Internal Governance and Real Earnings Management

The following post comes to us from Qiang Cheng, Professor of Accounting at Singapore Management University; Jimmy Lee, Assistant Professor of Accounting at Singapore Management University; and Terry Shevlin, Professor of Accounting at the University of California-Irvine.

In the paper, Internal Governance and Real Earnings Management, which was recently made publicly available on SSRN, we examine whether key subordinate executives can restrain the extent of real earnings management. We focus on key subordinate executives, i.e., the top five executives with the highest compensation other than the CEO, because we hypothesize that they are the most likely group of employees that have both the incentives and the ability to influence the CEO in corporate decisions. As argued in Acharya et al. (2011), key subordinate executives have strong incentives not to increase short-term performance at the expense of long-term firm value. This tradeoff between current and future firm value is particularly salient in the case of real earnings management (as compared to accruals earnings management) because over production and cutting of R&D expenditures are costly and can reduce the long term value of the firm.

The motivation for the research question is twofold. First, the majority of the papers in the literature explicitly or implicitly assume that the CEO is the sole decision maker for financial reporting quality and the impact of other executives has been generally overlooked. Recent studies argue that subordinate executives usually have longer horizons and they can influence corporate decisions through various means. We hypothesize that differential preferences arising from differential horizons can affect the extent of real earnings management. Second, while there are studies focusing on the impact of external corporate governance (e.g., board independence and institutional ownership), little is known about whether there are checks and balances within the management team. This lack of knowledge is an important omission because control is not just imposed from the top-down or from the outside, but also from bottom-up (Fama 1980).

Key subordinate executives usually care more about long-term firm value than the CEO for several important reasons. First, as argued in Acharya et al. (2011), some of these executives have the desire to become the CEO in the future. As candidates for the CEO position in the future, key subordinate executives care about cash flows the firm can generate in the future, which are in turn a function of the firm’s current investments. As a result, these executives are less likely to sacrifice long-term investments to meet short-term earnings targets. Second, key subordinate executives have more to lose from corporate underperformance. They are usually younger, have more remaining years of employment and thus care more about their reputation in the job market. Corporate operating failures due to a lack of long-term investments or financial reporting failures, have a disproportionate impact on subordinate executives’ welfare than on CEOs’.

Not only do key subordinate executives have incentives to increase long-term firm value, they also have the means to influence corporate decisions toward their preferences. Prior research argues that because key subordinate executives’ effort is an important determinant of current cash flows and the CEO’s welfare, the CEO will consider key subordinate executives’ preferences when making important corporate decisions; otherwise, subordinate executives might shirk, reducing current and future cash flows and the CEO’s welfare.

The above discussion implies that the effectiveness of internal governance depends on the decision horizon of key subordinate executives and the influence they have on the CEO. In this paper, we use the number of years until the retirement age (assumed to be 65) to capture these executives’ decision horizon and the level of their compensation relative to the CEO’s compensation to capture their influence on the CEO. We expect that the longer the horizon and the higher the relative compensation, the more effective is internal governance, and the lower the extent of real earnings management.

We test our hypothesis using 7,569 firm-year observations from the S&P 1500 firms in the period 1992-2010. The empirical results are consistent with our prediction. We find that the extent of real earnings management decreases with subordinate executives’ horizon and relative compensation. To corroborate the inference from the main analyses, we conduct a series of cross-sectional analyses. We find that the impact of internal governance is lower when the CEO is the founder of the firm and thus less myopic and in firms where the key subordinate executives are promoted by the current CEO, and the impact is stronger in more complex firms where key subordinate executives play a more important role. Lastly, we find that the impact of internal governance is stronger in firms with higher board independence, in firms with smaller boards, and in firms with higher institutional ownership, which suggests that effective external governance can enhance subordinate executives’ ability to influence the CEO’s decisions.

This paper contributes to the literature in two important ways. First, this paper is the first to examine how internal governance affects the extent of real earnings management. This examination is important as it sheds light on how the members of the management team work together and shape financial reporting. Second, our examination of internal governance provides a more complete picture of how firms work. Unlike prior research which generally views top executives as a unified team, this paper provides evidence that key subordinate executives can serve an important monitoring role and that effective internal governance can reduce the extent of CEO myopic behavior.

The full paper is available for download here.

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