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Interim CEOs More Apt to Inflate Company Earnings

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Nov 23rd 2015
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Concerns about earnings management are certainly not new, but a recent report adds a different wrinkle to the issue: Interim CEOs cook the books more than permanent successors do, and that makes it more likely they'll get the corner office.

The study, Passing Probation: Earnings Management by Interim CEOs and Its Effect on Their Promotion Prospects, published in the current issue of the Academy of Management Journal, makes clear that the position of interim CEO is generally more challenging because it's “often considered an ‘unplanned' leadership change with ambiguous strategic directions.” But the study proposes that interim chief executives are more likely to engage in earnings management so they can get in the good graces of board members and shareholders who are involved in choosing the next boss.

“Firms should therefore think very carefully before appointing an interim CEO,” write authors Guoli Chen of INSEAD, Shuqing Luo of the National University of Singapore, Yi Tang of Hong Kong Polytechnic University, and Jamie Y. Tong of the University of Western Australia.

If that appointment is unavoidable, the firm should – among other things – “equip itself with better internal corporate governance systems or adopt effective external governance mechanisms with which to better monitor the interim CEO's behavior,” they write.

What's more, directors should have the know-how necessary to assess an interim CEO, they said.

Their findings are based on financial statements of 138 US public companies that appointed interim CEOs. Each was compared to a firm in the same industry that had a CEO departure at about the same time but appointed a permanent successor. Further comparisons were based on how likely an interim CEO would be appointed according to company size, age, and financial performance, along with the former CEO's term of service, age, and whether the departure was unplanned or due to dismissal, death, or bad health.

In the sample, the interim CEOs served for an average of three quarters, and about 23 percent were appointed to permanent positions.

Discretionary accruals were used to measure earnings management because they generally entail some guessing. Average discretionary accruals during interim CEOs terms were compared to averages in the eight quarters before and after, and that difference was compared to averages recorded during the same periods by permanent CEOs. The finding? The averages by interim CEOs were almost 36 percent higher.

Interestingly, the study focused on within-GAAP earnings management because it carries minimum legal consequences and is easier to do, the authors write.

“Indeed, some executives have admitted that ‘they would work aggressively within the confines of GAAP to reduce the perception of uncertainty about their firms' prospects,'” according to a footnote that quotes another study.

Related articles:

Study: Earnings Management Key to Corporate Accounting Success
Study: Restatement Often Spur Similar Misreporting From Peer Firms

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