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).