Effect of CEO origin on accrual-based earnings management

This article looks at the question of whether the CEO origin impacts a company’s earnings management by manipulating accruals. This information will be helpful to external and internal auditors, Boards of Directors, Compensation Committees, among others.

1. Do outside CEO’s manage earnings more than inside CEO’s?

Suppose an external auditor is preparing for an annual audit and is told by the client that a new CEO started with the company at the beginning of the fiscal year.  Would this typically alarm the auditor?  The answer is probably yes, but only to some extent.  Usually, the auditor would not think that there may be a link between the new CEO’s origin and the possibility of more accrual-based earnings management.

As it turns out, the CEO origin may impact such earnings management practices.  In their search article titled “CEO Origin and Accrual-Based Earnings Management,” the authors (Yu Flora Kuang, Bo Qin, and Jacco L. Wielhouwer) draw a conclusion that external CEO’s – in the short term – tend to use accrual-based earnings management more than internal CEO’s.

When a company changes its CEO, the replacement can come from outside (an outside CEO) or be promoted from inside (an internal CEO).  The article authors indicate that an external CEO typically:

  • exhibits a more prominent desire and need to prove his/her abilities as the new CEO (to the market in general, to the Board of Directors, etc.), and
  • has a lower expectation that they will stay with the company in a long term (i.e., they either make it or not, so his/her behavior may be riskier).

Due to the above factors, an external CEO wants to show better financial results in the beginning and does that by using accrual-based earnings management more than internally promoted CEO’s.  This is logical: if I were an external CEO, I would try to show great performance so I can stay with the company in the long run; on the other hand, if I don’t show good performance and I leave the company, I don’t care much about the fact that the accrual-based earnings management back-fires later (i.e., accruals would need to be reversed at some point).

The authors noted that the tendency to use more discretionary accruals to manage earnings equalizes over a long term for external and internal CEO’s.  This is again logical because once a new CEO manages to stay with a company for at least several years, the likelihood of being fired due to poor initial performance decreases (compared to the first 1-2 years).

So, the next time you hear about a new CEO, it may be worth checking whether the CEO was hired from outside or promoted from within.  It may provide – on average – an interesting observation that the company under the new CEO will utilize more accrual-based earnings management if the CEO got hired from outside.

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