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Review of Quantitative Finance and Accounting

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04.09.2023 | Original Research

The effect of co-opted directors on real earnings management

verfasst von: Robin Chen, Hongrui Feng, Xuechen Gao, Shenru Li

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 4/2023

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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.

Vorheriger Artikel Former CEOs chairing the board: does it matter to corporate social and environmental investments?

Nächster Artikel The transfer of risk taking along the supply chain

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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).

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).

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/

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.

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

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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Titel: The effect of co-opted directors on real earnings management
verfasst von: Robin Chen
Hongrui Feng
Xuechen Gao
Shenru Li
Publikationsdatum: 04.09.2023
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 4/2023
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-023-01187-8

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