The Relationship between Earnings Management Incentives and CEO/CFO Turnover Likelihoods

Transcription

1 TILBURG UNIVERSITY Faculty of Economics and Business Studies Master Thesis Accounting September 2011 The Relationship between Earnings Management Incentives and CEO/CFO Turnover Likelihoods M.P.P. Coset - S Thesis supervisor: Y. Zeng Submission Date: 15- September ABSTRACT: This study examines the relation between earnings management incentives and CEO/CFO turnover likelihoods. 156 CEOs and 184 CFOs, named as culpable parties by the U.S. Securities and Exchange Commission (SEC) at 227 firms, brought from 2004 through 2008, are tracked. CEO and CFO removal rates for earnings management incentives that are harmful to the existing long- term shareholders are higher than those for the beneficial incentives. Also, 100.0% of the CEOs and CFOs at firms that had harmful earnings management incentives were dismissed shortly after the enforcement date. For beneficial and ambiguous incentives the job survival rates are higher. CEO/CFO turnover likelihoods are higher if the earnings management incentive is harmful. Turnover likelihoods are also significantly related to the firm s governance. Some evidence is found on the association between the CEO/CFO removal likelihood and the types of fraud incentives, but the results are sensitive to control variables for firm and governance characteristics. Finally, the CEO/CFO turnover is higher at firms where the CEO/CFO is responsible for the earnings management, compared to fraud firms where the CEO/CFO is not responsible for the fraud.

2 Title: The Relationship between Earnings Management Incentives and CEO/CFO Turnover Likelihoods Name: Michel Coset ANR: S Date and year of graduation: 30 September 2011 Faculty: Economics and Business Studies Department: Accounting Supervisor: Yachang Zeng Second Reader: Edith Leung 2

3 Preface With a lot of interest I have been working on my Master Thesis, which is about the relationship between earnings management incentives and the CEO/CFO turnover likelihoods. The Master Thesis is part of the Master Accounting at Tilburg University and from April 2011 until September 2011 I have been working on this thesis. The purpose of the thesis is to provide a better understanding into several earnings management incentives and the consequences for the CEOs and CFOs in terms of turnover and removal likelihoods. I would like to thank my supervisor at Tilburg University, Dr. Y. Zeng for the guidance, clear explanations, critical comments and good advice, during the process of making this thesis. Tilburg, 15 September 2011 M.P.P. Coset 3

4 Table of Contents The Relationship Between Earnings Management Incentives and CEO/CFO Turnover Likelihoods 1. Introduction Motivation Expected Results Research Design Contribution Outline Literature Review & Hypothesis Development Prior Literature Definition of Earnings Management Incentives Hypothesis Development Sample and Research Design Enforcement Process Research Sample Dependent Variables Independent Variables Control Variables Regression Models Results Incentives and Turnover Reasons Job Survival Descriptive Statistics and Correlations Regression Results Matched Sample Sensitivity Analysis Conclusion Appendices

5 The Relationship Between Earnings Management Incentives and CEO/CFO Turnover Likelihoods 1. Introduction 1.1 Motivation Earnings management has received huge attention from the public, press, investors, the financial community and regulators. Throughout the past several years, committing fraud on the financial statements has cost market participants, including investors, pensioners, creditors and employees more than $500 billion (Rezaee, 2002). Some large companies where fraud cases have been detected in the past are for example Xerox (2000), Enron (2001), Worldcom (2002), Royal Ahold (2003), Parmalat (2003) and more recently Lehman Brothers (2010). The top executives of these and other corporations were accused of committing accounting misstatements and in many cases were indicted and subsequently convicted. Former research has shown that firms will suffer from reputational damage as a consequence of the committed fraud (Karpoff and Lott Jr., 1993). Penalties imposed on the firms targeted by the legal are huge. Reputation losses are related to the firm s reliance on implicit contracts in its operations and substantial penalties are imposed on them for cooking the books (Karpoff et al., 2008). Firms that manipulate earnings also experience significant increases in their costs of capital when the manipulations are made public (Dechow et al., 1996). Since the firms endure large reputation losses, it would be interesting to investigate whether the individuals who are responsible for the misrepresentations also bear direct costs from the detected accounting frauds. According to prior literature (e.g. Burns and Kedia, 2006; Feng et al., 2011; Jiang et al., 2010), the firm s Chief Executive Officer (CEO) and Chief Financial Officer (CFO) are the ones having the most influence on earnings management. The purpose of the current study is to investigate the consequences of earnings management to the turnover likelihoods of responsible CEOs and CFOs. Prior literature already shows that there are consequences to the managers when the financial statements are misrepresented. Fully 93% of the managers lose their jobs by the end of the enforcement period. Most of them are explicitly fired. Culpable managers also bear substantial financial losses through restrictions on their future employment, their shareholdings in the firm and are fined by the U.S. Securities and Exchange Commission (SEC) (Karpoff et al., 2008). However, prior research did not pay attention to the different incentives that lead to the manipulation of earnings. The current study makes a distinction between three types of earnings management incentives, namely: (a) earnings management that is harmful to the existing shareholders, (b) earnings management that is beneficial to the existing shareholders and (c) earnings management that is ambiguous to the existing shareholders. The reason 5

6 for doing so is to investigate whether to expect different CEO/CFO turnover likelihoods after the accounting fraud is detected. According to the above, the main research question to be tested is as follows: Ø Is there a relationship between earnings management incentives and CEO/CFO turnover likelihoods? 1.2 Expected Results Given the above research question, the expected result is that there will be a higher CEO/CFO turnover rate for the earnings management incentives that are harmful to the existing shareholders. Subsequently, the expected result is that there will be a lower CEO/CFO turnover rate for the earnings management incentives that are beneficial to the existing shareholders. This is the expected result, because the Board of Directors makes decisions about the appointment of a CEO/CFO, and thereby mainly considers the benefits of the existing shareholders. According to a finding in prior literature by Feng et al. (2011), the equity incentives of a CFO when involved in accounting manipulations are similar to those of a CFO in non- manipulation firms. In contrast, a CEO of manipulation firms has higher equity incentives and more power than a CEO of non- manipulation firms. This explains that the CFO is involved in material accounting manipulations because they succumb to pressure from the CEO. Based on this finding and prior research on earnings management that mainly focused on the CEO incentives instead of CFO incentives (e.g., Burns and Kedia, 2006; Bergstresser and Philippon, 2006), the expected results for the CEO are stronger than those for the CFO. 1.3 Research Design In the current research, the information of 340 executives, of which 156 CEOs and 184 CFOs, named as culpable parties in releases by the U.S. Securities and Exchange Commission (SEC) at 227 firms, brought from 2004 through 2008, is studied. Some evidence is found that there is a relationship between the earnings management incentives and CEO/CFO turnover likelihoods. First, the removal rates for earnings management incentives that are harmful to the existing long- term shareholders are higher than those for the beneficial incentives. This applies to both the CEO and CFO. Second, the job survival rates for both the CEO and CFO are higher for beneficial and ambiguous earnings management incentives % of the CEOs and CFOs are dismissed, shortly after the enforcement date if the incentive is harmful. For beneficial incentives, these percentages are 93.1% (CEO) and 92.7% (CFO), and for ambiguous incentives these are 86.7% (CEO) and 96.9% (CFO). Third, the turnover likelihood for both the CEO and CFO is higher if the earnings management incentive is harmful. The turnover likelihood is also positively related to board independence and the fraction of blockholders. Some evidence is found that the CEO/CFO turnover likelihood decreases if the earnings management incentive is beneficial, but these results are sensitive to the control variables for firm and governance characteristics. These results are stronger for the CEO than for the CFO. Fourth, some evidence is found that the likelihood of removal is lower if the incentive is beneficial, but these 6

7 results are also sensitive to the control variables for firm and governance characteristics. No significant evidence is found that the likelihood of CEO removal is higher if the incentive is harmful. For the CFO there is some evidence that the removal likelihood is higher if the incentive is harmful. The removal likelihoods are positively related to the severity of the fraud case, board independence and the fraction of blockholders. Finally, the CEO/CFO turnover likelihood is higher if the CEO/CFO is responsible for the earnings management, compared to a matched sample of fraud firms where the CEO/CFO is not responsible for the management of earnings. In the matched sample, only 19.7% of the CEOs and 21.0% of the CFOs had a turnover between 6 months before and 6 months after the first SEC investigation date, while these percentages at the sample where the CEO/CFO is responsible for the earnings management are respectively 64.1% and 65.2%. No relations are found between the incentives and turnover likelihoods, for the matched sample. 1.4 Contribution In 2002, the Sarbanes- Oxley Act induced an increase of criminal penalties for accounting fraud and increased the personal exposure of the executives for the responsibility of misrepresented financial statements (Coates, 2007). Because fraudulent financial reporting may have significant consequences for the organization and for the public confidence in capital markets (Beasly et al., 1999), it would be relevant to investigate whether the responsible executives will also suffer damage for the management of earnings. Prior research by Karpoff et al. (2008) concluded that culpable managers are more likely to lose their jobs if they manipulated earnings. A weakness of that research was that it ignored the earnings management incentives. An important contribution of the current study is that it does take into account these incentives. By making a separation between harmful, beneficial, and ambiguous earnings management incentives, the expected outcomes are different. Besides, the current study also makes a distinction between the culpable CEOs and CFOs, because the expected results for both managers differ. This study also takes into account the severity of the fraud cases, the firm characteristics and the role of corporate governance to measure the relationship between earnings management and turnover likelihoods. 1.5 Outline The remainder of this study is organized as follows: In Section 2 the prior studies on management turnover after earnings management has been discovered are described. Then, the definition of earnings management and the earnings management incentives will be discussed. The incentives are placed into three categories: (1) harmful, (2) beneficial, and (3) ambiguous to the existing long- term shareholders. Thereafter, the hypotheses for this study will be developed. Section 3 provides an explanation of the sample and research design, Section 4 discusses the results of the study, and Section 5 concludes. 7

8 2. Literature Review & Hypothesis Development 2.1 Prior Literature There are several researches that examine earnings management in relation to management turnover. Karpoff et al. (2008) examined the consequences to managers for financial misrepresentation and found that 93% of the culpable individuals lose their jobs after the Securities and Exchange Commission (SEC) filed a complaint against them. Most of them are explicitly fired. Feroz, Park and Pastena (1991) reported that in more than 72% of the cases where firms were subjects of the SEC, at least one manager got fired or was forced to resign. Desai et al. (2006) did a similar investigation and found that 60% of the restating firms experienced a turnover in at least one manager within a year after the restatement. In contrast with the above findings, Beneish (1999) did not find a significant difference in the managerial turnover rate between sample firms and size-, age- and industry matched control firms. Also Agrawal et al. (1999) did not find a significant association between corporate fraud and managerial turnover over the period Thus, these findings imply that a culpable manager does not suffer any damage from his actions. The studies mentioned above use similar empirical approaches to measure the management turnovers. After identifying a specific event (e.g., news of legal violations or earnings restatements), turnover rates are measured among executives during a fixed window around that specific event. Unusual turnover rates, controlled for synchronized turnovers in matched control firms, are attributed to the misconduct. Desai et al. (2006) counted the executive s turnovers during a period of two years after the restatement date. A weakness of this study is that it included turnovers of executives that were not culpable to the misrepresentation. Also, the managers that left the company before and over two years after the earnings restatement date were not included in this research. Another problem in previous researches is that they do not control for governance characteristics. For example, the turnover probability is higher at firms with more individuals occupying the post of president, CEO, and chairman than in firms where one individual occupies all of these posts (Karpoff, 2008). These classification errors may explain the conflicting conclusions of the previous researches. In this study the employment of individuals identified by the SEC is tracked. Also the firm characteristics, governance characteristics and the severity of the fraud cases are documented. 8

9 2.2 Definition of Earnings Management Earnings are considered to be one of the most important information items provided in the financial statements of a firm. They are an indicator to find out to what extend a firm has engaged in value- added activities (Lev, 1989). In fact, the value of a firm is determined by the present value of its future earnings. An increase in earnings indicates an increase in firm value, while a decrease in earnings represents a decrease in the firm value (Penman, 2010). Many parties, like banks, employees, investors, etc. are interested in the financial statements, provided by the firm s management to make their decisions upon. Given the usefulness of earnings, it might be no surprise that the firm has a significant interest in how they report their earnings. Since the managers are responsible for the firm performance and their ability to influence the financial numbers to achieve their goals, their executions may have consequences for the reported earnings numbers. The choice by a manager of accounting policies, or actions affecting earnings, so as to achieve some specific reported earnings objective can be unified under the term Earnings Management (Scott, 2009) Detection of Earnings Management Earnings have two major components, namely cash flow and accruals. The determination of the accruals size requires estimation and judgment by the managers, this makes accruals more vulnerable to manipulate. The total accruals can be decomposed in nondiscretionary accruals and discretionary accruals (Yu, 2008). Since a manager can exercise some control over the discretionary accruals, these are used as the proxy for earnings management in a variety of studies. Dechow et al. (1995) discussed some models to detect earnings management by using the discretionary accruals: Healy (1985) tests for earnings management by comparing the mean total accruals, scaled by total assets. After the nondiscretionary accruals are determined, the discretionary accruals are calculated. Earnings management is seen as any deviation from the average in each period. A limitation of this model is that it does not take into account the sensitivity of the firm performance. The model of DeAngelo (1986) to estimate earnings management is not very different from the model of Healy (1985). They both assume that nondiscretionary accruals are constant over time and changes in accruals are the discretionary accruals. Jones (1991) identified that accruals depend on the business activities of the firm and abandoned the assumption that nondiscretionary accruals remain constant. However, earnings could still be managed through the influence of revenues. The limitation of this model is that it treats revenues as being nondiscretionary. Dechow et al. (1995) adjusted the Jones model and came up with the modified Jones model to detect earnings management, which controlled for the firm s economic circumstances on the nondiscretionary accruals. Also the revenue recognition on credit sales are taken into account, since they assume that it is easier to manage earnings over the revenue recognition of cash sales. Dechow and Sloan (1991) came up with the industry model, this model also abandoned the assumption that nondiscretionary accruals remain constant. However, it assumes that the variation of nondiscretionary accruals is common across firms that 9

10 are active in the same industry. This is also a limitation of the model, if earnings management is common within the industry of the firm, then it will not be detected. After an evaluation of the models to detect earnings management by using the discretionary accruals, Dechow et al. (1995) and Guay et al. (1996) concluded that the modified Jones model provides the most powerful tests on earnings management. Guay et al. (1996) also stated that the Healy model and the DeAngelo model are not assessing the discretionary accruals effectively, and do not take into account the management opportunism or earnings- increasing accruals that are used as a performance measure. The modified Jones model is widely used by other studies to detect earnings management. (e.g. Becker et al., 1998; Klein, 2002; Yu, 2008). Besides by measuring the discretionary accruals, earnings management can also be detected by measuring the small gains relative to small losses within a country or industry. According to Burgstahler and Dichev (1997), firms try to avoid losses. Managers will manage earnings by converting small losses into small gains. Investigating a low number of small losses relative to a high number of small gains might indicate the manipulation of earnings. Another way to detect earnings management is to study the enforcement actions for financial misrepresentation, initiated by the Securities and Exchange Commission (SEC) for violating the Generally Accepted Accounting Principles (GAAP), which require firms to keep and maintain books and records that accurately reflect all transactions. The problems with measuring discretion with an accruals model are avoided with this method, because it relies on external sources. It is used by several researchers, including Karpoff et al. (2008) and Dechow et al. (1996). Among other information, it identifies the culpable managers, the earnings management incentives and the beginning and ending periods of earnings manipulations. This is useful information for this study, so the enforcement actions by the SEC are used as a proxy for earnings management in the current research Beneficial/Harmful/Ambiguous Earnings Management Earnings management can be classified as harmful, beneficial or ambiguous to the existing long- term shareholders (Ronen and Yaari, 2008). First, earnings management can be classified as being harmful. Pernicious earnings management is the practice of using tricks to misrepresent or reduce transparency of the financial reports (Ronen and Yaari, 2008). Healy and Wahlen (1999) provide the following definition of earnings management: Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company, or to influence contractual outcomes that depend on reported accounting numbers. This definition frames the objective of earnings management as being to mislead stakeholders about the underlying economic performance of the firm. 10

11 This can occur if managers have an information advantage over the outside stakeholders, so that the managing of earnings is not likely to be transparent to outsiders. In their opinion it is misleading to the stakeholders, because the managers don t provide a right view on the financial information and thus it influences the decision- making process of the users. On the other hand, Dechow et al. (1996) argue that the manipulation of investor s perceptions of firm value is beneficial to existing shareholders if they can sell their stockholdings for a higher price. Earnings management may be beneficial because it potentially improves the information value of earnings (Jirapon et al., 2008). According to Arya et al. (2003) it would be too simple- minded to assume that earnings manipulation reduces transparency. A fundamental feature of decentralized organizations is the spread of information across people. Different people know different things and nobody knows everything. Managers may exercise discretion over earnings to communicate private information to stockholders and the public. If this is the case, then, earnings management might not be harmful to stockholders and the public. An empirical investigation by Subramanyam (1996) supports the contention that managers use their discretion to improve the ability of earnings to reflect fundamental value. There is also evidence that discretionary accruals, the accruals over which the manager can exercise some control, communicate information about future firm profitability. Fields et al. (2001) argue that earnings management occurs, because the managers have the flexibility to choose an accounting treatment, which maximizes their own utility. In this case, the managing of earnings will not be harmful to the shareholders, and compared to the definition provided by Healy and Wahlen (1999) this is a more neutral approach of earnings management. Ambiguous earnings management is about choosing an accounting treatment that is either opportunistic (maximizing the utility of management only) or economically efficient (Ronen and Yaari, 2008). 11

12 2.3 Incentives There are several causes that lead to earnings management. For example, financial distress may be a cause to manipulate earnings (Gilson, 1989). When the firms financial condition and performance worsens, the probability of occurrence of financial statement fraud increases (Dechow et al., 1996). Research by Razaee (2005) and results of the 1999 COSO (Committee of Sponsoring Organisations of the Treadway Commission) Report show several reasons for companies to engage in managing their earnings (Beasly et al., 1999). Based upon prior literature, the data collection through the Accounting and Auditing Enforcement Releases (AAERs), published by the U.S. Securities and Exchange Commission (SEC), court filings and press releases, the main incentives to manipulate earnings are identified. Each of them will be discussed in the following paragraphs, provided with examples from practice, including the decision whether the incentive is beneficial, harmful or ambiguous to the existing shareholders. An essential note is that this research focuses on the long- term shareholders, which do not have the intention to sell their shares shortly. They mainly consider the actual cash flows of a company, instead of just the ability to sell their shares at higher prices. They have more power on the decision which manager is better for the firm, in contrast to the short- term shareholders Officers compensation Since CEOs were under- incentivized to maximize the firm value, the attractiveness of performance- based compensation increased (Jensen and Murphy, 1990). Mehran (1995) found that the performance of a firm is positively related to the share of equity held by managers. However, highly incentivized CEOs engage in higher levels of earnings manipulation. According to Bergstresser and Philippon (2006), the manipulation of earnings is more evident at firms where the total potential compensation of a CEO is closely tied to values of stock and option holdings. Healy (1985) and Sloan (1996) also provided evidence that managers manipulate earnings to influence their bonus schemes and that they are able to influence the capital markets. In order to temporarily boost or reduce the reported income, often the discretionary accruals are used (Bergstresser and Philippon, 2006). Long- term shareholders mainly care about the actual cash flows of a firm. The described methods of earnings manipulation do not result in a cash inflow for the firm. In fact, it leads to a cash outflow, since the managers receive higher bonuses after the earnings are managed and the ability to sell their stock at higher prices. Image Entry, Inc. (AAER Release No. LR19834) is an example of a firm where earnings were manipulated in order to increase the officers compensation, the release document states: The Commission alleges that Deaton (CEO) managed a scheme to overstate Image Entry s earnings so that he could increase the amount of his earn out bonus. He overstated the firm s earnings to increase his bonus amounts from 2001 through Also at IBP, Inc. (AAER Release No. LR18809) the earnings were overstated during 1999 through 2000 by not charging certain expense items in the period they were incurred, but instead improperly included these amounts in inventory, 12

13 accounts receivables and prepaid expenses. The Commission alleges: Each of the defendants was motivated by personal compensation tied to the firm s financial performance. Since the officers compensation incentive does not result in a cash inflow for the company, and the executives profit from their higher bonuses, this incentive is considered to be harmful to the existing shareholders Avoid debt covenant violation An important incentive Dechow et al. (1996) found is to avoid debt covenant restrictions. According to the positive accounting theory s debt covenant hypothesis, the closer a firm is to violation of accounting- based debt covenants, the more likely the manager is to select accounting procedures that shift reported earnings from future periods to the current period (Watts and Zimmerman, 1986). For example, a borrowing firm may covenant to maintain specified levels of interest coverage, working capital, debt- to- equity, and/or shareholders equity. If such covenants are violated, the debt agreement might impose penalties, like constraints on dividends or additional borrowing. To prevent such violation, management may adopt accounting policies to raise current earnings (Scott, 2009). Because violation of covenants are generally considered to be costly events, managers of firms that are close to a violation of debt covenants make accounting decisions to avoid these events (e.g. DeFond and Jiambalvo, 1994; Sweeney, 1994). Managers will be more likely to make accounting choices that are income increasing (DeFond and Jiambalvo, 1993). DeFond and Jiambalvo (1994) also provide evidence that firms positively manipulate their earnings in the year prior to debt covenant violation. An example of a firm that managed earnings to avoid debt covenant violations is American Tissue Inc. (AAER Release No. LR18022). During 2000 and 2001 the firm inflated earnings by improperly capitalizing expenses as assets, overvaluing the inventories and create phony revenue and accounts receivables. By overstating its assets, American Tissue Inc. induced its lenders to continue to extend commercial credit while the firm was no longer creditworthy. Also the Allegheny Health, Education and Research Foundation (AAER Release No. LR16885) violated the securities laws by creating false financial statements. The release document states: Morrison (CFO) violated the securities laws by, among other things, creating, reviewing and approving false financial statements of AHERF, thereby masking, from at least December 1996 through July 1998, AHERF s severely deteriorating financial condition. Since debt covenant violations are costly events and reported earnings from future periods are shifted to the current period, the avoidance of debt covenant violations is considered to be beneficial to the existing shareholders Meeting analysts forecasts In order to meet analysts forecasts, earnings are often managed upwards (Burgstahler and Eames, 2006). Evidence of positive market responses to meeting analysts earnings forecasts is provided by several researches (e.g. Lopez and Rees, 2000; DeFond and Park, 2000). Bartov et al. (2002) finds that firms that meet the 13

14 expectations have significantly higher earnings forecasts and realized earnings than firms that do not. The abnormal returns are significantly greater for firms meeting expectations (Kasznik and McNichols, 2002). Reaching earnings benchmarks develops credibility with the market and helps to maintain or increase the firm s stock price (Graham et al., 2005). However, this incentive can also be related to the executives bonus contracts. Bonus payments provide managers economic incentives to meet analysts earnings forecasts (Matsunaga and Park, 2001). Huntington Bancshares, Inc. (AAER Release No. LR19243) is an example of a firm where the earnings management incentive was to meet analysts forecasts. The release document states: Huntington overstated both its 2001 operating earnings by $11.4 million and its 2002 operating earnings by 12.8 million to meet analysts expectations and management bonus targets. Another example is the Federal Home Loan Mortgage Corporation (AAER Release No. LR20304). As outlined in the Commission s complaint: Management exerted consistent pressure to have the company report smooth and dependable earnings growth and to present investors with the image of a company that would continue to generate predictable earnings. Thus, firms that meet analysts forecasts enjoy an increase in the firm s stock price and an increasing reputation. However, this incentive might be related to the personal wealth of the officers, when officers stock compensation is involved. Concluding, this earnings management incentive is considered to be ambiguous to the existing shareholders Avoid losses Several studies offer evidence of incentives to maintain consistent increases in earnings and to avoid reporting earnings decreases. Firms with a consistent pattern of earnings increases have higher price- to- earnings multiples. This premium is larger for longer series of increases in earnings and when the pattern of earnings increases is broken, this premium is eliminated or significantly reduced (Barth et al. (1995); DeAngelo et al. (1996) finds that firms will experience a negative abnormal stock return of 14% on average when a pattern of consistent earnings growth is broken. Additionally, Hayn (1995) provides direct evidence that firms avoid to report losses. There is a concentration of cases with small profits, while there are fewer cases of small losses, suggesting that firms engage in earnings manipulations to help them cross the red line for the year. Burgstahler et al. (1997) provides evidence that the frequencies of small earnings decreases and small losses are abnormally low, while the frequencies of small earnings increases and small positive earnings are abnormally high. Firms that can manage earnings at low cost are more likely to manage earnings to move from negative pre- managed earnings to positive post- managed earnings. Also, firms that report an earnings decrease (or report a loss) bear sharply higher costs in transactions with stakeholders than if the firms had reported an earnings increase (or profit). An example of a firm that manipulated earnings in order to avoid losses is Brightpoint Inc. (AAER Release No. LR20185). The release document states: The manager played a key role in a fraudulent scheme involving a purported insurance policy that enabled Brightpoint to conceal $11.9 million in losses that it sustained in Another example is Penthouse 14

15 International (AAER Release No. LR19048), the firm included a revenue of approximately $ 1 million in 2003, which it received as an upfront payment in connection with a five- year website management agreement. The inclusion increased changed a quarterly net loss of $ 167,000 to a purported net profit of $828,000. Thus, a firm has incentives to avoid losses with respect to employees, suppliers, customers, and other stakeholders in order to increase the reputation. Firms also experience a negative abnormal stock return when a pattern of consistent earnings growth is broken, so this earnings management incentive is considered to be beneficial to the existing shareholders Domestic and foreign corrupt practices Based upon the AAER- data, provided by the SEC, there are also cases where domestic/foreign corrupt practices take place, which cause the manipulation of earnings. For example, Faro Technologies (AAER Release No. LR20595). From 2004 through 2006, this firm paid bribes to employees in order to obtain sales contracts. None of these improper payments were accurately reflected in the firm s books and records. Another example of domestic foreign corrupt practices is Powerball International, Inc. (AAER Release No. LR19479), where a manager tried to hide his theft of $ 7,200 and to hide his failure to pay $ 40,000 for stock he had received through the exercise of warrants. Since in these cases the first order event is the corruption, and managers try to hide their corrupt practices by manipulating the earnings, this incentive is not relevant for this research. There are also cases where companies violate the Foreign Corrupt Practices Act (FCPA). In 1977, the FCPA enacted. It criminalizes the bribery of foreign officials by U.S. corporations and individuals pursuing business in other countries, and requires that companies with publicly- traded stock meet certain standards regarding their accounting practices, books and records, and internal controls (Perkel, 2003). Examples in the AAER- dataset of firms that violated the FCPA are Baker Hughes Inc. (AAER Release No. LR20094) and GE InVision, Inc. (AAER Release No. LR19078). Most of the cases with foreign corrupt practices are related to foreign subsidiaries of the firm and usually the lower level managers are the culpable ones. Since this research focuses on the top- level managers, the cases where foreign corrupt practices lead to earnings management are irrelevant. Thus, when the earnings management incentive is related to a domestic or foreign corrupt practice, then the case is irrelevant for the current study and will be excluded from the sample Insider trading An individual (commonly called insider ) may have privileged access to corporate information, which is not generally available and which materially affects investment decisions concerning the company s stock. The insider is supposed to choose between two options. He might abstain from any trading activity until the information becomes public, or he publicly discloses the information to the marketplace before trading. Illegal insider trading occurs when the insider does buy or sell securities on the basis of material, nonpublic information (Ausubel, 1990). 15

16 Beneish (1999) analyzed insider trades after earnings announcements that turned out to be overstated by a SEC enforcement action. He found that insiders sell more of their stock than expected in the period between the earnings announcement and the public disclosure of the overstatement. This suggests an interaction between earnings disclosures and stock trades by insiders in a position to influence disclosures. Insiders manage earnings to postpone bad news, which allows them to make profitable trades before the bad news is revealed (Ke et al. (2003); Beneish et al. (2001)) conclude that insiders manage earnings to sell their stock at higher prices. An example of a firm where insider trading was an incentive to manipulate earnings is Bennett Environmental, Inc. (AAER Release No. LR20009). The release document states: The defendants failed to inform the public about material changes to the contract, failed to correct prior false statements, and continued to misrepresent that the contract was in full force and effect and worth $200 million. Another example is NextCard, Inc. (AAER Release No. LR18905), where investors were misled and denied material information concerning the rising levels of losses on NextCard s portfolio and the top management was charged with insider trading. Instead of revealing the problems to investors, the managers made a series of undisclosed adjustments and failed to tell anyone about the bad circumstances. The existing shareholders make their decisions upon the publicly available information. In the case of insider trading, they are misinformed by the company s disclosures. This has a negative result to the firm s reputation, so the insider trading incentive is considered to be harmful Incentives from unit managers Not only the top managers have incentives to manipulate the firm s earnings, also the lower level business- unit managers might be incentivized to engage in earnings manipulation. If the managers are paid bonuses based upon the business unit earnings, then they will probably make discretionary accrual decisions to maximize their short- term bonuses (Healy, 1985; Guidry et al., 1999). American International Group, Inc. (AAER Release No. LR19560) is an example of a firm where business- unit managers were engaged in practices involving compensation funds and improper accounting. Since this research focuses only on the top- level managers, all cases where the lower- level business- unit managers were incentivized to engage in earnings management are irrelevant. These cases will be excluded from the sample External financing Dechow et al. (1996) investigated the motives for earnings manipulation and found that the desire to attract external financing at lower cost is an economically significant motivation for earnings manipulation. Restatement firms raise additional cash from equity markets around the time of their alleged manipulations. Richardson et al. (2002) show that restatement firms are on average high growth firms, have more frequent external financing needs, and raise larger amounts of cash. An example of a firm that had an external financing incentive to 16

17 manipulate earnings is Prudential Financial, Inc. (AAER Release No. LR20670). Prudential entered into a series of sham reinsurance contracts, written to look like they met the requirements to qualify for reinsurance accounting; in fact, they were subject to an oral side agreement that effectively eliminated any risk to either party and made such accounting improper. Since the overstated earnings lower the cost of external financing, the existing shareholders will also benefit from this. The cash outflows for the firm will be much less, thus this incentive is considered to be beneficial to existing shareholders Backdating of stock options Backdating of stock options involves the issuance of (in- the- money) stock options to an employee on one date, while providing documentation falsely asserting that (at- the- money) options were issued at an earlier date when the company s stock price was equal to the disclosed exercise price. For many officers, stock options account for over half of their total compensation (Fried, 2008). The ability for a manager to buy stock options at a price, while the value should be higher, increases the managers personal wealth. In fact, the manager takes away money from the firm. By issuing shares, the total number of shares will increase, while the total value remains the same. The price per option will decrease. This implies that a firm compensates more to the manager when stock options are backdated. Firms that are accused of stock options backdating, suffer huge economic consequences, for example they experience large negative abnormal returns and it will decrease the firm value (Bernile and Jarrell, 2009). Comverse Technology, Inc. (AAER Release No. LR19964) is an example of a firm where executives were accused of backdating stock option grants. As outlined in the Commissions complaint: Executives created company records that falsely indicated that Comverse s compensation committee had approved a grant of stock options on a date when, in reality, no such corporate action took place. Since this behavior leads to a decrease of the firm value and the price per option decreases, this incentive is considered to be harmful to the existing shareholders Other There are also some cases that cannot be unified under the above- mentioned incentives. For example, at FFP Marketing Company, Inc. (AAER Release No. LR19077), the managers fraudulently omitted to disclose that an internal investigation of the company s accounting failures, which caused the firm to delay filing its periodic reports. At Cedric Kushner Promotions, Inc. (AAER Release No ) the reported financial statements were materially false and misleading, there was a high urge to deliver the financial statements on time, no matter what the quality was. The management didn t take any steps to ascertain whether the filing was true and accurate. Taken into account the diversity of these cases, the other earnings management incentives are considered to be ambiguous to the existing shareholders. 17

18 The earnings management incentives and whether these are beneficial, harmful or ambiguous to the existing long- term shareholders are summarized in Table 1. Table 1 Overview of earnings management incentives, divided into beneficial / harmful / ambiguous / irrelevant!"#$"%&'$ ($"$)&#&*+,*-.)/+ 0.1&2/3/4!--$+$'*"%!""#$%&'()*+,-%.'/0#+.! 12+#3)4%50)*+2%./.0)6#+7/0#+.! 8%%0#.9)1./7:'0'();+&%$/'0'! CD0%&./7);#./.$#.9! E/$F3/0#.9)G0+$F)!-0#+.'!!0H%&! 2.4 Hypothesis Development In the first chapter the main question for this research is determined. This research question is as follows: Ø Is there a relationship between earnings management incentives and CEO/CFO turnover likelihoods? In the meantime, the provided earnings management incentives are divided into three groups, namely incentives that are beneficial to existing shareholders, incentives that are harmful to existing shareholders and incentives that are ambiguous to existing shareholders. The Board of Directors at a firm usually makes decisions about the appointment of a CEO/CFO. Since it is responsible for monitoring the actions of the top management, it thereby mainly considers the benefits of the existing shareholders. If a CEO/CFO manipulates earnings, it would be probable that the turnover probability will be dependent upon whether the earnings management was harmful to existing shareholders or not. Given the responsibility of the Board of Directors, the hypotheses to be tested are as follows: H1: After earnings management is detected, the CEO/CFO turnover likelihood is higher if the earnings management incentive is harmful to the existing shareholders. 18

19 The first hypothesis assumes that there is a positive relation between CEO/CFO turnover and harmful earnings management incentives. Since firms do not always provide the true CEO turnover reason and press releases do not always describe the leave as a forced termination (Weisbach, 1988; Warner et al., 1988), the first hypothesis will test turnover as a whole, without taking into account the different turnover reasons. Therefore, it considers a fixed window of 6 months before the first SEC investigation date and 6 months after the first SEC investigation date. If a turnover happens within this time period, it is assumed that the leave was associated with the SEC probe. H2: After earnings management is detected, the CEO/CFO removal likelihood is higher if the earnings management incentive is harmful to the existing shareholders. The second hypothesis assumes a positive relation between CEO/CFO removal and harmful earnings management incentives. Press releases through the Factiva website and Accounting and Auditing Enforcement Releases (AAERs), published by the SEC are studied to identify the different turnover reasons for the culpable CEOs/CFOs. In order to test the hypothesis, the turnover reason removal will be compared to the other turnover reasons, without taking into account when the turnover happened. H3: After earnings management is detected, the CEO/CFO turnover likelihood is higher if the CEO/CFO is responsible for the earnings management, compared to cases where the CEO/CFO is not responsible for the earnings management. The third hypothesis assumes a positive relation between CEO/CFO turnover and the indication whether the CEO/CFO is one of the responsible parties for the earnings management. To investigate this assumption, a matched sample of firms where earnings management is detected by the SEC, but where neither a CEO nor a CFO was the party against, is used. This will be compared to the original dataset. Karpoff et al. (2008) already found that culpable executives have significantly higher termination rates than unaccused executives at the same firms. The current study investigates the CEO/CFO turnover likelihoods at different firms; the expectation for this hypothesis is that the turnover likelihoods will be higher at firms where the CEO/CFO is responsible for the management of earnings. 19

20 3. Sample and Research Design 3.1 Enforcement Process The U.S. Securities and Exchange Commission (SEC) takes actions against firms that violate the Securities Exchange Act of 1934, which requires firms to comply with the financial reporting requirements. The details of these enforcement actions are published by the SEC in a series of Accounting and Auditing Enforcement Releases (AAERs). The SEC examines the financial statements of firms for violations of screening criteria and for suspicious subjective factors. If a case needs to be scrutinized, the staff of the SEC will conduct an informal investigation relating to the alleged violations. Pursuant to this informal inquiry, the firm will cooperate by providing information and documents to the SEC staff. If the informal probe reveals strong evidence of violating the laws, then the SEC may continue with a formal investigation. If this is the case, then the firm is required to disclose this to the shareholders. Since formal investigations are very costly, the SEC only pursues cases where it can reveal that the managers knew or should have known through better internal controls. Thus, it can be assumed that firms facing enforcement actions by the SEC, knowingly and on purpose managed earnings (Dechow et al., 1996). The timeline of an enforcement process in Figure 1 shows that a trigger event after the violation period results in an informal inquiry. Common trigger events for the SEC include restatements, auditor departures, and unusual trading (Karpoff et al. 2008). Thereafter, it might be pursued as an (in)formal investigation. Finally the SEC will file a complaint against the culpable officers and/or the firm on the enforcement date. This is the date on which the SEC filed the AAER. Figure 1 Timeline of an enforcement process Violation Period Enforcement Period Violation Begins Violation Ends Trigger Informal Formal Enforcement Event Investigation Investigation Date 20

21 3.2 Research Sample The AAERs, published by the SEC from 2004 through 2008 are the starting point for the data collection of the current study. The AAERs contain the enforcement actions for violating the Generally Accepted Accounting Principles (GAAP), initiated by the SEC. These data include the beginning and ending violation year and the enforcement dates per firm, identifies the culpable individuals and their position within the firm and provides a description of the violation case. The earnings management incentives are derived from this information. Also, an indication whether a CEO/CFO was one of the parties against in the case is provided. In order to find the CEO/CFO turnover information, the investigation dates, and the total amount of penalties which the SEC imposed on the firm and/or the convicted individuals, the press releases from the Factiva website are studied. In total there were 434 firms that violated the GAAP in 2004 through 2008, according to the AAERs. 69 of these firms had an incentive that was irrelevant for the purpose of this study and 62 of the total firms were cases where only an external auditor was culpable for the earnings manipulations. The remaining 303 firms can be split into firms where a CEO/CFO was involved in the fraud case and firms where neither a CEO, nor a CFO was involved in the fraud case. For the first two hypotheses, the final sample of 227 firms, where either a CEO or a CFO was responsible for the management of earnings, will be used. The 76 firms where neither a CEO nor a CFO was the party against will be used as a matched sample for the third hypothesis. Of these 227 firms, 16.7% was collected in 2004, 18.9% in 2005, 13.7% in 2006, 24.7% in 2007 and 26.0% in 2008 (Table 2 Panel B). The total list of the 227 firms, sorted per AAERs year, is attached in Appendix A. Table 2 Panel C provides the industry classification of the 227 firms. The sample firms are clustered in the manufacturing industry and the services industry with respectively 78 (34.4%) and 67 (29.5%) observations. Within the manufacturing industry, almost half of the observations are represented in the industrial and commercial machinery & computer equipment (SIC Code 35) and the electronic, electrical equipment & components sector (SIC Code 36). These are highly competitive industries in which there were a lot of innovations during the past years. Within the services industry, widely 77% of the observations are represented in the business services (SIC Code 73) sector. The increasing number of cases at this industry in 2008 might be due to the financial crisis. A more detailed clarification of the industry classifications is provided in Appendix B. Observing the incentives in Table 2 Panel D, most of the cases are related with meeting analysts forecasts (25.6%), followed by officers compensation (20.3%) and insider trading (19.4%). From the beneficial incentives, avoiding losses is the most common (10.6%). In total, there are 100 cases with harmful incentives, 48 cases with beneficial incentives, and 79 cases with ambiguous incentives. Within the 227 firms, 156 CEOs and 184 CFOs were identified as being responsible for the earnings management, which results in a total number of culpable executives of 340 to be observed in the current study (Table 2 Panel E). 21