Can Aspiring CEOs Mitigate Firm’s Earning Management?

• In Event: Financial Accounting Issues

Abstract

This study investigates the role of subordinate managers in monitoring myopic CEOs’ actions to mitigate earnings management. Subordinate managers have longer horizon in the firm compared to the CEO. Moreover, they have the power to withdraw their contributions to the firm, which will negatively affect the generation of cash flow in the current period. In this paper, we use the mean age difference between the top four subordinate managers and the incumbent CEO as a proxy for the difference in appropriation horizon between the CEO and his/her subordinates. Our findings suggest that internal governance, exercised by subordinate managers, can reduce the earnings management of the firm. The results show that internal governance reduces the likelihood firm will engage in earnings management practices to meet the short-term earnings targets. The results suggest that as the CEO age (CEO horizon) increase (decrease), it is more likely that the CEO will manage earnings. This indicates that when CEOs approach retirement, they may lack incentives to act in the best interest of their firms and they may not be too concerned with the long-run performance of their organizations. Furthermore, the results show a negative relationship between subordinate managers’ power and earnings management. These results suggest that the powerful subordinate managers can provide effective monitoring to constrain and counterbalance the potential self-serving actions of the CEOs, otherwise, their ability to monitor the CEO is weak and internal governance would be less effective. These findings are consistent with Acharya et al. (2011) theory, in which they suggest that if the CEOs dominate the contribution, they have no desire to limit their rent extraction in order to provide incentives for the subordinates. Further, the researcher shows that internal monitoring is more effective in firms that require a higher degree of firm specific knowledge and skills. The results suggest that internal governance is only effective in reducing the earning management practices for human intensive capital industries. In such industries, the subordinate managers have more importance for the production process and are less comparable to outsiders because of their proprietary knowledge. Therefore, it is difficult to replace an executive with another, leading to more power imposed on the myopic CEO. Our findings are robust after controlling for other governance mechanisms and across different earnings management models and internal governance measures.

Authors

• Marwa Azmy Soliman, The University of Memphis

• Mohamed A Mekhaimer, Clarkson University