Abstract

۱٫ Introduction

۲٫ Hypothesis development

۳٫ Sample and data

۴٫ Research design

۵٫ Results

۶٫ Conclusion

Acknowledgements

References

Abstract

     We examine the role of CEO social capital as an important driver of the widespread practice of real earnings management (REM). Using the number of social connections to outside executives and directors to measure CEO social capital, we first find that well-connected CEOs associate with higher levels and volatilities of REM. The positive relation between REM and CEO network size is stronger when the CEO connects with more informed and influential persons, and when a more severe misalignment of interests can occur. Second, we find a contagion of REM among well-connected CEOs in an industry. Third, the level of REM induced by a large CEO social network associates negatively with future operating performance. This result is consistent with social capital circulating REM-related information ex-ante and increasing the power and influence for the CEO to deviate from optimal operating policies ex-post. Social capital shields the well-connected executive in the takeover and labor markets despite possible suboptimal future operating performance. While the prior literature finds that CEO social capital reduces accrual earnings management, our findings suggest a dark side of CEO social capital: it induces excessive levels and volatilities of REM costly to the firm in the long run while imposing relatively low personal risk on the top executive.

Introduction

     We examine whether executives’ social capital affects firms’ real earnings management (REM), a practice whereby a manager purposely alters the firm’s cash flow to report earnings based on departures from the timing or structuring of normal or optimal operations. Considering the pervasive and popular use of REM, especially after the Sarbanes-Oxley Act (Gilliam et al., 2015; Koh et al., 2008; Brown and Caylor, 2005; Larcker et al., 2013), a significant body of literature has examined what drives REM practices and their operating consequences (e.g., Barton and Simko, 2002; Demski et al., 2004; Ewert and Wagenhofer, 2005; Zang, 2012). However, extant studies overlook an important human factor underlying a decision to engage in REM, the social capital of the executive who develops and implements the financial reporting practices. We contribute to the literature by being the first to examine the impact on REM practices of CEO social capital and its role as an important channel through which REM affects future firm operating performance.

Conclusion

     Based on established proxies for real earnings management (REM), and after employing a wide array of controls for other possible factors, we find a positive relation between CEO network size and the level and volatility of REM. We theorize that this positive relation occurs because the information-sharing and power and influence channels from a large CEO social network enable the use of REM to confer net personal benefits on the connected executive. This may even make the practice firm-wise desirable in the short-term because the firm reports a superior trend of earnings, beats earnings benchmarks, and may reduce information asymmetry, all of which can increase firm value. In the long-term, however, we show that large REM adjustments by well-connected CEOs associate with worse future firm performance, even in the absence of detection. But with takeover and labor market insurance, a well-connected CEO may not care about the possibility of worse future firm performance from the consequences of departures from normal or optimal operations from the use of REM. These CEO network benefits may also explain the pervasive and successful use of REM in practice. To our knowledge, we are the first to show that larger CEO networks associate with higher levels of REM. Those higher earnings adjustments, however, can degrade firm performance in the longer term. Thus, when a large CEO network amplifies the power and influence of the top executive, our study indicates that such CEO networks have a darker side regarding future firm performance.