EXECUTIVE’S EARLY TENURE AND EARNINGS MANAGEMENT

MyriaRafizKhasandy

Desi Adhariani

Department of Accounting, Faculty of Economics and Business, Universitas Indonesia

,

ABSTRACT

This research’s purpose is to determine the effect of CEO’s and CFO’searly tenure period to earning management behavior through accrual discretionary and real activity. CEO will earn good reputation if they can generate higher profits for the company during their tenure, so there are some indications that they will manage their earnings using their discretion as CEO in their early years of tenure, and so does CFO. This research uses manufacturing company listed in Indonesia Stock Exchange as the sample. The results show that CEO’s and CFO’s early years of tenure don’t have positive effect towards the earnings management behavior. This research also finds that institutional ownership can strengthen the positive effect of CEO’s early tenure period to earnings management behavior.

Type of Paper: Empirical

Keywords: CEO Tenure, CFO Tenure, Earnings Management, Monitoring System

  1. Introduction

Earnings management is often associated with agency conflict issues arising from agency relationships. The agency relationship is a contract between the owner (or shareholder) and the agent, with the intention that the agent can perform some services for the owner, one of which relates to the transfer of responsibility to the agency for decision making (Jensen and Meckling, 1976). Agent conflicts will arise if the agent does something against the interests of the owner (Ross, 1973).

The reputation of the Chief Executive Officer (CEO) is defined as the market perception of his ability (Zhang, 2009), which is often associated with success that emerged after his leadership in the company, such as an increase in market capitalization (shown through increasing stock prices), improvement in company financial ratios and also profit increasing. Individually, the reputation of the CEOwill have a long term impact for themselves, such as reappointment at the Annual General Meeting and the acquisition of bonus compensation in the future. Therefore, the CEO has a strong incentive to maintain his reputation in the presence of market participants, in this case including shareholders (Zhang, 2009).

Indication of earnings management not only appears on the CEO, but also the Chief Financial Officer. Jiang et al. (2010) finds that the incentives of CFO will influence earnings management more thanCEO’s incentives. CFO role right now is not only seen as a recorder of financial transactions only. Not only acting as one of the decision makers, the CFO also has the responsibility to present the correct information and can be used in the decision-making process (Arts, 2014). This is supported by Chava and Purnanandam (2010) which states that the risk CFO’s preference is more important than the CEO, especially in relation to financial decision making, including the choice of debt maturity and earnings management.

The CFO and the CEO may use their discretionary policy, for example by increasing costs which will decrease company’s profits in the first year of his tenure, such as sales, general and administrative expenses (Ali and Zhang, 2015). Such actions will make profits increase over the next year, so the CEO will be praised for doing so (Ali and Zhang, 2015). This action often referred as big bath accounting. By increasing company’s income, the market perceptions of the ability of the CEO’s in managing the company will also be increasing too, that will impact to the CEO’s reputation (Ali and Zhang, 2015).

Research related to tenure has not been done in Indonesia. Several previous studies have examined the impact of the change of term of office of CEO (Adiasih and Kusuma, 2012). Yuliana (2011) also found that the change of CEO had a positive effect on earnings management. The behavior of earnings management itself will tend to increase the company's profit by using management discretion, so it is not followed by improvement of company performance. Similar results were also found by Trisnantari (2012), which uses Tobin's Q to measure company performance.

The agency conflict causing incentives for management to perform earnings management can be overcome by several things, one of them through supervision. Ali and Zhang (2015) found that a good supervisory system can moderate the early influence of the CEO’s tenure on earnings management. Such supervisory systems can be done through institutional ownership and family ownership.

Koh (2003) states that companies with low institutional ownership have a tendency to do the discretionary accrual, and vice versa. Wang (2006) found that the higher the family ownership in a company, the higher the quality of the resulting profit. This is contrary to the research of Chi et al. (2015), Sanjaya (2010), and Razzaque et al. (2016) who found that there was a negative influence between family ownership and earnings management behavior. This is motivated by the theory of entrenchment effect that the concentrated shareholders will have the tendency to do their best to fulfill the interests of their group without considering the interests of other shareholders.

The research questions in this paper are:

  1. Is the Early Tenure of CEO and CFO have a positive effect on Earnings Management?
  2. Can high institutional ownership weaken the positive influence of the Early Position of the CEO and the CFO on Earnings Management?
  3. Can Family Ownershipsmoderate the positive effect of CEO’s and CFO’s early tenure on Earnings Management?

This research found that the CEO’s and CFO’s early tenure had no effect on earnings management. The results of this study are inconsistent with Ali and Zhang's research (2015), but consistent with several studies in Indonesia that examine the effect of the change of term of office of the CEO on earnings management, Adiasih and Kusuma (2012). The study also found that institutional ownership and family ownership cannot moderate the positive influence of the initial tenure of the CEO and the Finance Director on earnings management. In addition, from the additional analysis it is found that there is a tendency of the CEO to conduct earnings management in his fourth year of tenure, which is consistent with the research of Davidson III et al. (2007), who found that the executive (CEO or CFO) who are at the age of approaching retirement will be more focused on the company's current performance than the performance of the company to come.

  1. Literature Review

The earnings management occurs when management uses judgment in financial reports and in the preparation of transactions to amend financial statements either in order to mislead some stakeholders about the company's economic performance or to influence contractual outcomes depending on the accounting figures reported (Healy and Wahlen, 1999 in Adiasih and Kusuma, 2012).

This research uses 2 models of the earnings management calculation. The first model used is similar to the model used in Ali and Zhang's journals (2015), using accrual quality referring to McNichols (2002) model, which is a combination of Jones (1991) and Dechow and Dichev (2002) models. This discretionary accrual shows the amount of accruals based on management considerations, so that the greater the discretionary accrual, the greater the indication of earnings management behavior by the CEO.

Management considerations can also be made through a cost discretion account. Management can 'manage' costs by reducing certain costs so that the company's profits in the period of the positionincreases. The statement is consistent with the results of Pan et al., 2013 (Ali and Zhang, 2015). Therefore, the second model to be used is Roychowdhurry’s Model (2006), which measures theearnings management through manipulation of real activities. The manipulation of the real activities can be done in several ways, for example by aggressively cutting prices for the purpose of increasing sales (Graham et al., 2005 in Roychowdhurry, 2006).

The second model is used for the purpose of catching the phenomenon of the earnings managementthat is commonly done by the CFO as stated by Roychowdhurry (2006) that the CFO has a tendency to perform certain actions with the aim that the target profit set can be achieved. Therefore, the behavior of theearnings management performed by the CFO is usually done through real activities, not by using accrual (Roychowdhurry, 2006). This can reduce the quality of the profit value itself, because reported profits do not match the performance of the company. The action of the Director of Finance may be due to pressure from the company to generate a 'high' profit, so that if it does not happen, the reputation of the CFObecomes bad (Arts, 2014).

There are several studies that link between the reputation of the CEO and the quality of the profits. The reputation of the CFOcan be seen, one of them, through ‘never’ or ‘not’ accounting restatement is done. Mian (2001, in Arts, 2014) stated that the tenure of the CEO is inversely done to accounting restatement, where accounting restatement is referred to as one of the proxies indicating that the company's profit quality is poor. This is supported by Aier et al. (2005) stating that the CFO who has experience in the field of finance will have a tendency to rarely perform accounting restatement. Therefore, Matsunaga (2013, in Arts, 2014) stated that the CFO who cannot 'serve' the needs of the market (and investors) is more likely to have a short tenure. This is consistent with Beaudoin et al. (2012, in Rolf Arts, 2014) who stated that the quality of the CFO is in line to his/her tenure, the worse the quality of the CFO, the shorter his/her tenure at the company.

Research related to the tenure, both the CEO and the CFO, in Indonesia is limited. Most of the research related to the term of officeof the Director only uses a specific sample year, such as at the change of the tenure either at the end of the tenure or at the beginning of tenure (Adiasih and Kusuma, 2012). Adiasih and Kusuma (2012) useda sample change of tenure by dividing it into 2, namely: routine and non-routine shifts. The results of Adiasih and Kusuma (2012) itself contradicted with Ali and Zhang (2015), that there is no proven earnings management either at the end of the tenure year and the early years of the tenure year on routine or non-routine shifts, but these results are consistent with Murphy's research results and Zimmerman (1993, in Adiasihand Kusuma, 2012). Wandesca (2012) conducted a similar study, but using different samples of state-owned and Non-BUMN. The results of his research are consistent with Adiasih and Kusuma (2012), that the new CEO does not perform the earnings management at the turn of the position. This study also found that there is no indication of the earnings management in state-owned and non-state owned companies.

In contrast to Adhyatma (2014), he found that at a non-routine turn, there was a tendency that the CEO would undertake the earnings management by the big bath accounting method, that is by reducing early-year profits to boost profits over the next year. But in the first year before the change of tenure, both routine and non-routine, there is no indication of the earnings management, which is consistent with the research of Adiasih and Kusuma (2012).

The lack of research on the tenure and the change of the tenure of the CEOs in Indonesia and its relationship with the earnings management makes several areas that can be examined related to this matter. The results of the studies are also still inconsistent between one study and other studies, so it is hoped that this research can give a new picture on the practice of the earnings management in Indonesia and the timing trend of this practice by the Directors, both the CEO and the CFO. This is expected to provide a clearer picture so that investors can be more aware of the indication of the earnings management at certain times.

Hypothetical Review

Fama (1980) and Holmstrom (1982) stated that the market evaluates the ability of the CEO in his tenure, both in his current position and previous performance (Zhang, 2009). This may be one of the CEO's motivations to maintain a good reputation, in the hope that in the future when his tenure is over, the market (in this case the shareholders through the GMS) may appoint the CEO to re-take the position, because of his background experience and reputation as CEO (Fama, 1980 in Francis et al., 2008).

Information related to such experience and reputation is not available when the new CEO is appointed within the company, so that the market can only use the current information to assess the new CEO's capabilities. The current information can only be seen through the performance of the new CEO during his current term (Ali and Zhang, 2015). Then, this encourages management to work hard at the beginning of his tenure to produce good performance (Holmstorm, 1982 in Zhang, 2009).

The statement of Holmstorm (1982) is then argued by Ali and Zhang (2009) by stating that it can also make the new CEO take instant action, that is overstate profits in order to improve his performance in front of the market. This contrasts with the research of Francis et al. (2008). Francis et al. (2008) argued that topreputeddirectors would be more likely to take the earnings management action because of greater pressure, especially those are related to the prospect of the analyst, rather than the non-reputed directors.

However, Jiang et al. (2010) state that although the CEO is the highest leader and the CFOis merely an 'agent' of the CEO, the results of research by Jiang et al. (2010) found that the CFO has a greater influence on the earnings management than the CEO. This is because the CFO has a responsibility to meet the target of profit and investor's desire to increase the value of the company, so the action of the CFO has more tendency to lead to the earnings management (Jiang et al., 2010). This behavior tends to be done at the early of their tenure. In between, this behavior tends to be avoided because the both CEO and CFO try to maintain their reputation, so that they will behave passively. This is also consistent with the findings of Ali and Zhang (2015), who found that earnings management behavior tended to decline in the 3rd year and subsequent years. This leads to the following hypothesis:

H1a = The CEO’s early tenure has positive effect on earnings management.

H1b = The CFO’s early tenure has positive effect on earnings management.

Agency conflicts can be solved with several efforts, Scott (2012) mentions that one way to minimize agency conflict is to monitor, either directly or indirectly. Unfortunately, this supervision is directly proportional to agency costs, that is the more complex the structure of the company, the higher the agency cost is needed (Jensen, 1993).

Institutional Ownership can be used as an indicator that demonstrates a strong Monitoring System within a company. Institutions, as shareholders in large portions, will tend to supervise related companies, with a view to maintaining 'investments'. This is consistent with Koh's research (2003) which states that firms with low institutional ownership tend to make adiscretionary accrual in order to increase profits, and vice versa. Unfortunately, this has not been proven in Indonesia as shown in Indriani’s (2010) study which found that institutional ownership is not related to profits. This is consistent with the research of Kazemian and Sanusi (2015) who found that institutional investors were unable to control management discretion behavior. Kazemian and Sanusi (2015) also point out that institutional investors often focus only to short-term financial results, so that it may cause pressure for management to meet short-term financial targets, which can create incentives for management to make earnings management.

Institutional Ownership is used as a Moderating Variable between the effect of CEO’s early tenure on Earnings Management only found in Ali and Zhang's research (2015), but previous research found a contradictory relationship between Institutional Ownership and Earnings Management. Bushee (1998) and Collins et al. (2003) found that Institutional Investors may influence audit committees to participate actively in developing appropriate internal control procedures, thereby enhancing the accuracy of financial statements (Ali and Zhang, 2015).

An effective Monitoring System should be able to reduce the earnings management behavior in the company. The CEO and the CFOwill not be able to perform the earnings managementat his / her early tenure if the surrounding environment has a good and supportive Monitoring System, thus it leads to the following hypothesis:

H2a = High institutional ownership will weaken the positive effect of CEO’s early tenure on earnings management.

H2b = High institutional ownership will weaken the positive effect of CFO’s early tenure on earnings management.

Agency issues can also be reduced by family ownership, but only on certain portion of ownership (Arifin, 2003). Yang (2010) mentions that there is a difference in earnings management behavior between the CEO who came from the family (Family CEO) with the Family Director who is not from the family (Non Family CEO). Yang (2010) finds that the CEO who is not from the family has the motivation to earn earnings management by manipulating it more than the CEO who comes from the family.