Managerial Ability and Earnings Quality

doi:10.2139/SSRN.1650309

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Managerial Ability and Earnings Quality

Journal Article•DOI•

Managerial Ability and Earnings Quality

Peter R. Demerjian¹, Melissa Fay Lewis-Western², Baruch Lev³, Sarah E. McVay¹•Institutions (3)

University of Washington¹, Brigham Young University², New York University³

01 Mar 2013-Social Science Research Network-

TL;DR: This paper examined the relation between managerial ability and earnings quality and found that more able managers are associated with fewer subsequent restatements, higher earnings and accruals persistence, lower errors in the bad debt provision, and higher quality accrual estimations.

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Abstract: We examine the relation between managerial ability and earnings quality. We find that earnings quality is positively associated with managerial ability. Specifically, more able managers are associated with fewer subsequent restatements, higher earnings and accruals persistence, lower errors in the bad debt provision, and higher quality accrual estimations. The results are consistent with the premise that managers can and do impact the quality of the judgments and estimates used to form earnings.

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Journal Article•DOI•

Quantifying Managerial Ability: A New Measure and Validity Tests

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Peter R. Demerjian¹, Baruch Lev², Sarah E. McVay³•Institutions (3)

University of Illinois at Chicago¹, New York University², University of Washington³

31 Oct 2011-Social Science Research Network

TL;DR: The authors proposed a measure of managerial ability, based on managers' efficiency in generating revenues, which is available for a large sample of firms and outperforms existing ability measures and finds that the measure is strongly associated with manager fixed effects, and that stock price reactions to CEO turnover are positive (negative) when assessing the outgoing CEO as low (high) ability.

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Abstract: In this paper we propose a measure of managerial ability, based on managers’ efficiency in generating revenues, which is available for a large sample of firms and outperforms existing ability measures. We find that our measure is strongly associated with manager fixed effects, and that the stock price reactions to CEO turnovers are positive (negative) when we assess the outgoing CEO as low (high) ability. We also find that replacing CEOs with more (less) able CEOs is associated with improvements (declines) in subsequent firm performance. We conclude with a demonstration of the potential of the measure. We find that the negative relation between equity financing and future abnormal returns documented in prior research is mitigated by managerial ability, as more able managers appear to utilize equity issuance proceeds more effectively, illustrating that our more precise measure of managerial ability will allow researchers to pursue studies that were previously difficult to conduct.

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888 citations

Journal Article•DOI•

The impact of narrative disclosure readability on bond ratings and the cost of debt

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Samuel B. Bonsall¹, Brian P. Miller²•Institutions (2)

Ohio State University¹, Indiana University²

20 Mar 2017-Review of Accounting Studies

TL;DR: This paper examined the impact of financial disclosure narrative on bond market outcomes and found that less readable financial disclosures are associated with less favorable ratings, greater bond rating agency disagreement, and a higher cost of debt.

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Abstract: Prior research on the determinants of credit ratings has focused on rating agencies’ use of quantitative accounting information, but the there is scant evidence on the impact of textual attributes. This study examines the impact of financial disclosure narrative on bond market outcomes. We find that less readable financial disclosures are associated with less favorable ratings, greater bond rating agency disagreement, and a higher cost of debt. We improve causal identification by exploiting the 1998 Plain English Mandate, which required a subset of firms to exogenously improve the readability of their filings. Using a difference-in-differences design, we find that the firms required to improve the readability of their filings experience more favorable ratings, lower bond rating disagreement, and lower cost of debt. Collectively, our evidence suggests that textual financial disclosure attributes appear to not only influence bond market intermediaries’ opinions but also firms’ cost of debt.

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229 citations

Posted Content•

The Role of Managerial Ability in Corporate Tax Avoidance

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Allison Koester¹, Terry Shevlin², Daniel Wangerin³•Institutions (3)

Georgetown University¹, University of California, Irvine², University of Wisconsin-Madison³

21 Mar 2016-Social Science Research Network

TL;DR: How higher ability managers reduce income tax payments and find they engage in greater state tax planning activities, shift more income to foreign tax havens, make more R&D credit claims, and make greater investments in assets that generate accelerated depreciation deductions is examined.

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Abstract: Most prior studies model tax avoidance as a function of firm-level characteristics and do not consider how individual executive characteristics affect tax avoidance. This paper investigates whether executives with superior ability to efficiently manage corporate resources engage in greater tax avoidance. Our results show that moving from the lower to upper quartile of managerial ability is associated with a 3.15 (2.50) percent reduction in a firm’s one-year (five-year) cash effective tax rate (ETR). We examine how higher ability managers reduce income tax payments and find they engage in greater state tax planning activities, shift more income to foreign tax havens, make more R&D credit claims, and make greater investments in assets that generate accelerated depreciation deductions. Identifying a manager characteristic related to firms’ tax policy decisions adds to our understanding of the factors that explain the substantial variation in corporate income tax payments across firms.

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176 citations

Cites background from "Managerial Ability and Earnings Qua..."

...See the Appendix for detailed variable definitions....
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...Unlike other measures of managerial 5 See Demerjian et al. (2013) Appendix A for additional information regarding Equations 2a and 2b. Electronic copy available at: https://ssrn.com/abstract=2753152 13 accounting performance, more CEO media mentions, etc.), MASCORE is the only managerial ability…...
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...Lisowsky P (2010) Seeking shelter: Empirically modeling tax shelters using financial statement information....
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...See Demerjian et al. (2012) for additional details MASCORE_MGRFEit Manager fixed effect coefficient computed from estimating Equation 3 within the subsample of executives moving across firms over time where each executive is present at each firm for at least three years MASCORE_OTHERit Difference between MASCORE and MASCORE_MGRFE Electronic copy available at: https://ssrn.com/abstract=2753152 43 common equity (ceq) NOL_DECREASEit Indicator variable coded equal to one if the value of the NOL carryforward (tlcf) decreased in year t PRED_SHELTERit Predicted value from the following logit regression presented in Column 5 of PTFCFit Pre-tax free cash flows, defined as the ratio of (operating cash flows (oancf) – capital expenditures (capx) + cash taxes paid (txpd)) to total assets (at) PTROAit Pre-tax book income (pi) deflated by total assets (at) RDit Natural log of one plus research and development expense (xrd)....
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...See the Appendix for additional details regarding how these variables are constructed....
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Journal Article•DOI•

Internal Governance and Real Earnings Management

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Qiang Cheng¹, Jimmy Lee¹, Terry Shevlin²•Institutions (2)

Singapore Management University¹, University of California, Irvine²

01 Oct 2014-Social Science Research Network

TL;DR: In this paper, the authors examine whether internal governance affects the extent of real earnings management in U.S. corporations and find that the effect of internal governance is stronger for firms with more complex operations where key subordinate executives contribution is higher, is enhanced when CEOs are less powerful, and is weaker when the capital markets benefit of meeting or beating earnings benchmarks is higher.

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Abstract: We examine whether internal governance affects the extent of real earnings management in U.S. corporations. Internal governance refers to the process through which key subordinate executives provide checks and balances in the organization and affect corporate decisions. Using the number of years to retirement to capture key subordinate executives’ horizon incentives and using their compensation relative to CEO compensation to capture their influence within the firm, we find that the extent of real earnings management decreases with key subordinate executives’ horizon and influence. In cross-sectional analyses, we find that the effect of internal governance is stronger for firms with more complex operations where key subordinate executives’ contribution is higher, is enhanced when CEOs are less powerful, is weaker when the capital markets benefit of meeting or beating earnings benchmarks is higher, and is stronger in the post-SOX period, when real earnings management is likely more prevalent. The results are also robust to controlling for potential endogeneity concerns and to using alternative measures of internal governance that are used to rule out alternative explanations. This paper contributes to the literature by examining how internal governance affects the extent of real earnings management and by shedding light on how the members of the management team work together in shaping financial reporting quality.

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173 citations

Cites background from "Managerial Ability and Earnings Qua..."

...CEOs with higher compensation (which also signifies their ability in the competitive labor market) are less likely to engage in real earnings management, which suggests better-ability CEOs are associated with better earnings quality (Demerjian et al. 2013)....
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Journal Article•DOI•

CFO Narcissism and Financial Reporting Quality: CFO NARCISSISM AND FINANCIAL REPORTING QUALITY

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Charles Ham¹, Mark H. Lang², Nicholas Seybert³, Sean Wang⁴•Institutions (4)

Washington University in St. Louis¹, University of North Carolina at Chapel Hill², University of Maryland, College Park³, Rice University⁴

01 Dec 2017-Journal of Accounting Research

TL;DR: In this article, the effect of CFO narcissism, as measured by signature size, on financial reporting quality was investigated, and it was shown that narcissism predicts misreporting behavior, and that signature size predicted misreporting through its association with narcissism.

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Abstract: We investigate the effect of CFO narcissism, as measured by signature size, on financial reporting quality. Experimentally, we validate that narcissism predicts misreporting behavior, and that signature size predicts misreporting through its association with narcissism. Empirically, we examine notarized CFO signatures and find CFO narcissism is associated with more earnings management, less timely loss recognition, weaker internal control quality, and a higher probability of restatements. The results are consistent for within-firm comparisons focusing on CFO changes and are robust to controlling for CFO overconfidence and CEO narcissism. The results highlight the importance of CFO characteristics in the domain of financial reporting decisions.

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167 citations

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References

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Open Access

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Journal Article•DOI•

Measuring the efficiency of decision making units

[...]

Abraham Charnes¹, William W. Cooper², E Rhodes³•Institutions (3)

University of Texas at Austin¹, Harvard University², University at Buffalo³

01 Nov 1978-European Journal of Operational Research

TL;DR: A nonlinear (nonconvex) programming model provides a new definition of efficiency for use in evaluating activities of not-for-profit entities participating in public programs and methods for objectively determining weights by reference to the observational data for the multiple outputs and multiple inputs that characterize such programs.

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25,433 citations

Report•DOI•

A simple, positive semi-definite, heteroskedasticity and autocorrelation consistent covariance matrix

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Whitney K. Newey, Kenneth D. West

01 May 1987-Econometrica

TL;DR: In this article, a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction is described.

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Abstract: This paper describes a simple method of calculating a heteroskedasticity and autocorrelation consistent covariance matrix that is positive semi-definite by construction. It also establishes consistency of the estimated covariance matrix under fairly general conditions.

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18,117 citations

Journal Article•DOI•

Risk, Return, and Equilibrium: Empirical Tests

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Eugene F. Fama, James D. MacBeth

01 May 1973-Journal of Political Economy

TL;DR: In this article, the relationship between average return and risk for New York Stock Exchange common stocks was tested using a two-parameter portfolio model and models of market equilibrium derived from the two parameter portfolio model.

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Abstract: This paper tests the relationship between average return and risk for New York Stock Exchange common stocks. The theoretical basis of the tests is the "two-parameter" portfolio model and models of market equilibrium derived from the two-parameter portfolio model. We cannot reject the hypothesis of these models that the pricing of common stocks reflects the attempts of risk-averse investors to hold portfolios that are "efficient" in terms of expected value and dispersion of return. Moreover, the observed "fair game" properties of the coefficients and residuals of the risk-return regressions are consistent with an "efficient capital market"--that is, a market where prices of securities

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14,171 citations

Journal Article•DOI•

Industry costs of equity

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Eugene F. Fama¹, Kenneth R. French²•Institutions (2)

University of Chicago¹, Yale University²

01 Feb 1997-Journal of Financial Economics

TL;DR: In this paper, the authors show that standard errors of more than 3.0% per year are typical for both the CAPM and the three-factor model of Fama and French (1993), and these large standard errors are the result of uncertainty about true factor risk premiums and imprecise estimates of the loadings of industries on the risk factors.

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6,064 citations

"Managerial Ability and Earnings Qua..." refers methods or result in this paper

...AQ Standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (6) estimated by industry-year, where industries are defined per Fama and French (1997). Modified AQLoss% Modified standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (8) estimated by industry and the quintile rank of Loss%, where ranks are assigned annually by industry. Industries are defined per Fama and French (1997). Modified AQSI_Loss% Modified standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (8) estimated by industry and the quintile rank of Loss% Before Special Items, where ranks are assigned annually by industry. Industries are defined per Fama and French (1997). Loss% Before Special Items Loss percentage before special items The percentage of years reporting losses in net income (IBC) excluding the impact of special items over at least three of the last five years (t–4, t)....
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...AQ Standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (6) estimated by industry-year, where industries are defined per Fama and French (1997). Modified AQLoss% Modified standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (8) estimated by industry and the quintile rank of Loss%, where ranks are assigned annually by industry. Industries are defined per Fama and French (1997). Modified AQSI_Loss% Modified standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (8) estimated by industry and the quintile rank of Loss% Before Special Items, where ranks are assigned annually by industry....
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...2 Costs of poor earnings quality include higher cost of capital (Francis et al. 2004) and economically significant negative price reactions to the announcement of earnings restatements (Palmrose et al. 2004). 3 We hypothesize a positive relation between ability and earnings quality, which is opposite to the relation documented in Francis et al. (2008). Francis et al. (2008) measure CEO reputation with the number of articles mentioning the executive and document a negative association between the number of news articles pertaining to the company’s CEO and earnings quality based on the Dechow and Dichev (2002) accruals quality measure....
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...03), similar to that in Francis et al. (2004) and Dechow and Dichev (2002), where we have multiplied the standard deviation by 1....
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...AQ Standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (6) estimated by industry-year, where industries are defined per Fama and French (1997). Modified AQLoss% Modified standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (8) estimated by industry and the quintile rank of Loss%, where ranks are assigned annually by industry. Industries are defined per Fama and French (1997). Modified AQSI_Loss% Modified standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (8) estimated by industry and the quintile rank of Loss% Before Special Items, where ranks are assigned annually by industry. Industries are defined per Fama and French (1997). Loss% Before Special Items Loss percentage before special items The percentage of years reporting losses in net income (IBC) excluding the impact of special items over at least three of the last five years (t–4, t). We exclude the impact of special items by subtracting positive special items from IBC and adding back negative special items to IBC. Modified AQNegCFO% Modified standard deviation of accrual errors The decile rank (by industry and year) of 1 3 Standard Deviation (etþ1, etþ2, etþ3, etþ4), where etþn is the residual from Equation (8) estimated by industry and the quintile rank of Negative CFO% where ranks are assigned annually by industry. Industries are defined per Fama and French (1997). Negative CFO% Negative CFO percentage The percentage of years reporting negative cash flows from operations over at least three of the last five years (t–4, t)....
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Journal Article•DOI•

Interaction terms in logit and probit models

[...]

Chunrong Ai¹, Edward C. Norton²•Institutions (2)

University of Florida¹, University of North Carolina at Chapel Hill²

01 Jul 2003-Economics Letters

TL;DR: In this article, the authors present the correct way to estimate the magnitude and standard errors of the interaction effect in nonlinear models, which is the same way as in this paper.

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5,500 citations

"Managerial Ability and Earnings Qua..." refers background in this paper

...Note that Ai and Norton (2003) and Powers (2005) observe that standard software inaccurately calculates the marginal effect of interaction terms in logit and probit models....
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