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The effect of co-opted directors on real earnings management

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Abstract

Co-opted directors are those elected after a CEO takes office. In this paper, we examine how co-opted directors affect real earnings management. Our results show that, due to the lack of director independence, a board with more co-opted directors plays a weaker monitoring role, which significantly increases the level of real earnings management. A DID setting using the Sarbanes–Oxley Act of 2002 as a natural experiment demonstrates that there is most likely a causal effect of board co-option on real earnings management. Furthermore, we find that this causal effect is more pronounced in firms with poor corporate governance.

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Notes

  1. For example, the managers are likely to spend funds in empire building and less likely to distribute excess cash to shareholders (Marris 1963; Jensen 1986). There may be conflict between decisions of control and decisions of management (Fama and Jensen 1983). Executives (of Enron, Tyco, and WorldCom) entrench themselves in self-dealing in earnings management and use opaque financial reports to pursue their self-interested policies (Chava, Kumar, and Warga 2009). Managers with excessive control rights are more likely to pursue their own private benefits at shareholders’ expense (Masulis, Wang and Xie 2009). The effectiveness of independent directors is indeed weaker in strongly family-controlled firms (Prencipe and Bar-Yosef 2011).

  2. This occurs via CEO turnover-performance sensitivity and compensation (Coles et al. 2014), managerial myopia (Chintrakarn et al. 2016), powerful CEOs (Withisuphakorn and Jiraporn 2017), financial reporting quality (Cassell et al. 2018), and dividend policy (Jiraporn and Lee 2018).

  3. We thank Jeffrey L. Coles, Naveen D. Daniel, and Lalitha Naveen for making the director co-option data available at https://sites.temple.edu/lnaveen/data/

  4. We set missing values for advertising and/or R&D expenses to be 0 as long as there are available data on SG&A expenses. Advertising and R&D expenses might have been included in SG&A expenses and hence are not reported.

  5. We multiply both the abnormal decrease in discretionary expenses and abnormal cash flow from operationss by -1.

  6. The standard deviation of tenure-weighted co-option is 0.3239 and the average of REM1 is 0.0385. Thus, the increase of tenure-weighted co-option by one standard deviation increases REM1 by 0.3239 × 0.0313 = 0.0101, which is a 26.23% (0.0101/0.0385) change of the average.

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Author information

Authors and Affiliations

  1. International College of Sustainability Innovations, National Taipei University, 151 University Road, San Shia District, New Taipei City, 23741, Taiwan

    Robin Chen

  2. Black School of Business, Penn State Behrend, 281 Burke Center, Erie, PA, 16563, USA

    Hongrui Feng

  3. College of Business, University of Central Arkansas, 201 Donaghey Ave., COB 211P, Conway, AR, 72035, USA

    Xuechen Gao

  4. School of Business, Macau University of Science and Technology, Avenida Wai Long, Taipa, Macau, China

    Shenru Li

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  1. Robin Chen
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Correspondence to Xuechen Gao.

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We thank Yuan-Teng Hsu and Huai-Chun Lo for their insightful comments and encouragement.

Appendices

Appendix

Appendix A: Variable Definition

Variable

Definition

Data Source

Dependent variables

 

REM1

The sum of the standardized abnormal decrease in discretionary expenditures (AB_DISC) and abnormal production costs (AB_PROD)

Compustat

REM2

The sum of the standardized abnormal decrease in discretionary expenditures (AB_DISC) and abnormal cash flow from operations (AB_CFO)

Compustat

REM3

The sum of the standardized abnormal decrease in discretionary expenditures (AB_DISC), abnormal production costs (AB_PROD), and abnormal cash flow from operations (AB_CFO)

Compustat

Independent variables

 

TW Co-Option

The sum of the tenure years of co-opted directors divided by the total of all the directors’ tenure

Coles et al. (2014)

Co-Option

The number of directors elected after the CEO takes office, divided by board size

Coles et al. (2014)

TW Independent Co-Option

The sum of the tenure of co-opted independent directors divided by the total tenure of all directors

Coles et al. (2014)

Firm characteristics

 

ROA

The total net income divided by total assets

Compustat

Assets

The natural logarithm of total assets

Compustat

Leverage

The total debt divided by total assets

Compustat

BHR

The buy-and-hold one-year return

CRSP

Audit Tenure

A dummy variable equal to 1 if the firm is audited by its current auditor more than 4 years, and otherwise 0

I/B/E/S

MKBK

The market value of equity divided by the book value of equity

Compustat

Firm Age

The number of years since first listing in CRSP

CRSP

MTR

The tax rate on each additional dollar of income earned today

Graham and Mills (2008)

BIG4

A dummy variable equal to 1 if the firm is audited by top 5 auditors, and otherwise 0

I/B/E/S

Z-Score

(1.2 × working capital + 1.4 × retained earnings + 3.3 × EBIT + 0.999 × sales)/total assets

Compustat

Corporate governance characteristics

 

Board Independency

The percentage of independent directors divided by board size

RiskMetrics

Board Size

The natural logarithm of total board size

RiskMetrics

IO

The percentage of institutional ownership divided by total outstanding shares

Thomson-Reuters 13F

E-Index

The entrenchment index based on six provisions

Bebchuk et al. (2009)

CEO and director characteristics

 

Director Age

The natural logarithm of the director’s age

RiskMetrics

Female Director

A dummy variable that equals to 1 if a firm has at least one female director on the board, and 0 otherwise

RiskMetrics

Director Tenure

The natural logarithm of the director’s tenure

RiskMetrics

Duality CEO

A dummy variable that equals to 1 if a CEO is also the chairman of the board, and 0 otherwise

RiskMetrics

Appendix B: Correlation Table

 

(1)

(2)

(3)

(4)

(5)

(6)

(7)

(8)

(9)

(10)

(11)

(12)

(13)

(1) REM1

1

            

(2) REM2

0.95***

1

           

(3) REM3

0.98***

0.97***

1

          

(4) Co-option

− 0.08***

− 0.09***

− 0.09***

1

         

(5) Co-option Independent

− 0.07***

− 0.08***

− 0.07***

0.92***

1

        

(6) TW Co-option

− 0.09***

− 0.10***

− 0.09***

0.94***

0.84***

1

       

(7) TW Co-option Independent

− 0.08***

− 0.09***

− 0.08***

0.88***

0.92***

0.91***

1

      

(8) ROA

− 0.06***

− 0.10***

− 0.14***

0.01

0.02*

0.01

0.02**

1

     

(9) Assets

0.12***

0.12***

0.11***

− 0.11***

− 0.06***

− 0.14***

− 0.09***

0.03**

1

    

(10) Leverage

0.07***

0.11***

0.08***

− 0.04***

− 0.05***

− 0.04***

− 0.03***

− 0.20***

0.32***

1

   

(11) BHR

− 0.04***

− 0.07***

− 0.07***

− 0.01

− 0.01

− 0.01

0.01

0.10***

− 0.01

− 0.03***

1

  

(12) Audit Tenure

− 0.01

− 0.01

− 0.01

− 0.06***

− 0.06***

− 0.08***

− 0.09***

0.02*

0.02**

− 0.02*

− 0.02

1

 

(13) MKBK

− 0.18***

− 0.21***

− 0.23***

0.03**

0.02**

0.03***

0.04***

0.29***

0.03**

0.01

0.19***

− 0.03***

1

(14) MTR

0.12***

0.14***

0.12***

− 0.18***

− 0.12***

− 0.23***

− 0.19***

0.05***

0.42***

0.14***

− 0.01

0.13***

0.01

(15) Firm Age

0.02*

0.01

− 0.01

0.03**

0.01

0.02

0.01

0.23***

0.01

− 0.08***

0.03**

0.02*

0.11***

(16) Big4

0.02

0.02*

0.02

− 0.05***

− 0.04***

− 0.05***

− 0.04***

− 0.03***

0.24***

0.15***

− 0.01

0.04***

0.01

(17) Z− Score

− 0.19***

− 0.24***

− 0.24***

0.09***

0.06***

0.10***

0.07***

0.42***

− 0.30***

− 0.51***

0.14***

− 0.01

0.33***

(18) Board Independency

0.03**

0.03***

0.03***

− 0.01

0.21***

− 0.03

0.16***

− 0.01

0.22***

0.06***

0.01

− 0.01

− 0.01

(19) Board Size

0.09***

0.12***

0.09***

− 0.14***

− 0.13***

− 0.19***

− 0.17***

0.04***

0.56***

0.24***

− 0.02*

0.03***

0.02*

(20) IO

0.02

0.04***

0.05***

0.03***

0.04***

0.05***

0.05***

− 0.16***

− 0.57***

− 0.15***

− 0.05***

0.03***

− 0.17***

(21) E-Index

0.06***

0.07***

0.06***

− 0.02**

0.03***

− 0.02**

0.03**

− 0.06***

− 0.01

0.02*

0.05***

− 0.03***

− 0.07***

(22) Director Age

0.10***

0.10***

0.09***

− 0.03**

− 0.08***

− 0.02**

− 0.06***

0.01

0.07***

0.08***

0.10***

0.02

0.04***

(23) Female Director

0.06***

0.08***

0.06***

− 0.09***

− 0.02

− 0.12***

− 0.04***

0.04***

0.33***

0.11***

− 0.01

− 0.02*

0.06***

(24) Director Tenure

0.05***

0.05***

0.04***

− 0.19***

− 0.20***

− − 0.17***

− 0.16***

0.06***

− 0.01

− 0.01

0.03**

0.15***

− 0.04***

(25) Duality CEO

0.01

− 0.01

− 0.01

0.05***

− 0.04***

0.05***

− 0.02**

− 0.02

− 0.03**

0.06***

− 0.01

0.03***

0.05***

 

(14)

(15)

(16)

(17)

(18)

(19)

(20)

(21)

(22)

(23)

(24)

(25)

(14) MTR

1

           

(15) Firm Age

0.06***

1

          

(16) Big4

0.05***

− 0.02*

1

         

(17) Z-Score

− 0.17***

0.16***

− 0.16***

1

        

(18) Board Independency

0.22***

− 0.11***

0.08***

− 0.15***

1

       

(19) Board Size

0.35***

0.05***

0.17***

− 0.20***

0.15***

1

      

(20) IO

− 0.12***

− 0.09***

− 0.12***

− 0.03***

0.05***

− 0.28***

1

     

(21) E-Index

0.01

− 0.13***

0.01

− 0.10***

0.26***

0.06***

0.09***

1

    

(22) Director Age

0.13***

0.10***

0.04***

0.02*

− 0.17***

0.12***

− 0.16***

− 0.12***

1

   

(23) Female Director

0.22***

− 0.03**

0.13***

− 0.14***

0.31***

0.39***

− 0.13***

0.12***

− 0.08***

1

  

(24) Director Tenure

0.23***

0.01

− 0.07***

0.04***

− 0.01

0.06***

0.03***

0.15***

0.08***

− 0.02

1

 

(25) Duality CEO

− 0.01

0.15***

0.07***

0.02*

− 0.26***

0.03***

− 0.12***

− 0.39***

0.43***

− 0.11***

− 0.13***

1

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Chen, R., Feng, H., Gao, X. et al. The effect of co-opted directors on real earnings management. Rev Quant Finan Acc 61, 1315–1339 (2023). https://doi.org/10.1007/s11156-023-01187-8

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