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The influence of CEO and CFO power on accruals and real earnings management

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Abstract

In this study, we examine the effect of CEO and CFO power on both accruals and real earnings management (AEM and REM, respectively), and the extent to which CEO and CFO power mitigate the effect of one another on AEM and REM. We further examine whether the passage of the Sarbanes-Oxley Act (SOX) altered these effects. In the pre-SOX period, we find that AEM (REM) is greater when the CEO (CFO) is powerful relative to the CFO (CEO). In the post-SOX period, however, we find that the effect of relative CEO power on AEM subsides, whereas the effect of relative CFO power on REM persists. Additionally, we find evidence to suggest that powerful CFOs inhibit the AEM preferences of powerful CEOs in both the pre- and post-SOX periods. Finally, we find evidence to suggest that powerful CEOs inhibit the REM preferences of powerful CEOs in the pre-SOX period, but not in the post-SOX period. Collectively, our results suggest that the power of the CEO relative to the CFO is an important factor in the both the type and magnitude of earnings management.

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Notes

  1. Importantly for our analysis, Feng et al. (2011) do not include measures of CFO power in their analyses. Thus, the extent to which an interactive effect exists between powerful CEOs and CFOs is an unresolved empirical question.

  2. Adams et al. (2005) conclude that their results suggest that firms with powerful CEOs are those with the most extreme performance, both good and bad.

  3. Bebchuk et al. (2011) examined pay share for the CEO only and defined pay share as the CEO’s portion of the aggregate pay to the top 5 executives. Given that we include the CEO and CFO in our design, the Bebchuk et al. definition of pay share would lead to an arithmetic relationship in the measurement of the variable such that by definition higher pay for the CEO or CFO would lead to lower pay share for the CEO or CFO. To avoid such a mechanical relationship, we exclude the CEO and CFO from the denominator in the variable definition.

  4. Similar to Feng et al. (2011), when the firm reports compensation data for more than five executives, we use only the five highest paid executives. When the firm reports compensation data for fewer than five executives, we use the pay from the lowest paid executive in place of that of the missing executives.

  5. Advertising and R&D expense are set to zero if they are not reported in Compustat.

  6. We do not include an indicator variable for SOX because the correlation between SOX and the year indicator variables results in the SOX variable being dropped in some estimations. Additionally, the variance inflation factor for the SOX indicator variable exceeds 100 in the estimations. When the SOX indicator is included in the model, it has no effect on the coefficients of interest.

  7. We classified executives as “CEO” or “CFO” based on the position identifier field or job description in the database. When necessary, we also referred to original source documents to clarify classification. For example, we observed considerably more variation in the coding and description of chief financial officers than of chief executive officers. Our approach was to classify an executive as the CFO if (a) the indicator field = “CFO”, or (2) the job description indicated a comparable role, such as “chief accounting officer.” If neither of these criteria was clear, we referred to proxy statements and 10-Ks to identify the executive holding a position equivalent to CFO. We used a similar approach for data on board membership, discussed later.

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Authors and Affiliations

  1. School of Business, Wake Forest University, Winston-Salem, NC, 27106, USA

    Terry A. Baker

  2. Culverhouse School of Accountancy, Culverhouse College of Commerce and Business Administration, University of Alabama, Tuscaloosa, AL, 35487, USA

    Thomas J. Lopez & Austin L. Reitenga

  3. John T. Steed School of Accounting, Price College of Business, University of Oklahoma, Norman, OK, 73019, USA

    George W. Ruch

Authors
  1. Terry A. Baker
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  2. Thomas J. Lopez
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  3. Austin L. Reitenga
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  4. George W. Ruch
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Correspondence to Thomas J. Lopez.

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Baker, T.A., Lopez, T.J., Reitenga, A.L. et al. The influence of CEO and CFO power on accruals and real earnings management. Rev Quant Finan Acc 52, 325–345 (2019). https://doi.org/10.1007/s11156-018-0711-z

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