Sword of Damocles: Job Security and Earnings Management

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1 Sword of Damocles: Job Security and Earnings Management Chen Cai Cleveland State University Xiaohua Fang Florida Atlantic University Di Li Peking University 2018 WRDS Advanced Research Scholar Program August 22, 2018

2 Motivation Accurate financial information is crucial for a firm Capital budgeting Corporate management Executive evaluation and compensation... Outside parties rely on unbiased firm information Financial market: Valuation and investment Regulators: Monitor and scrutinize... Managers have incentives and discretion of misreporting earnings Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

3 Motivation Does CEO job status influence earnings management (EM) decision? And, if so, how? Extant evidence is mixed Murphy and Zimmerman (1993) and Pourciau (1993): Little evidence for departing CEOs to undertake more EM Guan, Wright, and Leikam (2005): More discretionary accruals (DA) prior to forced CEO turnover Liu and Xuan (2014): Meet or narrowly beat analyst forecast before CEO contract renewals Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

4 Motivation Problems of prior research Binary job status: secure vs. endangered Implicit assumption of CEO s choice: opportunistic EM Sample selectivity: surrounding CEO turnover prior to contract renewal Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

5 Motivation Problems of prior research Binary job status: secure vs. endangered Implicit assumption of CEO s choice: opportunistic EM Sample selectivity: surrounding CEO turnover prior to contract renewal In reality CEO job status: incremental and continuous CEO s choice: endeavor vs. EM Effects of job security: discipline vs. opportunism Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

6 Discipline by Forced Turnover I sponsored the death penalty laws because of my firm conviction that it would act as a significant deterrent and provide a true measure of justice to murder victims and their loved ones. George E. Pataki, Former Governor of New York State Disciplinary effects of forced CEO turnover Ex-ante effect discourages misbehaviors in the first place Ex-post effect punishes wrongdongs Most research focuses on ex-post effect We aim to provide evidence for ex-ante effect Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

7 Ex-ante Discipline Theoretical logic: Incentive compatibility condition induces agents to choose desirable actions and avoid undesirable ones Dismissal is costly for CEOs Significant loss of compensation and wealth (Jensen and Murphy, 1990; Dahiya and Yermack, 2008; Eckbo, Thorburn, and Wang, 2016) Enduring damage on reputation and future job opportunities (Brickley, Linck, and Coles 1999) EM is not riskless or cost-free EM constrains ability of achieving future objectives Hazarika, Karpoff, and Nahata (2012): EM leads to dismissal Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

8 Effects of CEO Job Security Ex-ante discipline Adverse job status is a wake-up call Simulates CEOs to exert effort to improve performance Improved performance reduces need of income-inflating EM Universal, and applies to incremental change in job security Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

9 Effects of CEO Job Security Ex-ante discipline Adverse job status is a wake-up call Simulates CEOs to exert effort to improve performance Improved performance reduces need of income-inflating EM Universal, and applies to incremental change in job security Opportunism Overstates earnings for seemingly quick improvement More likely when dismissal risk is imminent Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

10 Hypotheses Hypothesis 1 (Discipline Hypothesis). A decrease in job security has an disciplinary effect on CEOs action and motivates them to reduce earnings management. Specifically, the incentive of overstating earnings is constrained. Hypothesis 2 (Opportunism Hypothesis). When dismissal risk is high, continued deterioration of job security may motivate CEOs to engage in opportunistic earnings management, particularly overstating earnings. Which effect drives the relation between CEO job security and EM? In what situation does either of the effects play a greater role? Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

11 Results Preview Job (in)security measured using dismissal hazard Primary EM measure: discretionary accruals (DA) Disciplinary effect is prevalent Increase in hazard associated with a lower EM Mainly driven by income-increasing EM Evidence on the channel of disciplinary effect Increase in hazard associated with improved subsequent performance Lower investment, M&A, and higher R&D Similar results for real-activity based EM Opportunistic effect is possible when threat is imminent Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

12 Related Literature Earnings management: a long list Survey papers: Healy and Wahlen (1999) and Dechow, Ge, and Schrand (2010) CEO turnover and EM Murphy and Zimmerman (1993); Pourciau (1993); Guan, Wright, and Leikam (2005) Job security and corporate policies Cziraki and Xu (2014); Li and Zhao (2017); Liu and Xuan (2014) Disciplinary effect (ex-post penalty) of forced turnover Lehn and Zhao (2006); Hazarika, Karpoff, and Nahata (2012) Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

13 Sample ExecuComp firms from 1993 to 2011 Financial information from Compustat; stock return from CRSP Other database: ISS (former RiskMetrics), I/B/E/S, Thomson Reuters, etc. Sample size 16,148 firm-year observations for CEO job duration analysis 13,790 firm-year observations for analysis of EM 6,227 firm-year observations with positive DA 12,873 firm-year observations for real EM Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

14 Forced CEO Turnover Identification Forced CEO turnover classification following Parrino (1997) For all CEO turnovers, search on Google and Factiva for reasons: Forced turnover includes policy difference with board, fired, resignation because of poor performance or fraud other departures without six-month pre-announcement unless holding title of board chairman or taking executive position in another firm Death or health-related leaves are voluntary Exclude turnovers because of bankruptcy or being acquired Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

15 Measure of Job Security Measure job (in)security using dismissal hazard h t t 1(τ i,t 1, x i,t 1 ) = h 0 (τ i,t 1 ) exp(x i,t 1δ) Weibull baseline hazard: h 0 (τ i,t 1 ) = pτ p 1 i,t 1, h 0 (τ) 0 if p 1 τ i,t 1 : job duration (tenure) x i,t 1 : firm and CEO characteristics Dismissal likelihood in year t given job continuation till year t 1 Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

16 Measure of Job Security Measure job (in)security using dismissal hazard h t t 1(τ i,t 1, x i,t 1 ) = h 0 (τ i,t 1 ) exp(x i,t 1δ) Weibull baseline hazard: h 0 (τ i,t 1 ) = pτ p 1 i,t 1, h 0 (τ) 0 if p 1 τ i,t 1 : job duration (tenure) x i,t 1 : firm and CEO characteristics Dismissal likelihood in year t given job continuation till year t 1 Advantages Representative: Estimated for a large sample Cross-sectional and time-series variation Continuous measure Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

17 Hazard Estimation (1) (2) (3) Weibull 1 Weibull 2 Weibull 3 Stock return ( 7.09) ( 6.63) Industry induced stock return ( 1.94) Idiosyncratic stock return ( 7.84) ROA ( 1.94) Retirement age ( 2.14) ( 2.12) ( 2.13) Ownership 5% ( 2.87) ( 2.87) ( 2.85) CEO duality ( 2.85) ( 2.75) ( 2.78) Board size (0.84) (0.80) (1.02) Board independence ( 0.02) (0.01) ( 0.05) Constant ( 6.60) ( 6.86) ( 6.45) ln(p) ( 3.06) ( 3.10) ( 3.09) Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

18 Measure of Earnings Management Primary measure: discretionary accruals (DA) Performance-adjusted (Kothari, Leone, and Wasley, 2005) Residual of following regression for each (2-digit SIC) industry-year TA i,t 1 Sales i,t PPE i,t = β 1 + β 2 + β 3 Total Assets i,t 1 Total Assets i,t 1 Total Assets i,t 1 Total Assets i,t 1 + β 4 ROA i,t + ε i,t The greater positive (negative) DA, the more income-inflating (-deflating) EM Real EM (Roychowdhury, 2006): abnormal production costs, abnormal discretionary expenses Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

19 Univariate Results Pearson Correlation Portfolio Analysis Hazard DA Positive DA Negative DA Portfolio DA Positive DA Negative DA Hazard (Lowest hazard) DA Positive DA Negative DA (Highest hazard) t-statistic Evidence for disciplinary effect DA declines when hazard increases Mainly driven by effect on positive DA Evidence for opportunistic effect: nonlinear changes of positive DA Significance in portfolio analysis of negative DA: omitted variables Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

20 Multivariate Regressions EM i,t = α 0 + α 1 h t i,t 1 + β z i,t 1 + α j + α t + ε i,t OLS Truncated Regression (1) (2) (3) (4) (5) DA Positive DA Negative DA Positive DA Negative DA Hazard ( 3.12) ( 2.84) ( 0.76) ( 3.01) ( 0.42) Control variables Yes Yes Yes Yes Yes Industry dummies Yes Yes Yes Yes Yes Year dummies Yes Yes Yes Yes Yes R-squared Observations 13,790 6,227 7,563 6,227 7,563 Similar to univariate results Consistent with discipline hypothesis Increase in hazard constrains earnings overstatement Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

21 Focus on Income-Increasing EM Coefficient of Hazard Quantile of DA DA Coef. 95% CI DA Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

22 Schemes for Identification Can the results be interpreted as disciplinary effect? Control possible simultaneity (e.g., performance) Properly align timing of variables: avoid reverse causality Schemes to strengthen identification IV: industry-level CEO dismissal intensity Alternative measure of dismissal risk Subsample analysis based on other disciplines Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

23 Results: IV and Alternative Measures (1) (2) (3) (4) (5) (6) (7) Tenure- Three-Year Avg. Three-Year Avg. Three-Year Time- Three-Year Time- & Tenure- Ind. Dismissal Weighted Ind. Ind. Dismissal Tenure-Weighted. Ind. Weighted Avg. Ind. Weighted Avg. Ind. IV Intensity Intensity Intensity Dismissal Intensity Dismissal Intensity Dismissal Intensity Hazard ( 3.22) ( 1.49) ( 1.78) ( 1.67) ( 2.65) ( 1.69) ( 2.68) J-statistic p-value of J-statistic Control variables Yes Yes Yes Yes Yes Yes Yes Industry dummies Yes Yes Yes Yes Yes Yes Yes Year dummies Yes Yes Yes Yes Yes Yes Yes Observations 6,227 6,227 6,227 6,128 6,128 6,128 6,128 Results based on instrumented hazard supports discipline hypothesis IV passes overidentifying restriction test Alternative measures of dismissal risk lead to a similar conclusion First Stage Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

24 Results: Subsample Analysis Panel A: Firm Size Panel B: Number of Analysts Bottom Half Top Half Bottom Half Top Half Hazard ( 2.87) ( 1.28) ( 2.71) ( 0.96) Panel C: TNIC-3 Sales HHI Panel D: Inst. Ownership HHI Bottom Half Top Half Bottom Half Top Half Hazard ( 1.63) ( 2.58) ( 3.32) ( 1.07) Panel E: Inst. Top5 Ownership Panel F: Dedicated Inst. Ownership Bottom Half Top Half Bottom Half Top Half Hazard ( 3.45) ( 0.86) ( 2.78) ( 1.30) Regression Control Variables Control variables Yes Yes Yes Yes Industry dummies Yes Yes Yes Yes Year dummies Yes Yes Yes Yes The effect is more pronounced when other disciplines are weak Evidence supports discipline hypothesis Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

25 How Does Disciplinary Effect Work? Discipline hypothesis states Weak job security stimulates CEOs to exert effort Improved performance reduces the need of overstating earnings To establish the channel, we need to show Subsequent performance improves following a higher hazard Hazard influences real corporate decisions relevant to performance Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

26 Job Security and Subsequent Performance PFM i,t = α 0 + α 1 h t i,t 1 + α 2 PFM i,t 1 + β w i,t 1 + α i + α t + ε i,t (1) (2) (3) Q Stock Return Corrected ROA Hazard (11.41) (6.14) (4.13) Lagged dep. var (11.71) ( 10.62) (8.39) Control variables Yes Yes Yes Firm dummies Yes Yes Yes Year dummies Yes Yes Yes Observations 12,022 11,712 10,383 Q and stock return are less subject to managerial manipulation ROA is corrected for discretionary accruals Consistent with prediction of performance channel Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

27 Job Security and Corporate Decisions (1) (2) (3) (4) Investment R&D M&A SG&A Hazard ( 6.48) (3.32) ( 3.36) (0.63) Control variables Yes Yes Yes Yes Firm dummies Yes Yes Yes Yes Year dummies Yes Yes Yes Yes R-squared Observations 14,000 14,000 14,000 14,000 Refrain from acquisition and investment in physical assets Increase input for innovation Ambiguous evidence for cost control (SG&A) Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

28 Similar Effect for Real EM? Firms can temporarily boost sales by (Roychowdhury, 2006) Deep price discount and lenient credit terms Overproduction Cutting discretionary expenses, e.g., R&D, advertisement We examine Abnormal production costs (Ab PROD) Abnormal discretionary expenses (Ab DISCEXP) If disciplinary effect works similarly to real EM, we expect ( ) for Ab PROD (+) for Ab DISCEXP Construction of Real EM Measures Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

29 Results: Real Earnings Management (1) (2) Ab PROD Ab DISCEXP Hazard ( 2.15) (2.01) Control variables Yes Yes Industry dummies Yes Yes Year dummies Yes Yes R-squared Observations 12,873 12,873 Job insecurity indeed constrains real-activity based manipulation Further evidence for discipline hypothesis Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

30 Is Opportunistic Effect Possible Earnings management is costly CEOs overstate earnings when benefit exceeds cost Opportunistic EM is more likely when dismissal risk is high We examine two proxies High hazard Poor performance (stock return) Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

31 Opportunistic Effect: Study Based on Hazard (1) (2) (3) (4) (5) Hazard ( 0.96) ( 2.89) ( 2.82) ( 2.71) ( 3.73) Hazard Top 50% ( 0.57) Hazard Top 40% (1.53) Hazard Top 30% (1.27) Hazard Top 20% (0.90) Hazard Top 10% (2.62) Regression Control Variables Control variables Yes Yes Yes Yes Yes Industry dummies Yes Yes Yes Yes Yes Year dummies Yes Yes Yes Yes Yes Observations 6,227 6,227 6,227 6,227 6,227 Increase in hazard undermines disciplinary effect when hazard is very high Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

32 Opportunistic Effect: Study Based on Stock Return (1) (2) (3) (4) (5) Hazard ( 3.28) ( 3.29) ( 2.98) ( 2.67) ( 2.26) Hazard Bottom 10% (1.69) Hazard Bottom 20% (1.86) Hazard Bottom 30% (1.31) Hazard Bottom40% (0.92) Hazard Bottom 50% (0.59) Regression Control Variables Control variables Yes Yes Yes Yes Yes Industry dummies Yes Yes Yes Yes Yes Year dummies Yes Yes Yes Yes Yes Observations 6,227 6,227 6,227 6,227 6,227 Increase in hazard undermines disciplinary effect when return is very low Opportunistic effect is possible but seems local Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

33 Robustness Checks Alternative performance measures in hazard estimation Alternative hazard models in survival analysis of CEO job duration Alternative methods of estimating dismissal risk, e.g., Probit, OLS Various concerns, such as effects of CEO turnover Reversal of earnings management Analyst forecast Sarbanes-Oxley Act Pay-performance sensitivity Audit committee independence Other corporate governance mechanisms, e.g., G-index, E-index Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

34 Robustness to Dismissal Risk Estimation (1) (2) (3) (4) (5) (6) (7) (8) (9) Probit with OLS with Rare-Event Weibull 2 Weibull 3 Gompertz Cox Probit OLS CEO Tenure CEO Tenure Probit Hazard ( 2.29) ( 2.84) ( 2.91) ( 3.07) Probability ( 2.04) ( 2.19) ( 1.71) ( 2.07) ( 1.93) Control variables Yes Yes Yes Yes Yes Yes Yes Yes Yes Industry dummies Yes Yes Yes Yes Yes Yes Yes Yes Yes Year dummies Yes Yes Yes Yes Yes Yes Yes Yes Yes Observations 6,227 6,227 6,227 6,227 5,732 6,227 5,732 6,227 6,227 Dismissal hazard or probability is always negatively associated with earnings overstatement Alternative Hazard Estimation Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

35 Robustness to Various Concerns and Controls (1) (2) (3) (4) (5) (6) (7) (8) (9) Hazard ( 2.67) ( 2.95) ( 3.05) ( 3.07) ( 3.01) ( 3.08) ( 2.99) ( 2.33) ( 2.34) Lagged DA ( 2.41) Dummy (DAt 1 > DAt) ( 10.91) Meet forecast ( 1.69) SOX dummy (Year 2002) ( 1.86) Delta (2.92) Vega ( 0.86) Audit comm. ind (0.45) G-index (0.70) E-Index (0.97) Control variables Yes Yes Yes Yes Yes Yes Yes Yes Yes Industry dummies Yes Yes Yes Yes Yes Yes Yes Yes Yes Year dummies Yes Yes Yes Yes Yes Yes Yes Yes Yes Observations 5,140 6,211 6,211 6,089 6,227 5,900 5,554 5,411 5,411 Our results are quite robust Negative hazard-em relation is not driven by various alternative effects Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

36 Concluding Remarks Facing an adverse change in job security, CEOs can Improve performance Overstate earnings Disciplinary effect motivates CEOs to improve performance and reduces earnings management Opportunistic effect leads to more earnings manipulation We find that disciplinary effect dominates and is universal, while opportunistic effect plays a role only when dismissal risk is imminent Our evidence suggests that threat of forced turnover is an effective discipline mechanism to incentivize rightful actions Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

37 Construction of Real EM Measures Abnormal production costs are residual of following regression for each industry-year PROD i,t 1 Sales i,t Sales i,t = β 1 + β 2 + β 3 Total Assets i,t 1 Total Assets i,t 1 Total Assets i,t 1 Total Assets i,t 1 + β 4 Sales i,t 1 Total Assets i,t 1 + ε i,t Abnormal discretionary expenses are residual of following regression for each industry-year DISCEXP i,t 1 Sales i,t = β 1 + β 2 + ε i,t Total Assets i,t 1 Total Assets i,t 1 Total Assets i,t 1 Return to Real EM Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

38 Alternative Hazard Estimation Panel A: Dismissal Hazard (Probability) Estimation (1) (2) (3) (4) (5) (6) (7) (8) IV Probit with OLS with Rare-Event Weibull Gompertz Cox Probit OLS CEO Tenure CEO Tenure Probit Stock return ( 6.95) ( 7.11) ( 7.03) ( 6.61) ( 7.65) ( 6.59) ( 7.69) ( 6.72) Retirement age ( 2.11) ( 2.04) ( 1.96) ( 2.54) ( 3.89) ( 2.03) ( 2.85) ( 2.19) Ownership 5% ( 2.86) ( 2.72) ( 2.63) ( 3.73) ( 7.61) ( 3.26) ( 4.76) ( 5.43) CEO duality ( 2.84) ( 2.69) ( 2.22) ( 4.47) ( 4.20) ( 3.15) ( 2.84) ( 3.31) Board size (1.70) (0.80) (0.65) (3.11) (2.25) (2.79) (1.90) (2.90) Board independence ( 0.17) ( 0.33) ( 0.32) (2.68) (2.33) (2.17) (1.64) (2.28) ln(ceo tenure) ( 6.01) ( 5.73) ( 6.38) Ind. fire (3.92) Constant ( 7.32) ( 9.55) ( 7.00) ( 2.63) ( 5.09) (1.22) (1.73) ln(p) ( 2.96) γ ( 4.54) Industry dummies Yes Yes Yes Yes Yes Observations 16,148 16,148 16,148 15,030 16,148 15,030 16,148 16,148 Panel B: Summary Statistics of Hazard (Probability) Mean Std. dev th percentile th percentile th percentile Max Return to Hazard Return to IV Return to Robustness Cai, Fang, and Li (WARSP 2018) Job Security and Earnings Management August / 34

Relative Compensation and Forced CEO Turnover

Relative Compensation and Forced CEO Turnover Shahbaz Sheikh * Abstract This paper investigates if and how CEO compensation relative to the size and industry adjusted peer groups is related to forced CEO