An Empirical Examination of the Relationship Between Managerial Ability and Earnings Managemen

The increasing interest in executive compensation levels and the pay-performance debate has focused greater attention on the complex role that accounting information plays to administer competing value judgments. Managers administer these value judgments through earnings management, and the causes and consequences of earnings management are central to accounting's role. This study examined the empirical relationship between the earnings management practices of the two top executives and their perceived abilities. The notion that perceived managerial ability likely corresponded to executive compensation (Hambrick & D'Aveni, 1992) provided motivation for this study. Building on prior research, this study theorized that managers perceived as more capable, because they added more value to the firm, received more generous incentives compared to their less capable counterparts. The research design relied on agency theory to examine the significance of perceived managerial ability through its empirical relationship to earnings management. This study utilized a random sample of 114 pharmaceutical and biotechnology companies in the U.S., spanning the 10-year period from 2006 through 2015. The analytical approach involved hierarchical multiple linear regression that contrasted ordinary least squares with fixed effects analysis, and then examined the influence of multivariate outliers on the outcome of the regressions. The results of the statistical tests found no evidence to suggest significant associations between earnings management and CEO ability. However, this study also found evidence that the incentive ability proxy of the CFO likely induced more earnings management behavior among CFOs and to the degree considered contrary to investor interests, in that it reduced shareholder wealth and jeopardized long-term value creation. In essence, managerial actions that reduced shareholder and overall corporate value are incompatible with top-quality or superior managerial ability.