Jurnal UMP Social Sciences and Technology Management Vol. 3, Issue.

1, 2015

Profit Management In Relation To CEO Leave

(Case Study: Iran)

Alireza Erfani,
Associate Professor, Semnan University, Department of Economics and Management, Semnan, Iran
Alireza Masoudian
PhD student in economics Semnan University, employee of Bank Sepah
Corresponding Author
Abstract
This study deals with the experimental relationship between CEO leave and profit management in
Iran using a total number of CEO leaves out of which 483 people (64.6%) left voluntarily and 356
people (35.4%) left compulsorily between 1383 and 1392. In this researchCEO leaving is classified
into four groups depending on whether the ex-CEO leaves the company peacefully or compulsorily
and whether the new CEO is one of the company’s staff or he is recruited from outside. Profit
management is measured by means of both voluntary liability items and actual activity
management. For testing this theory multivariate analysis significance test was used. There are 10
independent variables and 3 dependent variables in this research. 7 items were tested with 3
dependent variables (profit management variable indices) namely, TAC, abPC and abCF. Results
show that voluntary leave does not meaningfully affect profit management. Also in case of
compulsory leave and internal substitution, remaining of some managers cannot promote profit
management in some industrial companies.
Key words: CEO leave; profit management; financial performance; company sovereignty

Introduction
The survey of literature related to profit management indicates an attempt on the part of researchers to understand
why managers seek to manipulate profit, how they manage profit, and what the consequence of this practice is.
Answering these questions accounts for a large portion of experimental research in accounting and financial reporting.
Company managers have different motivations for the management of reported financial performance of their
companies. They do this to enhance their loss compensation which is tied toaccounting profit, and when market reacts
suitably to extraordinary high liability items they profit from selling stocks (Jones, 1991; Dechow et al, 1995;
Dechow&Cichev 2002; Kothari et al. 2005). Actual transaction timing change such as advertisements or R&D activities
(Roychowdhury, 2006; Cohen et al. 2008; Cohen &Zarowin, 2010) provides some evidence of profit management in
different areas including agency, ownership, CEO leaving, and IPOs.
Problem statement
CEO leaving creates a special and rich ground for profit management which includes decisions made by both leaving
managers and incoming managers, and their motivations and opportunities for profit management may be different
depending on the kind of job leavings. The leaving CEO may seek to inflate the profit to gain a higher advantage in his
past working years, or to obtain management position or a better job after retirement to hide his weak performance.
The incoming CEO may wish to show profit reduction in the first year. The purpose of the so-called profit reduction
strategy is to reproach the weak performance of the previous manager. The impact of CEO leave on profit management
depends on board members’ decision for replacing the CEO. Indeed, many existing studies find upward earnings
management prior to the outgoing CEO’s departure and/or downward earnings management by the incoming CEO
(Dechow and Sloan, 1991; Pourciau, 1993; Brickley et al. 1999; Reitenga and Tearney, 2003; Conyon and Florou, 2004).
Although the above studies often distinguish between routine and non-routine departures, their results do not
distinguish between whether the incoming CEO has been promoted internally or recruited externally. The specific
context of CEO turnover is likely to have different implications for earnings management by both the departing and
incoming CEOs. For example, a retiring CEO in a routine departure would have less incentive to manage earnings
upward compared to a CEO who is forced to leave due to, for example, poor performance. The purpose of this study is
to investigate the experimental relationship between CEO leave and profit management in Iran.
Literature overview
Studies show that no research has been conducted so far with regard to profit management relating to CEO leaving in
Iran. Therefore this section just overviews the previous researches in general: Pourheidary and Hemmati (1383) studied
the impact of liability contracts, political costs, reward plans, and ownership on the profit management in the
companies registered in Tehran Stock Market between 1370 and 1380, and came to the conclusion that there is not a
negative and meaningful relationship between the company’s size and profit manipulation, there is a negative and

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meaningful relationship between company’s staff number and profit manipulation, and there is a positive and
meaningful relationship between management reward and profit manipulation.Studies based on Australian data also
provide evidence in support of a big bath, but there is little evidence of earnings management by the departing CEO
(Wells, 2002; Godfrey et al., 2003; Wilson and Wang, 2010).
Methodology
A- Variable measurement
JONG-SEO CHOI (2014) To confirm the exact date of turnover, we examined the company history, news articles, and
disclosure of executive changes reported in individual company websites and the Financial Supervisory Service’s
homepage. To check whether the names of CEOs changed from the previous year, we also compared the names of top
executives that appeared in quarterly reports of the year during which the turnover took place. We confirm that over
90% of the executive changes in our sample are made public in general stockholders’ meetings in March.We follow
Huson et al. (2001) and Jenter and Kanaan (2008) to identify if CEO departure is forced. If an article in the business
press indicates that the CEO was fired, was forced to leave, or left following a policy disagreement, then the departure is
identified as forced. When the CEO is under 60 and the article reporting the announcement of departure does not
report the reason for the departure as involving death, poor health, or acceptance of another position elsewhere, the
departure is also classified as forced. Finally, departure due to a merger, bankruptcy, or delisting is also classified as
forced. In all other cases, the departure is considered peaceful.Since we do not have access to the information
concerning CEOs in Iran, we assumed in this research that if the changed CEO is selected from the board members and
is related to previous years, he is considered as internal, and if otherwise he is external. Also to determine the voluntary
or compulsory nature of the leaving, we assumed that CEO leaving in the companies which have a mother company and
provide combinational financial statements is compulsory, and if otherwise it is voluntary. Rah Avard software has been
used for the information related to the study, and the reports and financial statements has been provided from stock
market. We have four types of CEO leaving in this research as follows:
1. Peaceful leave, internal substitution 2. Peaceful leave, external recruit 3. Compulsory leave, internal substitution 4.
Compulsory leave, external recruit.
B – Profit management criteria (measurement)
We examine earnings management during the last year of the departing CEO’s tenure (t = −1) and the first two years of
the new CEO’s tenure (t = 0,+1). We include the second year of the new CEO’s tenure to examine whether earnings
management is concentrated around the time of turnover or persistent over extended periods. Following prior studies,
we measure earnings management by both discretionary accruals and real activities management. For discretionary
accruals, we follow the cross-sectional models suggested by Dechow et al. (1995) and Kothari et al. (2005).
TACit = 𝛼0 + 𝛼1(1/Ait-1) + 𝛼2(ΔSit - ΔA Rit) + 𝛼3PPEit + 𝜀 it )1(
where ΔSit and ΔARit are the change in sales and accounts receivable respectively, scaled by lagged total assets, Ait−1,
and PPEit is net property, plant, and equipment scaled by Ait−1. Also TACit = EBXIit − CFit where EBXI is earnings
before extraordinary items and discontinued operations, and CF is operating cash flow taken from the cash flow
statement. Following Kothari et al. (2005), we also include a constant in the estimation. We use the residual from the
regression model in (1) as the discretionary accruals, denoted by DAMJ.
Our alternative measure of discretionary accruals is similar to the modified Jones model, except that it is augmented by
including ROAit−1. Kothari et al. (2005) compare the effectiveness of two alternative ways of controlling for
performance on measured discretionary accruals. The augmented version of accruals model as described by Kothari et
al. (2005) is given below:
TACit = 𝛽0 + 𝛽1(1/Ait-1) + 𝛽2(ΔSit - ΔA Rit) + 𝛽3PPEit + 𝛽4ROAit-1+𝜀 it (2)
Our second measure of discretionary accruals is the residual from the regression model (2), denoted by DAKW. For real
earnings management, we follow Roychowdhury (2006) and Cohen and Zarowin (2010), and consider three metrics of
the abnormal levels of cash flow from operations, production costs, and discretionary expenses. We express normal
cash flow from operations as a linear function of sales and change in sales in the current.In the present research the
voluntary costs include advertisement and R&D costs. Unfortunately in this area, too, precise information and
separately reported costs in financial statements are not available. Therefore we have considered two criteria from cash
flow extraordinary levels resulting from the operations of production costs. The ordinary cash flow resulting from the
operations is considered as a linear function of sales and sales change in the current period:
CFit = 𝛾1(1/Ait-1) + 𝛾2Sit + 𝛾3Δ Sit + 𝜀 it (3)
Production costs are defined as follows:
PRODit = COGSit + ΔINVit
where COGS is the cost of goods sold and ΔINVit denotes changes in inventory.
Following Dechow et al. (1998), normal COGS is estimated as a linear function of contemporaneous sales, whereas
normal inventory growth is estimated as a function of changes in sales in current and previous periods.Thus, we
estimate the normal level of production costs from the following industry-year regression:
PCit = 𝛿 1(1/Ait-1) + 𝛿 2Sit + 𝛿 3Δ Sit +𝛿Δ Sit-1+ 𝜀 it (4)

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We use these three variables as proxies for real earnings management: abCF denotes the abnormal cash flow from (3),
abPC denotes the abnormal production costs from (4), and abDE denotes the abnormal discretionary expenditure from
(5). For a given sales level, firms that manage earnings upwards are likely to have unusually low cash flow from
operations, and/or unusually low discretionary expenses, and/or unusually high production costs.Corporate governance
proxies.To proxy the effectiveness of a firm’s corporate governance, we use a number of variables related to its
ownership structure, board independence, and the characteristics of its external auditors. We define these variables
below and offer some rationale for their inclusion in the study.First, we choose several governance proxies based on the
firm’s ownership structure. CEOs with a controlling stake in the firm may have more incentives and opportunities to
manage earnings. On the other hand, block shareholders would want to prevent earnings management because the
market discounts the value of firms suspected of earnings management. In addition, foreign owners have tended to play
an important role in monitoring management in Korea after the Asian Financial Crisis in the late 1990s (e.g., Chang and
Shin, 2006). Thus our governance proxies based on ownership structure are: OWN = 1 if the CEO is the largest
shareholder, and 0 otherwise; BLOCK = 1 if the firm has one or more blockholders with more than 5% of the voting
stock, and 0 otherwise; FOR = the percentage of ownership held by foreign shareholders. Second, we use board
independence as another proxy for corporate governance, which is standard in the literature: OUTSIDE = the
proportion of independent directors on the board. or because they are also more concerned with their reputation
(DeAngelo, 1981).(Danos ‫ و‬Eichenseher ،1982) Our last proxy for governance relates to a firm’s external auditors. Since
external auditors attest to financial reports, they are probably the most important gatekeepers in blocking opportunistic
earnings management, and higher quality audits are more likely to result in more conservative earnings. One measure
of audit quality can be the size of audit firm either because larger auditors have more resources and can benefit from
economies of scale.
Firm performance and additional control variables
We use two alternative measures of corporate financial performance: industry-adjusted return on assets (ROA) and
industry-adjusted stock return. Industry-adjusted ROA is calculated by subtracting the median ROA of the industry
from the firm’s ROA. Similarly, industry-adjusted stock return is calculated as the 12-month return ending three months
after each fiscal year-end minus the contemporaneous equally weighted industry index return. Thus, the two
performance measures are: adjROA = firm ROA—median industry ROA during the same period; adjSR = stock return
over 12 months—median stock return of the industry.As noted by Khanna and Palepu (1999), a business group is an
organizational form that functions as an effective monitor of its affiliates and provides an internal labour market that
facilitates labour mobility when external labour markets are underdeveloped. We introduce a dummy variable to
capture the affiliation in the top 30 business groups: CHAEBOL = 1 if the firm is affiliated with the top 30 business
groups in a specific year, and 0 otherwise. In this research the last alternative for sovereignty is defined as follows: If
audit company in one year is the audit organization in Iran, BIG4=1; otherwise it will amount to zero. In this research
for the companies which have been among the 50 superior, CHAEBOL=1; otherwise it will amount to zero.As other
control variables, we use leverage (LEV) as measured by the ratio of total liabilities to total assets, and firm size (SIZE)
as measured by a natural log of total assets. These variables are used in many prior studies such as Chang and Shin
(2006) and Hazarika et al. (2012).
Research findings
Demographic statistics such as average, middle and deviation of criterion are used for distance variables. Table 1 and 2
present the information more precisely.
Table 1. Variable statistics
adjROA adjSR Chaebol OUTSIDE LEV Size statistics
5/2600 -/9471 0/1096 0/7183 1/6295 13/3634 Mean
2/8700 -8/0050 0/0000 /8000 1/4900 13/1350 Median
16/10360 77/24196 0/31263 /15682 0/64077 1/47439 Std/ Deviation
-36/80 -338/54 0/00 0/00 0/48 10/44 Minimum
117/44 544/68 1/00 0/88 6/80 18/45 Maximum

Table 2. Variable statistics

BIG4 abPC abCF TAC statistics
0/2631 2/19936 335067/0790 -12250/3053 Mean
0/0000 345056/0000 42066/0000 9141/5000 Median
0/44061 8/652896 1/494056 1/111336 Std/ Deviation
0/00 -34630/00 -2499452/00 -12967990/00 Minimum
1/00 92882702/00 16701986/00 7767743/00
Maximum

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Correlational coefficients among variables: There are 10 independent and 3 dependent variables in this research. In
table 3, 7 of them are tested with 3 dependent variables (profit management variable indices) namely, TAC, abPC and
abCF. These tests in this section are not the main hypotheses. However, they are considered to enhance the analysis
accuracy. Since variables are at distance level, Pearson significance test has been used. BIG4 size and Chaebol with TAC,
abPC and abCF have a meaningful relationship. These relations on abPC and abCF are positive, whereas they are
negative on TAC.
Table 3. Variable demographic test
abCF abPC TAC dependent
independent
0/515** 0/588** 0-/108** Size
0/000 0/000 0/003
0-/042 0-/092* 0/056 LEV
0/248 0/016 0/124
-0/008 0/003 0/060 adjSR
0/821 0/939 0/099
-0/039 0-/059 0/051 adjROA
0/286 0/126 0/168
0/296** 0/327** 0-/074* BIG4
0/000 0/000 0/043
-0/041 0-/030 0/049 OUTSIDE
0/268 0/439 0/186
0/225** 0/190** -0/138** Chaebol
0/000 0/000 0/000
** On the significance level of 99% or 1% error
* On the significance level of 95% or 5% error

The kind of CEO leave (voluntary and compulsory) and the information relating to CEO leave in industrial companies is
presented in table 4. Out of the whole number of CEO leaves, 483 leaves (64.6%) were voluntary and 265 leaves (35.4%)
were compulsory.

Table 4. Frequency distribution of CEO leaves

Total % number Options
64/6 64/6 483 voluntary
100/0 35/4 265 compulsory
100/0 748 whole number

The information concerning CEO leaving in industries is presented in table 5. Out of the whole number of CEO leaves,
31 (4.14%) are internal, 120 (16.04%) are external, and 597 (79.81%) are the rest.
Table 5. Frequency distribution of CEO leaves
Total % number Options
4/14 4/14 31 internal
20/18 16/04 120 external
100 79/81 597 rest
100/0 748 whole number

First hypothesis test result

In order to study peaceful leave and internal substitution, the profit management by both leaving CEO and incoming
CEO is likely to be insignificant. To test the hypothesis, the multivariate analysis significance test has been used. This
test measures the significance difference among several independent and dependent variables simultaneously. Here
profit management includes TAC, abCF, abPC. Independent variables are in accordance with hypotheses including
voluntary CEO leave and replacing new manager from the same industrial company, which is considered as internal
choice. In this hypothesis, voluntary choice in dependent variables of abPC and abCF creates a meaningful difference,
whereas it does not create a meaningful difference in TAC. The 0.000 value indicates a meaningful difference in
voluntary choice. The remaining managers in industrial companies do not create any difference in profit management

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in this test. In fact because the difference is insignificant, the hypothesis is rejected. Managers who leave voluntarily do
not create a meaningful difference in profit management. Table 6. shows the results in more details.

Table 6. Analysis results of independent and dependent variable multi-test

Significant F test Mean square f sum of squares source

0/066 2/404 3/12812 3 9/38412 TAC

0/000 16/346 3/72613 3 1/11814 abCF
/0000 16/337 1/14615 3 3/43715 abPC
0/205 1/607 2/09112 1 2/09112 TAC
0/000 42/973 9/79413 1 9/79413 abCF
0/000 46/994 3/29515 1 3/29515 abPC
0/400 0/709 9/22811 1 9/22811 TAC
0/035 4/444 1/01313 1 1/01313 abCF
0/257 1/289 9/03913 1 9/03913 abPC
0/087 2/945 3/83212 1 3/83212 TAC
0/504 0/447 1/01812 1 1/01812 abCF
0/565 0/332 2/32613 1 2/32613 abPC
1/30112 676 8/79714 TAC
2/27912 676 1/54115 abCF
7/01213 676 4/74016 abPC

Second hypothesis test results

In order to study the peaceful leave and external recruit, profit management by leaving CEO is likely to be insignificant.
But the incoming CEO may to some extent select rising profit management. Dependent variables in accordance with
hypotheses include voluntary leave of CEO and replacement of the new CEO from another industrial company, which is
considered as an external selection. In this hypothesis, the voluntary leave creates a meaningful difference in dependent
variables of abPC, abCF, whereas it does not create a meaningful difference in TAC. The 0.000 value indicates a
meaningful difference in voluntary leave. The remaining managers in this test create a difference in profit management,
that is, abPC and abCF; and the hypothesis is rejected. Remaining of some managers can also promote profit
management with a lower trust coefficient. Table 7 shows the results with more details.

Table 7. Analysis results of independent and dependent variable multi-test

Significant F test Mean square f sum of squares source

0/087 2/200 2/86512 3 8/59612 TAC

abCF
0/000 16/605 3/78113 3 1/13414
abPC
0/000 16/873 1/18115 3 3/54215
0/218 1/517 1/97612 1 1/97612 TAC
abCF
0/000 42/026 9/56813 1 9/56813
abPC
0/000 46/622 3/26215 1 3/26215
0/748 /103 1/34211 1 1/34211 TAC
abCF
0/023 5/173 1/17813 1 1/17813
abPC
0/095 2/793 1/95414 1 1/95414
0/146 2/123 2/76512 1 2/76512 TAC
abCF
0/005 7/793 1/77413 1 1/77413
abPC
0/045 4/026 2/81714 1 2/81714
1/30212 676 8/80414 TAC
abCF
2/27712 676 1/53915
abPC
6/99713 676 4/73016

Third hypothesis test results

In order to study the compulsory leave and internal replacement, the leaving CEO most probably selects rising profit
management, whereas the incoming CEO most probably selects descending profit management. Here the profit
management includes three variables of abPC, abCF and TAC. Independent variables in accordance with hypotheses
include the compulsory CEO leave and arrival of the new manager from another industrial company, which is
considered as an external choice. In this hypothesis the compulsory leave creates a meaningful difference in the

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dependent variables of abPC and abCF, whereas it does not create a meaningful difference in TAC. The 0.000 value
indicates a meaningful difference in compulsory leave. The remaining amount in this test does not create any difference
in profit management. Table 8 shows the results in more details. In fact in some of the industrial companies the
compulsory leave increases the profit level. In fact the hypothesis is confirmed. Remaining of some managers cannot
promote the profit management in some industrial companies.

Table 8. Analysis results of independent and dependent variable multi-test

Significant F test Mean square f sum of squares source
0/066 2/404 3/12812 3 9/38412 TAC
0/000 16/346 3/72613 3 1/11814 abCF
abPC
0/000 16/337 1/14615 3 3/43715
0/205 1/607 2/09112 1 2/09112 TAC
0/000 42/973 9/79413 1 9/79413 abCF
abPC
0/000 46/994 3/29515 1 3/29515
0/400 0/709 9/22811 1 9/22811 TAC
0/035 4/444 1/01313 1 1/01313 abCF
abPC
0/257 1/289 9/03913 1 9/03913
0/087 2/945 3/83212 1 3/83212 TAC
0/504 0/447 1/01812 1 1/01812 abCF
abPC
0/565 0/332 2/32613 1 2/32613
1/30112 676 8/79714 TAC
2/27912 676 1/54115 abCF
abPC
7/01213 676 4/74016

Fourth hypothesis test results

In order to study compulsory leave and external recruit, the profit management by both leaving CEO and incoming
CEO is most probably insignificant. Here the profit management includes 3 variables of abPC, abCF and TAC.
Independent variables in accordance with hypotheses include the compulsory CEO leave and arrival of the new
manager from another industrial company, which is considered as an external choice. In this hypothesis the
compulsory leave creates a meaningful difference in the dependent variables of abPC and abCF, whereas it does not
create a meaningful difference in TAC. The 0.000 value indicates a meaningful difference in compulsory leave. In fact in
these industrial companies the compulsory leave creates difference in profit. The hypothesis is rejected. Table 9 shows
the results in more details.

Table 9. Analysis results of independent and dependent variable multi-test

Type of leave Profit management

Leave Substitution Leaving CEO Incoming CEO
Peaceful Internal abCF,abPC(+) Insignificance
Peaceful External )+(abCF,abPC Insignificance
Compulsory Internal abCF,abPC)+( Insignificance
Compulsory External )+(abCF,abPC Insignificance

Conclusion
This research studies the profit management with regard to CEO leave by making use of executive manager changes in
large Iranian companies between 1383 and 1392. In this research the existing literature has been investigated through
different ways. First, four types of CEO leave were proposed depending on whether the leave took place peacefully or
compulsorily, and whether the appointment of the new CEO was done through internal growth (promoted from within
the company) or external recruitment. The logic of this classification is that any type of job leave is indicative of
motivations and different opportunities for both incoming CEO and leaving CEO. Second, the present research is the
first comprehensive study based on the obtained information that provides some evidence concerning the relationship
between CEO leave and profit management in the framework of Iranian companies.

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