three hypotheses are developed. These hypotheses are expressedin alternate form:

H1. During the time period 1999 through 2005, pension expenseis managed to avoid reporting a decrease in current earnings, which isbenchmark behavior.

H2. During the time period 1999 through 2005, pension expenseis managed to store up hidden reserves to avoid reporting a decreasein future earnings, which is smoothing behavior.

H3. Pension expense is managed less from both benchmark andsmoothing behaviors in the three years following the passage of SOXthan in the three years preceding the passage of SOX.

The estimated cross-sectional regressionmodel presented below isthe basic model used to test these hypotheses. Benchmark: Prior yearpretax income.

PenChg = α0 + α1MissD + α2 Entice + α3 Interaction + α4 Empl

+ ∑t=2004

t=2000αt × yrDt + ∑

i=51

i=1αi × indDi + + ε

ð1Þwhere:

PenChg The change in pension expense equal to current yearpension expense minus prior year pension expense allscaled by lagged assets.

Miss_D Dummy variable that equals 1 if the continuous variable,Enticeb0, and 0 otherwise.

Entice Continuous variable equal to pretax income absent manip-ulationminus the applicable benchmark all scaled by laggedassets.

Interaction Interaction variable equal to Miss_D times Entice.Empl Control variable equal to the number of employees for the

current year minus the number of employees for the prioryear all scaled by lagged assets.

yrDt Dummy variable for each applicable year 2000–2004, withthe 2002 dummy effects captured in the intercept.

indDi Dummy variable representing each applicable industry. Thenumber of industries for Eq. 2 is 52.

α0 Intercept for Entice≥0 where Miss_D=0.α0+α1 Intercept for Enticeb0 where Miss_D=1.α2 Incentive slope for Entice≥0 where Miss_D=0.α2+α3 Incentive slope for Enticeb0 where Miss_D=1.Benchmark: Prior year pretax income.

PenChg = α0 + β0 Post + α1MissD + α2 Entice + α3 Interaction

+ α4 Empl + β1MissD2 + β2 Entice2 + β3 Interaction2

+ β4 Empl2 + ∑t=2004

t=2000αt × yrDt + ∑

i=51

i=1αi × indDi + ε ð2Þ

where all variables except those listed below are previouslyexplained in the paper with Eq. 1. All previously def ined variablesare not redefined.

Post Dummy variable equal to 0 if data from two years precedingSOX and 1 if data from two years after SOX. If coded 0, thisdesignates the applicable time period before SOX. If coded 1,this designates the applicable time period after SOX.

Miss_D_2 Multiplied Miss_D times post to capture post time period.Entice_2 Multiplied entice times post to capture post time period.Interaction_2 Multiplied interaction times post to capture post time

period.Empl_2 Multiplied empl times post to capture post time period.Smoothing group information

α0 Intercept for smoothing group before SOX. Intercept forEntice≥0 where Miss_D=0.

β0 Measures whether the intercept differs in the two timeperiods for the smoothing group.

α0+β0 Intercept for the smoothing group after SOX.α2 Incentive slope for smoothing group before SOX. Incentive

slope for Entice≥0 where Miss_D=0.β2 Measures whether the incentive slope differs in the two

time periods for the smoothing group.α2+β2 Incentive slope for smoothing group after SOX.Benchmark group information

α0+α1 Intercept for benchmark group before SOX. Intercept forEnticeb0 where Miss_D=1.

β0+β1 Tests whether the benchmark group effect differs in the twotime periods.

α0+α1+β0+β1

Intercept for benchmark group after SOX.α2+α3 Incentive slope for the benchmark group before SOX.

Incentive slope for Enticeb0 where Miss_D=1.β2+β3 Tests whether the incentive slope effect for the benchmark

group differs in the two time periods.α2+α3+β2+β3

Incentive slope for the benchmark firms after SOX.

The regression analyses incorporate the dependent variable, PenChg,as the proxy for earnings management. Using the features in SFAS No.87, the prior year pension expense provides a logical expectation for the

3 Sensitivity tests are performed using the prior year number of employees to scalethe current year number of employees and then rerunning the regressions. Nosignificant differences are noted.

236 P.D. Parker et al. / Advances in Accounting, incorporating Advances in International Accounting 27 (2011) 233–241

f irm's current year premanaged pension expense. PenChg is calculatedas the current year pension expense minus the prior year pensionexpense all scaled by lagged assets. PenChg is the proxy for the extent ofmanipulation inpension expenseafter controlling for expected changes.

Three variables are included in the model to control for the ex-pected changes. The Empl variable controls for the change in thenumber of employees. The other two variables control for industry(indDi) and time (yrDt) fixed effects including applicable rate changes(assumed long-term rate of return, discount rate, and salary rate)from year to year. Variables in themodel are scaled by lagged assets tocontrol for f irm size.

Premanaged earnings (i.e., premanipulated earnings) relative to thebenchmark earnings represent the level of capital market incentives forearnings management. The capital market based incentive measure tomanipulate earnings is represented by the variable called Entice, as itrepresents the enticement to manipulate earnings. The independentvariable, Entice, is continuous and is calculated as the difference betweenpretax income absent pension manipulation and the applicable bench-mark earnings (i.e., prior year earnings). Entice is scaled by lagged assets.

Following Burgstahler and Eames (2006), a benchmark represent-ing target earnings is necessary. Our benchmark for target earnings isthe prior year reported earnings. The benchmark earnings are on apretax basis since pension expense is reported on a pretax basis infinancial statements. Income absent pension manipulation is con-structed using pretax income adjusted for the change in pensionexpense. Therefore, the measure for pension expense absent pensionmanipulation is the prior year pension expense. Control variables alsocapture the non-discretionary changes in pension expense.

A dummy variable (i.e., Miss_D) for hypothetically missing thebenchmark earnings is included in the analyses for both Eqs. 1 and 2.Miss_D is coded one for f irms that hypothetically miss their benchmarkearnings using premanaged earnings, whereas Miss_D is coded zero forf irms that hypothetically beat their benchmark earnings usingpremanaged earnings.

Miss_D will be interpreted as follows. If 1 is insignif icant, no dif-ference exists between the two groups of firms. If 1 is significant andnegative,firmsmissing their benchmark earnings have a lower interceptthan the other f irms. If 1 is signif icant and positive, firms missing theirbenchmark earnings have a higher intercept than the other f irms.

After controlling for expected changes in pension expense, theassociation between the pension expense change (i.e., PenChg) and thelevel of capitalmarket incentives (i.e., Entice) formanipulating reportedearnings constitutes theprimary test of interest in our study. In addition,since both smoothing and benchmark incentives exist and may not beequally important, the slope coeff icient on Entice is allowed to vary,with the expected sign on Interaction (i.e., 3) being nondirectional.

The dependent variable, PenChg, is expected to be positivelycorrelated with the incentive variable Entice. Accordingly, in bothEqs. 1 and 2, the slope coefficient for the group of firms that hypo-thetically beat their benchmark earnings is represented by α2. Theslope coefficient for the group of firms that hypothetically miss theirbenchmark earnings is represented by α2+α3. Thus, we are pre-dicting that α2N0, and that (α2+α3)N0.

The reasoning behind the predictions forα2 andα2+α3 is that thedependent variable, PenChg, is expected to move in the same direc-tion as the independent incentive variable, Entice. For example, if afirm has premanaged income equal to $.15 per share and benchmarkincome (i.e. prior year earnings) equal to $.13 per share, the firm isexpected to manipulate actual income by increasing pension expenseby $.02 in order to offset the $.02 excess in premanaged income. Inthis situation, there is a positive $.02 excess in premanaged income,and the change in pension expense (i.e., PenChg) is expected to move$.02 in a positive direction as well. The variable Entice (i.e. α2)captures the positive $.02 excess in premanaged income. Therefore,because PenChg and Entice move together in the same direction, apositive correlation is predicted.

On the other hand, if a f irm has premanaged income equal to $.13per share and benchmark income equal to $.15 per share, the firm isexpected to decrease pension expense by $.02 to offset the $.02negative premanaged income. The variable Entice (i.e., α2+α3)captures the negative $.02 deficiency in premanaged income. Again,because PenChg and Entice move together in the same direction, apositive correlation is predicted.

Since the coefficient on Interaction (i.e., α3) is predicted asnondirectional, it will be interpreted as follows. If α3 is positive, thisresult will indicate that f irms hypothetically missing their benchmarkearnings are actually decreasing pension expense (i.e., increasingincome) more to avoid missing their benchmark earnings, while f irmshypothetically beating their benchmark earnings are actually increasingpension expense (i.e., decreasing income) to smooth incomedownwardin the direction of their benchmark earnings. On the other hand, if α3 isnegative, this result will indicate that firms hypothetically missing theirbenchmark earnings are decreasing pension expense (i.e., increasingincome) less to avoid missing their benchmark earnings, while f irmshypothetically beating their benchmark earnings are actually increasingpension expense (i.e., decreasing income) to smooth incomedownwardin the direction of their benchmark earnings.

In other words, if α3 is signif icant and positive, f irms missing theirbenchmark earnings have a steeper slope than the other f irms. Incontrast, ifα3 is significant andnegative, f irmsmissing their benchmarkearnings have a flatter slope than the other f irms. However, if α3 isinsignificant, then both groups of firms have the same slope.

In summary, the aspiration of achieving the earnings target (i.e.,prior year earnings equal to the benchmark earnings) creates incentivesfor f irms that are in opposite directions depending on the level ofcurrent year premanaged earnings relative to their benchmark earnings.As a result, if f irms hypothetically beat their benchmark earnings, theyare expected to exhibit smoothing behavior by manipulating pensionexpense upward to decrease actual reported earnings so that theiractual reported earnings are closer to their benchmark earnings thantheir reported earnings would otherwise be. On the other hand, if firmshypothetically miss their benchmark earnings, they are expected toexhibit benchmark behavior by manipulating pension expense down-ward to increase actual reported earnings in order to reach theirbenchmark earnings.

Big bath behavior is another possible behavior that might occurand must be considered in our research design. This behavior occurswhen firms write off excessively large losses in a one-time chargeagainst earnings. Firms choose this behavior rather than take theselosses over time because the capital market places a high premium onfirms with steady growth in earnings (Barth et al., 1999). To addressthe issue of big bath behavior and its possible confounding effects, ourstudy uses a sample screening process that is expected to remove thebig bath firms. The screening process eliminates firms whose actualearnings performance is not close to their benchmark earnings per-formance. Another reason for the screening process is that firms closerto their benchmark earnings are more likely to exhibit sensitivity toearnings management incentives such as benchmark behavior andsmoothing behavior. Firms missing their benchmark earnings by alarge amount are expected to exhibit big bath behavior and aretherefore eliminated from the sample.

Empl is a control variable to account for any variation in the de-pendent variable (i.e., PenChg) attributable to the change in thenumber of employees from year to year. Empl is calculated as thecurrent year number of employees minus the prior year number ofemployees all scaled by lagged assets.3 In addition, the inclusion of thecontrol variable, Empl, is expected to mitigate confounding resultsattributable to changes in organizational structure such as mergers

Table 1Sample selection and industries.

Sample selection for $.10 EPS Eq. 1 Eq. 2

Beginning sampleFirm observations in original Compustat data set covering extended period 1995–2008 327,880 327,880Less: Missing observations including firms that do not have defined benefit pension plans −314,554 −314,554Firm observations before screening 13,326 13,226

Final Sample per $.10 EPS screenFirm observations before screening 13,326 13,326Less: Firm observations eliminated by the $.10 EPS screen; observations outside the applicable time period for each equation; and firm observationswhere firms do not have two consecutive years of data needed to calculate the applicable variables

−12,603 −12,688

Firms in final sample before outlier deletions 723 638Less: Outlier deletions −7 −26Firms in final sample after outlier deletions 716 612Number of industries 58 56

Beginningsample

The sample begins with all firm observations with data from the Compustat files for the period 1995 through 2008. Firms are eliminated that do not havedefined benefit pension plans and for missing observations. The remaining firm observations are those before the application of the screening process.

Finalsample

The final sample begins with the firm observations before the screening process. Then firm observations are eliminated by the $.10 screening process andthe elimination of firm observations outside the applicable time period for each equation.

$.10 EPSscreens

The ad hoc $.10 earnings per share screen is on a pretax basis and is intentionally designed to focus only on firms that actually narrowly meet or miss theirapplicable benchmark. Therefore, if the applicable actual pretax performance per common share minus the applicable pretax benchmark performance percommon share is greater than $.10 or less than $.10 then the firm is deleted from the sample.The comparison is made between the applicable actual pretax benchmark performance per share and the applicable actual pretax performance per shareinstead of the applicable hypothetical premanaged performance per share. The rationale is to mitigate the possible correlation between the samplepartitioning criteria and the independent regression variables.

Industries There are 58, 58, and 56 industries respectively for the three equations.

4 No significant differences in regression results are noted using the eight-cent andtwelve-cent screens.

237P.D. Parker et al. / Advances in Accounting, incorporating Advances in International Accounting 27 (2011) 233–241

and acquisitions. A positive relationship is predicted between thechange in pension expense (i.e., PenChg) and the change in thenumber of employees from year to year (i.e., Empl). The reason is thatan increase in the number of employees is expected to result in anincrease in pension expense, whereas a decrease in the number ofemployees is expected to result in a decrease in pension expense.Therefore, a positive slope coefficient is predicted for Empl.

Several studies (Dhaliwal, Gleason, & Mills, 2002; Schwartz, 2001)suggest managersmay attempt to guide analysts' earnings forecasts inorder to meet analysts' benchmarks. Therefore, if managers do notmanage pension expense or do effectively guide analysts' earningsforecasts, there should be no association between the change in pen-sion expense (i.e., PenChg) and the amount that firms hypotheticallymiss or hypothetically beat their benchmarks (Dhaliwal et al., 2002).

Eq. 2 is designed to capture the effects for benchmark and smoothingbehavior before (i.e., 1999, 2000 and 2001) and after (i.e., 2003, 2004and 2005) SOX. There are 176 observations before and 436 observationsafter the passage of SOX, or a total of 612 observations for testing Eq. (2).

To capture the pre and post effects in Eq. (2), the dummy variablePost is coded 0 if the data are before SOX, and is coded 1 if the data areafter SOX. Additional interaction variables are used to expand Eq. (1).These additional variables and interpretation information are ex-plained with the equation models above. Therefore, for conciseness,these items are not repeated.

If SOX is effective in making financial reporting more transparent,then firm managers are expected to manage pension expense less onaverage in the three years following its passage than they are in thethree years preceding its passage. Therefore, we are hypothesizingthat SOX is effective at making financial reporting more transparent.

4. Sample selection and other statistical considerations

The initial data set consists of 327,880 observations for the period1995 through 2008 that are derived from the Compustat database.After eliminating f irmswithout defined benefit pension plans and anymissing data observations, 13,326 firm observations remain. For af irm to remain in the sample, it must have two years of consecutivedata available because of scaling by lagged assets. When the timeperiod is narrowed to include only the seven year period covering1999 through 2005 and then applying the ten-cent screening process

and deleting outlier observations, there are 716 and 612 firm ob-servations left for testing (Table 1).

Our screening process follows the concept in Dhaliwal et al. (2002)where only f irm observations are selected whose difference betweenthe actual earnings per share and the benchmark earnings per shareis within a narrowly specified range. This is done in order to studyf irms that are expected to be more sensitive to earnings managementincentives.

Dhaliwal et al. (2002) use a f ive-cent after tax earnings per sharescreen to analyze whether or not firms manipulate taxes in anypredictablemanner inmanaging earnings.We select a ten-cent pretaxearnings per share screen, where only firm observations are selectedwhose difference between the pretax benchmark earnings per shareand the actual pretax earnings per share arewithin the specified rangeof ten cents. However, since our selection of a ten-cent pretax earningsper share screen may be considered by some researchers as arbitrary,we conduct additional sensitivity tests using both an eight-cent pretaxearnings per share screen and a twelve-cent pretax earnings per sharescreen.4

Our ten-cent screening process is done on a f irm by firm per sharepretax basis. The nucleus point for determining the acceptable rangefor the sample of interest is the f irm's applicable pretax benchmarkamount. For inclusion in the sample, the f irm's applicable pretaxactual performance amount is compared with the nucleus point todetermine if the actual performance amount is within the acceptablerange, which is within plus or minus ten cents from the applicablebenchmark amount. So in essence, to be included in the sample, af irm's actual performance must be within ten cents of the applicablebenchmark performance.

Researcher opinions vary concerning the best methodology forhandling outlier observations. To mitigate possible bias effects, wedelete outlier observations with an absolute studentized value greaterthan 2.2 (Table 1). Multicollinearity is a common problem that affectsregression analysis when two or more of the independent variablesare highly correlated. Heteroscedasticity is another common problemthat affects regression analysis when the variances of the regression

Table 2Cross sectional pooled effects estimation using $.10 screen with year and industry fixed effects.

PenChg = α0 + α1 MissD + α2 Entice + α3 Interaction + α4 Empl + ∑t=2005

t=1999t × yrDt + ∑

i=57

i=1αi × indDi + ε (1)

Panel A: Eq. 1— Prior year's earnings

Final sample: n=716 Outliers trimmed Cross sectional pooled effects estimation 1999, 2000, 2001, 2002, 2003, 2004, 2005

Variable Prediction Coefficient One tail p-value

Intercept + .0020 .0143Miss_D − −.0012 .0034Entice + .1008 .0001Interaction +/− −.0155 .2691α0+α1 − .0008 .1891α2+α3 + .0853 .0001F-statistic as p-value .0001R2 .2435

n Number of firm observations in the sample.PenChg Dependent variable representing the change in pension expense calculated as current year pension expense minus prior year pension expense all scaled by

lagged assets.Miss_D Dummy variable equal to 1 if Enticeb0, and zero otherwise. If coded 1, the firm would hypothetically miss its applicable benchmark using pretax income absent

manipulation. If coded 0, the firm would hypothetically meet or beat its applicable benchmark using pretax income absent manipulation.Entice Continuous independent variable calculated as pretax income absent manipulation minus the applicable benchmark all scaled by lagged assets. Pretax income

absent manipulation is pretax income plus current year pension expense minus prior year pension expense.Interaction Represents an interaction variable calculated as miss_d multiplied times entice to yield the incremental portion of entice for the group that would have missed

their benchmark using pretax income absent manipulation.α0+α1 Intercept for the group of firms that hypothetically miss their applicable benchmark using pretax income absent manipulation.α2+α3 Incentive slope for the group of firms that hypothetically miss their applicable benchmark using pretax income absent manipulation.

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errors are not constant. Neither multicollinearity nor heteroscedas-ticity is a problem in our study.

5. Results and interpretations

Table 1 summarizes the sample selection for both of the twoequations. Firms in each of the final samples represent all of the firmsthat are available for testing after applying the ten-cent earnings pershare screen and outlier observation deletions. Firms in the finalsamples are close to their benchmark performances and are expectedto show evidence of stronger incentives to manipulate earningsthrough benchmark and smoothing behaviors, which is the primaryfocus of our study. The observations in the final samples for Eqs. (1)and (2) are 716 and 612. There are 58 and 56 industries respectivelyfor the two equations (Table 1).

Table 2 reports the regression results for the Eq. 1 regressionmodel, where PenChg represents manager manipulation. PenChg isexpected to be positively correlated with Entice, our incentivevariable of interest. The incentive slope is captured in the model forthe firms that hypothetically beat their benchmark earnings by α2,and for the firms that hypothetically miss their benchmark earningsby α2+α3. The slope on Entice (i.e., α2 and α2+α3) represents theestimated average change in pension expense when the applicableincentive variable increases or decreases by one unit. If managersare more concerned with reaching their benchmark earnings thansmoothing their earnings, we predict that α3N0.

The slope coefficient (i.e., α2N0) for the firms that hypotheticallybeat their benchmark earnings is expected to be statistically signi-ficant and is testedwith a t-test. The slope coefficient (i.e.,α2+α3) forthe firms that hypothetically miss their benchmark earnings isexpected to be statistically significant and is tested with an F-test.

Our underlying justification is based on the belief that pensionmanipulation is a function of the value of the magnitude of hypo-thetically missing or hypothetically beating the benchmark earningsbased on premanaged earnings. Therefore, the economic substance iscaptured in the regression models by the main effects of the incentivevariable for these two groups (benchmark and smoothing) of f irms.

Table 2 reports the results of the association test in Eq. 1 using theten-cent pretax earnings per share screen for the time period 1999

through 2005. The significant F-statistic (p-value=.0001) indicatesstrong evidence for the existence of the predicted linearity and inferthat the linear relationship between the change in pension expense(i.e., PenChg) and the independent explanatory variables exists ashypothesized.

The goodness-of-fit measure, R2, indicates the proportion ofvariation in the dependent variable (i.e., PenChg) explained by thecombination of the independent explanatory variables. The R2 measurefor Eq. (1) is .2435. The inference is that thedatafit the regressionmodelrelatively well. Signs are in the expected direction, except for theintercept (i.e., α 0+α 1) for benchmark firms in Table 2, which is notsignificant. Since the reporting of the individual control variable resultsserves no meaningful purpose for interpretation, they are not reported.

The slopes on Entice capture the average magnitude of change inpension expense (i.e., PenChg) when a one-unit change occurs in theincentive variable (i.e., 2 and 2+3). The slope coefficient on Entice isstatistically significant (p-value=.0001) for both benchmark andsmoothing firms. Firms hypothetically missing their benchmarkearnings are reducing pension expense by $.09 for every $1 thatpremanaged earnings are below the benchmark earnings (i.e., prior yearearnings). In contrast, firms hypothetically beating their benchmarkearnings are increasing pension expense by $.10 for every $1 thatpremanaged earnings are above the benchmark earnings (i.e., prior yearearnings).

Therefore, as stated inHypothesis 1, benchmarkfirms are decreasingpension expense to avoid reporting a decrease in earnings during theseven year period 1999 through 2005 (Table 2). As predicted inHypothesis 2, smoothingfirmsare increasingpension expense to reducecurrent year earnings during the same period (Table 2).

Table 3 reports the results of Eq. 2, which tests Hypothesis 3, with asignificant F-statistic (p-value=.0001) and R2 value equal to .2787.Here the observation data are combined for the three years precedingthe passage of SOX with those of the three years following SOX.

For the benchmark firms, the intercept before SOX is represented by(α0+α1) and is not statistically significant (p-value=.1480). The slopeon (β0+β1) measures the intercept between the time periods andindicates no significant (p-value=.1171) difference. The intercept afterSOX is represented by (α0+α1+β0+β1) and is not statisticallysignificant (p-value=.4776).

Table 3Cross sectional pooled effects estimation using $.10 screen with year and industry fixed effects.

PenChg = α0 + 0 Post + α1Miss D + α2 Entice + α3 Interaction + α4 Empl + β1MissD2 + β2 Entice2 + β3 Interaction2 + β4 Empl2 + ∑t=2005

t=1999αt × yrDt + ∑

i=55

i=1αi × indDi + ε (2)

Panel A: Eq. 2 — Prior year's earnings

Outliers trimmed final sample: n=612 before and after SOX Cross sectional pooled effects estimation 1999, 2000, 2001 comparison 2003, 2004, 2005

Variable Prediction Coefficient One tail p-value

Intercept + .0012 .0159Post − −.0006 .1030Miss_d − −.0006 .1229Entice + .0300 .1202Interaction +/− .0780 .0222Miss_d_2 +/− −.0000 .4828Entice_2 +/− .1427 .0004Interaction_2 +/− −.2420 .0001α0+β0 + .0006 .1290α2+β2 + .1727 .0001α0+α1 − .0006 .1480β0+β1 − −.0006 .1171α0+α1+β0+β1 − −.0000 .4776α2+α3 + .1080 .0001β2+β3 − −.0993 .0009α2+α3+β2+β3 + .0087 .2444F-statistic as p-value .0001R2 .2787

n Number of firm observations in the sample.PenChg Dependent variable representing the change in pension expense calculated as current year pension expense minus prior year pension expense all scaled by lagged assets.Miss_D Dummy variable equal to 1 if Enticeb0, and zero otherwise. If coded 1,

the firm would hypothetically miss its applicable benchmark using pretax income absent manipulation. If coded 0,the firm would hypothetically meet or beat its applicable benchmark using pretax income absent manipulation.

Post Dummy variable equal to 0 if data from two years preceding SOX and 1 if data from two years after SOX. If coded 0, this designates the applicable time period before SOX.If coded 1, this designates the applicable time period after SOX.

Entice Continuous independent variable calculated as pretax income absent manipulation minus the applicable benchmark all scaled by lagged assets.Pretax income absent manipulation is pretax income plus current year pension expense minus prior year pension expense.

Interaction Represents an interaction variable calculated as miss_d multiplied times entice to yield the incremental portion of entice for the group that would havemissed their benchmark using pretax income absent manipulation.

Empl Control variable calculated as the number of employees for the current year minus the number of employees for the prior year all scaled by lagged assets.Miss_D_2 Multiplied miss_d times post to capture post time period.Entice_2 Multiplied entice times post to capture post time period.Interaction_2 Multiplied interaction times post to capture post time period.Empl_2 Multiplied employee times post to capture post time periodSmoothing group informationα0 Intercept for smoothing group before SOX. Intercept for Entice≥0 where Miss_D=0.β0 Measures whether the intercept differs in the two time periods for the smoothing group.α0+β0 Intercept for the smoothing group after SOX.α2 Incentive slope for smoothing group before SOX. Incentive slope for Entice≥0 where Miss_D=0.β2 Measures whether the incentive slope differs in the two time periods for the smoothing group.α2+β2 Incentive slope for smoothing group after SOX.Benchmark group informationα0+α 1Intercept for benchmark group before SOX. Intercept for Enticeb0 where Miss_D=1.β0+β1 Measures whether the intercept differs in the two time periods for the benchmark group.α0+α1+β0+β1 Intercept for benchmark group after SOX.α2+α 3Incentive slope for the benchmark group before SOX. Incentive slope for Enticeb0 where Miss_D=1.β2+β3 Tests whether the incentive slope effect for the benchmark group differs in the two time period.α2+α3+β2+β3 Incentive slope for the benchmark firms after SOX.

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For the benchmark firms, the $.11 slope on Entice+Interaction(i.e., α2+α3) is the incentive slope before SOX and is significant(p-value=.0001). The slope on Entice_2+Interaction_2 (i.e., β2+β3) tests whether the dollar effect of the variable of interest differsin the two timeperiods before and after thepassage of SOX.A significant(p-value=.0009) difference exists in the two time periods with anegative $.10 change effect. The $.01 slope on Entice+Interaction+Entice_2+Interaction_2 (α2+α3+β2+β3) is the incentive slope afterthe passage of SOX and is not significant (p-value=.2444). It appearsthat benchmark firms are decreasing pension expense (i.e., increasingincome) $.10 less in the three years after SOX than they are in the threeyears preceding SOX.

For the smoothing firms, the intercept before SOX is representedby α0 and is statistically significant (p-value=.0159). β0 measureswhether the intercept differs in the two time periods before and afterthe passage of SOX. The result indicates no significant (p-value=.1030) difference in the two time periods. The intercept after SOX isrepresented by α0+β0 and is not statistically significant (p-value=.1290).

For the smoothing firms, the $.03 slope on Entice (i.e., α2) is theincentive slope before SOX and is not significant (p-value=.1202).The slope on Entice_2 (i.e., β2) tests whether the dollar effect of thevariable of interest differs in the two time periods. There is asignificant (p-value=.0004) difference in the two time periods with a$.14 change effect. The $.17 slope on Entice+Entice_2 (i.e.,α2+β2) isthe incentive slope after SOX and is significant (p-value=.0001).Smoothing firms appear to be increasing pension expense (i.e.,decreasing income) $.14 more in the three years after SOX thanthey are in the three years preceding SOX.

Therefore, the evidence presented in Table 3 does support Hypoth-esis 3 in that pension expense ismanaged less frombenchmark behaviorin the three years following the passage of SOX than in the three yearspreceding SOX. However, the evidence presented in Table 3 does notsupport Hypothesis 3 in that pension expense is managed more fromsmoothingbehavior in the three years following the passage of SOX thanin the three years preceding SOX. Our study, therefore, provides mixedevidence that SOX is effective in making financial reportingmore trans-parent and representative of actual financial position, at least in the areaof pension expense.

6. Summary conclusions

The passage of the Sarbanes Oxley Act of 2002 is an attempt byCongress to make financial reporting more transparent and to makefirm managers more accountable for the fair presentation of reportedearnings in their financial statements. If SOX accomplishes these ob-jectives, it is logical to expect managers to manage reported earningsless after the passage of SOX than before the passage of SOX. However,on the other hand, capital market incentives put intense pressure onmanagers tomeet their benchmark earnings (i.e., prior year earnings).As a result, managers continue to have strong incentives after SOX tomanage both their current year earnings to meet expectations as wellas to store up hidden reserves to meet future earnings expectations.

Our research contributes to the literature by showing that firmsuse pension expense as a discretionary accounting item in a predict-able manner to manipulate actual reported earnings in the directionof their target earnings during the period 1999 through 2005. Sig-nificant test results indicate that pension expense is managed toenable both benchmark and smoothing behaviors, supporting bothHypotheses 1 and 2. However, test results are mixed for Hypothesis 3.Significant test results support Hypothesis 3 in that pension expenseis managed less from benchmark behavior in the three years followingthe passage of SOX than in the three years preceding SOX. However,test results do not support Hypothesis 3 in that pension expense is notmanaged less from smoothing behavior in the three years followingthe passage of SOX than in the three years preceding SOX.

In essence, firms hypothetically missing their benchmark earningsare expected and are shown to manipulate actual pension expensedownward to increase actual current year reported earnings.However, firms hypothetically beating their benchmark earnings areexpected and are shown to manipulate actual pension expenseupward to decrease actual current year reported earnings. Therefore,both groups of firms are successfully manipulating pension expense inthe direction that moves their actual current year reported earningscloser to their benchmark earnings than these earnings wouldotherwise be.

For the three years preceding the passage of SOX, both benchmarkand smoothing firms are shown to manipulate pension expense withbenchmark behavior stronger than smoothing behavior. Benchmarkbehavior f irms manipulate pension expense by $.11 for every $1 thattheir pre-managed earnings are below the target earnings. Smoothingbehavior f irms manipulate pension expense by $.03 for every $1 thattheir pre-managed earnings are above the target earnings. However, forthe three years after the passage of SOX, there is a reduction in bench-mark behavior and an increase in smoothing behavior. Benchmarkbehavior firms manipulate pension expense by $.01 for every $1 thattheir pre-managed earnings are below the target earnings. Smoothingbehavior firms manipulate pension expense by $.17 for every $1 thattheir pre-managed earnings are above the target earnings.

One plausible explanation for the reversal in direction of manipu-lation is that to avoid higher possible litigation exposure, auditors mayhave focused most of their attention immediately after the passageof SOX on constraining firm manager efforts to manage earnings up-ward, while inadvertently focusing less attention on constraining firmmanager efforts to manage earnings downward. As a result, regardingthe magnitude of manipulation, a behavioral role reversal was possiblebetween the benchmark firms and the smoothing firms.

Since smoothing firms do not manage pension expense less in thethree years following the passage of SOX, our study provides mixedevidence concerning the effectiveness of SOX in making financial re-porting more transparent and representative of actual financial position.

Our researchfindings should be of interest to theU.S. Congress, SEC,PCAOB, AICPA, educators, investors, creditors, auditors, and others, asit provides timely and relevant information about the effectiveness ofthe Sarbanes Oxley Act of 2002 to reduce financial statement mani-pulation in the area of pension expense. Perhaps our research will bea stimulus for regulators to rethink the current position regardingpension expense measurement and reporting.

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