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MSc Thesis:
The relationship between CFOs tenure and
financial reporting quality
Student: Emiel Knepper
Student Number: 10423974
Education: MSc Accountancy and Control, variant Control track
Institution: University of Amsterdam, Faculty of Economics and Business
Supervisor: Mario Schabus
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Abstract
This thesis examines the relationship between CFOs tenure and financial reporting quality. Using a sample that consists of 1,911 American stock listed firms, I examined the effects of Chief Financial Officer’s (CFO) tenure on the financial reporting quality (FRQ). In order to measure FRQ, I use accounting conservatism as a measurement of FRQ. My prediction is that CFO tenure has a positive effect on accounting conservatism. Based on the timely loss recognition from Basu (1997) the level of conservatism will be examined. I find no supporting evidence that CFOs tenure has a positive impact on the FRQ. This paper contributes by filling the gap of investigating the impacts of CFO’s properties with financial reporting quality.
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Tabel of Contents
1 Introduction ... 4
2 Literature Review ... 5
2.1 Agency theory in accounting ... 5
2.2 Accounting Conservatism and Financial Reporting Quality (FRQ) ... 7
2.2.1 Definition of FRQ ... 9
2.2.2 Effects of FRQ ... 9
2.3 Chief Financial Officer (CFO) ... 10
2.4 Tenure ... 10
3 Research methodology ... 12
3.1 Empirical model ... 12
3.2 Measurement of control variables ... 13
3.3 Sample selection ... 14
4 Results ... 15
4.1 Descriptive statistics ... 15
4.2 Results and analysis ... 18
5 Conclusion ... 19
References ... 20
Appendix ... 25
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1 Introduction
Financial statements and disclosures are important reports for investors to evaluate firm
performance (Healy &Palepu 2001).According to the Statement of Financial Accounting Concepts No. 8 (SFAC No. 8) the objective of financial reporting is to provide financial information about the reporting entity that is useful to all stakeholders. Lambert et al. (2007) demonstrate that the quality of financial reports can influence the cost of capital of firms and that clarifies the important role of the quality of the financial statements. Dechow et al. (2010) describes the financial reporting quality (a.k.a. FRQ) as “Higher quality of financial reporting provides more information about the feautures of a firm’s financial performance that are relevant to a specific decision made by a specific decision-maker.”
This study examines the managerial reaction of executives on (un)favorable future firm prospects and how that is reflected in the financial statements. Many different types of
measurements have been used in research in order to measure FRQ. According to Dechow et al. (2010) state that the persistence, magnitude of accruals, residuals from accrual models, smoothness of cash flows, timely loss recognition, benchmarks, earnings response coefficient and external indicators of earnings restatements are commonly used indicators to determine the FRQ. The timely loss recognition indicator combats the management’s natural optimism by reporting bad news more timely than good news. Accounting conservatism requires a timelier recognition of unfavorable news than favorable news (Ahmed &Duellman 2013, Watts 2003). Choi and Pae (2011) argue that firms that have a higher level of commitment to business ethics have a higher degree in accounting conservatism. This research defines the accounting conservatism as the same indicator for FRQ as the timely loss recognition indicator. This study assumes that managers who are more prudence to reporting expected earnings are more conservatism and have therefore higher quality of financial reporting.
This study looks at role of Chief Financial Officers (CFOs) in firms and their relation to FRQ. Geiger and Taylor (2003) emphasize the importance of the responsibility that the CFO has over the reported financial results by mentioning that not only the CEO, but also the CFO can be personally accountable for the accuracy and completeness as a result of Sarbanes-Oxley (SOX) Act.The CFO retains the final responsibility for the representation of the financial performance of the firm ( 2001).
In more detail, this research examines how the tenure of the CFO influences the FRQ. Given that CFOs care about their external reputation for career concerns, CFOs are interested in meeting or beating earnings benchmarks (Graham et al. 2005). This means that not onlybonuses give incentive for executives to enhance financial results but future career prospects for the CFO play an important role as well. For example, executives performance is often measured by financial results, which leads
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to increased external reputation.(Milbourn 2003). Further, CFOs indicate that career concerns of managers affects the financial reporting decisions (Francis et al. 2008). This is supported by Jian and Lee (2011) as they argue that managers prefer to make investment choices that are beneficial for their reputation rather than investment choices that benefits the shareholders.
Oyer (2008) shows that management reputation is sensitive to financial results. The
reputation of a manager may decrease when they report unsatisfactory results even if the economic market is in bad condition. Subsequently, termination is more sensitive to performance, especially in the beginning of the tenure (Chevalier & Ellison 1999). This suggests that CFOs have the incentive to use less reporting conservatism in their beginning of their tenurein order to retain their position. Ryan et al. (2009) finds that long tenured executives are less likely to be fired and therefore
managers have the incentives to have a long tenure at the firm. This strengthens the suggestion that a beginning CFO is more likely to report more favorable financial results than actual financial results in the beginning of the tenure.
Based upon prior literature, I expect a relationship between the tenure of the CFO and the FRQ. Long-tenured CFOs are more likely to use accounting conservatism than short-tenured CFOs.
There has been much research conducted to investigate which characteristics of executives influences the FRQ. Mostof this acadamic work focused on characteristics of the CEO and a little research is based on that of the CFO. The CFO is also an executive member of the board of directors and should have the most financial knowledge of the team. This makes it surprisingly that there has been little research performed in the relationship between the characteristics of the CFO and the FRQ.Although there are many papers about CEO and financial reporting quality and little research about CFO and their relation with corporate governance – according to my knowledge – no study to date has investigated the relationship between CFO tenure at a firm and FRQ.
2 Literature Review
2.1 Agency theory in accounting
In an agency relationship, the agent (i.e. manager) acts on behalf of the principal (i.e. shareholder) (Shapiro 2005). That is, the manager should act (only) on behalf of the shareholders’ interests.The agency problem contains a conflict of interest between the agents and the principles (Jensen
&Meckling, 1976; Shapiro, 2005).That means that the agency problem arises when managers are not working towards shareholders’ interests.
Managers could have incentives to introduce bias and noise into the estimated values of the assets or estimated future profits that are reported in the financial statements. Jensen & Murphy
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(1990) provide evidence that CEO compensation changes positively to increasements of market stocks. The paper of Basu (1997) states that information that has a negative effect on managers’ compensation could be an incentive for the manager to leave out of the financial reports. This bias and noise that is added to the financial statements, could therefore enhance the compensation of the managers. However, shareholders are not able to or it is too expensive to verify what the managers are actually doing (Eisenhardt 1989). These costs are known as the agency costs.
The importance of the quality of the financial statements is indicated by Watts (2003) by mentioning the agency problem that could appear between managers and shareholders. Even though managers are forthcoming that they provide sufficifient financial information, they are less likely to provide information (e.g. bad projects and poor future earnings) that reduces their own wealth (Armstrong et al. 2010). Thisbias and noise of estimated values in financial reports decreases the quality.
This agency problem can be mitigated by having accounting standards which tend to favor conservatism (Ahmed et al. 2002, Nikolaev 2009).LaFond and Watts (2008) describe accounting conservatism as a mechanism that reduces the managers’ ability to overestimate future returns.Their argument therefore is that accounting conservatism requires a timelier loss recognition over profit recognition (Nikolaev 2009, Watts 2003). The incentive of managers to hide information that adversely affect their compensation is then mitigated by a timelier loss recognition (Kim & Zhang 2010). The opposite of conservative accounting, aggressive accounting, leads to higher financial misreporting (Burns &Kedia 2008). By this method of accounting, future earnings and net assets are too optimistic or too confident reported and that leads to an improper image of the actual financial position of the firm. Aggressive accounting is more often used by firms that use performance-based compensations for their managers and this leads to more restatements in the financial reports (Burns &Kedia 2006). These findings strengthens the assumptionthat aggressive accounting decreases the quality of the financial reports.Schrand and Zechman (2012) found evidence that
overconfidencedmanagers are more likely to account project to optimistic and are therefore more restatements faced.This is supported by the paper of Ahmed and Duellman (2012) because they provided a negative relation between managerial overconfidence and accounting conservatism. They showed that overconfidenced managers overestimate their future profits. As stated before,
accounting conservatism requires a timelier loss recognition over profit recognition and managers should therefor use a safety margin in their estimated future returns.For example, that could prevent managers from investing in a project that has a negative net present value but provides the company short-term benefits.
Brickley et al. (1985) provide evidence that companies that compensate managers based on long-term performances experience a higher stock market reaction than companies with a
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term compensation plan. This paper implies that long-term performance plans are encouraging managers to make the right decisions for the firm and that would enhance the shareholders wealth. Their decision-making horizon increases and that motivates managers to operate for long-term objectives rather than short-term benefits only (Tehranian et al. 1987).That implies that long-term goals aligns managers’ and shareholders’ interests and mitigates the agency problem. As stated before, accounting conservatism mitigates to optimistic future returns by the management. Short term objectives that favors managers personal wealth may lead to under or overinvestment in long-term projects (Bebchuck& Stole 1993). Ahmed and Duellman (2007) also state that accounting conservatism supports the reducing deadweight losses arising from agency conflicts. They found evidence that corporate control mechanisms assist firms with agency problems.
All that provides support that the conflict of interest between managers and shareholders may be reduced with conservative accounting, which will increase overall financial reporting quality.
2.2 Accounting Conservatism and Financial Reporting Quality (FRQ)
The main purpose of afinancial report is to measure performance and wealth of the reporting entity (Lim, 2010). Financial statements are important for potential investors, lenders and other creditors in order for them to make informed decisions in keeping, buying or selling their shares and providing loans(FASB 2010). Therefore, financial reporting information supports investors decisions. The financial statements of the reporting entity should faithfully represent the economic reality (FASB 2010). In this research, the quality of financial information is referred to as Financial Reporting Quality (FRQ). The definition of quality is determined as evaluated quality with respect to decisions that are made based on the reported financial performance (Dechow et al. 2010). As future economic profits are uncertain, the managers possess valuable knowledge about the operations of the firm (Basu 1997). Because managers are more familiar with the daily operations, they gain more specific information about the firms’ daily operations (Beyer et al. 2010). The asymmetric
information function gives them incentives to use their private information to overstate financial performances and consequently stock prices during their tenure (LaFond& Watts 2008). The fact that managers are also the shareholders of the firm, reinforces their incentives to overestimate future returns in order to increase their stock (Lafond& Watts 2008).
This is supported by Basu (1997) as that paper states that managers have incentives to conceal information that could decrease their compensation. Managers withhold bad news but reveal good news immediately to investors (Kothari et al. 2009). Nagar (1999) finds that managerial performance assessment is a managers’ concern when it comes up to firm performance. Their further career concerns can motivate managers to withhold bad news (Kothari et al. 2009). Hermalin
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and Weisbach (2007) state that owners and investors asses the managers based on the information that has been given to them. A lack of information disclosure limits the ability of external parties to effectively monitor and discipline the managers (Nagar et al. 2003).This creates the possibility for managers to have great short-term performances but therefore ignore the long-term performances. . For example, projects that generate profits on the short-term of their lifetime but have a negative net present value over the whole lifetime, enhance managers short-term compensation but are not firms’ best decisions. Accounting conservatism prevents managers for investing in projects that have ex ante a negative net present value (Ball &Shivakumar 2005). Accounting conservatism reduces the managers’ ability to manipulate accounting numbers (LaFond& Watts 2008). This accounting method thereforeobstructs the asymmetric information about future losses and enhances the validity of future economic cash flows
Prior research emerges conservatism in two forms: conditional and unconditional
conservatism (Beaver & Ryan 2005). Unconditional conservatism (news independent) stems from the application of accounting policies that reduce earnings independent of economic news (Pae et al. 2005). Examples that are given by the paper of Beaver and Ryan (2005) are immediate expenses of costs and higher depreciation of book value of property, plant and equipment than economic depreciations. Conditional conservatism (news dependent) is defined as the higher verification of recognizing favorable news than unfavorable news (Basu 1997, Goh & Li 2011). This interpretation posits that bad news will be recognized in a timelier manner than good news. Book values are written down under sufficiently negative circumstances but are not written back up under positive circumstances (Beaver & Ryan 2005). This paper focusses on conditional conservatism. The
interpretation of Basu (1997) will be followed as this is the most used method to measure conservatism.
Firms that use conservative accounting receive easier and cheaper external financing and have a lower default risk (Francis et al. 2013). This suggests that accounting conservatism favors shareholders’ interest. Ahmed and Duellman (2011) show that firms with relative more conservative accounting have significantly higher future profitability. If conservatism leads to higher FRQ, higher FRQ leads to higher future economic benefits.
Moreover, prior research found empirical evidence about the positive relationship between corporate governance and accounting conservatism. One measure for corporate governance (i.e. independence of the board)has a positive relationship with FRQ (Shiri et al. 2012). This suggests that strong corporate governance should enhance FRQ. Ample prior research shows that firms with strong corporate governance mechanisms have a higher level of accounting conservatism (García Lara et al. 2009, Chi et al. 2009). There is a positive relationship between anti-takeover protection, level of CEO involvement and the degree of accounting conservatism (García Lara et al. 2009). In
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addition to that, adequate corporate governance controls result in better monitoring of the management and enhances the degree of accounting conservatism (Chi et al. 2009). Although accounting conservatism is not required after the introduction of SOX, firms incorporate losses more quickly than profits in the post-SOX period (Lobo and Zhou, 2006). The increase of personal penalties to CEOs and CFOs for manipulated reporting could be an incentive to avoid overstated earnings. Lobo and Zhou (2006) also state that financial consultants advice their clients a more conservative
approach after the implementation of SOX. Overall, firms and CFOs that emphasize a high degree of accounting conservatism are expected to have a higher quality of financial reporting.
2.2.1 Definition of FRQ
As already mentioned in the introduction of this paper, Dechow et al. (2010) describes the financial reporting quality (a.k.a. FRQ) as “Higher quality of financial reporting provides more information about the features of a firm’s financial performance that are relevant to a specific decision made by a specific decision-maker.”. They state that the decision-relevance of the information determines the quality of the financial reports. The FRQ is consistent with valuation perspectives, where investors see the firm as a long-term profit-generating entity and the value of the firm is based on estimating and discounting future cash flows (Dichev et al. 2013). The extent to which financial reports faithfully present earnings and future cash flows is defined as the quality (Schipper& Vincent 2003).
2.2.2 Effects of FRQ
The degree of quality of the financial statements provides how much information is reported about the firm’s financial performance (Dechow et al. 2010).The financial benefits of higher financial reporting quality for firms is showed by Leuz and Verrecchia (2004). They show that poor-quality reports creates an information risks to investors. In order to compensate this risk, investors require a higher return for their investment (Schipper& Vincent 2003). In this setting, high-quality reports provides the firm with higher investment efficiency and therefore an increase in future cash flows(Easley &O’hara 2004).Firms with high-quality reports are more transparent to their shareholders about the financial performance and that reduces the information asymmetry. This shows that FRQ plays an important financial role for firms. Ball and Shivakumar (2008) support this by showing that initial public offering (IPO) firms report more conservatively. The monitoring role by rating agencies, more involvement of auditors, higher regulations and the market that demands a higher quality of the financial statements are factors that increases the importance of the financial reports for public companies than that is required for private companies. Public investors face a
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higher risk of information asymmetry than private investors. Firms therefore improve their financial reports prior to an IPO.
2.3 Chief Financial Officer (CFO)
The CFO has the primary responsibility for the financial reports (Collins et al. 2008). In addition to this fiduciary duty, the CFO is also involved with decisions that are made at top level within the firm. This provides the CFO with a contradiction in duties.Indjejikian and Matejka (2009) indicate that the CFO performs a dual role within organizations.They conclude that the CFO checks financial decisions that he made by himself. The question that raises is whether it is appropriate if performance-based compensation of the CFO is based on the financial performance that is reported by himself. With their unique position – relative to other executives – they could be more engaged to manipulate the accounting numbers (Feng et al. 2011). Geiger and North (2006) examined the relationship between a new appointed CFO and the corporate financial reporting. They present evidence that changes in CFOs are associated with reductions in the reported discretionary accruals.
This suggests that the individual characteristics of the CFO influences the FRQ. This is supported by Ge et al. (2011) as they argue that the CFO’s personal characteristics(e.g. gender, age and educational background) influences the accounting practices of the firm. They also provided evidence that influence of the CFO on the accounting practices is higher when there is a high job demand for CFOs and a high CFO job discretion. Accounting standards and regulations cannot avoid all kind of possible misuse as long as individual judgment or evaluations are part of it(Parfet, 2000). Parfet (2000) states that tone at the top and corporate ethics are also essential components that determines the FRQ. This provides the CFO the possibility to manipulate the actual performance because they can still manipulate the numbers within the boundaries of the accounting standards (Parfet, 2000). Schrand and Zechman (2012) showed that overconfidentexecutives misreport more. To meet or exceed earnings expectations, CFOs can manipulate the financial resultsby adjusting performances with which is called the “screw-driver” effect (Graham et al. 2005). “You turn the screws just a little bit so that it fits” and the firm meets or exceeds the expectations. This way of preparing the financial statements is contradictory to their ultimate responsibility about the completeness and correctness of the financial reports (Mian, 2001).
2.4 Tenure
Graham et al. (2005) find that managers want to meet or exceed the expected financial performances in order to improve the their reputation. Reputation is a valuable asset for managers.Cianci and Kaplan (2010) find that external stakeholders approve an implausible
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explanation for poor performance more easily for well reputed managers than non-reputed
managers.A reason for that could be that users of the financial reports believe that reputation of the top executives is the key factor of FRQ (Francis et al. 2008). This has a significant influence on the financial reporting decisions.Reasons to meet or exceed earnings expectations are to build credibility, enhance stock price, report growth possibilities but also to improve their reputation (Graham et al. 2005). In order to attain these objectives, CFOs are willing to sacrifice long-term value and smooth earnings. These findings provides strong evidence that managers care about their reputation. Talented managers are valuable for the firm and when the manager has a longer tenure at the firm, the confidence in the manager grows (Ryan et al. 2008). For example, there are less meetings with the Board of Directors when the CEO performs well. With their gained reputation, they are able to haggle more autonomy and less scrutiny. In addition, long-tenured managers are less likely to be firedand managersgain knowledge and experience in their field (Luo et al. 2013). Chevalier and Ellison (1999) find that termination is more sensitive to performance for managers that are in the beginning of their career and have not been able to build a career yet. Appointing a highly reputed CEO creates a strong impression to stakeholders that the firm will be successful in the future (Sinha et al. 2012). With these findings, we can conclude that managers care about their reputation because of their further career opportunities. That suggests that financial incentives are not the only reasons toincrease earnings, if necessary by manipulating financial statements. In order to attain a higher reputation, reporting financial performances that meet or exceed expectations is an incentive for the manager. Another considerable incentiveis the rewards of the stock market for firms meeting or beatingexpectations (Bartov et al. 2002). However, Desai et al. (2006) find that managers that face accounting restatements because of aggressive accounting incurred significant losses in reputation. Given this, there are two contradictory incentives. On the one hand, aggressive reporting could enhance the performanceof the CFO and therefore, they may have a longertenure. On the other hand, aggressive accounting increases the risk ofaccounting restatements and therefore loss in reputation through legal suits. In addition to legal penalties for executives, financial accounting restatements are related to reputational loss for managersinternally (Srinivasan 2005). As already documented by the paper of Ryan et al. (2008), management reputation increases over tenure. That suggests that long-tenured CFOs already gained reputation and may therefore be more conservative in their accounting choices. On the other hand, in order to gain reputation, short-tenured CFOs may be less conservative. Based on these assumptions I therefore formulate the following hypothesis:
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3 Research methodology
3.1 Empirical model
Researchers use three different type of measures to asses whether conservatism exists (Watts 2003 part 2). Net asset measures, earnings and accrual measures and earnings/stock return relation measures are these types. Watts (2003 part 2) states that all three measures rely on the effect of conservatism’s asymmetric recognition of gains and losses. The most used measure to test whether conservatism exists is the asymmetric timeliness measure of Basu (1997). Basu (1997) uses firms’ stock return to see what impact that has on firms’ earnings. According to Watts (2003 part 2), this way of measuring conservatism is classified as earnings/stock return relation measure. Basu (1997) interprets conservatism as a tendency to require a higher degree of verification for recognizing good news than bad news. This way of measuring conservatism is, as explained in the literature review before, considered as conditional conservatism. Bad news is recognized more timely than good news in earnings. Basu (1997) also found that negative earnings changes are less persistent than positive earnings changes. Therefore, the greater timeliness of earnings for bad news implies that negative (unexpected) returns are more sensitive to earnings than positive (unexpected) returns.
Basu (1997) regression model:
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+
+
Basu (1997) uses stock returns and earnings to measure the relationship between positive stock returns and negative stock returns. Basu (1997) finds that negative stock returns turned out to have a higher association with earnings than stock returns do that are positive. The model above is shown as follows. is the standardized earnings per share where states for firm and states for fiscal year. The earnings per share is divided by the share price at the beginning of the fiscal year. is the return on firm from fiscal year . The return is calculated as the difference between the end-of-year share price and beginning-of-year share price plus dividends, and divided by the beginning-of-year share price. When is negative, it implies that returns of the firm in that fiscal year were negative and those are defined as bad news periods. The other way around, a positive implies positive return of the firm in that fiscal year and is defined as a good news period. The coefficient
measures the sensitivity of earnings to good news (positive return). The coefficient measures the sensitivity of earnings to bad news (negative returns). is a dummy variable which equals one if
is negative and zero if positive. To test whether a firm uses a conservative approach in their accounting valuations, the focus of the analysis is on the difference between coefficient (good
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news) and coefficient (bad news). Conservative accounting is considered when coefficient is higher than coefficient .
This regression model is the starting point for my regression equition to test the hypothesis that is formulated in the literature review. This research examines the relationship between CFO’s tenure and conservatism. A conservative approach of financial reporting is considered as a higher quality of financial reports. The hypothesis in the research is based on the assumption that CFOs plan to continue their jobs, which is associated with the long-term goals of the firm. However, if CFOs are in their last year of their tenure, incentives to focus on short-term benefits for the firms are arising for their own wealth, such as short-term based compensations (Dechow & Sloan, 1991). Therefore, CFOs could have incentives to report less conservative and that effects the regression. In order to take out the bias in the outcomes of the regression model, the final year of the CFO’s tenure will be excluded from the sample.
The important variables for the regression are earnings per share deflated by the beginning-of-year share price (EPS), the end-beginning-of-year share price minus beginning-beginning-of-year share price plus dividends, divided by the beginning-of-year share price (RETURN) and the CFO’s tenure (TENURE). The dependent variable is EPS and the independent variables are RETURN and TENURE. In this regression, there are nine control variables included which will be explained in detail in paragraph 3.2. This results into the following regression model;
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+
+
+
+
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+
The coefficient measures the responsiveness of EPS to bad news (negative RETURN) with TENURE. And coefficient measures the responsiveness of EPS to good news (positive RETURN) with TENURE. With these outcomes, the effects of the TENURE on conservatism will be examined.
3.2 Measurement of control variables
There are nine control variables used in this study. The growth in sales (SALES_GROWTH) is measured as a percentage of the annual sales growth in total sales. Ahmed and Duellman (2007) argue that large growth of sales often inflates the market expectations of future sales and that effects the market value of the firm. The size of the firm (FIRM_SIZE) is determined as the natural log of the total assets. LaFond and Watts (2008) find that large firms have less asymmetric information and present financial information more often. Additionally, Watts and Zimmerman (1978) argue that
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large firm face more political costs, which induces them to report more conservative. The leverage control variable (LEVERAGE) is defined as the long-term debt divided by the total assets. Watts (2003) argues that firms with a high level of leverage tend to have greater conflicts between
shareholders and debt-holders. Given the significance of penalties imposed by SOX to CFOs, the post SOX period is likely to be more reliable and accurate (Chang et al. 2012). Lobo and Zhou (2006) finds that discretionary reporting behavior has become more conservative in the post SOX period. A dummy variable is is included to control the influence of SOX (SOX_D) on conservatism. The dummy variable (SOX_D) contains 1 for pre-SOX period and contains 0 for post-SOX period. Watts (2003) mentioned that litigations risks are higher for firms that overestimate their current assets. Litigation costs of overestimated book values are higher than underestimated book values and therefore management has incentives to report more conservative. Techonology companies have higher litigation risks than other companies (Chang et al. 2012, Francis et al. 2009). A dummy variable is included as a control variable (LITIGATION_D). The dummy variable contains 1 for high litigation risk and contains 0 for low litigation risk. The last dummy variable controls for firms that are audited by one of the Big Four auditors (BIG4_D). Michas (2011) argues that firms which have an auditor of one of the Big Four auditors, report more conservative. The firms that have an auditor of the Big Four contains 1 and 0 for non Big Four auditor. The control variable stock market performance
(MARKET_PERF) is measured by multiplying the common outstanding shares with share price. The control variable board size (BOARD_SIZE) is measured as the total number of board members. The age of the CFO (AGE) is the last control variable in this research.
3.3 Sample selection
Data regarding the initial sample is started from the years 1992 through 2013 and contains 28,743 observations from the Execucomp database and Compustat. The Execucomp database provides information about compensation of executives and supports this research to estimate the CFO’s tenure. Compustat provides information about annual report data of listed North American companies.
After merging the dataset from Execucomp with Compustat and excluding observations with missing data, the exclusion of missing observations contains 11,177. This paper excludes firms in financial insitutions, insurance companies and real estate firms (SIC-Code 6500-6999). That leads to a exlcusion of 4,371 observations. By removing the observations where the CFO is in his final year in his tenure, 3,620 observations are excluded. The total exclusion consists of 19,168 observations and leads to a final sample with 9,575 firm-year observations from 1,911 firms.
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The effect of outliers are mitigated by winsorizing the bottom and top 1% of the variables SALES_GROWTH, FIRM_SIZE, LEVERAGE, MARKET_PERF, TENURE, RETURN and EPS.
Table 1: Sample Composition
Observations
Observations from Execucomp and Compustat 28,743 Less: Excluding observations with missing data (11,177)
Exluding financial institutions, insurance companies and real
estate firms (4,371)
Excluding observations with final year CFO tenure (3,620)
Final sample for regression 9,575
4 Results
4.1 Descriptive statistics
Table 2 reports the summery statistics of the final sample of this research. The mean of AGE of a CFO is 50.16 years and the median is 50 years. 19% of the final sample consists of pre-SOX period
observation years. In this sample, 88% of the firms has an auditor from the “big four” auditors. The mean of LEVERAGE, which is reflected as long-term debt divided by total assets, is 19% for this sample. The average TENURE of a CFO is 4.19 years with a standard devation of 3.01 years. The median of the TENURE of the CFOs is 3 years. The average RETURN of the firms in this research 0.13 with a standard deviation of 0.61. On average, firms have a positive RETURN and positive EPS in this sample. These averages are similar to prior literature (e.g. Dietrich et al. 2007, Roychowdhury & Watts, 2007). The study of Dietrich et al. (2007) uses two samples for their research. The sample that contains the period between years 1991 and 2001 have a negative earnings per share on average. This is different compared to the sample in this study. This study, however, uses a sample from years 1992 till 2013, which contains a longer period. The average of the dummy variable DR is 0.44 which means that 44% of the observation years have a negative return and 66% has a positive return.
Table 3 represents the correlations table. Correlations from prior literature (Khan & Watts, 2009) of the correlations AGE, EPS, FIRM_SIZE and LEVERAGE are comparable with this study. The only exception is that the correlation between LEVERAGE and FIRM_SIZE is negative by the study of Khan and Watts (2009) and the this study provides an significant positive relation. With a significance
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level of 95%, we find that there is a positive correlation between RETURN and EPS. There is no significance correlation between TENURE and RETURN, but there is a significant positive relation between EPS and TENURE.
Table 2: summary statistics
Mean S.D. Min .25 Mdn .75 Max
AGE 50.16 6.64 30.00 46.00 50.00 55.00 87.00 BOARD_SIZE 5.60 1.16 1.00 5.00 5.00 6.00 14.00 SOX_D 0.19 0.39 0.00 0.00 0.00 0.00 1.00 BIG4_D 0.88 0.32 0.00 1.00 1.00 1.00 1.00 LITIGATION_D 0.32 0.47 0.00 0.00 0.00 1.00 1.00 SALES_GROWTH 0.11 0.26 -0.52 -0.01 0.08 0.18 1.33 FIRM_SIZE 7.35 1.59 3.65 6.20 7.21 8.40 11.34 LEVERAGE 0.19 0.18 0.00 0.01 0.17 0.30 0.87 TENURE 4.19 3.01 1.00 2.00 3.00 5.00 15.00 RETURN 0.13 0.61 -0.86 -0.21 0.05 0.32 3.48 EPS 0.03 0.14 -0.99 0.03 0.05 0.08 0.26 MARKET_PERF 5957.65 15231.91 15.14 515.35 1349.92 4031.34 111079.1 DR 0.44 0.50 0.00 0.00 0.00 1.00 1.00 RETURN_x_DR -0.13 0.21 -0.86 -0.21 0.00 0.00 0.00 DR_x_TENURE 1.82 2.86 0.00 0.00 0.00 3.00 15.00 RETURN_x_TENURE 0.53 2.83 -12.92 -0.60 0.13 1.11 52.20 RETURN_x_DR_x_TENURE -0.51 1.03 -12.92 -0.60 0.00 0.00 0.00
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Table 3: correlation table
AGE BOARD_ SOX_D BIG4_D LITIGATI SALES_G FIRM_S LEVERAG TENURE RETURN EPS MARKET DR AGE 1.000 BOARD_SIZE 0.0098 1.000 SOX_D -0.0455*** 0.1754*** 1.000 BIG4_D 0.0397*** 0.0872*** -0.2125*** 1.000 LITIGATION_D -0.0960*** 0.0070 -0.0067 -0.0053 1.000 SALES_GROWTH -0.0688*** -0.0090 0.0923*** -0.0396*** 0.0622*** 1.000 FIRM_SIZE 0.1153*** 0.1388*** -0.1484*** 0.2929*** -0.1331*** -0.0137 1.000 LEVERAGE 0.0053 0.0696*** 0.0369*** 0.0968*** -0.2251*** -0.0418*** 0.2877*** 1.000 TENURE 0.3447*** -0.1115*** -0.1337*** 0.0328*** -0.0536*** -0.0549*** 0.1003*** 0.0007 1.000 RETURN 0.0016 -0.0625*** -0.0614*** -0.0092 0.0244* 0.0346*** -0.0404*** -0.0081 -0.0169 1.000 EPS 0.0375*** -0.0173 -0.0084 0.0400*** -0.0238* 0.1616*** 0.1496*** -0.0880*** 0.0738*** 0.0203* 1.000 MARKET_PERF 0.0752*** 0.0446*** -0.0724*** 0.1023*** 0.0664*** 0.0403*** 0.5801*** -0.0123 0.0266* 0.0081 0.0831*** 1.000 DR -0.0282* 0.0427*** 0.0687*** -0.0252* 0.0244* -0.0384*** -0.0601*** 0.0187 -0.0246* -0.6218*** -0.1384*** -0.0772*** 1.000 * p < 0.05 (two-tailed) ** p < 0.005 (two-tailed) *** p < 0.001 (two-tailed)
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Table 4: regression analysis
Source SS df MS Number of obs = 9575
Model 24.422135 15 1.62814233 F ( 15, 9559) = 103.46 Residual 150.423047 9559 .015736274 Prob > F = 0.0000 Total 174.845182 9574 .018262501 R-squared = 0.1397 Adj R-squared = 0.1383 Root MSE = .12544 EPS Coef. Std. Err. t P>|t| [95% Conf. Interval]
DR -.0022479 .0066848 -0.34 0.737 -.0153516 .0108558 RETURN -.0672878 .0044764 -15.03 0.000 -.0760626 -.058513 RETURN_x_DR .2738219 .0152322 17.98 0.000 .2439636 .3036801 TENURE -.0015847 .0007424 -2.13 0.033 -.00304 -.0001293 DR_x_TENURE .0001439 .0012796 0.11 0.910 -.0023644 .0026521 RETURN_x_TENURE .0085331 .0009836 8.68 0.000 .0066051 .010461 RETURN_x_DR_x_TENURE -.0199 .0031425 -6.33 0.000 -.0260599 -.0137401 AGE -.0000281 .0002079 -0.13 0.893 -.0004356 .0003794 BOARD_SIZE -.002402 .0011557 -2.08 0.038 -.0046673 -.0001366 SOX_D .0103182 .0034871 2.96 0.003 .0034828 .0171537 BIG4_D .0027648 .0042323 0.65 0.514 -.0055314 .011061 LITIGATION_D -.0065822 .002852 -2.31 0.021 -.0121728 -.0009916 SALES_GROWTH .0793994 .0050425 15.75 0.000 .0695149 .0892838 FIRM_SIZE .0125379 .0009112 13.76 0.000 .0107518 .0143239 LEVERAGE -.089918 .0078107 -11.51 0.000 -.1052286 -.0746074 _cons -.001262 .013154 -0.10 0.924 -.0270467 .0245227
4.2 Results and analysis
Table 4 shows the results from the regression of the final sample which contains 9,575 observations for the period 1992 – 2013. The adjusted R-squared results in 13.83%, which indicates that the independent variables explain 13,83% of the dependent variable.
As explained in the research methodology before, the coefficient of the variable RETURN, , measures the sensitivity of earnings to good news. The coefficient of the variable RETURN_x_DR, , measures the sensitivity of earnings to bad news. A conservative accounting approach is expected when the bad news has a greater impact on EPS and therefore a positive , indicates accounting conservatism. The table shown above depicts that the coefficient of RETURN is significant negative and the coefficient of RETURN_x_DR is significant positive. This is consistent with the study of Basu (1997), where bad news is reported on a more timelier basis than good news. Based on the
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The effects of TENURE on the coefficients are on a confidence level of 99% signifcant for the coefficients of RETURN_x_TENURE ( ) and RETURN_x_DR_x_TENURE ( ). The outcomes of the coeffecients indicates that TENURE has a contrary effect on conservatism. The slope (measures the sensitivity of good news) is positive an slope (measures the sensitivity of bad news) is negative. That indicates that good news is reported on a more timelier basis than bed news. The hypothesis that CFO’s tenure does not have an effect on financial reporting quality is rejected. There is support that TENURE has a significant impact on accounting conservatism. This regression provides evidence that TENURE has a negative impact on the accounting conservatism.
5 Conclusion
This research investigates the relationship between Chief Financial Officer’s (CFO) tenure and the financial reporting quality. In more detail, the effects of the tenure of the CFO on the accounting conservatism has been investigated. This study contributes to prior literature, because there has no research been done between the CFO tenure and the financial reporting quality, up to now. I predicted that short-tenured CFOs would be less conservative then long-tenured CFOs. At the beginning of his tenure, the CFO tries to gain reputation and would therefore account less conservative. When the CFO gained reputation, he tries to avoid to lose it by accounting restatements and would therefore account more conservative.
Using Basu’s model I investigated the effects of the tenure of the CFO on accounting conservatism. I found that the tenure of the CFO has a contrary effect than my predictions. I found no evidence that CFO tenure has a positive impact on accounting conservatism.
Using American stock listed firms, the impact of SOX as a moderator between the relationship of CFO tenure and FRQ, could be a further recommendation for new research. This paper used a sample from 1992 till 2013. The effects of SOX has been taken into account as a control variable. The moderating effect of the SOX variable could be new possible research.
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Appendix
Variable definitions
Variable name Description
Dependent variable
EPS Earnings per share standardized by the beginning-of-year share price
Independent variables
DR Dummy variable equal to one if returns are negative, zero
otherwise
RETURN End-of-year share price minus beginning-of-year share price plus dividends, divided by the beginning-of-year share price
TENURE Tenure of the current CFO
Control variables
AGE Age of the current CFO
BIG4_D Dummy variable equal to one if auditor is one of the Big Four auditors, zero otherwise
BOARD_SIZE Number of directors on the board
FIRM_SIZE Natural log of total assets
LEVERAGE Long term debt, divided by total assets
LITIGATION_D Dummy variable equal to one if firm has high litigation risk, zero otherwise
MARKET_PERF Share price multiplied by the common outstanding shares SALES_GROWTH Percentage of the annual sales growth in total sales
SOX_D Dummy variable equal to one if respective year is in post Sox period , zero otherwise
