An empirical analysis of the relation between aggressive behavior and earnings management

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1 An empirical analysis of the relation between aggressive behavior and earnings management Name: Dennis Bouten Date of completing: 2012, June 28 Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 1

2 An empirical analysis of the relation between aggressive behavior and earnings management Master thesis Department Accountancy, Faculty of Economics and Business Studies, Tilburg University Name: Dennis Bouten ANR: Supervisor Tilburg University: Stephan Hollander Supervisor Deloitte: Paul Swirc Date of completing: 2012, June 28 Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 2

3 Preface This master thesis rounds off the Master in Accounting. The writing of the thesis has gone through ups and downs. Especially in the beginning I had some difficulties to define suitable hypotheses. Deloitte gave me the possibility to write my thesis at their office in Breda. Without this possibility, it would have been much harder to motivate myself and finish my thesis within 3 months. In addition, Deloitte gave me access to all facilities I needed. Via this way, I want to thank all employees of Deloitte Breda. In particular, I want to thank Paul Swirc, who was my supervisor at Deloitte. He gave me several real-life examples and we intensively discussed all the aspects of this thesis. A second word of thanks goes to my supervisors of Tilburg University, Stephan Hollander and Yachang Zeng, who asked me to participate in this research. Without their invitation, it would have been much harder to write an interesting thesis like this. Already in December 2011, we had our first group meeting, in which the supervisors introduced their idea. Since we had to handcollect a lot a data, some follow students and I started the data collection procedure in the beginning of this year. I have to thank both supervisors for their enthusiasm and their quick responses to questions. In particular, I appreciate my individual supervisor, Stephan Hollander, for his contribution by reading this thesis and giving feedback, which increased the level of this thesis. Last but not least, I have to thank my family, friends, girlfriend and housemates. Without their involvement, it was impossible for me to motivate myself to write this thesis so quickly. Today I finished my thesis and after defending my thesis, I will continue to challenge myself in the future with what I learned. The working life changed my daily rhythm and leisure time became less, but the writing of this thesis gave me a lot of satisfaction. This is the end of my full-time studying life, and after the summer break, another life will start. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 3

4 Summary Accounting research suggests that aggressive behavior has a negative impact on a firm s reporting quality, but it is hard to empirically capture this. To shed new light on the relation between aggressive behavior and earnings management, this research relies on recent literature in the fields of psychology and sociology. They posit that the facial width to height ratio (WHR) is a reliable cue for aggressive behavior (Carre, McCormick & Mondloch, 2009; Carre, Putman & McCormick, 2009a). The first hypothesis states that aggressive CEOs are more likely to engage in earnings management. The results give some support for this hypothesis, but do not take into account that CEO behavior is balanced by other forces, such as corporate governance. This research develops a new proxy for corporate governance, since previous research documented inconsistent results (Larcker et al., 2007). Assumed is that aggressive boards are more likely to mitigate the likelihood of earnings management, since it is harder for CEOs to overrule/fool these boards. In contrast to the expectations, unaggressive boards mitigate the likelihood of earnings management. In addition, the results show that CEOs only engage in earnings management in the presence of aggressive boards. Additional checks show that board diversity is also a condition for aggressive CEOs to engage in earnings management. This might suggest that aggressive CEOs corroborate with aggressive board members and subsequently overrule /exclude unaggressive board members in order to meet earnings thresholds. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 4

5 Content 1. Introduction Literature Incentives for earnings management Earnings management: Done by CEO or CFO? Corporate governance Facial width to height ratio Hypothesis development Research design Regression model Sample Results Descriptive results Regression model Robustness checks Conclusion and limitations References Appendix 1: Facial WHR Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 5

6 1. Introduction Earnings management is a well-documented topic in accounting research. Firms and managers have several incentives to engage in earnings management, such as avoiding covenant violations, increasing bonuses and meeting or beating analysts forecasts (Burgstahler & Eames, 2006; Dichev & Skinner, 2002; Healy, 1985). Therefore, managers might exercise discretion in reporting an earnings number that is different from the real earnings number. Recent research documents evidence of individual CEO effects on firm policies (Bamber, Jiang & Wang, 2010; Betrand & Schoar, 2003). However, it is not clear which CEO characteristics are driving this. Several researchers (Fosberg, 2011; Tang, Crossan & Rowe, 2011; Jensen, 1993) note that aggressive and powerful CEOs have a negative impact on firms reporting quality, but it is hard to empirically capture this. Research in the fields of sociology and psychology argues that testosterone levels are positively associated with aggressive behavior (Carre, McCormick & Mondloch, 2009; Carre, Putman & McCormick, 2009a). These testosterone levels can be captured by the facial width to height ratio (WHR), which measures the distance between the left and right zygion to the distance between the brow and upper lip. Wong, Ormiston and Haselhuhn (2011) hypothesize and document that firms, whose CEO has a relatively wider face, perform better financially than their competitors. Since the facial WHR is a reliable proxy for aggressive behavior and subsequently influences financial performance, this raises the question whether the reported earnings number is achieved by earnings management. The following research question for this explorative research will be investigated: Is there a relation between aggressive behavior and earnings management? Accounting literature argues that dominant and aggressive CEOs have a negative impact on firms reporting quality (Fosberg, 2011, Tang et al., 2011; Jensen, 1993). Since the facial WHR is a reliable cue of aggressive behavior and individual CEOs can affect firm policies (Carre et al., 2009; Betrand & Schoar, 2003), it is hypothesized that aggressive CEOs, captured by the facial WHR, are more likely to engage in earnings management. One of the goals of corporate governance is to mitigate the likelihood of earnings management. Previous research identified several proxies for effective corporate governance, but reported inconsistent results (Larcker, Richardson & Tuna, 2007). In this research, a new proxy for corporate governance will be developed. The board of directors is active on the highest managerial level and is responsible for advising and monitoring executive management. In addition, it has to ratify important decisions. It is therefore plausible that the board of directors is the most important internal control mechanism. Assumed is that aggressive boards are better able to perform their monitoring and advising tasks, since it is harder for the CEO to overrule these boards, resulting in a lower likelihood of earnings management. The second hypothesis states that aggressive boards mitigate the likelihood of earnings management. Evidence from the S&P 1000 indicates weak evidence that firms of aggressive CEOs are more likely to engage in earnings management. The second hypothesis assumes that aggressive boards mitigate the likelihood of earnings management. In contrast to the expectations, aggressive (unaggressive) boards increase (mitigate) the likelihood of earnings management. Additional checks show that board diversity is also a condition for aggressive CEOs to engage in earnings management. This might suggest that aggressive CEOs corroborate with aggressive board Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 6

7 members and subsequently overrule or exclude unaggressive board members in order to meet earnings thresholds. This thesis contributes to the existing corporate governance and earnings management literature in several ways. Prior studies focused primarily on demographic characteristics, but reported inconsistent results (Larcker et al., 2007). Although both topics are well-documented in accounting literature, little is known about the influence of aggressive behavior on firms reporting quality. This thesis therefore extends prior research by relying on research in the fields of psychology and sociology, which argues that observable physical characteristics impact personal traits. To my knowledge, this research is the first that investigates the relationship between aggressive behavior, captured by the facial WHR, and earnings management. Consistent with previous research, this thesis provides evidence that aggressive behavior has a negative impact on a firm s reporting quality. Even through CEOs and boards with relatively wider faces are more likely to engage in earnings management, it seems unlikely that the facial structure of candidates will be studied when attracting new employees. This research also contributes to the existing literature by developing a new proxy for corporate governance. However, while a negative relation was expected between board aggressiveness and earnings management, the results indicate a positive relation. The remainder of this thesis is organized as follows. Chapter two discusses prior research with respect to earnings management and corporate governance. The hypotheses based upon prior research are developed in the third chapter. Chapter four outlines the research design. The fifth chapter presents the descriptive results and the regression model. The last chapter concludes and gives an overview of the limitations and opportunities for future research. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 7

8 2. Literature This chapter discusses prior research regarding earnings management and corporate governance. The topic of the first paragraph is earnings management and gives an overview of which incentives managers might have to engage in earnings management. Subsequently, the influence of individual managers on earnings management will be discussed. The third paragraph discusses the most important parties with respect to corporate governance. The last paragraph introduces the facial width to height ratio, a new topic in accounting literature Incentives for earnings management Earnings are important statistics for internal (management, employees) and external (shareholders, debt holders, tax authorities) stakeholders. Earnings consist of cash flows and accruals, and the accruals can be divided into discretionary and non-discretionary accruals. The non-discretionary accruals are adjustments to the firm s cash flow and are mandated by Generally Accepted Accounting Principles (GAAP). For example, it is required that fixed assets are depreciated in a systematic manner. In contrast, discretionary accruals are adjustments to cash flows selected by the manager. The manager can choose if he uses the straight line or the accelerated depreciation method to depreciate fixed assets. The result of the accelerated depreciation is that current earnings will be lower, resulting in higher future earnings. This suggests that discretion can be used to shift earnings between periods, which is called earnings management. More formally, earnings management is described as using judgment in financial reporting and in structuring transactions to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting (Healy & Wahlen, 1999, p. 368). Earnings management should not be confounded with fraud. The most important difference is that earnings management occurs within the boundaries of GAAP, while fraud violates GAAP. From the definition of earnings management, it follows that using discretion is something bad. However, earnings management has costs and benefits. The costs are the potential misallocation of resources that arise from earnings management. Benefits include potential improvements in management s communication of private information to stakeholders (Healy & Wahlen, 1999). Judgment is necessary because the goal of using accruals is to report an earnings number that provides a better measure of economic performance than cash flows. Eliminating all flexibility would eliminate the usefulness of earnings. Dechow (1994) argues that earnings are a better prediction of future cash flows than current cash flows. To engage in earnings management, managers must have incentives. These will be discussed below. Avoid debt covenant violations Firms can borrow money by entering into public or private debt contracts. Restrictions to debt covenants are added to reduce the agency problem. This problem might arise because the agent (borrower) will not always act in the best interest of the principal (lender) (Jensen & Meckling, 1976). The borrower has this incentive when he wants to maximize personal utility. Without covenant restrictions, debt holders can claim less collateral in the case of default, since most assets Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 8

9 left the organization. The debt covenant hypothesis the idea that managers make accounting choices to reduce the likelihood of debt covenant violations is investigated by Dichev and Skinner (2002). Based on lending agreements, Dichev and Skinner report an unusually small number of loans with financial measures just below covenant thresholds and an unusually large number of loans just above covenant thresholds. This suggests that managers make accounting choices to avoid covenant violations. Increase compensation Shareholders are the owner of the company, and in an ideal situation, they directly monitor management s actions. However, direct monitoring is practically impossible. Therefore, a board of directors is appointed and management compensation contracts are used. To goal of compensation contracts is to align the interests of management with the interests of the shareholders (Jensen & Meckling, 1973). To ensure that managers will pursue the targets of the shareholders, managers receive stock- and option based compensation. The use of stock- and option based compensation increased significantly during the last two decades, aimed to reduce the agency problem. However, previous research is not consistent whether stock- and option based compensation increased shareholders wealth. Bergstresser and Philippon (2006) provide evidence that CEOs, which compensation is more sensitive to the company s share price, are more likely to engage in earnings management. In addition, highly incentivized managers have incentives to smooth earnings in years with good performance by avoiding large positive earnings surprises (Cheng and Warfield, 2005; Healy, 1985). Healy (1985) notes that managers have incentives to manage earnings (upwards and downwards) in attempt to boost compensation. Healy argues that managers bonuses move between the upper (highest bonus) and lower bound (lowest bonus) and are dependent of performance. When earnings are between the lower and upper bound, the manager has incentive to manage earnings to the upper bound, which increases his/her compensation. When the realized earnings exceed the upper bound or are below the lower bound, managers use discretionary accruals to defer a part of the realized earnings to the next period. Managers will do so, because next year s target will be easier to achieve. Issuing stock Teoh, Welch and Wong (1998) argue that firms manage earnings upwards before the issuance of new stock. They have this incentive, since higher earnings increase the issuance-price of new shares. In the years after the stock issuance, these firms perform significantly worse, suggesting that earnings are managed. Consistent with Sloan (1996), a negative relation exists between the magnitude of earnings management and subsequent stock price returns. This relation is more pronounced for firms whose offers subsequently attract lawsuits, suggesting that these firms opportunistically manipulate earnings (DuCharme, Malatesta & Sefcik, 2004). Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 9

10 Meet thresholds Previous literature identifies three thresholds that managers want to achieve: Report positive earnings, sustain recent performance and meet analysts expectations 1. Meeting thresholds is important, since it has stock price consequences. Meeting or just beating results in an increase in stock prices, while just missing the target is associated with stock price declines (Skinner & Sloan, 2002). Comparing the thresholds, a hierarchy emerges. However, previous research is not consistent about which one is the most important (Brown & Caylor, 2005; Graham, Harvey & Rajgopal, 2005; Dechow, Richardson & Tuna, 2003; DeGeorge et al., 1999). Brown and Caylor document a shift in hierarchy: Until the mid-1990s, the threshold of reporting positive earnings was the most important one, while subsequently meeting analysts expectations became more important. Minimize tax expenses Reported earnings numbers under U.S. GAAP and tax rules are different from each other, which is caused by different reporting rules under each system. In order to increase accounting earnings, managers can decrease tax expenses. However, tax rules allow less discretion than U.S. GAAP (Plesko, 2002). For example, GAAP allows discretion to determine provisions for bad debts. In contrast, tax rules require that receivables are written down when they are no longer collectible and provisions for bad debts are not allowed. Since U.S. GAAP allows more discretion with respect to revenue and expense recognition, earnings management occurs primarily in ways that affect book income, and not taxable income (Phillips, Pincus & Rego, 2003). Avoid industry regulation While most managers and companies have incentives to manage earnings upwards, regulated firms might have the opposite incentive. All firms are regulated to some degree, but this is more pronounced for the banking and utility industry (Healy & Wahlen, 1999). Watts and Zimmerman (1986) argue that "consumer product firms with rapid product price increases are more politically susceptible than other firms and therefore more likely to change accounting procedures to reduce reported profits (p. 362). Han and Wang (1990) note that oil companies, which reported high profits during the Persian Gulf crisis, managed earnings downwards to avoid regulation. Similar results are found in the television and chemical industry during periods of congressional scrutiny to avoid potential regulation (Key, 1997; Cahan, Chavi & Elmendorf, 1997). Horizon problems Expenses with respect to research and development (R&D) are mostly immediately expensed under U.S. GAAP. Since real activities are managed, this is a kind of real earnings management. Managers who want to boost short term earnings, or are close to retirement, have incentives to cut these R&D expenditures, resulting in higher earnings and bonuses. However, reductions in R&D expenditures may damage future earnings since the company has less innovative advantages. Baber, Fairfield and Haggard (1991) argue that changes in R&D spending are associated with a small earnings decline or a small loss. This suggests that managers have incentives to focus 1 Some researchers suggest that the discontinuities in the frequency distribution are not a proxy for earnings management (Durtschi & Easton 2009; Durtschi & Easton 2005) Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 10

11 on short term performance instead of increasing shareholders wealth. In contrast, Dechow and Sloan (1991) note that a decrease in R&D expenditures is associated with managers who are close to retirement, not with poor financial performance. Based on these results, Cheng (2004) investigated whether compensation committees prevent reduction in R&D expenses. The results indicate that when a CEO is close to retirement or when the firm reports a small earnings decline or a small loss, there is a positive relationship between CEO compensation and R&D expenditures. This suggests that compensation committees have the power to mitigate reductions in R&D expenditures Earnings management: Done by CEO or CFO? The neoclassical economic view of the firm argues that managers are homogeneous and that different managers are regarded as perfect substitutes for one another (Betrand & Schoar, 2003). This theory suggests that individual managers cannot affect firm policies. Heterogeneity is also limited by the selection processes of top managers. For example, most CEOs of Fortune 1000 firms are white males with college degrees, many from elite institutions (Datz, 2000). In contrast, the upper echelons theory (Hambrick & Mason, 1984) suggests that individual managers can affect firm s reporting quality. For example, Bamber, Jiang and Wang (2010) provide evidence that demographic characteristics of managers have influence on voluntary disclosures. Betrand and Schoar (2003) argue that certain executives characteristics are associated with conservatism, while other are associated with aggressive strategies. Another indicator that managers matter can be observed from the capital markets: When Armstrong became CEO of AT&T, the market value of AT&T increased with $3.8 billion. The market value of Kodak increased with $1.4 billion when Fisher was announced as CEO. The previous paragraph noted that CEO equity incentives are positively associated with the likelihood of earnings management (Bergstresser & Philippon, 2006; Cheng & Warfield, 2005). The role of the CFO should also be considered, since the CFO is the key player in the financial reporting process. While CEOs can argue that they do not have enough knowledge about financial accounting, this is more difficult for CFOs. Jiang, Petroni and Wang (2010) suggest that CEO and CFO equity incentives are both positively associated with earnings management and this relation is stronger for the CFO. DeJong and Ling (2009) document similar results, but argue that the magnitude of the accruals is smaller for the CFO. A possible explanation is that the CFO is the agent of the CEO (Graham & Harvey, 2000) and a CEO can replace the CFO (Mian, 2001; Fee & Hadlock, 2004). So it may be that the CFO makes decisions consistent with the wishes of their CEO. Geigner and North (2006) show the likelihood of earnings management decreases after the appointment of a new CFO, suggesting that the CFO has less incentives to maximize personal wealth. Feng, Ge, Luo and Shevlin (2011) compared the equity incentives from manipulating and non-manipulating firms. Between both groups, CFO equity incentives are the same. However, CEOs of manipulating firms have higher equity incentives than CEOs of matched firms. This suggests that CFOs become involved in manipulation under pressure from the CEO. Concluding, CEOs and CFOs equity incentives are both positively associated with earnings management, but this relation is stronger for the CEO. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 11

12 2.3. Corporate governance Agency problems arise when agents do to not fully bear the consequences of their decisions. To solve the agency problem and explain how organizations survive, Fama and Jensen (1983) focus on the relationship between ownership (shareholders) and control (management). Without effective control procedures, decision-making managers are more likely to take actions that deviate from the interests of shareholders. In an effective system, decision making should be separated (to some extent) from decision control to mitigate the agency problem. Despite this theory, several scandals occurred. The global financial crisis and the occurrence of several scandals in the last decade have heightened the need for effective corporate governance. The organization for Economic Co-operation and Development (OECD, 2004) argues that effective corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring. Corporate governance involves a set of relationships between a company s management, its board, its shareholders and other stakeholders (OECD, 2004). The most important parties with respect to corporate governance will be discussed below. The board of directors plays a major role in setting strategy, formulating objectives and providing direction for management (COSO, 2012). The board consists of executive (inside) and non-executive (outside) directors (in a one tiered-board). An ideal situation is a combination of both, since executive directors have valuable specific information about the firm while nonexecutive directors are necessary to solve the agency problem. Even if the board delegates a lot of decisions to several management functions, it retains ultimate control. Board members are appointed by nominating committees. When the CEO is involved with nominating board members, he/she might vote for members to which he is personally connected. This board member appears to be independent, but is not independent in fact. Carcello, Neal, Palmrose and Scholz (2011) argue that when the CEO has a seat on the nominating committee, the likelihood of affiliated board members increases, reducing board independence. Nowadays, nominating committees have to be fully independent (Sarbanes-Oxley Act, 2002, section 301). Also, boards with more non-executive directors are more effective, since these firms have a lower likelihood of earnings management (Peasnell, Pope & Young, 2005), shareholders wealth increases in management buyouts (Lee et al, 1992) and CEO turnover of poorly performing firms is higher when the board consists of more nonexecutive directors (Weisbach, 1988). Beasley (1996) investigated the relationship between board independence and financial statement fraud. The results indicate that boards with more nonexecutive directors have a lower likelihood of fraud. This suggests that more independent boards are better able to observe the financial reporting process. Based on best practices, COSO (2010) recommends firms to have a board with a majority of independent members. In most U.S. companies, the CEO is at the head of the board of directors. Some argue that this unitary leadership structure is superior, because it provides a better flow of information to the board of directors. A disadvantage of this system is that it becomes harder for the board to remove this CEO (Goyal & Park, 2002). In contrast, other researchers argue that the dual leadership structure is more effective. When both roles are separated, the board of directors is better able to control opportunistically behavior by the CEO (Fosberg, 2011). Adams et al. (2005) argue that powerful CEOs experience high performance variability; they report big losses or big wins. Even if a Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 12

13 CEO has more power than other executives, this can be constrained if other forces (board of directors, corporate law, CEO personal characteristics) function effectively (Tang et al., 2011). The audit committee is responsible for meeting with the external auditor, overseeing the firm s financial reporting process and reviewing internal controls. To improve financial reporting quality, audit committees should consist of independent members, each of whom is financially literate (BRC 1999). For example, when affiliated directors dominate the audit committee, management can pressure its auditor to issue an unqualified opinion or dismiss her when a going concern opinion is issued (Carcello and Neal, 2003; Carcello and Neal, 2000). To further increase independence, new rules are established that prohibit former employees and family members of the executive team to serve on the audit committee. Several researchers (Abbott, Parker & Peters, 2004; Xie, Davidson & DaDalt, 2002; Klein, 2002) argue that firms with independent audit committees, which meet at least four times a year and have a financial specialist, are more effective. After the occurrence of several scandals in the beginning of 2000, SOX was introduced in June The act brings about some of the largest changes to federal securities laws since the adoption of the securities law in 1933 and To improve financial transparency and corporate governance, SOX limits the providing of audit and non-audit services to the same client and audit committees should consist of fully independent members. Also, the CEO and CFO are required to certify that all reports are fairly presented and every annual report must include an internal control report (SOX 302/404). Prior to SOX, management was the primary driver of corporate governance and auditors perceived audit committees as weak and ineffective (Cohen et al., 2002). Subsequent to SOX, this analysis was repeated. Cohen et al. (2010) argue that auditors perceive audit committees as more active and powerful. However, audit committee members can still be connected to executives. They may have worked together, studied at the same university or play golf in the same golf club. Ties between the CEO and audit committee are positively associated with earnings management, while they are negatively associated with internal control weaknesses in SOX 404 reports (Bruynseels & Cardinaels, 2012). Ownership structures also play a role in reducing the agency problem between management and shareholders. Jensen and Meckling (1976) assume that large shareholders have incentives to monitor management and serve as an extra control mechanism, which reduce the agency problem. Managerial ownership, such as stock- and option based compensation, are also used to mitigate the agency problem. As noted in the previous paragraph, managerial ownership might give managers incentives to cook the books. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 13

14 2.4. Facial width to height ratio The upper echelons theory documents evidence of individuals on firms reporting quality (Hambrick & Mason, 1984). However, it is not clear which characteristics are driving this. Several researchers argue that aggressive and powerful CEOs have a negative impact on firm s reporting quality (Fosberg, 2011; Tang et al., 2011; Jensen, 1993), but it is hard to empirically capture this. Literature in psychology and sociology suggests that testosterone levels influence human behavior, which can be captured by the facial width to height ratio (WHR, Verdonck et al., 1999). This ratio measures the distance between the left and right zygion to the distance between the brow and upper lip. An example is shown in appendix one. The facial WHR emerges due to increased testosterone concentrations at puberty and is independent of body size, race and age (Verdonck et al. 1999). Weston, Friday and Lio (2007) note that growth trajectories of male and female diverge at puberty for bizygomatic width (the width of the face) but not for upper facial height (from upper lip to mid-brown). When the testosterone levels shaped the facial structure during puberty, they influence actual behavior later in life. Comparing the facial WHR of men and woman, men s facial WHR is positively associated with aggressive and dominant behavior, while this relation is insignificant for woman (Carre, Putman & McCormick, 2009a; Carre & McCormick; 2008). Deaner, Goetz, Shattuk and Schonotala (2012) replicated the study of Carre & McCormick, but reported inconsistent results. Carre, McCormick and Mondloch (2009) asked participants to judge pictures of men displaying neutral facial expressions. They conclude that men s with a higher facial WHR are perceived as more aggressive. Another experiment used trust games to investigate the relationship between the facial WHR and male trustworthiness. Participants had the option to collaborate for mutual financial gain or to exploit for greater personal gain. Results suggest that male participants with relatively wider faces are more likely to exploit their counterpart (Stirrat & Perrett, 2010). The relation between unethical behavior and physical traits is investigated by Haselhuhn and Wong (2011). They conclude that only men s facial WHR is positively related to cheating and the use of deception. An interesting result of this research is the inclusion of the role of power. Participants had to answer questions as I can get people to listen to what I say. The results indicate that men s facial WHR is related to power, and power is subsequently related to cheating behavior. This suggests that power mediates the relationship between the facial WHR and cheating. The relation between the facial WHR and power is important, since powerful people focus on the big picture instead of the details, tend to view their external environment optimistically and are more likely to engage in behavior that are consistent with currently held goals (Galinsky, Jordan & Sivanathan, 2008). Based on these findings, Wong, Ormiston and Haselhun (2011) assume and document that firms, whose CEO has a relatively wider face, perform financially superior compared to their competitors. Similar results are documented by Rule and Ambady (2008). They argue that successful and unsuccessful firms can be distinguished based on perceptions of the CEO s face. In contrast, Graham, Harvey and Puri (2010) note that firms of competent looking CEOs receive a higher compensation, but their firms do not perform financially better. Concluding, testosterone levels shape the facial structure during puberty, which influence (actual and perceived) behavior and performance later in life. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 14

15 3. Hypothesis development In this chapter, the hypotheses will be developed. Prior research regarding earnings management, corporate governance and aggressive behavior will be combined. Recent research states that individual executives can affect firm policies (Bamber et al., 2010; Jiang et al., 2010; Betrand & Schoar, 2003). However, it is not clear which characteristics are driving this. Several researchers (Fosberg, 2011; Tang et al., 2011; Jensen, 1993) argue that powerful and aggressive CEOs have a negative effect on firms reporting quality, but it is hard to empirically capture this. Literature in psychology and sociology suggests that testosterone levels are positively associated with dominant and aggressive behavior (Carre et al., 2009; Carre et al., 2009a; Galinsky et al., 2008). These testosterone levels can be captured by the facial width to height ratio (WHR), which is independent of body size, race and age (Verdonck et al. 1999). Wong et al. (2011) provide evidence that firms, whose CEO has a relatively wider face, perform financially superior compared to their competitors. Since the facial WHR is a reliable cue of aggressive behavior and subsequently influences financial performance, this raises the question whether the reported earnings number is achieved by earnings management. Aggressive behavior, captured by the facial WHR, could be an important indicator of earnings management, but research in accounting with respect to this topic is limited. This raises the motivation for this explorative research and the following research question: Is there a relation between aggressive behavior and earnings management? To answer this research question, several hypotheses will be formulated. To engage in earnings management, managers must have incentives, such as avoiding covenant violations and meeting analysts forecasts (Dichev & Skinner, 2002; Burgstahler & Eames, 2006). Feng et al. (2011) suggest that CEOs and CFOs can both exercise discretion over accounting earnings, but this relation is stronger for the CEO. While the CFO has more financial reporting knowledge, the CEO is more incentivized and the CFO serves as the agent of the CEO (Graham & Harvey, 2000; Feng et al., 2011). Since aggressive CEOs have a negative effect on firms reporting quality (Fosberg, 2011; Tang et al., 2011; Jensen, 1993), the first hypothesis assumes that aggressive CEOs are more likely to engage in earnings management. H 1 : Aggressive CEOs are more likely to engage in earnings management The hypothesis above may be too pessimistic, since it does not take into account that CEO behavior is balanced by other forces, such as the board of directors and corporate law. The goal of corporate governance is to provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring (OECD, 2004). Previous research identified several proxies for effective corporate governance, but reported inconsistent results (Larcker et al., 2007). In this research, a new proxy for corporate governance will be developed. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 15

16 The board of directors is active on the highest managerial level and is responsible for advising and monitoring executive management. Even through the board of directors delegates most functions to executive management, it retains ultimate control. In addition, it has to ratify important decisions. It is therefore plausible that the board of directors is the most important internal control mechanism. Tang et al. (2011) document that powerful boards weaken the likelihood that CEOs will report big losses. The main tasks of the board are to monitor and advise executive management. How well the board can fulfill these tasks depends on his aggressiveness. Assumed is that aggressive boards are better able to exercise their tasks, since it is harder for the CEO to overrule these boards, resulting in a lower likelihood of earnings management. The second hypothesis states that aggressive boards mitigate the likelihood of earnings management. H 2 : Aggressive boards mitigate the likelihood of earnings management Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 16

17 4. Research design This chapter discusses the research design. The first paragraph presents the regression model, outlines the data collection procedure and discusses the variables. The second paragraph presents the sample Regression model Previous literature identified several proxies for earnings management by using various accrual measures. Accruals are adjustments to the firm s cash flow. While the non-discretionary accruals are mandated by U.S. GAAP, the discretionary accruals are selected by the manager. When discussing earnings management, researchers focus on the discretionary accruals. Dechow, Sloan and Sweeney (1995) compared five models and suggest that the modified Jones model has the most power to detect earnings management. When the models are applied to a random sample of firms, all of the models appear to be well specified. However, when firms with extreme financial performance are selected, all models (other than the modified Jones) have a low likelihood to detect earnings management. Dechow et al. (1995) highlight the importance of controlling for financial performance, which is done by Kothari, Leone and Wasley (2005). Results indicate that performance matching removes earnings management that is motivated by extreme financial performance. However, even though performance matching increases the power of the model, misspecification problems are still present. This research will be done for the S&P 1000 and data about the facial WHR are only available for the fiscal year Due to a relatively small sample size, the (modified) Jones model is not the best model to detect earnings management. In addition, since the sample period takes places during the financial crisis, accrual-based models might give an implausible view and bias the results. During the financial crisis, most firms perform less than before. Since most firms already perform bad, managers might have incentives to take a big bath, which makes next year s earnings target easier to achieve. Another reason which undermines the use of accrual-based models is that there is a shift from accrual to real-based earnings management after the passage of SOX in 2002 (Cohen, Dey and Lys, 2008). Real-based earnings management suggests that firms manage earnings by real activities, such as providing price discounts to boost sales and overproducing to reduce the cost of goods sold. Graham et al. (2005) argue that managers prefer real-based earnings management instead of accrual-based earnings management, because this is less likely to be detected. In contrast to accrual-based models, real earnings management has direct cash flow consequences. However, since real earnings management does not capture all earnings management, this is also a noisy proxy for detecting earnings management. This thesis will focus on another proxy for earnings management meeting earnings thresholds. This proxy has more direct market consequences relative to other proxies, such as abnormal accruals. Skinner and Sloan (2001) argue that meeting earnings thresholds results in higher stock prices, while missing them results in lower stock prices. In addition, this proxy incorporates the effect of cash flow manipulation. Graham et al. (2005) argue that CFOs prefer just meeting thresholds, since this increases creditability and makes it easier to achieve next year s Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 17

18 target. If management is unable to meet an earnings threshold, the market interprets this as the existence of certain problems at the firm. Previous literature identifies three thresholds that managers want to achieve (Brown & Caylor, 2005; DeGeorge et al., 1999): reporting positive earnings, sustaining recent performance and meeting analysts expectations. Brown and Caylor (2005) compared the thresholds and documented a shift in hierarchy: Until the mid-1990s, reporting positive earnings was the most important one. Subsequently, meeting analysts expectations became more important, followed by sustaining recent performance. Consistent with Cheng and Warfield (2005), meeting and just meeting thresholds will be used as an indicator of earnings management. This results in six proxies for earnings management. However, due to the lack of sufficient data, there is a very small number of firms that reported an earnings per share (EPS) of zero and just above zero. Therefore, (just) reporting positive earnings will not be used as an indicator of earnings management. This leaves four proxies for earnings management. The first two proxies relate to meeting analysts expectations, which is achieved by managing earnings upwards and forecasts downwards (Brown & Eames, 2006; DeGeorge et al., 1999). Managers have incentives to meet analysts expectations, but analysts try to anticipate reported earnings. This results in an interesting game, since analysts predict an earnings number that subsequently will be manipulated in response to their prediction. Analysts expectations are managed downwards during conference calls, in which executives influence analysts by telling them in which directions they have to think about next period s earnings. (DeGeorge et al., 1999). Consistent with previous research, two proxies will be used to identify whether analysts expectations are met (Vafeas, 2005; Cheng & Warfield, 2005; Matsumoto, 2002). The first threshold (ANALYST) is met when the earnings surprise (actual EPS expected EPS) is positive. The second threshold (JUST-ANALYST) is met when the earnings surprise is between 0,00 and 0,01 cents over the median analyst forecast. To obtain relevant results, the last forecast prior to the announcement of annually earnings will be taken. In order to compare apples with apples, both numbers will be obtained from I/B/E/S, since the same earnings components are included and excluded in the realized and forecasted earnings number. The third and fourth proxy relate to sustaining recent performance. Based on interviews with CFOs, Graham et al. (2005) document that executives care most about growth in earnings. The importance of sustaining performance is strengthened by firms policymakers. For example, in the annual report of Coca Cola of 2011, they state that these performance share units require achievement of certain financial measures, primarily compound annual growth in earnings per share. (Annual report Coca Cola 2011, p. 115) Myers, Myers and Skinner (2006) find that firms reporting continuous growth in annual earnings are priced at a premium, which increases with the length of the string. This premium reduces when the string is broken, given managers incentives to manage earnings upwards. These firms also smooth their earnings, which makes next year s target easier to achieve. Just meeting thresholds result in higher stock prices, while the incremental effect of exceeding thresholds is limited (Skinner & Sloan, 2002). Two proxies will be used to determine whether a firm was able to sustain their financial performance. The first one (SUSTAIN) is met when a firm reported a higher earnings number in 2009 than in The second threshold (JUST- SUSTAIN) is met when the reported earnings number is the same or a maximum of 2% higher than previous year s earnings (Vafeas, 2005). Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 18

19 To examine the relation between aggressive behavior and earnings management, logistic regressions will be used. Earnings management is captured by four proxies: Meeting analysts expectations (ANALYST), just meeting analysts expectations (JUST-ANALYST), sustaining recent performance (SUSTAIN) and just sustaining recent performance (JUST-SUSTAIN). For simplicity, only two regression models will be developed, which will control for effects of factors that have previously been shown to be associated with earnings management. The dependent variable takes the value 1 if a threshold is met and 0 otherwise. Regressions are done on annual data, since these are audited by the external auditor. Since quarterly data are not audited, they give less assurance that the reported earnings numbers are within the boundaries of GAAP. The regression model below is based on the model of Vafeas (2005) and will be used to test the first hypothesis. Vafeas model controls for several board and audit committee characteristics. These are replaced by a variable that captures aggressive CEO behavior (CEO). To the model of Vafeas, three variables of Matsumoto (2002), which are also associated with meeting analysts expectations, are added. The second regression model is identical to the first, but the CEO variable will be replaced by variables that also control for aggressive board behavior. P(EM) = ß 0 + ß 1 *CEO + ß 2 *INSIDE + ß 3 *M2B + ß 4 *LITIGATION + ß 5 *LOSS + ß 6 *MV + ß 7 *DUR + ß 8 *R&D + ß 9 *LABOR + ß 10 *POSUE + ß 11 *#FE + e P(EM) = 1 if the earnings threshold is met; 0 otherwise CEO = 1 if the facial WHR of the CEO belongs to the 30% highest facial WHRs of all CEOs in the S&P 1000; 0 otherwise INSIDE = Percentage of common stock owned by top 5 executives at fiscal yearend M2B = Market capitalization divided by book value of equity at fiscal year-end LITIGATION = 1 is company belongs to SIC codes (biotechnology), and (computers), (electronics) or (retailing); 0 otherwise LOSS = 1 is the company reported negative earnings; 0 otherwise MV = Natural logarithm of market capitalization at fiscal year-end DUR = 1 if the company is active in the durable goods industry (SIC codes , 2450, , 2830, 3010, ); 0 otherwise R&D = R&D / total assets LABOR = 1 (gross property, plant and equipment divided by total gross assets) POSUE = 1 if the firm reports a positive change in earnings compared to previous year; 0 otherwise FE = (Reported earnings number 1 st forecast of the fiscal year) / stock price at the beginning of the fiscal year Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 19

20 Main variables of interest Research in psychology and sociology argues that aggressive behavior can be captured by the facial WHR (Wong et al., 2011; Carre et al., 2009; Weston et al., 2007). This ratio measures the distance between the left and right zygion to the distance between the brow and upper lip. In the first step, EXECUCOMP is used to identify all CEOs and board members for fiscal year Firms with female CEOs are excluded, since the facial WHR is only a proxy for aggressive behavior in men (Haselhuhn and Wong, 2011; Carre and McCormick, 2008). Subsequently, students started the data collection procedure. To find the right pictures, the CEOs (board) first and family name (obtained from EXECUCOMP) are entered in google images. When no picture was found, the company name was added in the search bar. When still no image is found, the company s website, Forbes website and the company s annual report are consulted. If more than one picture for the same person is found, the best picture is selected. This is the one with a neutral face expression and is facing forward. As last, all photos are entered in a self-developed software tool, which measures the facial WHR. Manual tests are done to prove the accuracy of the software tool. The first hypothesis assumes that aggressive CEOs are more likely to engage in earnings management, since aggressive CEOs have a negative impact on firms reporting quality (Fosberg, 2011; Tang et al., 2011; Jensen; 1993). A dummy variable will be used to capture aggressive behavior and takes the value 1 if the CEO is aggressive. Since the facial WHRs of all CEOs are normally distributed (untabulated), the group is not split at the average/median. Aggressive CEOs (CEO) are those whose facial WHR belong to the 30% highest facial WHRs of all CEOs in the S&P A positive sign on CEO is expected. The second hypothesis states that aggressive boards (BOD) mitigate the likelihood of earnings management. The rationale behind this is that it is harder for CEOs to overrule aggressive boards. Assumed is that aggressive boards are those which median facial WHRs belong to the 30% highest facial WHRs of all boards in the S&P For the second hypotheses, all sample firms are classified into three groups based on the 30% highest values on CEO and BOD: CEO low : The company has an unaggressive CEO (CEO<2,17). This dummy variable is the base level and will not be included in the regression model. CEO high -BOD low : The company has an aggressive CEO (CEO>2,17), but no aggressive board (BOD<2,19). A positive sign on this coefficient is expected. CEO high -BOD low : The company has an aggressive CEO (CEO>2,17) and board (BOD>2,19). No significant sign on this coefficient is expected. Control variables Following prior research, several control variables that might be correlated with meeting earnings thresholds are included. Meeting thresholds results in higher stock prices, which increase the value of shares held by executives (INSIDE). Since incentivized managers are more likely to engage in earnings management, a positive sign on INSIDE is expected. (Vafeas, 2005; Cheng & Warfield, 2005; Bergstresser & Phillipon, 2006). Meeting or just beating an earnings benchmark results in higher stock prices, while just missing the target is associated with stock price declines (Skinner and Sloan, 2002). Since growth stocks exhibit an asymmetrically large negative price response to bad news, managers of growth firms (M2B) have more incentives to engage in earnings Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 20

21 management. Lower stock prices can precipitate shareholder litigation (Ali & Kallapur, 2001). To avoid lawsuits, firms with high litigation risk (LITIGATION) have incentives to meet earnings thresholds (Matsumoto, 2002). Consistent with previous literature (Vafeas, 2005; Matsomoto, 2002), a dummy variable is used to identify industries with a high litigation risk. Firms with negative earnings (LOSS) have fewer incentives to meet or beat analyst s expectations, therefore a negative coefficient is expected (Vafeas, 2005; Matsumoto, 2002). Since larger firms spend more on R&D and have scale advantages, they are more likely to achieve earnings thresholds (Cheng & Warfield, 2005; Vafeas, 2005; Matsomoto, 2002). Firm size is captured by the natural logarithm of equity capitalization (MV). Matsumoto (2002) investigated which firm characteristics are associated with meeting analysts expectations. These are added to the model of Vafeas. Besides stakeholders and management, other stakeholders (suppliers, customers, employees) also rely on firm s financial reporting. These stakeholders have a limited ability to fully process all information about the company, and therefore rely on analysts consensus. Bowen et al. (1995) and Matsumoto (2002) argue that those firms, which rely on implicit claims with their stakeholders, are more likely to engage in earnings management. The degree to which these firms rely on implicit claims is captured by: Membership in a durable goods industry (DUR), using the SIC codes: , 2450, , 2830, 3010 and , Research and Development (R&D) expenditures scaled by total assets (R&D), and A measure of labor intensity (LABOR), equals to 1 minus the ratio of gross total property, plant and equipment to gross total assets Assumed is that firms with higher values for each of these variables, rely more on implicit claims with their stakeholders. Consistent with Matsumoto (2002), positive coefficients on these variables are expected. A firm s previously reported earnings number is also associated with the likelihood of earnings management. Matsumoto provides evidence that firms that increased their performance (POSUE) are more likely to achieve analysts expectations (Matsumoto, 2002). Consistent with Matsumoto, a positive sign on POSUE is expected. For analysts, it is hard to determine expected earnings when firms earnings are volatile. Cheng and Warfield (2005) and Matsumoto (2002) argue that firms with volatile earnings are more likely to meet analysts expectations, but this holds only for firms with positive earnings surprises (actual EPS expected EPS). Consistent with Matsumoto (2002), volatility is measured by the initial forecast error (FE). This is the difference between actual EPS and the first analyst expectation of the fiscal year, scaled by the share price at the beginning of the fiscal year. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 21

22 4.2. Sample The initial sample for both hypotheses contains all firms listed on the S&P 1000 for the fiscal year Since women s facial WHR is not a proxy for aggressive behavior, these are excluded. For several CEOs and board members, no pictures were found or the quality was too bad. In total, for 310 firms, students collected pictures from the CEO and all (2548) board members. Subsequently, financial institutions (SIC codes ) and utilities (SIC codes ) are excluded, since regulated firms have different incentives than non-regulated firms (Vafeas, 2005). For example, oil companies managed earnings downwards in periods of high profits to avoid regulation (Han & Wang, 1990). This reduces the sample with 77 observations. Consistent with Vafeas (2005), regressions are done on annual data. For the remaining observations, information on analyst forecasts and on the corresponding actual earnings per share (EPS) figures is collected from Institutional Brokers Estimate System (I/B/E/S). Subsequently, firms for which COMPUSTAT and EXECUCOMP provide insufficient financial data are deleted. This leaves a final sample of 227 observations. The results are shown in table 1. Table 1: Sample Sample # Firms S&P No picture / woman Financial institutions and utilities 77 - No I/B/E/S data 5 - No EXECUCOMP data 0 - No COMPUSTAT data 1 Final sample 227 Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 22

23 5. Results This chapter discusses the results. The first paragraph shows some descriptive results. The second paragraph presents the regression model and discusses the results. Some robustness checks are done in the third paragraph Descriptive results This paragraph reports several descriptive results. Table 2 gives an overview of all earnings surprises (table 2a) and earnings changes (table 2b) of the S&P 1000 for the fiscal year To calculate the earnings surprise, the median analysts forecast is subtracted from the actual EPS. Consistent with Cheng and Warfield (2005), there are more firms that met and exceeded analysts forecasts (80%) than firms that missed analysts forecasts (20%). Of all earnings surprises, 8% of the firms had an earnings surprise of 0 cent, while 5% (3%) missed analysts expectations by 1 (2) cent. In contrast to Cheng and Warfield, table 2a reports a lower percentage of firms that just meet analysts expectations (0 and 1 cent). A plausible explanation is that it was harder for analysts to judge firms earnings during the financial crises. Table 2b shows an overview of all earnings changes. Since the variation in earnings changes is large, the earnings changes are assigned to a 10% interval. Even though the most firms reported an earnings decrease (62%), the number of firms that just increased performance (30) is greater than the number of firms that reported a small earnings decrease (24). Table 2a: Earnings surprises Table 2b: Earnings changes Cents # % % Change # % -<5 19 8% <-50% 47 21% % -50% - -40% 19 8% % -40% - 30% 13 6% % -30% - -20% 18 8% % -20% - -10% 19 8% % -10% - 0% 24 11% % 0% - 10% 30 13% % 10% - 20% 25 11% % 20% - 30% 9 4% % 30%- 40% 9 4% > % >40% 14 6% Total % Total % Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 23

24 Descriptives Descriptive statistics on the dependent variables, main variables of interest and control variables are reported in table 3. To reduce the influence of outliner observations, the continuous variables are winsorized at the 1 st and 99 th percentiles. All numbers are based on 227 observations. The first proxy for earnings management is meeting analysts expectations. Of the S&P 1000, 80% of the firms met or beat analysts forecasts (ANALYST). This percentage is almost 15% higher than the percentage reported in Matsumoto (2002). For this difference, there are two plausible explanations. Firstly, Matsumoto reported an increase in the percentage of firms that meet analysts expectations over time. This is caused by a greater analyst following and an increasing effort over time by I/B/E/S to ensure a consistency between expected and realized earnings (Beaver et al., 2008). Secondly, it is hard for analysts to determine expected earnings during crises. This suggests that analysts were too pessimistic about companies earnings. Just meeting analysts expectations (JUST-ANALYST) is achieved by 15% of the firms. The third proxy for earnings management is sustaining recent performance. 38% of the sample firms reported a higher earnings number in 2009 than in the year before (SUSTAIN), while only 4% reported an earnings number that was a maximum of 2% higher than in 2008 (JUST-SUSTAIN). The second and third blocks show the main variables of interest (continuous and discrete). The average facial CEO WHR is 2,09, while this ratio for board members is 2,15. This difference is significant at the 1% level (untabulated). This can be caused by the fact that the facial CEO WHR is measured conservatively. Aggressive CEOs (CEO) are those which facial WHR belong to the 30% highest facial WHRs of all CEOs in the S&P Based on this assumption, the discrete average CEO is 0,30. Aggressive boards are those whose facial WHRs belong to the 30% highest facial WHR of all boards in the S&P For the second hypothesis, dummy variables are used to capture CEO behavior (aggressive or unaggressive) and board behavior (aggressive or unaggressive). This results in 3 dummy variables. The base level is CEO low and is the complement of CEO. Of the firms with an aggressive CEO, 20% have an unaggressive board (CEO high -BOD low ), while 10% have an aggressive board (CEO high -BOD high ). Not surprisingly, the sum of the three dummies is equal to 1. Top 5 executives own on average 0,21% of the shares (INSIDE), while the median executives own only 0,05% of the shares. This suggests that some executives possess a relatively high percentage of the shares. These percentages cannot be compared to those reported in Vafeas (2002), since he documents no descriptive statistics about all variables. Of the S&P 1000, 32% of the firms are active in a high litigation risk industry (LITIGATION) and 6% reported negative earnings (LOSS) in All firms in the sample are relatively large (MV), since they represent the S&P However, some sample firms are very large, since the average MV is much higher than the median MV. Comparing the variables that proxy for firms which rely on implicit claims with their shareholders with those of Matsumoto (2002), there are some differences. Table 3 reports a lower percentage of firms that are active in the durable goods industry (DUR) and firms are less labor intensive (LABOR), while the expenses with respect to R&D (R&D) doubled. This suggests that larger firms spend relatively more on R&D and have more fixed assets. Matsumoto (2002) reported that 66% of the firms were able to increase their earnings. In 2009, only 38% of the firms reported an earnings increase. This can be imputed to the financial crisis. The average forecast error (FE) in both tables is equal. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 24

25 Table 3: Descriptive results Explanatory variables Mean Median Min. Max. Dependent variables ANALYST 0,80 1,00 0,00 1,00 JUST-ANALYST 0,15 0,00 0,00 1,00 SUSTAIN 0,38 0,00 0,00 1,00 JUST-SUSTAIN 0,04 0,00 0,00 1,00 Main variables of interest (continuous) CEO 2,09 2,09 1,78 2,43 BOD 2,15 2,15 1,98 2,35 Main variables of interest (discrete) CEO 0,30 0,00 0,00 1,00 CEO low 0,70 1,00 0,00 1,00 CEO high -BOD low 0,20 0,00 0,00 1,00 CEO high -BOD high 0,10 0,00 0,00 1,00 Control variables INSIDE 0,21 0,05 0,00 3,30 M2B 1,31 1,09 0,20 4,62 LITIGATION 0,32 0,00 0,00 1,00 LOSS 0,06 0,00 0,00 1,00 MV 241,9 79,8 7, ,9 DUR 0,41 0,00 0,00 1,00 R&D 0,03 0,01 0,00 0,19 LABOR 0,60 0,63 0,09 0,93 POSUE 0,38 0,00 0,00 1,00 FE -0,01 0,00-0,25 0,24 - The four dependent variables are dummy variables and take the value 1 if a certain earnings threshold is met and 0 otherwise. In order to compare 'apples' with 'apples', all earnings numbers are subtracted from I/B/E/S. Only in this table, for the main variables of interest, the continuous and discrete numbers are reported. For descriptive purposes, statistics on the actual, rather than the log. market value of equity (MV) are presented (in millions). For the remaining tables, the log of market value of equity is used. Univariate results The previous table presented descriptive statistics about all sample firms. In this paragraph, firms of aggressive and unaggressive CEOs will be compared. In the first two columns of table 4, the Levene test for equality of variances is performed. The results indicate that the variances for the variables JUST-SUSTAIN, CEO and LITIGATION are significantly different for firms with aggressive and unaggressive CEOs. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 25

26 Subsequently, the means of both groups are compared. Column 3 represents firms with aggressive CEOs and column 4 represents firms with less (no) aggressive CEOs. Firms with aggressive CEOs are more likely to meet the four earnings thresholds, since all differences (aggressive unaggressive) are positive. However, from a statistical point of view, there is only evidence that aggressive CEOs are more likely to just sustain financial performance (p-value 0,04). Based on these results, there is some evidence that aggressive CEOs are more likely to engage in earnings management. Comparing the board facial WHRs of both groups, no difference emerges. Comparing the control variables, firms of aggressive CEOs are more likely to be active in high litigation risk industries and aggressive CEOs own a lower percentage of shares. However, these differences are not significant at the 10% level. The other control variables also show no significant differences between both groups of firms 2. Table 4: Univariate results Explanatory variables Levene statistic Sig. CEO Diff. t-stat. Sig. aggressive unaggressive Dependent variables ANALYST 1,54 0,22 0,83 0,79 0,04 0,61 0,55 JUST-ANALYST 0,61 0,44 0,16 0,14 0,02 0,40 0,69 SUSTAIN 2,26 0,13 0,42 0,36 0,06 0,85 0,40 JUST-SUSTAIN 34,45 0,00 0,09 0,01 0,07 2,10 0,04 Main variables of interest (continuous) CEO 10,25 0,00 2,27 2,00 0,26 21,67 0,00 BOD 0,10 0,76 2,15 2,15 0,00 0,17 0,87 Control variables INSIDE 1,16 0,28 0,19 0,22-0,03-0,35 0,73 M2B 0,27 0,60 1,33 1,30 0,04 0,30 0,77 LITIGATION 6,76 0,01 0,39 0,29 0,10 1,44 0,15 LOSS 0,78 0,38 0,07 0,06 0,02 0,45 0,66 MV 1,24 0,27 7,95 8,00-0,04-0,50 0,62 DUR 1,48 0,23 0,45 0,40 0,05 0,71 0,48 R&D 0,82 0,37 0,03 0,03 0,00-0,49 0,63 LABOR 0,01 0,95 0,60 0,60 0,00 0,02 0,98 POSUE 2,26 0,13 0,42 0,36 0,06 0,85 0,40 FE 0,03 0,87-0,01-0,01 0,00 0,09 0,93 - Aggressive CEOs are those whose facial WHR belong to the 30% highest facial WHRs of all CEOs in the S&P The Welch and Brown-Forsythe tests are performed to test for robustness. Results indicate no differences compared with the Levene test. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 26

27 Correlation matrix The correlation matrix is shown in table 5. Three of the six correlations between the four proxies for earnings management are significantly positive. The highest correlations exist between ANALYST and JUST-ANALYST (0,205) and between SUSTAIN and JUST-SUSTAIN (0,245). The correlation between JUST-SUSTAIN and ANALYST (JUST-ANALYST) is insignificant, which indicates that they capture different types of earnings management. The first hypothesis assumes a significant relation between aggressive CEOs and earnings management. CEO is positively correlated with all proxies for earnings management, but only the correlation between CEO and JUST-SUSTAIN is significant (0,185). Based on these correlations, there is some evidence that aggressive CEOs are more likely to engage in earnings management. The second hypothesis assumes that aggressive boards mitigate the likelihood of earnings management. The correlation between CEO high -BOD high and JUST-SUSTAIN is significant (0,253), suggesting that firms with aggressive CEOs and boards are more likely to report a small earnings increase. In addition, the correlation between CEO high -BOD high and ANALYST becomes significantly positive (0,13). In contrast to the expectations, these results indicate that aggressive boards increase, rather than mitigate, the likelihood of earnings management. Aggressive CEOs are more likely to just sustain financial performance, but the correlation (0,023) becomes insignificant when firms have unaggressive boards (CEO high -BOD low ). Concluding, aggressive CEOs are more likely to engage in earnings management, and is strengthened (mitigated) by aggressive (unaggressive) boards. Some variables that capture aggressive CEO/board behavior are significantly correlated with the several proxies for earnings management, but none of them are correlated with the control variables. Consistent with previous research, there is weak evidence that inside ownership (INSIDE) is positively related with earnings management (Cheng & Warfield, 2005; Vafeas, 2005). In line with Vafeas (2005) and Matsumoto (2002), firms with high growth opportunities (M2B) and firms with a high litigation risk (LITIGATION) are more likely to engage in earnings management. The correlation between firms with negative earnings (LOSS) and the several proxies for earnings management are all negative, but in contrast to previous research, neither of them is significant (Vafeas 2005; Matsumoto 2002). In addition, there is no evidence that larger firms are more likely to achieve earnings thresholds. This can be explained by the fact that all firms in the sample are relatively large, since the sample consists of firms in the S&P Several variables that proxy for firms that rely on implicit claims with their shareholders correlate significantly with the different proxies for earnings management. Also, the correlation between these variables is significant (0,332, 0,310 and 0,242). This is not surprising, since these are meant to proxy for essentially the same. Therefore, the principal components method of factor analysis is used to reduce the three variables to a single variable (ICLAIM) 3. Three of the four correlations between POSUE and the proxies for earnings management are significantly positive, suggesting that firms with an increase in earnings are more likely to meet earnings thresholds. At last, there is some evidence that firms for which analysts make too optimistic expectations (FE) are more likely to sustain performance. 3 Retaining factors with eigenvalues greater than 1 results in the retention of one factor, consistent with the assumption that the three factors proxy for a single variable. The correlation between the new variable (ICLAIM) and the individual variables (DUR, R&D, and LABOR) are 0,768, 0,717 and 0,697. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 27

28 Table 5: Correlation matrix Pearson-correlation (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) (17) ANALYST (1) 1,205**,161* 0,095 0,04-0,052,130* 0,086 0,085,224** -0,056 0,025 0,059,228** 0,088,161* 0,099 JUST-ANALYST (2),205** 1 0,116 0,057 0,026-0,021 0,069-0,074 0,084 0,037-0,106 0,053 0,059 0,111,158* 0,116 0,04 SUSTAIN (3),161* 0,116 1,245** 0,056 0,036 0,039,161*,322**,162* -0,087 0,022-0,103,180**,235** 1,000**,198** JUST-SUSTAIN (4) 0,095 0,057,245** 1,185** 0,023,253** -0,009 0,012 0,073-0,049-0,021 0,033 0,086 0,073,245** 0,039 CEO (5) 0,04 0,026 0,056,185** 1,763**,508** -0,023 0,02 0,099 0,03-0,033 0,047-0,033 0,001 0,056 0,006 CEO high -BOD low (6) -0,052-0,021 0,036 0,023,763** 1 -,169* 0,005 0,01 0,052 0,099 0,008-0,001-0,094-0,017 0,036-0,072 CEO high -BOD high (7),130* 0,069 0,039,253**,508** -,169* 1-0,042 0,017 0,081-0,086-0,062 0,073 0,076 0,025 0,039 0,105 INSIDE (8) 0,086-0,074,161* -0,009-0,023 0,005-0,042 1,191**,140* -0,034-0,013 -,141* 0,006 0,08,161* -0,006 M2B (9) 0,085 0,084,322** 0,012 0,02 0,01 0,017,191** 1,286** -,204**,250** -0,071,369**,205**,322**,133* LITIGATION (10),224** 0,037,162* 0,073 0,099 0,052 0,081,140*,286** 1-0,02 0,1,149*,495**,225**,162* 0,004 LOSS (11) -0,056-0,106-0,087-0,049 0,03 0,099-0,086-0,034 -,204** -0,02 1 -,177**,156* 0,1 -,144* -0,087 -,496** MV (12) 0,025 0,053 0,022-0,021-0,033 0,008-0,062-0,013,250** 0,1 -,177** 1-0,054 0,038 0,02 0,022 0,121 DUR (13) 0,059 0,059-0,103 0,033 0,047-0,001 0,073 -,141* -0,071,149*,156* -0,054 1,332**,310** -0,103-0,058 R&D (14),228** 0,111,180** 0,086-0,033-0,094 0,076 0,006,369**,495** 0,1 0,038,332** 1,242**,180** 0,107 LABOR (15) 0,088,158*,235** 0,073 0,001-0,017 0,025 0,08,205**,225** -,144* 0,02,310**,242** 1,235** 0,097 POSUE (16),161* 0,116 1,000**,245** 0,056 0,036 0,039,161*,322**,162* -0,087 0,022-0,103,180**,235** 1,198** FE (17) 0,099 0,04,198** 0,039 0,006-0,072 0,105-0,006,133* 0,004 -,496** 0,121-0,058 0,107 0,097,198** 1 **. Correlation is significant at the 0.01 level (2-tailed) *. Correlation is significant at the 0.05 level (2-tailed) Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 28

29 5.2. Regression model The regression model is shown in table 6. The dependent variables are ANALYST, JUST-ANALYST, SUSTAIN and JUST-SUSTAIN. All four models, except the second, are significant at the 1% level 4,5,6. Since the Cox & Snell R 2 and Nagelkerke R 2 are not reported in previous research (Matsumoto, 2002; Vafeas, 2005; Cheng & Warfield, 2005), a comparison of them is therefore not possible. The regression model in the columns 1, 5, 9 and 13 are used to test the first hypothesis. Columns 3, 7, 11 and 15 are used to test whether aggressive boards mitigate the likelihood of earnings management. The results from table 6 indicate that all coefficients on CEO are positive, but only the coefficient in column 13 (JUST-SUSTAIN) is significant at the 10% level (p-value 0,02). This suggests that there is some evidence that aggressive CEOs are more likely to engage in earnings management and gives some support to the first hypothesis. When the board aggressiveness variables are added to the model, there is a limited increase in the power of the several models. The coefficients on CEO high -BOD low and CEO high -BOD high in column 3, 7 and 11 are all insignificant. This suggests that aggressive CEO and board behavior is not associated with (just) meeting analysts forecasts and sustaining recent performance. However, the coefficient on CEO high -BOD high in column 15 (JUST-SUSTAIN) is significant (p-value 0,00), while the coefficient on CEO high -BOD low is insignificant (p-value 0,32). These results indicate that aggressive CEOs are more likely to report a small earnings increase, but only when the board is also aggressive. This finding is contrary to the expectations, and therefore the second hypothesis is rejected. In contrast with previous research, most of the control variables are not significant at the 10% level. This suggests that firms had fewer incentives to (just) meet earnings thresholds during the crisis of The control variables in table 6 confirm that different firm characteristics are associated with meeting and just meeting earnings thresholds (Matsumoto, 2002). Consistent with Vafeas (2005), incentivized executives (INSIDE) and growing firms (M2B) are more likely to report an earnings increase. The results also indicate that firms within high litigation risk industries (LITIGATION) are more likely to meet analysts expectations. In contrast to previous research (Matsumoto, 2002), there is no evidence that firms making loss (LOSS) are less likely to achieve earnings thresholds. In addition, the results provide no evidence that larger firms (MV) are more likely to achieve thresholds. This is not surprising, since all sample firms are large. The variable ICLAIM is positively related with JUST-ANALYST. This indicates that firms, which rely on implicit claims with their stakeholders, are more likely to just meet analysts expectations. Consistent with previous research, firms with a positive forecast error (FE) are more likely to sustain financial performance (Matsumoto 2002). 4 The second model (JUST-ANALYST) becomes significant at the 1% level when the dependent variable (earnings surprise) is between 0,00 and 0,02 cents over the median analyst forecast. However, the coefficients on the main variables of interest are still insignificant. 5 Collinearity diagnostics on the final model are conducted. In all regressions, values on VIF are between 1.1 and 1,6, suggesting that collinearity is not a problem. 6 Tests for heteroskedasticity cannot be performed, since SPSS does not include this function. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 29

30 Table 6: Meeting earnings thresholds Explanatory variables expec. ANALYST JUST-ANALYST SUSTAIN JUST-SUSTAIN sign β Sig. β Sig. β Sig. β Sig. β Sig. β Sig. β Sig. β Sig. Main variables of interest (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) CONSTANT 0,30 0,91 0,15 0,96-3,21 0,26-3,42 0,23 0,32 0,88 0,37 0,87-22,73 0,99-32,29 0,99 CEO + 0,10 0,79 0,14 0,74 0,24 0,47 2,11 0,02 CEO high -BOD low + -0,28 0,52-0,05 0,92 0,31 0,41 1,12 0,32 CEO high -BOD high not significant 1,57 0,14 0,44 0,45 0,10 0,84 3,61 0,00 Control variables INSIDE + 0,54 0,37 0,58 0,34-0,69 0,26-0,69 0,27 0,53 0,09 0,53 0,09-0,23 0,83-1,07 0,55 M2B + -0,13 0,59-0,14 0,56 0,05 0,83 0,05 0,83 0,74 0,00 0,74 0,00-0,77 0,16-1,06 0,16 LITIGATION + 1,27 0,02 1,26 0,02-0,24 0,60-0,25 0,59 0,26 0,46 0,26 0,46-0,20 0,83-0,46 0,68 LOSS - -0,14 0,87 0,02 0,98-19,89 1,00-19,87 1,00 0,39 0,63 0,36 0,66-26,62 1,00-35,78 1,00 MV + 0,09 0,77 0,11 0,73 0,15 0,66 0,18 0,61-0,26 0,36-0,26 0,35-0,13 0,86 0,42 0,61 ICLAIMS + 0,27 0,17 0,27 0,17 0,43 0,05 0,42 0,06 0,10 0,54 0,11 0,52 0,67 0,17 0,63 0,26 POSUE + 0,65 0,13 0,66 0,13 0,65 0,13 0,67 0,12 21,74 0,99 27,58 0,99 FE + 3,26 0,42 3,07 0,46-4,52 0,47-4,92 0,43 9,70 0,01 9,84 0,01-45,74 0,32-81,97 0,18 Significance/power of models Chi-square 21,38 25,41 14,85 15,33 38,56 38,69 27,75 37,10 Sig. 0,01 0,01 0,10 0,12 0,00 0,00 0,00 0,00 Cox & Snell R 2 0,09 0,11 0,06 0,07 0,16 0,16 0,12 0,13 Nagelkerke R 2 0,14 0,17 0,11 0,12 0,21 0,21 0,44 0,50 - Logistic regressions are used to test the impact of aggressive behavior on earnings management. The first model controls only for aggressive CEOs, while the second controls also for board aggressiveness. The dependent variable in the regression model takes the value 1 if an earnings threshold is met and 0 otherwise. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 30

31 5.3. Robustness checks For 310 firms, students collected pictures of CEOs and all board members. However, some people on the pictures looked a little bit skew or the picture had a low resolution. Unreported results indicate that the difference in the facial WHR of CEOs between high and low quality pictures is significant at the 5% level (2,07 vs. 2,13). In addition, the facial WHR of board members is lower for high quality pictures (2,13) than for low quality pictures (2,19). This difference is also significant. Since all pictures are rated by an independent person (1 bad quality, 0 high quality), the analysis of table 6 can be refined. To the regression model, two variables are added that control for the quality of the pictures: Q_CEO: 1 if the CEO picture is rated as a high quality picture; 0 otherwise Q_BOD: Value between 0 and 1, dependent on the percentage of high quality board pictures Comparing the several R 2 s with table 6, table 7 reports a limited increase in power. All the coefficients on Q_CEO are insignificant. The coefficients on Q_BOD in column 7, 9 and 11 are significantly positive (p-values of 0,10, 0,07 and 0,08). This indicates that board members, whose facial WHR is measured accurately, have more incentives to engage in earnings management. Consistent with table 6, the coefficients on CEO in column 13 and CEO high -BOD high in column 15 are still significantly positive, while the coefficient on CEO high -BOD low remains insignificant. This confirms the finding of table 6: Aggressive CEOs are more likely to engage in earnings management, but only when the board of directors is also aggressive. Board diversity The previous tables used dummy variables to investigate the relation between aggressive behavior and earnings management. The results provide some evidence that aggressive behavior is associated with earnings management. While the analyses of previous tables are based on the median facial WHR to identify aggressive boards, it ignores board members that have a low or high facial WHR. Previous research argues that board diversity (percentage outside directors, gender, ethnic background, proportion of foreigners) is related with firm performance and earnings management (Chapple et al., 2012; Vafeas, 2005; Rose 2007). For example, firms with more independent board members (outsiders) are less likely to engage in earnings management (Vafeas, 2005). Even though there is no agreed definition for board diversity, it can be described as the concept of diversity related to board composition and the varied combination of attributes, characteristics and expertise contributed by individual board members in relation to board process and decision making (Van der Walt & Ingley, 2003, p. 219). To shed further light on the relation between board diversity and earnings management, the standard deviation for the board facial WHR is calculated. Assumed is that a higher standard deviation represent diverse boards. A dummy variable is used to capture heterogeneous boards (coded 1) and homogeneous boards (coded 0). The distinction is made on the median standard deviation. To test the additional impact of board diversity on earnings management, five dummy variables are created. Consistent with table 6, the first one (CEO low ) is the base level and will not be included in the regression model. The other dummies are defined as follows: Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 31

32 Table 7: High quality pictures Explanatory variables expec. ANALYST JUST-ANALYST SUSTAIN JUST-SUSTAIN sign β Sig. β Sig. β Sig. β Sig. β Sig. β Sig. β Sig. β Sig. Main variable of interest (1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11) (12) (13) (14) (15) (16) CONSTANT 0,06 0,98-0,23 0,93-4,18 0,16-4,43 0,14-0,46 0,84-0,43 0,85-25,66 0,99-33,79 0,98 CEO + 0,12 0,77 0,15 0,72 0,23 0,49 2,51 0,02 CEO high -BOD low + -0,30 0,49-0,09 0,87 0,26 0,51 1,55 0,20 CEO high -BOD high - 1,69 0,12 0,52 0,38 0,18 0,73 3,76 0,00 Q_CEO -0,08 0,84-0,11 0,78 0,06 0,89 0,01 0,98-0,10 0,75-0,10 0,77 0,36 0,73 0,28 0,80 Q_BOD 1,16 0,21 1,36 0,15 1,68 0,12 1,74 0,10 1,42 0,07 1,41 0,08-3,04 0,12-2,81 0,19 Control variables INSIDE + 0,49 0,40 0,53 0,36-0,67 0,30-0,69 0,30 0,50 0,10 0,50 0,10-0,23 0,82-0,75 0,59 M2B + -0,13 0,60-0,14 0,57 0,08 0,74 0,08 0,74 0,75 0,00 0,76 0,00-0,90 0,09-1,06 0,13 LITIGATION + 1,30 0,02 1,30 0,02-0,23 0,63-0,24 0,62 0,29 0,43 0,29 0,43-0,19 0,86-0,44 0,70 LOSS - -0,25 0,77-0,10 0,91-19,99 1,00-19,96 1,00 0,32 0,70 0,31 0,71-30,88 1,00-37,91 1,00 MV + 0,04 0,91 0,06 0,86 0,13 0,72 0,16 0,67-0,27 0,34-0,27 0,33-0,03 0,97 0,45 0,58 ICLAIMS + 0,26 0,20 0,26 0,20 0,43 0,05 0,41 0,06 0,09 0,62 0,09 0,61 0,63 0,23 0,62 0,28 POSUE + 0,60 0,16 0,59 0,18 0,54 0,22 0,56 0,20 25,67 0,99 30,35 0,99 FE + 2,48 0,54 2,09 0,62-5,51 0,39-5,98 0,35 8,94 0,02 9,00 0,02-61,86 0,25-90,05 0,15 Significance/power of models Chi-square 23,01 27,63 17,49 18,19 42,10 42,12 30,81 34,22 Sig. 0, ,09 0,11 0,00 0,00 0,00 0,00 Cox & Snell R 2 0,10 0,12 0,07 0,08 0,17 0,17 0,13 0,14 Nagelkerke R 2 0,15 0,18 0,13 0,14 0,23 0,23 0,48 0,53 Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 32

33 CEO high -BOD low -SD low : The company has an aggressive CEO, unaggressive board and a homogenous board CEO high -BOD low -SD high : The company has an aggressive CEO, unaggressive board and a heterogeneous board CEO high -BOD high -SD low : The company has an aggressive CEO, aggressive board and a homogenous board CEO high -BOD high -SD high : The company has an aggressive CEO, aggressive board and a heterogeneous board Table 8: Board diversity Explanatory variables ANALYST JUST-ANALYST SUSTAIN JUST-SUSTAIN β P-value β P-value β P-value β P-value (1) (2) (3) (4) (5) (6) (7) (8) Main variables of interest CONSTANT -0,48 0,86-4,03 0,18-0,38 0,87-31,94 0,99 CEO high -BOD low- SD low 0,64 0,42 0,75 0,19 0,67 0,19 1,25 0,37 CEO high -BOD low- Sd high -0,76 0,14-19,12 1,00-0,05 0,93 1,25 0,39 CEO high -BOD high- SD low 0,61 0,58 0,00 1,00-0,72 0,30-15,80 1,00 CEO high -BOD high- SD high 19,86 1,00 0,92 0,23 1,01 0,14 5,14 0,00 Control variables INSIDE 0,61 0,33-0,71 0,26 0,56 0,08-0,51 0,73 M2B -0,16 0,52-0,02 0,93 0,74 0,00-0,70 0,34 LITIGATION 1,27 0,02-0,27 0,58 0,25 0,49-0,80 0,49 LOSS 0,10 0,91-19,69 1,00 0,45 0,59-30,06 1,00 MV 0,19 0,56 0,27 0,47-0,17 0,55 0,77 0,40 ICLAIMS 0,25 0,22 0,42 0,05 0,14 0,40 0,66 0,26 POSUE 0,61 0,16 0,59 0,19 23,89 0,99 FE 2,46 0,56-5,26 0,40 9,99 0,01-62,92 0,27 Significance/power of models Chi-square 30,12 23,88 43,33 37,91 Sig. 0,00 0,02 0,00 0,00 Cox & Snell R 2 0,12 0,10 0,17 0,15 Nagelkerke R 2 0,20 0,18 0,24 0,59 In contrast to the table 6 and 7, the second model in table 8 is significant (p-value 0,02). In addition, the chi- and R 2 of all models are higher, suggesting that controlling for board diversity increases the power of the model. Consistent with table 6 and 7, the main variables of interest in column 1 until 6 are insignificant. The coefficient on CEO high -BOD high -SD low in column 7 is insignificant, while this on CEO high -BOD high -SD high is significantly positive (p-value 0,00). This finding indicates that aggressive CEOs and boards are more likely to just sustain financial performance, but only when the board is heterogeneous. This might suggest that aggressive CEOs corroborate with aggressive board members and subsequently overrule /exclude unaggressive board members in order to just sustain financial performance. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 33

34 6. Conclusion and limitations Accounting literature argues that dominant and aggressive CEOs have a negative impact on firms reporting quality (Fosberg, 2011, Tang et al., 2011; Jensen, 1993), but it is hard to empirically capture this. This research therefore relies on literature in the fields of psychology and sociology. They argue that testosterone levels are positively associated with aggressive behavior, which can be captured by the facial WHR (Carre & McCormick, 2008, Carre et al., 2009). This master thesis is the first that explores the relation between aggressive behavior, captured by the facial WHR, and earnings management. The following research question is investigated: Is there a relation between aggressive behavior and earnings management? The first hypothesis states that aggressive CEOs are more likely to engage in earnings management. Earnings management is captured by four proxies, but the results only indicate that aggressive CEOs are more likely to report a small earnings increase. This suggests that there is some evidence for the first hypothesis. Corporate governance should provide proper incentives for the board and management to pursue objectives that are in the interests of the company and its shareholders and should facilitate effective monitoring (OECD, 2004). In this research, a new proxy for corporate governance is developed, since previous literature reported inconsistent results (Larcker et al., 2007). Assumed is that aggressive boards are better able to exercise their advising and monitoring tasks, resulting in a lower likelihood of earnings management. In contrast to the hypothesis, the results provide some evidence that aggressive (unaggressive) boards increase (mitigate) the likelihood of earnings management. This thesis is subject to several limitations. The persuasiveness of this evidence depends critically on the proxies for earnings management. One of the motives for earnings management is meeting analysts expectations, but this proxy relies heavily on analysts ability to estimate accurate forecasts. Since most control variables in the regression model are not significant, this suggests that managers have different incentives during the financial crisis. Since the data collection procedure took a long time, this research focuses on the 1000 largest U.S. companies for the fiscal year Using the largest firms resulted in a relative high number of CEO and director pictures. A disadvantage of using this sample is that the results may not generalize to a broader population of firms. The sample period covers fiscal year 2009, in which the financial crisis occurred. Firms and managers might therefore have fewer incentives to meet earnings thresholds. Furthermore, as argued by Carre et al. (2009), the facial WHR is only one of many cues to propensity for aggression. In addition, it is possible that the relationship between facial expressions and aggressive behavior reflects emotional condition, such as angriness and happiness. This thesis also raises some unanswered questions, which are opportunities for future research. It is assumed that the CEO has the most incentives to engage in earnings management. The role of the other executives should also be considered. Especially the role of the CFO should be deliberated, since the CFO is the key player in financial reporting. CEOs can be involved with the nomination of board members. It is therefore interesting to investigate the change in board aggressiveness and CEO tenure/turnover. In this research, earnings management is used as dependent variable. However, aggressive behavior might also be associated with fraud, restatements and CEO/board compensation. Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 34

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41 Appendix 1: Facial WHR Masterthesis Accountancy: An empirical analysis of the relation between aggressive behavior and earnings management 41