Earnings management has become a topic of enormous interest to academics, practitioners, regulators, and the financial press in recent years. Executives are often said to face incentives to undertake earnings management on behalf of their firms, either in the form of accruals manipulations or by undertaking real activities in order to try to achieve earnings benchmarks. Most of the extant academic literature links these incentives for earnings management, directly or indirectly, to explicit contracts. By contrast, a recent survey of executives by Graham, Harvey and Rajgopal (2005) documents that more than three quarters of respondents consider upward mobility in the labor market to be more important than short-run compensation benefits in driving earnings management decisions.
This disconnect between the contract-based motivations underlying most prior academic studies and practitioners’ own representations of the considerations driving their behavior leads us to investigate the role of non-contractual career stage incentives over earnings management. We hypothesize and find that younger managers are less opportunistic in both accruals manipulations and in undertaking real activities to achieve earnings management objectives. Our results are robust across alternative empirical proxies for career stage and to controlling for other known factors affecting earnings management, including proxies for direct compensation-based incentives over earnings. Overall, our study provides evidence in support of the notion that non-contractual career stage concerns impact executives’ earnings management behavior.
The classic career concerns model originally due to Holmstrom (1982, 1999) suggests that managers will undertake more unobservable behavior during the early stages of their careers in order to influence the market’s beliefs about their quality type, while more established managers are expected to undertake less effort in the later stages of their careers because their type has already been established in the labor market. We extend this Holmstrom (1982, 1999) model to include features of the accrual account-ing performance measurement system. The reversing nature of accounting accruals results in our model generating the surprising prediction that younger executives will have lower propensities to undertake accruals manipulations than their more established counterparts. Our empirical results are consistent with the model’s prediction. After controlling for other known determinants of earnings management, including explicit earnings-based compensation incentives, we find that more established CEOs undertake more income-increasing accruals than do younger CEOs. Our results are robust across alternative age-based proxies for career stage.
We extend our empirical tests to consider career concern motivations for earnings management via real activities-related decisions. Efficient market theories suggest that managers undertaking value-destroying real activities will be subject to discipline in the form of job loss either by direct removal by the firm’s board of directors or through eventual dismissal when the sub-optimally managed firm is taken over. We investigate the hypothesis that more established managers, who are likely to be more entrenched in their positions and thus at lower threat of removal, will have greater propensities to undertake real activities earnings management. Consistent with predictions, we find that younger managers undertake less real activities management across two dimensions of real activities suggested by Roychowdhury (2006). Specifically, we document that younger CEOs are associated with lower abnormal production costs and higher levels of abnormal discretionary expenses. These results are also robust across alternative measures of career stage and to controlling for other known determinants of real activities earnings management, including explicit earnings-based compensation incentives.
Our final tests examine the earnings management trade-offs faced by executives at early versus more established stages in their careers under circumstances associated with heightened pressures to meet earnings benchmarks. For a subsample of firms that are close to missing analyst estimates, we find that younger managers seem to choose the “lesser of two evils” by choosing to manage accruals rather than undertake real, potentially longer-term value destroying activities to meet the earnings threshold.
This study contributes to the literature by documenting the importance of a non-contracting-based incentive for earnings management. As far as we are aware, this is the first study to document the role of career concerns in accruals and real activities earnings management. We provide both theoretical and empirical support for the notion that more established executives have stronger incentives to engage in more income-increasing earnings management, and potentially more value-destroying activities, relative to their younger counterparts.
The remainder of the paper is organized as follows. Section 2 reviews the literature and develops hypotheses. Section 3 describes our sample selection and data . Section 4 presents our empirical tests and Section 5 concludes.
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