We document that accrual‐based earnings management increased steadily from 1987 until the passage of the Sarbanes‐Oxley Act (SOX) in 2002, followed by a significant decline after the passage of SOX. Conversely, the level of real earnings management activities declined prior to SOX and increased significantly after the passage of SOX, suggesting that firms switched from accrual‐based to real earnings management methods after the passage of SOX. We also document that the accrual‐based earnings management activities were particularly high in the period immediately preceding SOX. Consistent with these results, we find that firms that just achieved important earnings benchmarks used less accruals and more real earnings management after SOX when compared to similar firms before SOX. In addition, our analysis provides evidence that the increases in accrual‐based earnings management in the period preceding SOX were concurrent with increases in equity‐based compensation. Our results suggest that stock‐option components provide a differential set of incentives with regard to accrual‐based earnings management. We document that while new options granted during the current period are negatively associated with income‐increasing accrual‐based earnings management, unexercised options are positively associated with income‐increasing accrual‐based earnings management.

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