Corporate governance experts like to wring their hands when companies name an interim chief executive. It’s often seen as a failure of chief executive succession, one that brings with it the risk of project delays, nervous investors and second-guessing on decisions
The study, published in the Academy of Management Journal, found evidence of more earnings inflation by interim chief executives than by permanent successors. Perhaps even more unsettling: The more aggressively they tinkered with the numbers, the more likely it was that they would be named to take the job on a lasting basis.
“If the interim CEO doesn’t get the permanent job, they can lose face. It can be embarrassing,” said Guoli Chen, a professor at INSEAD based in Singapore who worked on the research. “So it looks like they have the motivation to try to get promoted. We do find that interim CEOs, when compared to the normal succession, are much more likely to manage earnings in an upward fashion.”
The researchers looked at what is known as “within-GAAP earnings management,” or financial tweaks that fall within Generally Accepted Accounting Principles. They include “discretionary accruals,” or accounting items that require some estimating, such as predicting the value of inventory. Unlike earnings manipulations or restatements, such moves are not punished by the U.S. Securities and Exchange Commission and generally have little legal fallout for executives.
But, Chen notes, “legitimate doesn’t mean harmless.” Even if chief executives do not violate the letter of what is acceptable, they can violate its spirit, creating a comeuppance that can hit shareholders down the road. “The key idea is earnings management may give a distorted picture of the true quality of the firm,” Chen said, “and it will get certain punishment from the stock market.”
The decision to put interim chief executives in the job permanently could be based on massaged numbers rather than their managerial prowess. For a chief executive, such “impression management,” as it is known in academic literature, means that “during the interim period I look marvelous, but essentially my earnings are disguised,” Chen said.
The study analyzed financial statements of 138 companies in which an interim or acting chief executive had been named between 2004 and 2008, and paired each with an industry peer in which the succession went directly to a permanent leader. On average, during the period studied, the magnitude of the discretionary accruals was 36 percent higher for the interim chief executives than for the permanent chief executives.
It also found that the more the chief executive tweaked the numbers, the more likely it was that he or she would get the permanent nod. That effect was compounded if there were not many analysts covering the company or accounting experts on the board.
The study’s finding is a reminder of the importance of having directors with accounting expertise, as well as some who are not so busy serving on other boards that they cannot commit enough time to oversight during the transition. The findings are also of concern because interim chief executives are often put in place when companies are struggling — earnings management amid already poor performance can further mask for shareholders what is going on in the company.
In the paper, the authors do not mince words: “Promoting such interim CEOs to the permanent position may not be in the best interests of shareholders, because they may in fact be incapable of leading the firm.”
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