The differential effects of incentives and monitoring on earnings management at the time of a CEO change

Abstract

In recent years, chief executive officer (CEO) compensation levels have become increasingly earnings-based. This has provided a potential opportunity for CEOs to manage earnings in order to affect their own compensation levels. Recent research indicates that the incentives for earnings management may be particularly strong at the time of a CEO change. This research investigates the relationship CEO incentives and monitoring devices may have on the degree of earnings management. A sample of 218 CEO changes were obtained from the 1987 and 1988 Disclosure database. A regression approach was used to examine the relationship of five CEO incentive variables (routine CEO change, tenure of the CEO, the company's financial performance, CEO stock holdings, and the succession route of the new CEO) and two monitoring variables (board composition and ownership structure) to potential earnings management. Changes in key financial statement variables at the time of a CEO change were used to proxy for earnings management. Results indicate that potential earnings management at the time of the CEO change is related to both CEO incentives and monitoring devices. CEO incentive variables as a group were found to be more important in explaining possible earnings management than were monitoring variables. The company's financial performance and the CEO's tenure were the most important incentive variables. A subsample of the companies based upon their exchange affiliation disclosed that CEO incentives and monitoring devices better explained financial statement variable changes for companies listed on the New York/American Stock Exchanges than for companies listed on the Over-The-Counter market. The results suggest the importance of considering both CEO incentives and monitoring devices when attempting to explain possible earnings management. The research findings should benefit shareholders, regulators, and the general public, who may be interested in the incentive and monitoring conditions that would diminish the likelihood of earnings management by an outgoing CEO.