Don’t let the ball drop: Outside CEOs and earnings management

Ball drop klein

By dr. Yu Flora Kuang, dr. Bo Qin and prof. dr. Jacco L. Wielhouwer     

The revolving door for top corporate management has attracted considerable attention from both popular media and academics. It is generally considered good due diligence to look beyond a firm’s borders for CEO candidates, such that virtually every company faced with a CEO vacancy now conducts an outside search. Accounting scandals such as those at Worldcom, Enron, Ahold and Parmalat have also focused attention on the issue of managerial reporting of earnings. This study investigates how the origin of a CEO, whether internal or external, influences a firm’s accrual-based earnings management and how the effects of CEO origin evolve over a CEO’s tenure.

Conventional wisdom suggests that the job security of CEOs recruited from outside a company is more closely related to firm performance than is the case for CEOs promoted from inside, due to external labour market considerations, contract constraints, board pressures, and so forth. Outside CEOs therefore exhibit a stronger desire to demonstrate their superior performance immediately after taking the helm. Furthermore, outside CEOs tend to remain in office for shorter periods than their inside peers. As a result, outside CEOs are less likely to bear the long-term consequences of their actions, because they have usually left the firm for their next appointment by the time these materialize. We would therefore expect firms with new CEOs recruited from outside to report higher income-increasing accruals during the early years of their tenure than firms with new CEOs promoted from inside the company. However, we can expect the situation to be different if an outside CEO is able to survive the first few years of her or his tenure. Then this leader will have established a reputation and proven his or her abilities to the board and the labour market. Inside and outside CEOs thus stand an equal chance of facing the long-term consequences of their actions. In other words, the short-term view that is taken by outside CEOs at the beginning of their tenure does not persist, but instead declines as their decision horizon extends beyond the initial years of service. Hence, we hypothesize that after the first few years of service, discretionary accruals by outside CEOs will be similar to those by inside CEOs.

WHAT IS ACCRUAL-BASED EARNINGS MANAGEMENT?
Using discretionary accruals is often considered a primary method for firms to manage earnings, but what is the idea behind accrualbased earnings management? Bergstresser and Philippon give a vivid example in a paper that they published in the Journal of Financial Economics in 2006:


Consider a firm that owns a finite-lived goose, laying golden eggs. While cash may have been used for the initial purchase of the goose, accrual accounting attempts to match this initial outflow against the future inflows from this investment. The cost of the goose is thus spread over current and future periods… A true picture of the firm’s income requires an adjustment for the use of the goose, and thus the difference between cash flows and earnings reflects the depreciation of the firm’s asset during the period. And conditional on cash flow, the firm can reduce or increase its reported earnings by assuming a higher or lower rate of deprecation.


Other examples of discretionary accruals include the timing and amounts of extraordinary items such as write-offs and provisions for reorganization, credit losses, inventory values, and so forth, whereby managers are able to determine when and how much of revenues and expenses to classify on a current income statement. Such flexibility in accounting choices creates possibilities for managers to manipulate reported earnings.

FINDINGS AND DISCUSSION
Our sample consisted of 5,607 CEO-year observations (1,341 CEOs) between 1992 and 2008. Figure 1 shows how discretionary accruals change with CEO tenure in our sample, after removing the impact of firm-level factors, industry effects and time trends. We find that on average, CEOs recruited from outside a company report higher discretionary accruals at the beginning of their tenure (i.e., = 3 years after appointment). The extent of earnings management subsequently becomes more comparable between inside and outside CEOs, as shown by the converging of the two lines after the fourth year of tenure.

We derive several key findings from our analyses: (1) compared with CEOs that are groomed internally, CEOs airdropped from the outside manipulate earnings upward more intensively in the short run; (2) as CEOs’ expectations about staying align after a few years, the difference in discretionary accruals by internal and outside CEOs also grows insignificant. We thus find a ‘transition’ whereby outside CEOs match inside CEOs in their use of discretionary accruals.

PRACTICAL IMPLICATIONS
Our study yields several important implications for practice. First, our results emphasize the importance of maintaining financial reporting quality and constraining earnings manipulation. Extending the managerial horizon and decoupling the link between short-term accounting performance and managerial incentives may function effectively to de-motivate opportunistic managerial financial reporting. Second, although the performance record from prior employment is often considered a key factor in external hiring decisions, our findings suggest that outside CEOs have both an incentive and an opportunity to ‘create’ excellent performance by staying with a firm for a short period of time and relying on earnings management. It should be the task of a firm’s nomination committee to examine a candidate’s performance record, for instance by investigating the subsequent performance after the candidate has left his or her previous employer. Third, a firm’s board and audit committee should beware of possible earnings manipulation and short-term decision-making by new CEOs, especially in the case of an external appointment. Earnings management is often difficult for individual investors to detect due to the complexity of accounting rules. Investors should also be aware of new CEOs’ discretion with regard to reporting and, in turn, put less emphasis on bottom-line accounting earnings when evaluating a firm’s performance. Managerial commitment to longterm profitability and sustainability should be given more weight in performance evaluation.

 

Average Discretionary Accruals over CEO Tenure
       BalDrop Grafiek

This figure shows the observed development of discretionary accruals (after excluding other elements that affect discretionary accruals) over tenure for outside (bold line) versus inside (normal line) CEOs. The horizontal line represents CEO tenure and the vertical line represents the level of de-trended discretionary accruals; 0 represents the year immediately prior to the appointment.


For further inquiries about the research project, please contact Dr. Yu Flora Kuang, y.kuang@vu.nl.