Concepto de Empleo

Earnings management strategies have been examined in a variety of contexts, including compensation plans (Healey 1985), provisions for bad debts (McNichols and Wilson 1988), labour contract negotiations (Liberty and Zimmerman 1986), import relief investigations (Jones 1991), management buyouts (De Angelo 1986; Perry and Williams 1994), proxy contests (De Angelo 1988), financially distressed companies (Defend and Jiambalvo 1994; De Angelo, De Angelo and Skinner 1994), take-over bids (Eddey and Taylor 1999).

Studies of earnings management strategies within the context o f executive turnover are particularly sparse. Most of the explanations offered in the literature regarding the behaviour of financial variables surrounding executive departures involve mainly three non-mutually exclusive classes of potential managerial discretion (Murphy and

Zimmerman 1993). Firstly, outgoing top executives approaching a known departure

(e.g. retirement) are likely to make accounting or investment decisions to increase earnings (and eamings-based compensation) in their final year at the expense of future

earnings (the “horizon” hypothesis). Secondly, outgoing CEOs in poorly performing

companies threatened by termination take income-increasing accounting or investment

decisions in an attempt to cover-up the firm’s deteriorating performance and hence,

delay their termination (the “cover-up” hypothesis). Finally, incoming CEOs make

income-decreasing accounting or investment decisions (e.g. write off unwanted operations and unprofitable divisions) in order to boost future earnings at the expense of

the transition-year earnings and hence, blame the bad performance to their predecessor and establish their tenure (the “big-bath” hypothesis).

The majority of the studies in this literature focus on choices of accounting policy. The current section does not provide an extensive review of this part of the earnings management literature. Instead the section starts with a brief review of these studies. It then proceeds with a detailed discussion of earnings management studies associated with executive turnover, where the type of managerial discretionary behaviour is due to the horizon and/or the cover-up phenomenon and earnings management is performed through investment decisions.

Accounting choices span a broad spectrum of alternatives, ranging from highly visible changes in accounting methods to much less obvious bias in accounting estimates. Early studies suggest strong associations between large discretionary write-offs and executive turnover. For example, based on a sample of 36 US firms that experienced a top management change as opposed to a sample of 100 US firms that experienced a non-top management change and a sample of 100 US firms that did not experience a change at all. Moore (1973) reports that discretionary accounting decisions (e.g. write-offs) are more likely to be made in a period of a change in management. Strong and Meyer (1987) focus on a sample of 120 US firms who made large discretionary write-offs over the period 1981-1985. According to their results, 39% of the firms experience a senior management change in the period of the write-off. Finally, Elliott and Shaw (1988) analyse the behaviour of 240 firms during 1982-1985 using matched pair samples. Their results reveal that the most significant difference between non-write off firms and write­

off firms is the relatively high occurrence of senior management changes in the write­ off firms.

Pourciau (1993) focuses her investigation on the discretionary accounting choices of departing CEOs based on her interesting insight that the personal gains from earnings

management are likely to be higher after non-routine CEO changes than routine CEO

changes. She argues that before routine CEO changes, the successor may monitor the financial reporting decisions of the retiring CEO. And subsequently the retiring CEO, as a continuing member of the board of directors, may monitor the financial reporting decisions of the successor. Furthermore, a weak profit reports poorly on both CEOs, discouraging the retiring CEO from inflating earnings before stepping down. Based on a total of 73 non-routine CEO departures, Pourciau’s results fail to support the cover-up hypothesis, but do support the big-bath hypothesis.

Finally, two more studies use Australian data to investigate the big-bath hypothesis where managerial discretionary behaviour is observed through accounting choices. In the first one. Wells (2000) draws on a sample of 65 CEO changes in Australia’s top 100 listed companies over the period 1984-1994 and reports only weak evidence of negative unexpected accruals in the period of CEO change, but stronger evidence of downward earnings management through abnormal and extraordinary items. Contrary to his hypotheses. Wells finds some evidence of negative earnings management in the period following the CEO change. In the second one, Godfrey, Mather and Ramsay (2001) use a sample of 19 CEO retirements and 44 CEO resignations during 1992-1998 and document downward earnings management in the year of the CEO change and upward earnings management in the year after the CEO change whilst both types of

discretionary behaviour are strongest for the sub-sample where the CEO change was due to a resignation. In contrast with Wells (2000), Godfrey et al. (2001), therefore, find evidence supporting the big-bath hypothesis.

Real cash flow choices, such as changes in investing decision at the time of CEO departure have, however, received much less attention in the earnings management literature". The horizon hypothesis was first empirically investigated by Butler and Newman (1989) who study a sample of firms that experienced CEO departures in 1982. They focus on changes in finished-goods inventory, capital expenditures and R&D surrounding the CEO departures. Butler and Newman find no evidence that the departing CEOs systematically manipulate these variables to increase short-term earnings performance. They suggest that their inability to document evidence in support of the horizon problem could be due to their failure to isolate the circumstances under which the problem is more pronounced.

Following Butler and Newman (1989), Dechow and Sloan (1991) provide a more powerful test of the horizon problem by focusing on the circumstances in which managers’ incentives to engage in discretionary behaviour are the strongest. Accordingly, their analysis concentrates on: a) R&D expenditure: the greater the negative impact of the investment decision on the firm’s short-term profitability the more pronounced the horizon problem, and b) firms that have a top executive compensation plan that is tied to earnings: the stronger the link between CEO compensation and earnings performance the more pronounced the horizon problem.

Baber et al. (1991) and Perry and Grinaker (1994) present evidence consistent with the hypothesis that managers time R&D expenditure to smooth reported income. They do not, however, explore the above managerial discretionary behaviour within the context of executive turnover.

R&D expenditure is measured in two different ways: a) the difference in R&D scaled by sales, and b) the continuously compounded growth rate of R&D.

Drawn on a sample of 405 manufacturing firms in R&D-intensive industries (a total of 58 CEO changes ) from 1974 to 1988 and using regression analysis, they find that the growth in R&D expenditures is reduced during the CEOs’ final years in office. In addition, they demonstrate that the reductions in R&D expenditures are mitigated through CEO stock holdings, where the latter is measured by the value of the ordinary and option holdings as a proportion of the total CEO salary and bonus compensation. Dechow and Sloan (1991) argue that the observed decreases in R&D expenditure around CEO departures are consistent with the horizon predictions, since CEOs who are 64 or 65 years old (and hence are close to retirement) are more likely to cut R&D. Finally, they demonstrate that R&D reductions cannot be explained by poor share performance (that is often argued to be related with); the coefficient estimate of abnormal stock returns is negative but not significant under both definitions of R&D expenditure.

The latter finding, however, could be attributed to the particular sampling process of the study. Specifically, the age of the majority of the sample’s departing CEOs (60%) is 64 years and above whilst only seven executives are below 58 years old. The majority of the companies have mandatory retirement policies at the age of around 63 whilst a number of papers has demonstrated that routine departures (e.g. retirements) are not related to firm performance (Coughlan and Schmidt 1985; Warner et al.1988). The above, therefore, could explain the fact that Dechow and Sloan find no evidence o f poor

performance prior to both the CEO departures and the reductions in investment expenditure.

In contrast with Dechow and Sloan (1991), Gibbons and Murphy (1992) find no direct evidence in support of the prediction that as managers approach retirement they reduce investment projects. Instead o f the growth rate of R&D expenditure they focus on the level of three measures of corporate investment: a) R&D expenditure, b) advertising expenditure, and c) capital expenditure. Based on a sample of 1,631 CEOs who leave office during the 1970-1988 they construct each CEO's investment profile, i.e. the time series of investment expenditures beginning with the CEO's first year in office and ending with the first full fiscal year of his successor.

Their analysis provides evidence suggesting that all three types of corporate investment increase rather than decrease as the CEO nears retirement. Results remain robust even after controlling for market-wide trends in investment expenditure, different lengths of CEO tenure and CEO retirement age. In attempting to replicate Dechow’s and Sloan’s results, Gibbons and Murphy find that estimates of declining R&D growth surrounding management transitions are highly dependent on both model specification and sample construction. An important criticism of this study is, however, that Gibbons and Murphy (1992) do not identify the departure reason. Instead, the entire analysis is based on the

assumption that CEOs retire, since 60% of them were between 60 and 66 years old

when they left.

Finally, Murphy and Zimmerman (1993) depart from previous studies by estimating the extent to which changes in potentially discretionary variables are explained by poor

economic performance rather than by direct managerial discretion with the explicit incorporation of the endogeneity of CEO turnover. In their study, they analyse simultaneous changes in several variables. These include: a) R&D expenditure, b) advertising expenditure, c) capital expenditure, d) accounting accruals and earnings, e) sales, f) assets and g) stock prices. In contrast with Dechow and Sloan (1991), they document little evidence supporting the horizon hypothesis; instead declines in the growth rate of R&D, advertising and capital expenditures preceding departures are better explained by the overall performance of the firm. Controlling for firm performance results in insignificant departure year dummy variables in the R&D models. Controlling for the endogeneity of CEO turnover, through a two-stage regression analysis, results in insignificant departure year dummies in the majority of the rest discretionary-variable models.

Murphy and Zimmerman (1993) are actually the first to explicitly investigate the cover- up hypothesis in the context of CEO turnover where investment choices are used to measure managerial opportunistic behaviour. In particular, another important contribution of this study is that it provides a stronger test of the horizon and the cover- up hypotheses by focusing on certain sub-samples in which the above phenomena are predicted to be more pronounced. Accordingly, Murphy and Zimmerman (1993) partition the entire sample in three main ways. Firstly, into those cases where firm performance is above the median (i.e. superior performers) and those cases where performance is below the median (inferior performers). Secondly, into routine CEO departures and non-routine CEO departures. Thirdly, into routine CEO departures with superior performance and non-routine CEO departures with inferior performance. The horizon hypothesis is predicted to be stronger in the cases of superior performers and/or

routine departures whilst the cover-up phenomenon is expected to be more pronounced in the case of inferior performers and/or non-routine departures.

The analysis fails to support the horizon hypothesis whereas it provides some evidence consistent with the cover-up predictions. For example, Murphy and Zimmerman document that non-routinely departing CEOs reduce capital expenditure more than routinely departing CEOs in their final years, which is inconsistent with the horizon hypothesis. Furthermore, they report that accruals are higher in the years before CEO turnover for inferior-performing CEOs than superior-performing CEOs, suggesting they are covering up. Nevertheless, accruals are not significantly higher before CEO turnover for non-routine than routine departures. Their evidence therefore, does not consistently support the cover-up hypothesis.

Undoubtedly, Murphy and Zimmerman (1993) provide a very comprehensive analysis of the investment behaviour surrounding CEO turnover. Nevertheless, a number of interesting observations are worth mentioning. Firstly, partitioning CEO changes into routine and non-routine based on the age of the departing CEO is very likely to lead to misleading conclusions. A number of studies, including the current thesis, argue that a rigorous executive turnover classification requires more and better information (Warner et al. 1988; Weisbach 1988; Huson et al. 2001). Secondly, another problem arises in comparing the routine and non-routine CEO change samples. As Smith (1993, p.342) points out “the cover-up hypothesis predicts that earnings are inflated to conceal poor performance before non-routine CEO changes. The horizon hypothesis predicts that earnings are inflated before normal retirements. If both hypotheses are true, significant differences between the two samples may not be detected”. Finally, as Murphy and

Zimmerman (1993) argue any conclusion regarding managerial discretion is conditional on an assumption about whether the incoming or the outgoing CEO controls the financial variables in the transition year (i.e. the year of the change). And until a more accurate way of determining which has control of the transition year is found, the power of the tests to detect managerial discretion and the ability to distinguish among the various explanations is compromised.

The evidence on the whole issue is mixed, and still an under-investigated area. Moreover, most o f the findings come from the United States. Apparently, there has been extremely little research done on the relation between executive turnover and managerial investment behaviour, in the UK. The only available work is an unpublished study by Conyon, Machin and Menezes-Filho (1997) who investigate the horizon hypothesis based on a sample of 90 top British CEOs who left office during the period 1970-1994. They report results based on two different methodologies, the first focusing on investment profiles over the entire executive careers, and the second based on a before and after analysis of what happens to investment at and around the time surrounding CEO turnovers. Conyon et al. show that investment seems to decline during the last few years of an executive’s career based on the first approach whilst the second approach fails to support the hypothesis. Finally, consistent with Dechow and Sloan (1991) they demonstrate that executive departure is less associated with a cutback in investment if the CEO holds a significant portion of the company’s ordinary shares.

Despite the valuable insights of the above study, it suffers from certain criticisms most of which arise from the fact that the study is a very preliminary one and hence there is a number of measurement and specification problems. Finally, a very important limitation

of this paper is that information regarding CEO departures is based on a survey carried out in 1994 among a sample of UK quoted companies. Bearing in mind that the majority of the companies have incentives not to review truthfully their CEOs’ job separation (Weisbach 1988), there is a good reason to believe that the measure of CEO departure adopted in this study is subject to considerable noise.

The work in Chapter 6 is the first rigorous study of investment decisions of departing CEOs based on UK data. Specifically, the chapter concentrates on two different types of managerial opportunistic behaviour, namely the horizon phenomenon and the cover-up phenomenon. Moreover, the quality of the data of the current thesis enables Chapter 6 to extend the overall literature in a number of ways that will be fully explained at a later stage.