Journal of Accounting and Economics 16 (1993) 317-336.

North-Holland

Earnings management and

nonroutine executive changes*

Susan Pourciau

Received May 1991. final version received March 1992

This paper examines evidence of earnings management associated

with nonroutine esecutive changes. The empirical evidence is
consistent with the hypothesis that incoming executives manage
accruals in a way that decreases earnings in the year of the executive
change and increases earnings the following year. Further. incoming
executives record large write-offs and special items the year of the
management change. Contrary to expectation, departing executives
record accruals and write- offs that decrease earnings during their last
year of tenure. Several possible reasons for this result are suggested.

1. Introduction

This paper investigates the relation between top

executive changes and discretionary accounting
choices. Evidence is offered that helps increase our
understanding of the executive change process and the
incentives to use earnings management techniques
before. during, and after top executive turnover. This
study contributes to the literature exploring
managerial behavior. the role of accounting in
corporate contracting, and situation-specific incentives
for earn- ings management.
DeAngelo (1988) presents evidence that earnings
management occurs in proxy contests, when
executives are threatened with losing control of their
companies. DeAngelo finds that incumbent
managers use discretionary

Corresporu/r!lcr ro; Susan Pourciau. College of Business, Florida

State University. Tallahassee, FL 32306-1042, USA.
*This paper has benefited from the comments of Tom Schaefer.
Jerry Zimmerman. the conference participants at the University of
Rochester. and the workshop participants at the Florida State
University. Linda DeAngelo provided helpful suggestions on an
earlier version of this paper. Very special thanks are due to Abbie
Smith (the discussant), Ross Watts (the editor). and an anonymous
referee for their insightful comments. Research assistance was
provided by Tim Louvers. Bob Rambo, and Mark Wilder.

016%4101,93~$05.00 c 1993-Elsetier Science Publishers B.V. All

accounting choices to increase income during the proxy

fight. Further. success- ful dissidents manage earnings
downward when elected and report rebounding
earnings the following year. which supports their
claims of superior manage- ment. Studies by Elliott and
Shaw (1988), Strong and Meyer (1987), and Moore
( 1973) document strong associations between large
discretionary write-offs and executive turnover. As in
the case of proxy contests, this initial ‘earnings bath’
allows the new management team to attribute poor
performance to the previous managers and subsequently
report improved performance.
It is proposed here that the circumstances
surrounding certain types of executive turnover
provide incentives for incumbent and successor
managers to make opportunistic accounting choices.
The circumstances surrounding execu- tive changes vary.
To construct a powerful test of earnings management
in the presence of executive changes, it is useful to
identify situation-specific factors that provide special
incentives and opportunities for certain discretionary
ac-counting choices.
Executive changes can be classified as routine or
nonroutine. ‘Routine’ execu- tive changes are those in
which the company structures an orderly, well-planned
process of turnover, as described by Vancil (1987).
Routine changes typically conclude with the retirement
of the top executive, who often remains a member of the
board of directors. As discussed in section 2, the
structure of the routine executive change reduces the
incentives and opportunities for earnings manage- ment.
In ‘nonroutine’ executive change, the company is not
in a position to plan an orderly process of executive
succession, due to inadequate time and or insuffi-cient
opportunity to select and groom a successor CEO with
the support of the incumbent. Nonroutine changes
include most resignations, both voluntary and
nonvoluntary. It is suggested here that the environment
surrounding nonroutine executive changes provides
incentives and opportunities for earnings manage-
ment. Nonroutine executive changes are often
unplanned, making it difficult for the directors and
stockholders to structure the turnover in a way that
minimizes the opportunities and incentives for earnings
management.
In this study, 73 firms are identified as having
experienced nonroutine execu- tive changes. The results of
the empirical tests provide weak evidence consistent with
the hypothesis that incoming executives manage
accruals and record write-offs in a way that decreases
earnings in the year of the executive change and
increases earnings the following year. Contrary
to
expectation. departing executives record accruals and
write-offs that decrease earnings during their last year.
Conclusions are limited due to the difficulty of
controlling for firm performance, the presence of
cross-sectional correlation in the data, and the
possible misspecification of the expectation models
utilized.
The remainder of the paper is organized as follows.
Section 2 describes the process of executive change and
explores incentives for earnings management in this
process. The third section describes the sample
. Vancil paints a picture

sample firms. This is followed by the empirical tests and

results in section 4 and summary and discussion in
section 5.

2. The process of executive change

Each executive change is unique. Turnover in top

management occurs as a result of a variety of
circumstances, including voluntary or nonvoluntary
retirement or resignation, proxy contests,
embezzlement, divorce, and other ‘personal reasons’. A
sampling of quotes from the Wall Street Journal

(WSJ) reveals the unique aspects of executive change.

UTL Corporation said C.C. Lee resigned as president

and chief executive officer pending Defense Department
review of his security clearance. which
it suspended last week. (WSJ, 2/10/88)

R.P. Scherer Corporation’s president and another top

officer resigned in the wake of the proxy battle that the
president lost to his estranged wife, the
company’s largest shareholder. (WSJ, 1l/l l/88)

Melvin Klinghoffer claims he was effectively fired as

president and chief executive officer of Action Staffing,
Inc. . . . when the board . . . ordered
him not to step foot in the company’s office.
(WSJ, 9/15/88)

‘It simply became evident that there were differences in

both management philosophy and operating policy
between Mr. Lemasters and the board’, (Mr.
Whohlstetter) said. ‘It was mutually agreed that
the interest of all parties would be best served by
a change in management’, he added. (WSJ, 5,‘1,87)

Global Natural Resources Inc. said its president and

chief executive officer resigned and directors launched an
investigation into ‘misuse of assets’ on
a construction project. (WSJ, 5/l l/88)

Although special circumstances surround every

executive change. each change can be classified as one
of two general types, routine and nonroutine. It is
suggested here that routine and nonroutine executive
changes provide differen- tial incentives and opportunities
for earnings management.

2.1. Routine esecutire chnnges

Vancil (1987) investigates the process of CEO

succession in a study of top executive turnover in large,

of routine executive change’ as a fairly orderly,

well-orchestrated process in which the reputation of the
former CEO is dependent upon the success of the
replacement CEO.
Vancil describes one common process of
executive change as the ‘relay process’. In these cases,
a successor is chosen several years in advance of the
anticipated retirement of the incumbent CEO.
During the transition period. power and authority are
gradually handed over to the chosen replacement until.
finally and anti-climactically, the title of CEO is
formally given to the successor. Another model of
executive succession is the ‘horse race’ in which
several contenders are identified early and engage in
a fairly open competition to determine who will
become the next CEO. The choice of the relay process,
or horse race, is dependent upon the culture of the
company and the environment in which it operates,
according to Vancil.
Vancil’s research concentrates on routine, planned
executive turnover, with a relatively ordered process
of CEO succession. Under this process, the former and
successor executives have the same goal: to make
the incoming CEO successful. If the new executive is
unsuccessful, it reflects badly on the former CEO’s
judgment and management skills. In the case of
routine executive changes, then, there is little conflict
of interest between the old and the new executives
which might lead to opportunistic earnings
management.
Further, there are few opportunities for earnings
management in this scenario. Since the incoming top
executive is an insider, he or she is able to closely
monitor the decisions of the outgoing CEO. In
addition. since the former CEO typically remains on the
board of directors, he or she is in a position to monitor
the new chief executive. The process is structured in a
way that minimizes moral hazard, providing less
incentive and reduced opportunity for earnings
manage- ment. Dechow and Sloan (1991) report results
consistent with the notion that the method of CEO
succession affects the tendency for departing executives
to manage discretionary investment expenditures to
improve short-term earnings.
There are
occasions when the process of executive
change is not
orderly and well-planned. In these cases,
there are greater incentives and opportunity for
earnings management due to the conflict of interests
between the parties involved.

2.2. Nonroutine esecrrtice clumges

A nonroutine top executive change is one in which

the company does not have adequate opportunity to
select and groom a successor. These changes are

‘It should be noted that Vancil (1987) does not specifically

distinguish between routine and nonroutine executive changes. The
author of this paper suggests this dichotomy as one approach to
exploring the executive change process. A similar approach is
adopted by Merrill and Waterhouse (1992).

relatively unplanned and the company is unable to

take the time necessary to structure the executive
turnover. Further, the former CEO leaves the company
and does not function as a resource enhancing orderly
succession.
An obvious example of a nonroutine management
change is the forced resignation of a top manager. As
Vancil (1987, p. 5) points out: ‘Deposing an incumbent
CEO is an almost impossible task for the board of
directors as a group and the result is that most boards
have a high tolerance for mediocrity.’ Empirical research
supports the assertion that top executive turnover is a
rela-tively rare event. Studies by Coughlan and Schmidt
(1985). Warner et al. (1988), and Weisbach (1988)
indicate that the probability of executive change in a
firm that is in the lowest performance decile may range
between 6 and 13 percent; the probability of executive
change in a top-decile company is between 3 and 9
percent. The possibility of termination is a threat that
managers likely take very seriously because termination
is such a dramatic event, made all the more serious by
its infrequency.
It is assumed in this research that managers can
fairly accurately predict the probability of their being
asked to resign. When an executive is performing
poorly, it is not easy to ask him or her to leave, as
pointed out by Vancil(1987). The manager is given some
time to prove himself or herself. Further, informa- tion
must be gathered, feedback obtained, coalitions
formed, and so on. until a majority of the directors
request a resignation. The manager is not isolated from
these events and can likely judge the seriousness of the
situation. Anecdotal evidence supports this contention.
An article in the Wall Street Journal (4 14/88) suggests
that the time horizon and incentive for incumbent
officers are obvious:

Mr. Farber said that he had been trying to persuade

the board to remove Mr. Leonard since last year, but
that it decided to act when the exact size of the 1987 loss
was determined.

It is suggested here that the executive can predict the

likelihood that he or she will be asked to resign, but that
there is a certain amount of lead time during which the
executive attempts to avoid or delay resignation. One
avenue for this behavior is through the management
of earnings; the executive will point to the improving
financial statements as evidence of his/her improving
performance.
Previous research demonstrates a significant relation
between firm perform- ance and the probability of
executive change, implying that performance is a
signal to company monitors regarding the performance
of the top executive. Coughlan and Schmidt (1985) and
Warner et al. (1988) demonstrate that stock market
performance is a significant predictor of executive
turnover. Weisbach (1988) concludes that, in addition
to market performance, accounting-based performance
measures (such as income) are also related to executive
change.
Executives at the helm of poorly performing
companies have incentives to make discretionary
accounting choices that serve to increase earnings.

contrary to the suggestion by Healy

(1985) that
managers of poorly performing firms choosewill
income-decreasing accruals if they are out of the
money in terms of the annual bonus. Healy’s
hypothesis suggests that the overall wealth position of
the manager will be improved by delaying income to a
later period when a bonus would be payable. If,
however, the executive is threatened by termination,
the choice of income-decreasing accruals would not be
expected to increase his or her wealth.
There are at least two reasons to expect earnings
management that improves reported performance in an
executive’s final years. First, it is suggested that
opportunistic managers are trying to affect the
probability or the timing of forced resignation. If
managers believe any increase in earnings is viewed
positively by the board of directors, they will have
incentives to make account- ing decisions
opportunistically. This strategy would not be effective if
the board can identify and discount the effects of
income-increasing accounting decisions. However, these
choices are not easily identifiable in an already noisy
proxy for management performance; the effects of
discretionary accounting procedures add additional
noise to the performance signal.
A second explanation for income-increasing
accounting decisions in a period of poor performance is
the possibility that managers use their discretion over
accounting choices as a signal of their inside
information. This view implies that the executives
believe that current income is an inaccurate predictor
of future earnings. Executives then use earnings
management techniques to convey in-formation to the
market regarding their inside information about future
protit- ability. The ‘opportunism’ view and the ‘signalling’
explanation are both consist- ent with the hypothesis
that executives of poorly performing companies will
select income-increasing earnings management
techniques.’
The above discussion relates primarily to forced
resignations or terminations. Another example of a
nonroutine executive change is a voluntary
resignation. Executives who resign voluntarily (for
instance, to take a better position) also have incentives
to make income-increasing accounting decisions.
First, the manager may wish to further reinforce his or
her reputation and send a signal to the new company;
second, the manager may be eligible for an annual
bonus or other pay based on accounting earnings;
third, the executive may wish to make it more difficult
for the replacement manager to meet or exceed the
previously established performance. To the extent that
the boards of direc- tors are unable to identify the
manipulation, these incentives can result in earnings
management in the case of voluntary resignations as
well as forced resignations.

‘The opportunism and signalling hypotheses are presented by

DeAngelo (1988. p. 7) in her study of earnings management associated
with proxy contests. It is not possible to distinguish managers’
motives in this study. therefore the results do not allow us to
draw conclusions regarding the explanatory power of these
hypotheses.

The successor executive also has incentives to manage

earnings. Vancil(l987, p. 67) describes the role of a new
CEO as follows.

Summing up, almost any CEO must face three critical

tasks early in his tenure: (1) tnanaging the expectations
of his officers and directors; (2) taking ownership of the
strategic thrust of the corporation during his tenure:
and (3) building confidence among all parties by
achieving an initial, realistic set
of performance gods in his first year or two.
(emphasis added)

To manage expectations and reach performance

goals, it is suggested that the new executive attempts to
blame the previous executives for poor performance,
allowing the new management team to take credit for
improving performance. This can be accomplished
through initial large discretionary write-offs to focus
attention on the inferior decisions of prior
management. The combination of early write-offs and
later income-increasing earnings management presents
the new executive team in the best light. This behavior
sets a low benchmark against which performance is
judged and, at the same time, increases the ability of
the executive to make income-increasing decisions in
the near future.
This discussion indicates a high degree of
opportunism driving the new managers; an
alternative explanation is that the new CEO may
recognize problems previously ignored by prior
management. Therefore, new execu- tives are not
necessarily inappropriately making large write-offs;
they may be recording write-offs which should have
been recognized by the previous managers.
 Previous research [Elliott and Shaw (1988) and
Strong and Meyer (1987)] provides support for the
hypothesis that new executives make large discretion- ary
write-offs. In the sample of large discretionary write-offs
examined by Elliott and Shaw, 39 percent of the firms had
experienced a change in the chief executive officer,
president, and/or chief financial officer during the year
of the write-off. Strong and Meyer report that the
most significant difference between their paired
samples of write-off and non-write-off companies was
the high incidence of change in senior management in
the write-off firms. This evidence is consis- tent with the
contention that new executives seek to blame prior
managers for poor results, and,‘or that the previous
executives failed to make the appropriate write-off when
needed.

3. Sample selection and description

The discussion above suggests that the process

of nonroutine executive change is a fertile environment
for earnings management. To construct a power- ful test
of this hypothesis, it is necessary to identify
nonroutine executive changes. Table 1 summarizes the
sample selection process.
 Table I
Selection of sample of nonroutine top executive changes. lY85-1988.

Keyword search of Compact Disclosure:

Resigned CEO chairman president

Retired CEO chairman president

Terminated CEO chairman president

Total cites

1.083 Multiple cites for same cornpan)

(241) Total companies from search

842 No executive change”

( 188) Total executive change companies

654 Deletions:
Financial institutions. regulated companiesh
(160)
‘Routine’ executive change’
(267)
Mi scellaneous“

054) Total sample

73

“For instance. if the President’s letter of ABC Company stated. ‘Mr. X. retired CEO and chairman

of XYZ Company, joined our Board of Directors this year’. the

keyword search process would select this company even though no
executive change occurred.
hFinancial institutions and regulated companies are deleted due to
the unique incentives created by the reporting environment in which
they operate.
“ Routine’ executive changes include: II those changes which
were described in the company’s annual report or in the Mall Street
Jottr~ol as retirements, and 2) resignations when the executive was
reported to have remained on the company’s board of directors or
continued to serve the company in some other capacity (e.g.. as a
consultant).
“The miscellaneous category includes all other deletions
including: I) bankrupt companies, 2) foreign companies. 3) more
than one person resigned from the same position over a three-year
period. and 4) missing data.

keyword
regulated companies. Another 154 vvere deleted for a
variety of reasons. includ- ing bankruptcy. foreign
incorporation, missing data, and the resignation of
more than one person from the same position over a
three-year period.
Also excluded from the final sample are 267
companies which I identified as ‘routine’ executive
changes. ‘Routine’ executive changes include: 1)
those changes which were described in the company’s
annual report or in the Wall Street Journnl as
retirements, and 2) resignations when the executive
was reported to ha1.e remained on the company’s board
of directors or continued to serve the company in some
other capacity (e.g.. as a consultant). As discussed
previously, the incentives created by routine and
nonroutine executive turnover are very different. The
theory suggests that nonroutine executive changes pro-
vide greater incentives and opportunities for earnings
management than does routine turnov’er. Therefore, to
construct a powerful test of the earnings manage- ment
hypothesis. I examine the cases in which earnings
management techniques are most likely. i.e., the
nonroutine executive changes. Vancil’s (1987) character-
ization of routine executive turnover suggests that
retirements are generally well-planned. Further. the
retention of the former executive on the board of
directors or as an advisor is evidence of a routine
executive change. For the purposes of sample selection,
companies fitting this description are classified as
routine; any executive changes not classified as routine
are considered nonrou- tine and constitute the final
sample of 73 firms.
A profile of the sample is presented in table 2.
The sample companies represent a fairly wide range
of size and performance (panel A) as well as industry
(panel C). Panel B of table 2 presents information
regarding the years of the turnovers and the companies’
exchange listings. Compact Disclosure pro- vides the
dates of the executive changes which were verified,
when possible, in the Iti111 Srreer Jourd. As shown in
panel B of table 2, the resigning manager’s last year was
1986 or 1987 for over 90 percent of the firms in the
sample and approximately 75 percent of the sample
companies are OTC firms.
For the purposes of this study, the resigning
manager’s last year of tenure is identified as the latest
year during which he/she had been in the management
position through the year as well as throughout the
three months following fiscal year-end. For instance, a
manager of a 12/31 year-end company who
resigned on 12 31,/87 had his/her final year of tenure in
1986, since the executive did not maintain the position
through the first quarter of 1988. This approach is an
attempt to identify the last year during which the
executive had control of the annual financial statements.
A manager resigning as of 12/31/87 would not likely
have had input into the determination of accruals and
other discretionary accounting decisions affecting the
financial statements that are issued during the first
quarter of 1988. For this company, the year of executive
change is identified as 1987. The year of executive
change is the first year the resigning executive does not
appear to have control over the year-end financial
statements. It should be noted that the empirical

Table Z
Profile of sample of 73 firms changing top executives over the period
1985-1988. Panel ;\ presents descriptive statistics on market value.
total assets. and net income (loss): panel B summarizes
exchange listings and years; panel C analyzes industry membership.

Punel A: Fitwwicll rwi&les

Mean Std. dev. Med. Min. Max.

Market value of equity”.h 54.139 119,938 13.163

650 841.956 Total assets”.b 76.953
205.61 I 10.895 I 1.596.537
Net income”.b (loss) (468) 6.991 (536) (25,544) 1’
__. 43’__

8: Erc~htrnyrlisriqs
Last year of Number of
Exchange Sumber of
resigning manager companies listing companies

1985 2
NYSE 7
1986 25
ASE II
1987 43
OTC 25
1988 2

Total 2
Total 73

Panrl c: Itlt/lrsrr~
Number of Sumber of
Z-digit SIC code Industry companies Z-digit SIC code, Industry companies

I Agriculture I
12 Coal I
I3 Oil and gas 5
I7 Special construction I
23 Textile-apparel 1
27 Publishing and printing 2
 6
28 Chemical products
33 Steel-related I
35 Mfg.. & office II
machines. equipment
36 Electric and electronic 4
equipment
37 Autos. airplanes. etc. 2
38 Instruments and 8
photograph)
39 Toys and leisure I
50 Durable goods 4
51Wholesalers I
58 Restaurants 1
59 Miscellaneous retailers 3
71 Personal services I
73 Business service 3
agencies
75 Auto rental 1
78 Entertainment I

79 Recreation I
80 Health care services 5
87 Engineering. mgmt. 3
services
Total 2
‘Market value of equity, total assets, and net income (loss) are
all reported in thousands of dollars.
bMeasures reflect values for the last full year of the resigning
manager’s tenure as executive.

executive change year. When the change year is defined

as the year in which the resignation occurred, there are
virtually no significant results supporting the
hypotheses advanced in this paper.

Susm

Portrciuu. Etrmings manugenwnr und nonrourinr e.recurire changes

327

Tvvo performance measures for the executive change

firms are presented in table 3. Accounting return on
common equity and market-adjusted security return
were computed for the two years prior to the executive
change year, the year of the change (year 7), and the year
following the change. Both performance measures reveal
a downward trend for the period T - 2 through T. These
results are consistent with those
of Coughlan and
Schmidt (1985), Warner et al. (1988). and Weisbach
(1988) who document a period of poor performance
prior to executive change. Although performance
appears to rebound somewhat in year T + 1. it remains
negative. Analyses of sales, net income, and return on
assets yield the same pattern of declining performance
from year T - 2 through year T, follovved by improving
performance in year T + 1. Similarly, market value of
equity and total assets decrease from T - 2 to T,
followed by an increase in size. This pattern of
performance for the sample firms suggests the
importance of controlling for firm performance when
testing for earnings management. This issue is discussed
further in the next section.

4. Empirical tests

4. I, C’uriuhle t~~eusurement and llypotheses

I examine unexpected earnings, accruals, cash flows,

and special items for the years T - 1, T. and T + 1. The
earnings measure is net income, which is made up of
cash flow effects and accruals [see Wilson (1987)].
Total accruals are defined as net income minus cash
flow, where cash flow is working capita1 from operations
plus current accruals5 Current accruals are defined as
the changes in all working capital accounts except
cash, marketable equity securities, and short-term
maturities of long-term debt; working capital from
operations is net income adjusted for income from
discontinued operations, changes in deferred taxes.
depreciation, amortization, and unremitted earnings
of unconsolidated subsidiaries.
Because earnings, accruals, cash flows, and special
items vary with the size of operations and overall firm
performance, each measure is scaled by current-year sales
prior to differencing. The scaled measures should
provide a better proxy for the discretionary component
of the accounting numbers, controlling for firm
performance. This procedure may, however, induce an
unexpected change even

‘Although there are no specific hypotheses regarding cash Rows,

the cash flow information is provided for completeness. Due to the

construction of the variables, unexpected earnings should equal
unexpected cash Rows plus unexpected accruals. The measurements
in table 4 do not satisfy this additivity feature: earnings measurements
were tested for firms for which unexpected accruals and cash flows
couid not be determined. When table 4 is reproduced using only the
28 firms for which data is available for all years and for all

variables, the conclusions of the analysis are unchanged.

 TJble 3

Means and medians for return on equity and securtty market return
measures for years surrounding executive resignations for 73 firms

changing rnp executives over the period 19Y5-1988 tp-values in

parenthesest.”

Starket-adjusted
Return on equityb security returni

Number
~~.~____
Yea? of firms Mean hledian hleun !vledian

T-2 44 - O.OhX 0.0 146

0.1160 - 0.1351
(0.2880) (0.68781 t0.3580) (0.3155)

T-1 52 - 0.03s2 - 0.049 I

- 0.0% I - 0.1353
(00060l (0.0084) (01191) to.0’24)

7 61 - 0.22s5 - 0.1333

- 0.1765 - 0.3 I57

(0.00021 (0.0001) (0.0373) (0.0115)

7-+ I 59 - 0.1271 - 0.0618

- 0.12’8 - 0.3415
t00023t t0.0013) (0.3438, t0.0008)

“The null hypothesis tested is that the mean or medtan is zero.

bReturn on equity, = Net income,,‘Market value of common

equity,- ,.

‘Security market return, =

[tsecurity price, - Security price, _ I1Security price, _ ,] - Average

market return. Prices are adjusted for dividends. splits. etc. Avera?
market return is based on an average of NYSE, ASE. and OTC
companies published by Valuehne. Inc.
dThe year of executive change. year r. is the first year the

incoming executive appears to have control over the annual financial

statements. Control over annual financial statements is evidenced by
the executive being in his, her esecutive position at the end ofthe tirst
quarter following year-end.

if one does not exist due to the possibility of

changing profit margins. As an alternative approach,
earnings, accruals, and cash flows are deflated by the
level of sales for the preceding year. This analysis yields
results very similar to those using the current sales
deflator and. therefore. are not reported here.6
Further, as an alternative to the total accruals
measure. the current and noncurrent accruals were
examined separately to determine if a single type of
accrual was driving the results. This approach yields
results consistent with those of the total accruals
measure. and so are not reported here. In addition, it
should be noted that the accruals measure includes the
effects of special items and discretionary write-offs, so
the tests of accruals and vvrite-offs are not
independent. However, when the accruals measure is
defined to exclude the effects of special items, the
results of statistical tests are virtually identical to those
reported in table 4.
For earnings, accruals. and cash Rows, a random
walk process is assumed. The random walk model has
been shown to be as good a predictor of future

‘The results for years T and T + I are virtually identical to those

reported in this paper: the year T - I results are slightly more

significantly negative (i.e.. more extreme negative earnings and

accrualsl.

annual earnings as other, more complicated.

expectations models [e.g., see Albrecht. Lookabill, and
McKeown (1977). Ball and Watts (1972), and Watts
and Leftwich (1977)].’ There is little time series
evidence with regard to annual cash flows and accruals,
so a random walk process is assumed for these variables
as well. Recent research by Dechow (1992). however,
indicates that accruals are negatively correlated in the
first differences, suggesting measurement error in this
research. For the special items variable. a random
walk process is not assumed; due to the nature
of special items and write-offs, the expected value of this
measure is zero. When a random
is walk expectation
utilized for the special items, the
are empirical results
consistent with those resulting from the expecta- tion of
zero special items, and so are not reported here.
The first set of hypotheses relates to the behavior of
the resigning executive. It is expected that an executive
anticipating possible resignation will undertake
earnings management techniques to report increased
accounting earnings. To examine this, I compute the
unexpected earnings and unexpected accruals for the
year prior to the executive change, the manager’s last
year of tenure with control over the annual financial
statements. For all hypotheses, the random walk model
is used to estimate the expectations for earnings and
accruals. The unexpected component of earnings or
accruals. therefore, is the change in the measure from
the previous year. In addition. these variables are
deflated by sales, as previously discussed. The
alternative hypotheses are stated below.

H 1: Unespecreri earnings are positive the year prior to

the esecutice change year

(year T - I).

H2: Unexpected accruals increase incotne in the year

prior to the esecutice

change Jear (year T - I).

The second set of hypotheses relates to the behavior

of the new executive. It is expected that the new executive
will at first attempt to minimize earnings using
accounting discretion, but will subsequently manage
earnings upward in an effort to portray the improved
performance by the new management team.
H3: Unespecteti earnings
are negative the year of the executite change (!,ear T).

H4: Unexpected accruals decrease income itt the year

of the e.uecrrrire change
(year T).

H5: Unexpected earnings are positice the year

following the executive change
(year T + 1)

‘A random walk with drift may improve the expectation model.

For many of the firms in this sample. however. measures for

earnings. cash flow. and accruals are unavailable for a number of

years prior to the executive change. making it difficult to determine a

reasonable drift term.

330 Susun Pourciau.

Eumings manugmlenr and nonroutinr execulire changes

H6: Unexpected accruals increase income in the year

following the esecutice
change (year T + 1)

There is evidence from previous research that new

executives may take steps beyond accruals management
in order to take an earnings bath their first year. Large
discretionary write-offs are correlated with executive
changes, according to Strong and Meyer (1987) and
Elliott and Shaw (1988).

H7: Special items and discretionary write-offs are

negative the year of the execu-
tive change (year T).

4.2. Results

Figs. 1and 2 provide an overall picture of the

accounting numbers reported by sample companies,
and table 4 provides the results of the statistical tests.

“SW

0.15

0.1

0.05

-0.05

-0.1

T-S T-4 f-3 T-2 T-l T T+l T+2

- Median Unexpected Earnings - Median

Unexpected Accruals
Fig. 1. Median unexpected accruals and earnings for the period
beginning five years before and ending two years after the executive
change (year T) for 73 firms changing top executives over the
period 19851988.
The unexpected components of earnings and accruals are defined
as the first difference of the variable, after scaling by sales [e.g., UE,
= (E, S,) - (E,_, S,_ ,)I. The year of executive change, year T, is the
first year the incoming executive appears to have control over
the annual financial statements. Control over annual financial
statements is evidenced by the executive being in his/her
executive position at the end of the first quarter
following year-end.
Sum Pourciuu.

Eumings nwnugenrenr unJ nonroutine esecrtrire chunges

-0.02 --

-0.03 --

-0.04 --

-0.05 --

4.06 *-

-0.07 J I

T-S T4 T-3 T-2 T-l 7 T+1 T+2

Fig. 2. Trimmed means of special items for the period beginning five

years before and ending two years after the executive change (year

7-) for 73 firms changing fop executives over the period The two

1985-1988.
extreme observations for each year are deleted due to the effect of

outliers. The year of executive change, year K is the first year the
incoming executive appears to have control over the annual financial

statements. Control over annual financial statements is evidenced by

the executive
being in his ‘her executive position at the end of the first

quarter following year-end.

Examination of unexpected accruals and earnings of fig.

1 reveals an interesting pattern over the seven-year
period T - to T + 2. The
5 scaled unexpected
measures are relatively smooth over the years T - 5
to T - 2, but fluctuate widely in the period T - I to
T + 2, with especially high values in T + 1, the year
following the executive change. This illustration is
consistent with the hypotheses regarding T and T + 1
but inconsistent with the expectation for T- 1
The statistical tests in table 4 provide weak support
for these findings. The results of signed-ranks tests are
consistent with the hypothesis that incoming executives
manage earnings downward using accruals in year Tand
then reverse the behavior in year T + 1.The results of
tests on the means of the unexpected measures do not,
in general, provide statistically significant results. The
non- parametric tests are relied upon here due to the
presence of outliers affecting parametric results and the
relatively small sample size. It should be noted that the
signs of the means and medians are generally
consistent.
 The sample companies are concentrated in time
and, to a lesser extent, concentrated in a limited
number of industries. The empirical results may be
influenced by the possible cross-sectional correlation in
the variables, overstat- ing the significance levels of
hypothesis tests. The cross-sectional correlation limits
the generalizability of the results.

Mean and median statistics for unexpected earnings. accruals. cash

tlous. and special Items for the years surrounding executive
resignations for 73 firms changing top esecut~vcs ober the period
1985519X8.

Unexpected Unexpected Unexpected Unexpected

earning” accruals” cash flous’ special itemsh

ILtrr T - I’
Predicted sign +
Mean 0.169
(p-\alueJd (0.264)
Median - 0.022
(p-\alueF (O.SYh)
,t 59
Yrw 7.“
Predicted sign
Mean - 0.230
(p-value+ (0.3091
Median - 0.046’
(p-value)d (0.020)
,I 64
YCLI).r + I’
Predicted sign +
Mean 0.653
(p-\alue)d (0.1211
Median 0.064’
@-valueId (0.001)
,I 53

+ ‘,

- 0.206 - 0.057
(0.641) (0.079)

- 0.066 0
10.927) (0.057)
43 66

0.870 - 0.066’
(0.773) (0.001)

- 0.075’ 0’
(0.019) (0.001)
50 71

+
I.SJO’ - 0.796 - 0.012
(0.010) (0.1691 10.1461
0.17” - 0.030 0
 (0.002) (02821 10.1091

46 16 54
“The unexpected components of eat-nings. accruals, and cash Hous are defined as the first

difference of the variable. after scaling by sales [e.g..

L’E, = (E,, S,) - (E, _ , S,_ ,)I,
%nexpected special items is based on an expectation of zero special
items each year. ar.d is scaled by level of sales (e.g.. L’S!, = SI, S,).
‘The year of executive change. year r. is the first year the
incoming executive appears to habe control over the annual financial
statements. Control o\er annual financial statements is evidenced by
the executive being in his’her executive position at the end ol’ the first
quarter follouing year-end.
“P-values are one-tailed for tests with specified expected signs.
and tbo-tailed for tests uith no expectation.
‘Significant at the 0.05 level.

The year T - 1 results are contrary to expectation.

Examination of fig. 1sug- gests a possible explanation for
the income-decreasing accruals in year T - 1.
Unexpected accruals in year T - 2 serve to increase
income. It is possible that the incumbent executive
anticipated a possible resignation a year or more prior
to year T - 1 and, at that point, began to manage
ple size of 50.

Although statistical tests of the T - 2 unexpected

accruals reveal that they are not significantly different
from zero, the cumulative effect of several years of
income management may have forced the executives to
take a bath in T - 1
There are other explanations for these results. First,
since the actual turnover rate among top executives
is
quite low, executives may not consider resignation a real
possibility and therefore do not attempt accrual
management techniques. Instead, consistent with
Healy’s (1987) research, they take a bath in T - 1to
maximize their future expected compensation given an
earnings-based pay plan.
Also consistent with these results is the argument that
the unexpected accruals measure used here does not
adequately control for firm performance character- istics.
As Murphy and Zimmerman (1993) point out,
management turnover is associated with poor firm
performance. The relation between earnings and
executive change is likely a tangled web of poor
performance and earnings management. The ability to
test one hypothesis depends upon the ability to
control for the other factor. Scaling by sales is an
attempt to control for nondiscretionary environmental
changes such as poor performance. To the extent that
this technique is unsuccessful, other factors could be
driving the results. Further, when a firm begins to
perform poorly, interested parties may increase
monitoring of management. In the presence of
intense monitoring, incentives and opportunities for
accruals management decline.
Fig. 2 provides an overview of the special items and
write-offs (Compustat item # 17) .This graph presents
the mean values of reported special items, deleting for
each year the two extreme observations due to
outliers.’ Special items are relatively small in the years
T - 5 through T - 2. but large write-offs occur in years
T - I and T. The statistical significance of the special
items are reported in table 4, providing results
consistent with hypothesis H7. Incoming executives
make significant write-offs when they take charge of the
organization, as has been found in previous studies.
There was no hypothesis, however, concerning the
departing managers taking large write-offs. Although
not expected. this is consistent with the evidence
regarding accruals. The incumbent executives record
write-offs and special items their last year of tenure, just
as they record income-decreasing accruals. The
explanations advanced previously with regard to
accruals in year T - I apply to special items in T - 1as
well.

*The deletion of the two extreme values of special items for each

year minimizes the effect of unusual values. The years for which

the trimmed means are substantially different from the untrimmed

means are years T - 4, T - 3. and T - 1. The untrimmed (trimmed)

means for each of these years is as follows: T - 4 - 0.049 ( - 0.008).

T - 3 - 0.022 (- 0.009). and r - 1 - 0.057 (- 0.034). The write-offs

causing these swings ranged between 80 and 183 percent of sales.

Each of these extreme values was more than six standard deviations

away from the untrimmed mean. It should also be noted that medians

for all the years were equal to zero. The number of observations ranged

from 18 (year T + 2) to 71 (year T). with an average sample size

of 50.

5. Summary and discussion

This paper investigates the relation between

nonroutine executive changes and discretionary
accounting choices. Previous research provides
evidence that. in certain situations, managers have
incentives to make discretionary account- ing decisions in
their own best interests. This study tests this
hypothesis in the presence of nonroutine executive
change.
Analysis is performed on a sample of 73 top executive
resignations during the period 1985-1988. For each of
the firms, I examine earnings, accruals, cash flows, and
special items and write-offs over a three-year period (the
year prior to the change, the year of the change, and
the following year).
The results suggest that incoming executives record
accruals and write-offs in a way that decreases earnings
the year of the executive change and increases earnings
the following year, as suggested by the earnings
management hypo- thesis. However, as previously
discussed, this pattern of results may be a func- tion of
the performance of the company. To the extent that the
research design does not appropriately model
expectations and/or control for performance, the
evidence does not allow one to distinguish between
the earnings management and the poor performance
explanations.
Contrary to expectations, departing executives
record accruals and write-offs that decrease earnings
during their last year. Possible explanations for this
result are discussed. These include the following: I) the
misspecification of the time horizon in this research,
suggesting that in year T - I the income-decreasing
accruals serve to reverse the effects of several
years of income-increasing accruals, 2) the failure of
the empirical measures to adequately control for firm
performance, 3) the manager’s inability to predict his
or her termination, 4) the interest in maximizing
accounting-based compensation, and 5) the increase in
monitoring activities associated with poor firm
performance.
It is likely that the limitations of the model
specification and the data limitations inherent in the
sample account for the pattern of results. As has been
noted, it is impossible to determine the onset of
earnings management behavior by the departing
executive. On the other hand, the time frame for the
behavior of the incoming manager is fairly clear. Given
the large magnitude of the big bath and its reliable
timing, the write-offs and accruals of the new executive
are more apparent in the data. Earnings management
by the departing manager could occur over several
years prior to the turnover. It is plausible that the
executive successfully managed earnings, avoiding
termination, for a number of years. Due to the sample
selection, these executives would not appear in the
sample as a management change until the year he or she
could no longer increase earnings opportunistically and
was forced to make some income-decreasing
write-offs. This scenario is consistent with the results
obtained.
The sample selection is imperfect, since it is
impossible to isolate situations in which executive
change is imminent. By selecting firms that

turnover, the sample is biased toward firms whose

executives were not successful in managing earnings.
The sample selection process excludes managers who
might have anticipated trouble. but were successful
in managing earnings upwards, thereby avoiding
termination. This scenario is consistent with the
suggestion that executives included in the sample are
those who had managed earnings upwards in preceding
years but were no longer able to continue the process
and/or their efforts were swamped by the firm’s poor
performance. Further, the routine nonroutine dichotomy
is subjective and companies may be misclassified,
weakening the power of the empirical tests.
There are problems in measuring earnings, accruals,
and cash flows; these problems are accentuated by the
necessity of forming expectations of these variables.
The expectations are particularly suspect in the
situation of impend- ing executive change, since turnover is
highly correlated with poor firm perform- ance and there
are likely to be changes in operating and financing
decisions which affect the variables examined. To
control for these effects, the measures are scaled by
sales.
The evidence presented here contributes to research
on executive turnover, managerial behavior. the role
of accounting in corporate contracting. and
situation-specific incentives for earnings management.
Further, the study raises additional research questions.
The routinenonroutine dichotomy for executive change
is one approach to examining these issues, but there
are other ways to classify executive changes which may
provide insights. Improved measures of discretionary
accounting choices will benefit this research and
several other areas of research. Further, controlling for
firm performance and other correlated variables will
increase the power of the tests. Research has
demonstrated that discretionary write-offs are
associated with executive change and are also
correlated with poor firm performance. Disentangling
these correlations will strengthen the reasonableness of
a causal link between executive changes and write-offs.

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