Earnings management and the stock market response to the Sarbanes‐Oxley Act based on a measure of competitive strategy

Purpose – Conventional wisdom implies that firms manage earnings to maximize the wealth of the manager, the value of the firm and/or the amount of information in the market. The purpose of this paper is to offer an additional explanation. Design/methodology/approach – Using companies from the Standard & Poor's 500 index and an annual report disclosure ranking, the authors employ a standard t ‐test of means across groups to check for differences in disclosure based on a competitive strategy measure (CSM). The CSM classifies industry rivals into strategic complements or substitutes. The authors also test for differences in earnings management using discretionary accruals and using event study methodology examine how stock returns respond to the Sarbanes‐Oxley Act. Findings – The authors show that earnings management is a tool used by firms based on the level of competitive strategy within the industry. It was found that firms competing as strategic substitutes are more likely to actively engage in earnings management through discretionary accruals when the informational environment permits. It was also found that substitute firms suffer greater negative wealth effects than complement firms in response to the Sarbanes‐Oxley Act. Originality/value – This is one of the first empirical articles to examine how competitive strategy affects earnings management and the stock market response to the Sarbanes‐Oxley Act of 2002.