In the paper, Do Managers Manipulate Earnings Prior to Management Buyouts?, which was recently made publicly available on SSRN, we investigate accounting manipulation prior to buyout transactions in the UK during the second buyout wave of 1997 to 2007. Prior to management buyouts (MBOs), managers have an incentive to deflate the reported earnings numbers by accounting manipulation in the hope of lowering the subsequent stock price. If they succeed, they will be able to acquire (a large part of) the company on the cheap. It is important to note that accounting manipulation in a buyout transaction may have severe consequences for the shareholders who sell out in the transaction: if the earnings distortion is reflected in the stock price, the stock price decline cannot be undone and the wealth loss of shareholders is irreversible if the company goes private subsequent to the buyout. Mispriced stock and false financial statements are still issues frequently mentioned when MBO transactions are evaluated. The UK’s Financial Services Authority (FSA, 2006) ranks market abuse as one of the highest risks and suggests more intensive supervision of leveraged buyouts (LBOs). The concerns about mispriced buyouts are therefore a motive to test empirically whether earnings numbers are manipulated preceding buyout transactions.
Posts Tagged ‘Earnings management’
Reputation concerns create strong incentives for independent directors to be viewed externally as capable monitors as well as to retain their most valuable directorships. In our paper, Reputation Incentives of Independent Directors: Impacts on Board Monitoring and Adverse Corporate Actions, which was recently made publicly available on SSRN, we extend this literature significantly by examining the effects of differential reputation incentives across firms that arise when a director holds multiple directorships.
Firms having boards composed of a greater portion of independent directors for whom this directorship represents one of their most prestigious are associated with firm actions known to reward directors and are negatively associated with firm actions known to be costly to director reputations. Specifically, they are associated with a lower likelihood of covenant violations, earnings management, earnings restatements, shareholder class action suits and dividend reductions. In addition, we also find they are positively associated with stock repurchases and dividend increases.
In our paper, Do Investors Understand ‘Operational Engineering’ before Management Buyouts?, which was recently made publicly available on SSRN, we use a sample of management buyouts (MBOs) from 1985-2005 and a matched subsample of post-MBO firms to examine three questions. First, we examine whether firms undertake different types of activities to lower earnings before MBOs. Second, to see whether outside investors and the market understand such ‘operational engineering’ activities, we study the impact of these activities on target firms’ stock returns and MBO deal characteristics including deal premium and likelihood of deal completion. Third, we examine the relation between pre-MBO earnings-reducing activities and the post-MBO operating performance.
With the Great Recession of 2007-2009 exposing deficiencies of the world’s most advanced financial markets, leveraged buyouts (LBOs) have ‘reemerged’ as a solution to the many challenges facing corporate sectors. Unlike publicly listed firms, LBO firms are characterized by concentrated ownership, active monitoring and high leverage. A growing strand of literature shows that LBO firms can create value through ‘financial, operational and governance engineering’ (Kaplan and Stromberg, 2009). In fact, Jensen (1989) argues that LBOs should replace publicly held corporations as the dominant corporate organizational form.
The power of short-term shareholders in widely-held public firms is widely blamed for “short-termism”: directors and executives feel pressured to boost the short-term stock price at the expense of creating long-term economic value. The recent financial crisis, which many attribute to the influence of short-term shareholders, has renewed and intensified these concerns.
To reduce short-termism, reformers have sought to strengthen the number and power of long-term shareholders in public corporations. For example, the Aspen Institute has recommended imposing a fee on securities transactions and making favorable long-term capital gains rates available only to investors that own shares for much longer than a year. Underlying these proposals is a long-standing and largely uncontested belief: that long-term shareholders, unlike short-term shareholders, will want managers to maximize the economic pie created by the firm.
I recently posted a paper on SSRN explaining why this rosy view of long-term shareholders is wrong. In my paper, The Uneasy Case for Favoring Long-term Shareholders, I demonstrate that long-term shareholder interests do not align with maximizing the economic pie created by the firm – even when shareholders are the only residual claimants on the firm’s value. In fact, long-term shareholder interests might be less well aligned with maximizing the economic pie than short-term shareholder interests. In short, we can’t count on long-term shareholders to be better stewards of the firm simply because they hold their shares for a longer period of time.
In the paper, Internal Governance and Real Earnings Management, which was recently made publicly available on SSRN, we examine whether key subordinate executives can restrain the extent of real earnings management. We focus on key subordinate executives, i.e., the top five executives with the highest compensation other than the CEO, because we hypothesize that they are the most likely group of employees that have both the incentives and the ability to influence the CEO in corporate decisions. As argued in Acharya et al. (2011), key subordinate executives have strong incentives not to increase short-term performance at the expense of long-term firm value. This tradeoff between current and future firm value is particularly salient in the case of real earnings management (as compared to accruals earnings management) because over production and cutting of R&D expenditures are costly and can reduce the long term value of the firm.
The motivation for the research question is twofold. First, the majority of the papers in the literature explicitly or implicitly assume that the CEO is the sole decision maker for financial reporting quality and the impact of other executives has been generally overlooked. Recent studies argue that subordinate executives usually have longer horizons and they can influence corporate decisions through various means. We hypothesize that differential preferences arising from differential horizons can affect the extent of real earnings management. Second, while there are studies focusing on the impact of external corporate governance (e.g., board independence and institutional ownership), little is known about whether there are checks and balances within the management team. This lack of knowledge is an important omission because control is not just imposed from the top-down or from the outside, but also from bottom-up (Fama 1980).
In the paper, Earnings Quality: Evidence from the Field, which was recently made publicly available on SSRN, we provide insights about earnings quality from a new data source: a large survey and a dozen interviews with top financial executives, primarily Chief Financial Officers (CFOs). Why CFOs? While it is clear that there are important consumers of earnings quality such as investment managers and analysts, we focus on the direct producers of earnings quality, who also intimately know and potentially cater to such consumers. In addition, CFOs commonly have a formal background in accounting, which provides them with keen insight into the determinants of earnings quality, including the advantages and limitations of GAAP accounting. CFOs are also key decision-makers in company acquisitions (see Graham, Harvey and Puri 2012), which implies that they have working knowledge of how to evaluate earnings quality from an outside perspective.
My paper, Insider Trading via the Corporation, recently posted on SSRN, critically examines the regulations applicable to U.S. firms trading in their own shares and puts forward a proposal for reform.
Publicly-traded U.S. firms buy and sell a staggering amount of their own shares in the open market each year. Open-market repurchases (“OMRs”) alone total hundreds of billions of dollars per year; in 2007, they reached $1 trillion. Firms are also increasingly selling shares in the open market through so-called “at-the-market” issuances (“ATMs”).
When a U.S. firm trades in its own shares, its trade-disclosure requirements are minimal. The firm must report only aggregate trading activity, and not until well into the following quarter. Thus, the firm can secretly buy and sell its own shares in the open market for several months, and never disclose the exact details of its trades to shareholders and regulators. The lack of detailed disclosure, I explain, makes it difficult to detect illegal trading on material inside information; the lack of timely disclosure makes it difficult for investors to determine when the firm is trading on valuable but sub-material information.
In our paper, Earnings Management from the Bottom Up: An Analysis of Managerial Incentives below the CEO, which was recently made publicly available on SSRN, we analyze all components of compensation packages for CEOs and for managers at levels below that of the CEO. Pay-for-performance contracts are a critical instrument to align the interests of principals and agents (Jensen and Meckling, 1976). While it can be optimal to make the agent the residual claimant of the firm’s profit, under numerous conditions principals are better off employing weaker incentives. These include situations with poor measures of performance and multitasking environments, when agents reduce their motivation in response to financial incentives, and when principal and agent have differing priors.
Another cost of high-powered incentives is that they provide managers with incentives to manipulate the firm’s reported earnings. For example, equity incentives can entice managers to boost reported earnings just before they exercise options or sell stock. There are now a number of academic studies – and many anecdotes – that document this link between the structure of chief executive officer (CEO) compensation and various measures of earnings manipulation (e.g., Beneish and Vargus, 2002; Bergstresser and Philippon, 2006; Peng and Roell, 2008). These papers generally focus on one component of compensation for the top position—equity incentives for the CEO. In this paper, we extend this literature by analyzing all components of compensation packages for CEOs and for managers at lower levels. To our knowledge, this study is the first that analyzes the relationship between CEO, division manager, and chief financial officer (CFO) compensation and earnings management in a large sample of firms.
In our paper, Internal Corporate Governance, CEO Turnover, and Earnings Management, forthcoming in the Journal of Financial Economics, we examine whether executives who manage earnings increase the risk of losing their jobs. We find that earnings management is strongly associated with the subsequent likelihood of forced CEO turnover, but is not significantly related to voluntary turnover. This basic result holds through several test specifications, including multinomial logistic regressions and competing risks hazard models. In the short run, aggressive earnings management in any given year is associated with an increased likelihood of forced ouster the next year. And in the long run, a CEO’s job tenure is negatively related to earnings management over the time he or she is in the CEO position. Similar results hold when we examine the forced turnover of CFOs. A large battery of sensitivity tests reported in the Internet Appendix indicate that these results are robust to alternate measures of earnings management and different model specifications.
Prior research has documented that current U.S. corporate tax laws create incentives for some U.S. multinational corporations (MNC) to delay repatriation of foreign earnings in order to defer taxation on those earnings and hold greater amounts of cash abroad. The current financial accounting treatment for taxes on foreign earnings under ASC 740 potentially exacerbates this issue and increases the incentive to avoid the repatriation of foreign earnings by allowing firms to designate foreign earnings as permanently reinvested and to defer the recognition of the U.S. tax expense related to foreign earnings for financial reporting purposes. In our paper, Permanently Reinvested Earnings and the Profitability of Foreign Cash Acquisitions, which was recently made publicly available on SSRN, we predict and document that the combined effect of these tax and financial reporting incentives likely lead to significant agency costs. Namely, managers of U.S. MNCs with high levels of both permanently reinvested earnings and cash holdings are more likely to make value-destroying acquisitions of foreign target firms. Our findings are consistent with anecdotal evidence from the popular press. For example it has been suggested that a significant determinant of Microsoft’s decision to acquire Skype for $8.5 billion was that Skype was a foreign company with headquarters in Luxemburg, enabling Microsoft to use foreign cash “trapped” overseas to make the acquisition (Bleeker 2011).