SYNOPSIS We examine whether firms resort to real earnings management when their ability to manage accruals is constrained by higher quality auditors. In settings involving strong upward earnings management incentives, i.e., for firms that meet or just beat earnings benchmarks and firms that issue seasoned equities, we find that city-level auditor industry expertise and audit fees are associated with higher levels of real earnings management. We find similar, albeit weaker, results for the Big N auditors. Our paper suggests an unintended consequence of higher quality auditors constraining accrual earnings management, namely, firms resorting to potentially even more costly real earnings management. We also find that longer auditor tenure is associated with greater real earnings management, which could suggest merits of mandating audit firm rotation. JEL Classifications: M40; M41.

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During the past decade, new regulations have been adopted to improve audit committee effectiveness. Prior research has generally provided evidence in support of these regulations and suggests that a more independent and expert audit committee is more effective. We posit that CEO power reduces or even eliminates the improvements in audit committee effectiveness resulting from independent and financially expert committee members. Thus, CEO power may result in an audit committee that appears effective in form but is not in substance. We construct a composite index for CEO power by combining ten CEO characteristics and employ the incidence of internal control weaknesses as a proxy for audit committee monitoring quality. Since all the firms in our sample have completely independent audit committees, we use financial expertise to examine the impact of CEO power on audit committee effectiveness. We find that, when CEO power is low, audit committee financial expertise is negatively associated with the incidence of internal control weaknesses. However, as CEO power increases, this association monotonically weakens. When CEO power reaches a sufficiently high level, this association is no longer negative. The moderating effect of CEO power on audit committee effectiveness is more prominent when the CEO extracts more rents from the firm through insider trading. Our results are not driven by the CEO's involvement in director selection. Our paper suggests that more expert audit committees in form do not automatically translate into more effective monitoring. Rather, the substantive monitoring effectiveness of audit committees is contingent on CEO power. * Accepted by Dan A. Simunic. The authors thank Dan Simunic, Steven Salterio, two anonymous reviewers, le pouvoir du DG r eduit, voire neutralise l'am elioration de l'efficacit e des comit es d'audit attribuable a l'ind ependance et aux comp etences financi eres de ses membres. Ainsi, le pouvoir des DG pourrait faire en sorte que le comit e d'audit donne l'impression d'être efficace sans l'être v eritablement. Les auteurs cr eent un indice compos e relatif au pouvoir du DG en regroupant dix caract eristiques des DG, et ils utilisent l'incidence des lacunes du contrôle interne a titre de variable de substitution repr esentant la qualit e de la surveillance exerc ee par le comit e d'audit. Puisque toutes les soci et es de leur echantillon poss edent des comit es d'audit totalement ind ependants, ils utilisent les comp etences financi eres pour etudier l'incidence du pouvoir du DG sur l'efficacit e du comit e d'audit. Les auteurs constatent que, lorsque le pouvoir du DG est faible, les comp etences financi eres du comit e d'audit sont en relation n egative avec l'incidence des lacunes du contrôle interne. Toutefois, lorsque le pouvoir du DG augmente, cette relation s'att enue. Lorsque le pouvoir du DG atteint un niveau suffisamment elev e, la relation n'est plus n egative. L'effet mod erateur du pouvoir du DG sur l'efficacit e du comit e d'audit est plus marqu e lorsque le DG tire...

The SEC has long asserted that earnings management practices result in adverse consequences for investors. We examine whether SEC oversight affects firms' accounting quality in terms of earnings management trade‐offs. We expect that increased firm‐specific regulatory scrutiny, in the form of an SEC comment letter, will induce management to switch from accrual‐based earnings management (AEM), which is a main focus of the SEC, to real‐activities‐based earnings management (REM), which is not likely to be commented on in the SEC's review process. Consistent with our predictions, we find that AEM is lower and REM is higher following the receipt of a comment letter, relative to non‐comment‐letter years and a propensity‐score‐matched sample of non‐comment‐letter firms. However, we do not find a significant difference in total earnings management (i.e., the sum of AEM and REM), suggesting that the higher REM acts as a substitute for lower AEM activity. We further find that our results are driven by accounting comments relating to estimates and accruals and not by classification‐only comments, which suggests that a comment letter that does not question specific issues associated with estimates and accruals is not a strong enough signal to induce the firm to change earnings management behavior. Additionally, the shift to REM is attenuated for firms with high institutional ownership. These results collectively suggest that the comment letter process effectively constrains AEM but has the unintended consequence of firms, on average, switching to REM.

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