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MSc Thesis:

The relationship between CFOs tenure and financial reporting quality

Student: Emiel Knepper

Student Number: 10423974

Education: MSc Accountancy and Control, variant Control track

Institution: University of Amsterdam, Faculty of Economics and Business

Supervisor: Mario Schabus

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Abstract

This thesis examines the relationship between CFOs tenure and financial reporting quality. Using a

sample that consists of 1,911 American stock listed firms, I examined the effects of Chief Financial

Officer’s (CFO) tenure on the financial reporting quality (FRQ). In order to measure FRQ, I use

accounting conservatism as a measurement of FRQ. My prediction is that CFO tenure has a positive

effect on accounting conservatism. Based on the timely loss recognition from Basu (1997) the level of

conservatism will be examined. I find no supporting evidence that CFOs tenure has a positive impact

on the FRQ. This paper contributes by filling the gap of investigating the impacts of CFO’s properties

with financial reporting quality.

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Tabel of Contents 1 Introduction .......................................................................................................................................... 4

2 Literature Review ................................................................................................................................. 5

2.1 Agency theory in accounting ......................................................................................................... 5

2.2 Accounting Conservatism and Financial Reporting Quality (FRQ) ................................................ 7

2.2.1 Definition of FRQ .................................................................................................................... 9

2.2.2 Effects of FRQ ......................................................................................................................... 9

2.3 Chief Financial Officer (CFO) ........................................................................................................ 10

2.4 Tenure ......................................................................................................................................... 10

3 Research methodology ....................................................................................................................... 12

3.1 Empirical model ........................................................................................................................... 12

3.2 Measurement of control variables .............................................................................................. 13

3.3 Sample selection .......................................................................................................................... 14

4 Results ................................................................................................................................................ 15

4.1 Descriptive statistics .................................................................................................................... 15

4.2 Results and analysis ..................................................................................................................... 18

5 Conclusion .......................................................................................................................................... 19

References ............................................................................................................................................. 20

Appendix ................................................................................................................................................ 25

Variable definitions ........................................................................................................................... 25

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1 Introduction Financial statements and disclosures are important reports for investors to evaluate firm

performance (Healy &Palepu 2001).According to the Statement of Financial Accounting Concepts No.

8 (SFAC No. 8) the objective of financial reporting is to provide financial information about the

reporting entity that is useful to all stakeholders. Lambert et al. (2007) demonstrate that the quality

of financial reports can influence the cost of capital of firms and that clarifies the important role of

the quality of the financial statements. Dechow et al. (2010) describes the financial reporting quality

(a.k.a. FRQ) as “Higher quality of financial reporting provides more information about the feautures

of a firm’s financial performance that are relevant to a specific decision made by a specific decision-

maker.”

This study examines the managerial reaction of executives on (un)favorable future firm

prospects and how that is reflected in the financial statements. Many different types of

measurements have been used in research in order to measure FRQ. According to Dechow et al.

(2010) state that the persistence, magnitude of accruals, residuals from accrual models, smoothness

of cash flows, timely loss recognition, benchmarks, earnings response coefficient and external

indicators of earnings restatements are commonly used indicators to determine the FRQ. The timely

loss recognition indicator combats the management’s natural optimism by reporting bad news more

timely than good news. Accounting conservatism requires a timelier recognition of unfavorable news

than favorable news (Ahmed &Duellman 2013, Watts 2003). Choi and Pae (2011) argue that firms

that have a higher level of commitment to business ethics have a higher degree in accounting

conservatism. This research defines the accounting conservatism as the same indicator for FRQ as

the timely loss recognition indicator. This study assumes that managers who are more prudence to

reporting expected earnings are more conservatism and have therefore higher quality of financial

reporting.

This study looks at role of Chief Financial Officers (CFOs) in firms and their relation to FRQ.

Geiger and Taylor (2003) emphasize the importance of the responsibility that the CFO has over the

reported financial results by mentioning that not only the CEO, but also the CFO can be personally

accountable for the accuracy and completeness as a result of Sarbanes-Oxley (SOX) Act.The CFO

retains the final responsibility for the representation of the financial performance of the firm (

2001).

In more detail, this research examines how the tenure of the CFO influences the FRQ. Given

that CFOs care about their external reputation for career concerns, CFOs are interested in meeting or

beating earnings benchmarks (Graham et al. 2005). This means that not onlybonuses give incentive

for executives to enhance financial results but future career prospects for the CFO play an important

role as well. For example, executives performance is often measured by financial results, which leads

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to increased external reputation.(Milbourn 2003). Further, CFOs indicate that career concerns of

managers affects the financial reporting decisions (Francis et al. 2008). This is supported by Jian and

Lee (2011) as they argue that managers prefer to make investment choices that are beneficial for

their reputation rather than investment choices that benefits the shareholders.

Oyer (2008) shows that management reputation is sensitive to financial results. The

reputation of a manager may decrease when they report unsatisfactory results even if the economic

market is in bad condition. Subsequently, termination is more sensitive to performance, especially in

the beginning of the tenure (Chevalier & Ellison 1999). This suggests that CFOs have the incentive to

use less reporting conservatism in their beginning of their tenurein order to retain their position.

Ryan et al. (2009) finds that long tenured executives are less likely to be fired and therefore

managers have the incentives to have a long tenure at the firm. This strengthens the suggestion that

a beginning CFO is more likely to report more favorable financial results than actual financial results

in the beginning of the tenure.

Based upon prior literature, I expect a relationship between the tenure of the CFO and the

FRQ. Long-tenured CFOs are more likely to use accounting conservatism than short-tenured CFOs.

There has been much research conducted to investigate which characteristics of executives

influences the FRQ. Mostof this acadamic work focused on characteristics of the CEO and a little

research is based on that of the CFO. The CFO is also an executive member of the board of directors

and should have the most financial knowledge of the team. This makes it surprisingly that there has

been little research performed in the relationship between the characteristics of the CFO and the

FRQ.Although there are many papers about CEO and financial reporting quality and little research

about CFO and their relation with corporate governance – according to my knowledge – no study to

date has investigated the relationship between CFO tenure at a firm and FRQ.

2 Literature Review

2.1 Agency theory in accounting In an agency relationship, the agent (i.e. manager) acts on behalf of the principal (i.e. shareholder)

(Shapiro 2005). That is, the manager should act (only) on behalf of the shareholders’ interests.The

agency problem contains a conflict of interest between the agents and the principles (Jensen

&Meckling, 1976; Shapiro, 2005).That means that the agency problem arises when managers are not

working towards shareholders’ interests.

Managers could have incentives to introduce bias and noise into the estimated values of the

assets or estimated future profits that are reported in the financial statements. Jensen & Murphy

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(1990) provide evidence that CEO compensation changes positively to increasements of market

stocks. The paper of Basu (1997) states that information that has a negative effect on managers’

compensation could be an incentive for the manager to leave out of the financial reports. This bias

and noise that is added to the financial statements, could therefore enhance the compensation of

the managers. However, shareholders are not able to or it is too expensive to verify what the

managers are actually doing (Eisenhardt 1989). These costs are known as the agency costs.

The importance of the quality of the financial statements is indicated by Watts (2003) by

mentioning the agency problem that could appear between managers and shareholders. Even

though managers are forthcoming that they provide sufficifient financial information, they are less

likely to provide information (e.g. bad projects and poor future earnings) that reduces their own

wealth (Armstrong et al. 2010). Thisbias and noise of estimated values in financial reports decreases

the quality.

This agency problem can be mitigated by having accounting standards which tend to favor

conservatism (Ahmed et al. 2002, Nikolaev 2009).LaFond and Watts (2008) describe accounting

conservatism as a mechanism that reduces the managers’ ability to overestimate future returns.Their

argument therefore is that accounting conservatism requires a timelier loss recognition over profit

recognition (Nikolaev 2009, Watts 2003). The incentive of managers to hide information that

adversely affect their compensation is then mitigated by a timelier loss recognition (Kim & Zhang

2010). The opposite of conservative accounting, aggressive accounting, leads to higher financial

misreporting (Burns &Kedia 2008). By this method of accounting, future earnings and net assets are

too optimistic or too confident reported and that leads to an improper image of the actual financial

position of the firm. Aggressive accounting is more often used by firms that use performance-based

compensations for their managers and this leads to more restatements in the financial reports (Burns

&Kedia 2006). These findings strengthens the assumptionthat aggressive accounting decreases the

quality of the financial reports.Schrand and Zechman (2012) found evidence that

overconfidencedmanagers are more likely to account project to optimistic and are therefore more

restatements faced.This is supported by the paper of Ahmed and Duellman (2012) because they

provided a negative relation between managerial overconfidence and accounting conservatism. They

showed that overconfidenced managers overestimate their future profits. As stated before,

accounting conservatism requires a timelier loss recognition over profit recognition and managers

should therefor use a safety margin in their estimated future returns.For example, that could prevent

managers from investing in a project that has a negative net present value but provides the company

short-term benefits.

Brickley et al. (1985) provide evidence that companies that compensate managers based on

long-term performances experience a higher stock market reaction than companies with a short-

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term compensation plan. This paper implies that long-term performance plans are encouraging

managers to make the right decisions for the firm and that would enhance the shareholders wealth.

Their decision-making horizon increases and that motivates managers to operate for long-term

objectives rather than short-term benefits only (Tehranian et al. 1987).That implies that long-term

goals aligns managers’ and shareholders’ interests and mitigates the agency problem. As stated

before, accounting conservatism mitigates to optimistic future returns by the management. Short

term objectives that favors managers personal wealth may lead to under or overinvestment in long-

term projects (Bebchuck& Stole 1993). Ahmed and Duellman (2007) also state that accounting

conservatism supports the reducing deadweight losses arising from agency conflicts. They found

evidence that corporate control mechanisms assist firms with agency problems.

All that provides support that the conflict of interest between managers and shareholders

may be reduced with conservative accounting, which will increase overall financial reporting quality.

2.2 Accounting Conservatism and Financial Reporting Quality (FRQ) The main purpose of afinancial report is to measure performance and wealth of the reporting entity

(Lim, 2010). Financial statements are important for potential investors, lenders and other creditors in

order for them to make informed decisions in keeping, buying or selling their shares and providing

loans(FASB 2010). Therefore, financial reporting information supports investors decisions. The

financial statements of the reporting entity should faithfully represent the economic reality (FASB

2010). In this research, the quality of financial information is referred to as Financial Reporting

Quality (FRQ). The definition of quality is determined as evaluated quality with respect to decisions

that are made based on the reported financial performance (Dechow et al. 2010). As future

economic profits are uncertain, the managers possess valuable knowledge about the operations of

the firm (Basu 1997). Because managers are more familiar with the daily operations, they gain more

specific information about the firms’ daily operations (Beyer et al. 2010). The asymmetric

information function gives them incentives to use their private information to overstate financial

performances and consequently stock prices during their tenure (LaFond& Watts 2008). The fact that

managers are also the shareholders of the firm, reinforces their incentives to overestimate future

returns in order to increase their stock (Lafond& Watts 2008).

This is supported by Basu (1997) as that paper states that managers have incentives to

conceal information that could decrease their compensation. Managers withhold bad news but

reveal good news immediately to investors (Kothari et al. 2009). Nagar (1999) finds that managerial

performance assessment is a managers’ concern when it comes up to firm performance. Their

further career concerns can motivate managers to withhold bad news (Kothari et al. 2009). Hermalin

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and Weisbach (2007) state that owners and investors asses the managers based on the information

that has been given to them. A lack of information disclosure limits the ability of external parties to

effectively monitor and discipline the managers (Nagar et al. 2003).This creates the possibility for

managers to have great short-term performances but therefore ignore the long-term performances. .

For example, projects that generate profits on the short-term of their lifetime but have a negative

net present value over the whole lifetime, enhance managers short-term compensation but are not

firms’ best decisions. Accounting conservatism prevents managers for investing in projects that have

ex ante a negative net present value (Ball &Shivakumar 2005). Accounting conservatism reduces the

managers’ ability to manipulate accounting numbers (LaFond& Watts 2008). This accounting method

thereforeobstructs the asymmetric information about future losses and enhances the validity of

future economic cash flows

Prior research emerges conservatism in two forms: conditional and unconditional

conservatism (Beaver & Ryan 2005). Unconditional conservatism (news independent) stems from the

application of accounting policies that reduce earnings independent of economic news (Pae et al.

2005). Examples that are given by the paper of Beaver and Ryan (2005) are immediate expenses of

costs and higher depreciation of book value of property, plant and equipment than economic

depreciations. Conditional conservatism (news dependent) is defined as the higher verification of

recognizing favorable news than unfavorable news (Basu 1997, Goh & Li 2011). This interpretation

posits that bad news will be recognized in a timelier manner than good news. Book values are

written down under sufficiently negative circumstances but are not written back up under positive

circumstances (Beaver & Ryan 2005). This paper focusses on conditional conservatism. The

interpretation of Basu (1997) will be followed as this is the most used method to measure

conservatism.

Firms that use conservative accounting receive easier and cheaper external financing and

have a lower default risk (Francis et al. 2013). This suggests that accounting conservatism favors

shareholders’ interest. Ahmed and Duellman (2011) show that firms with relative more conservative

accounting have significantly higher future profitability. If conservatism leads to higher FRQ, higher

FRQ leads to higher future economic benefits.

Moreover, prior research found empirical evidence about the positive relationship between

corporate governance and accounting conservatism. One measure for corporate governance (i.e.

independence of the board)has a positive relationship with FRQ (Shiri et al. 2012). This suggests that

strong corporate governance should enhance FRQ. Ample prior research shows that firms with

strong corporate governance mechanisms have a higher level of accounting conservatism (García

Lara et al. 2009, Chi et al. 2009). There is a positive relationship between anti-takeover protection,

level of CEO involvement and the degree of accounting conservatism (García Lara et al. 2009). In

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addition to that, adequate corporate governance controls result in better monitoring of the

management and enhances the degree of accounting conservatism (Chi et al. 2009). Although

accounting conservatism is not required after the introduction of SOX, firms incorporate losses more

quickly than profits in the post-SOX period (Lobo and Zhou, 2006). The increase of personal penalties

to CEOs and CFOs for manipulated reporting could be an incentive to avoid overstated earnings. Lobo

and Zhou (2006) also state that financial consultants advice their clients a more conservative

approach after the implementation of SOX. Overall, firms and CFOs that emphasize a high degree of

accounting conservatism are expected to have a higher quality of financial reporting.

2.2.1 Definition of FRQ

As already mentioned in the introduction of this paper, Dechow et al. (2010) describes the financial

reporting quality (a.k.a. FRQ) as “Higher quality of financial reporting provides more information

about the features of a firm’s financial performance that are relevant to a specific decision made by a

specific decision-maker.”. They state that the decision-relevance of the information determines the

quality of the financial reports. The FRQ is consistent with valuation perspectives, where investors

see the firm as a long-term profit-generating entity and the value of the firm is based on estimating

and discounting future cash flows (Dichev et al. 2013). The extent to which financial reports faithfully

present earnings and future cash flows is defined as the quality (Schipper& Vincent 2003).

2.2.2 Effects of FRQ

The degree of quality of the financial statements provides how much information is reported about

the firm’s financial performance (Dechow et al. 2010).The financial benefits of higher financial

reporting quality for firms is showed by Leuz and Verrecchia (2004). They show that poor-quality

reports creates an information risks to investors. In order to compensate this risk, investors require a

higher return for their investment (Schipper& Vincent 2003). In this setting, high-quality reports

provides the firm with higher investment efficiency and therefore an increase in future cash

flows(Easley &O’hara 2004).Firms with high-quality reports are more transparent to their

shareholders about the financial performance and that reduces the information asymmetry. This

shows that FRQ plays an important financial role for firms. Ball and Shivakumar (2008) support this

by showing that initial public offering (IPO) firms report more conservatively. The monitoring role by

rating agencies, more involvement of auditors, higher regulations and the market that demands a

higher quality of the financial statements are factors that increases the importance of the financial

reports for public companies than that is required for private companies. Public investors face a

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higher risk of information asymmetry than private investors. Firms therefore improve their financial

reports prior to an IPO.

2.3 Chief Financial Officer (CFO) The CFO has the primary responsibility for the financial reports (Collins et al. 2008). In

addition to this fiduciary duty, the CFO is also involved with decisions that are made at top level

within the firm. This provides the CFO with a contradiction in duties.Indjejikian and Matejka (2009)

indicate that the CFO performs a dual role within organizations.They conclude that the CFO checks

financial decisions that he made by himself. The question that raises is whether it is appropriate if

performance-based compensation of the CFO is based on the financial performance that is reported

by himself. With their unique position – relative to other executives – they could be more engaged to

manipulate the accounting numbers (Feng et al. 2011). Geiger and North (2006) examined the

relationship between a new appointed CFO and the corporate financial reporting. They present

evidence that changes in CFOs are associated with reductions in the reported discretionary accruals.

This suggests that the individual characteristics of the CFO influences the FRQ. This is

supported by Ge et al. (2011) as they argue that the CFO’s personal characteristics(e.g. gender, age

and educational background) influences the accounting practices of the firm. They also provided

evidence that influence of the CFO on the accounting practices is higher when there is a high job

demand for CFOs and a high CFO job discretion. Accounting standards and regulations cannot avoid

all kind of possible misuse as long as individual judgment or evaluations are part of it(Parfet, 2000).

Parfet (2000) states that tone at the top and corporate ethics are also essential components that

determines the FRQ. This provides the CFO the possibility to manipulate the actual performance

because they can still manipulate the numbers within the boundaries of the accounting standards

(Parfet, 2000). Schrand and Zechman (2012) showed that overconfidentexecutives misreport more.

To meet or exceed earnings expectations, CFOs can manipulate the financial resultsby adjusting

performances with which is called the “screw-driver” effect (Graham et al. 2005). “You turn the

screws just a little bit so that it fits” and the firm meets or exceeds the expectations. This way of

preparing the financial statements is contradictory to their ultimate responsibility about the

completeness and correctness of the financial reports (Mian, 2001).

2.4 Tenure Graham et al. (2005) find that managers want to meet or exceed the expected financial

performances in order to improve the their reputation. Reputation is a valuable asset for

managers.Cianci and Kaplan (2010) find that external stakeholders approve an implausible

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explanation for poor performance more easily for well reputed managers than non-reputed

managers.A reason for that could be that users of the financial reports believe that reputation of the

top executives is the key factor of FRQ (Francis et al. 2008). This has a significant influence on the

financial reporting decisions.Reasons to meet or exceed earnings expectations are to build credibility,

enhance stock price, report growth possibilities but also to improve their reputation (Graham et al.

2005). In order to attain these objectives, CFOs are willing to sacrifice long-term value and smooth

earnings. These findings provides strong evidence that managers care about their reputation.

Talented managers are valuable for the firm and when the manager has a longer tenure at the firm,

the confidence in the manager grows (Ryan et al. 2008). For example, there are less meetings with

the Board of Directors when the CEO performs well. With their gained reputation, they are able to

haggle more autonomy and less scrutiny. In addition, long-tenured managers are less likely to be

firedand managersgain knowledge and experience in their field (Luo et al. 2013). Chevalier and

Ellison (1999) find that termination is more sensitive to performance for managers that are in the

beginning of their career and have not been able to build a career yet. Appointing a highly reputed

CEO creates a strong impression to stakeholders that the firm will be successful in the future (Sinha

et al. 2012). With these findings, we can conclude that managers care about their reputation because

of their further career opportunities. That suggests that financial incentives are not the only reasons

toincrease earnings, if necessary by manipulating financial statements. In order to attain a higher

reputation, reporting financial performances that meet or exceed expectations is an incentive for the

manager. Another considerable incentiveis the rewards of the stock market for firms meeting or

beatingexpectations (Bartov et al. 2002). However, Desai et al. (2006) find that managers that face

accounting restatements because of aggressive accounting incurred significant losses in reputation.

Given this, there are two contradictory incentives. On the one hand, aggressive reporting could

enhance the performanceof the CFO and therefore, they may have a longertenure. On the other

hand, aggressive accounting increases the risk ofaccounting restatements and therefore loss in

reputation through legal suits. In addition to legal penalties for executives, financial accounting

restatements are related to reputational loss for managersinternally (Srinivasan 2005). As already

documented by the paper of Ryan et al. (2008), management reputation increases over tenure. That

suggests that long-tenured CFOs already gained reputation and may therefore be more conservative

in their accounting choices. On the other hand, in order to gain reputation, short-tenured CFOs may

be less conservative. Based on these assumptions I therefore formulate the following hypothesis:

H1: The tenure of the CFO is related to firm’s FRQ

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3 Research methodology

3.1 Empirical model Researchers use three different type of measures to asses whether conservatism exists (Watts 2003

part 2). Net asset measures, earnings and accrual measures and earnings/stock return relation

measures are these types. Watts (2003 part 2) states that all three measures rely on the effect of

conservatism’s asymmetric recognition of gains and losses. The most used measure to test whether

conservatism exists is the asymmetric timeliness measure of Basu (1997). Basu (1997) uses firms’

stock return to see what impact that has on firms’ earnings. According to Watts (2003 part 2), this

way of measuring conservatism is classified as earnings/stock return relation measure. Basu (1997)

interprets conservatism as a tendency to require a higher degree of verification for recognizing good

news than bad news. This way of measuring conservatism is, as explained in the literature review

before, considered as conditional conservatism. Bad news is recognized more timely than good news

in earnings. Basu (1997) also found that negative earnings changes are less persistent than positive

earnings changes. Therefore, the greater timeliness of earnings for bad news implies that negative

(unexpected) returns are more sensitive to earnings than positive (unexpected) returns.

Basu (1997) regression model:

+ + +

Basu (1997) uses stock returns and earnings to measure the relationship between positive stock

returns and negative stock returns. Basu (1997) finds that negative stock returns turned out to have a

higher association with earnings than stock returns do that are positive. The model above is shown as

follows. is the standardized earnings per share where states for firm and states for fiscal

year. The earnings per share is divided by the share price at the beginning of the fiscal year. is the

return on firm from fiscal year . The return is calculated as the difference between the end-of-year

share price and beginning-of-year share price plus dividends, and divided by the beginning-of-year

share price. When is negative, it implies that returns of the firm in that fiscal year were negative

and those are defined as bad news periods. The other way around, a positive implies positive

return of the firm in that fiscal year and is defined as a good news period. The coefficient

measures the sensitivity of earnings to good news (positive return). The coefficient measures the

sensitivity of earnings to bad news (negative returns). is a dummy variable which equals one if

is negative and zero if positive. To test whether a firm uses a conservative approach in their

accounting valuations, the focus of the analysis is on the difference between coefficient (good

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news) and coefficient (bad news). Conservative accounting is considered when coefficient is

higher than coefficient .

This regression model is the starting point for my regression equition to test the hypothesis

that is formulated in the literature review. This research examines the relationship between CFO’s

tenure and conservatism. A conservative approach of financial reporting is considered as a higher

quality of financial reports. The hypothesis in the research is based on the assumption that CFOs plan

to continue their jobs, which is associated with the long-term goals of the firm. However, if CFOs are

in their last year of their tenure, incentives to focus on short-term benefits for the firms are arising

for their own wealth, such as short-term based compensations (Dechow & Sloan, 1991). Therefore,

CFOs could have incentives to report less conservative and that effects the regression. In order to

take out the bias in the outcomes of the regression model, the final year of the CFO’s tenure will be

excluded from the sample.

The important variables for the regression are earnings per share deflated by the beginning-

of-year share price (EPS), the end-of-year share price minus beginning-of-year share price plus

dividends, divided by the beginning-of-year share price (RETURN) and the CFO’s tenure (TENURE).

The dependent variable is EPS and the independent variables are RETURN and TENURE. In this

regression, there are nine control variables included which will be explained in detail in paragraph

3.2. This results into the following regression model;

+ + + + +

+ +

The coefficient measures the responsiveness of EPS to bad news (negative RETURN) with

TENURE. And coefficient measures the responsiveness of EPS to good news (positive RETURN)

with TENURE. With these outcomes, the effects of the TENURE on conservatism will be examined.

3.2 Measurement of control variables There are nine control variables used in this study. The growth in sales (SALES_GROWTH) is

measured as a percentage of the annual sales growth in total sales. Ahmed and Duellman (2007)

argue that large growth of sales often inflates the market expectations of future sales and that

effects the market value of the firm. The size of the firm (FIRM_SIZE) is determined as the natural log

of the total assets. LaFond and Watts (2008) find that large firms have less asymmetric information

and present financial information more often. Additionally, Watts and Zimmerman (1978) argue that

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large firm face more political costs, which induces them to report more conservative. The leverage

control variable (LEVERAGE) is defined as the long-term debt divided by the total assets. Watts

(2003) argues that firms with a high level of leverage tend to have greater conflicts between

shareholders and debt-holders. Given the significance of penalties imposed by SOX to CFOs, the post

SOX period is likely to be more reliable and accurate (Chang et al. 2012). Lobo and Zhou (2006) finds

that discretionary reporting behavior has become more conservative in the post SOX period. A

dummy variable is is included to control the influence of SOX (SOX_D) on conservatism. The dummy

variable (SOX_D) contains 1 for pre-SOX period and contains 0 for post-SOX period. Watts (2003)

mentioned that litigations risks are higher for firms that overestimate their current assets. Litigation

costs of overestimated book values are higher than underestimated book values and therefore

management has incentives to report more conservative. Techonology companies have higher

litigation risks than other companies (Chang et al. 2012, Francis et al. 2009). A dummy variable is

included as a control variable (LITIGATION_D). The dummy variable contains 1 for high litigation risk

and contains 0 for low litigation risk. The last dummy variable controls for firms that are audited by

one of the Big Four auditors (BIG4_D). Michas (2011) argues that firms which have an auditor of one

of the Big Four auditors, report more conservative. The firms that have an auditor of the Big Four

contains 1 and 0 for non Big Four auditor. The control variable stock market performance

(MARKET_PERF) is measured by multiplying the common outstanding shares with share price. The

control variable board size (BOARD_SIZE) is measured as the total number of board members. The

age of the CFO (AGE) is the last control variable in this research.

3.3 Sample selection Data regarding the initial sample is started from the years 1992 through 2013 and contains 28,743

observations from the Execucomp database and Compustat. The Execucomp database provides

information about compensation of executives and supports this research to estimate the CFO’s

tenure. Compustat provides information about annual report data of listed North American

companies.

After merging the dataset from Execucomp with Compustat and excluding observations with

missing data, the exclusion of missing observations contains 11,177. This paper excludes firms in

financial insitutions, insurance companies and real estate firms (SIC-Code 6500-6999). That leads to a

exlcusion of 4,371 observations. By removing the observations where the CFO is in his final year in his

tenure, 3,620 observations are excluded. The total exclusion consists of 19,168 observations and

leads to a final sample with 9,575 firm-year observations from 1,911 firms.

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The effect of outliers are mitigated by winsorizing the bottom and top 1% of the variables

SALES_GROWTH, FIRM_SIZE, LEVERAGE, MARKET_PERF, TENURE, RETURN and EPS.

Table 1: Sample Composition

Observations

Observations from Execucomp and Compustat 28,743

Less: Excluding observations with missing data (11,177)

Exluding financial institutions, insurance companies and real

estate firms (4,371)

Excluding observations with final year CFO tenure (3,620)

Final sample for regression 9,575

4 Results

4.1 Descriptive statistics Table 2 reports the summery statistics of the final sample of this research. The mean of AGE of a CFO

is 50.16 years and the median is 50 years. 19% of the final sample consists of pre-SOX period

observation years. In this sample, 88% of the firms has an auditor from the “big four” auditors. The

mean of LEVERAGE, which is reflected as long-term debt divided by total assets, is 19% for this

sample. The average TENURE of a CFO is 4.19 years with a standard devation of 3.01 years. The

median of the TENURE of the CFOs is 3 years. The average RETURN of the firms in this research 0.13

with a standard deviation of 0.61. On average, firms have a positive RETURN and positive EPS in this

sample. These averages are similar to prior literature (e.g. Dietrich et al. 2007, Roychowdhury &

Watts, 2007). The study of Dietrich et al. (2007) uses two samples for their research. The sample that

contains the period between years 1991 and 2001 have a negative earnings per share on average.

This is different compared to the sample in this study. This study, however, uses a sample from years

1992 till 2013, which contains a longer period. The average of the dummy variable DR is 0.44 which

means that 44% of the observation years have a negative return and 66% has a positive return.

Table 3 represents the correlations table. Correlations from prior literature (Khan & Watts,

2009) of the correlations AGE, EPS, FIRM_SIZE and LEVERAGE are comparable with this study. The

only exception is that the correlation between LEVERAGE and FIRM_SIZE is negative by the study of

Khan and Watts (2009) and the this study provides an significant positive relation. With a significance

16

level of 95%, we find that there is a positive correlation between RETURN and EPS. There is no

significance correlation between TENURE and RETURN, but there is a significant positive relation

between EPS and TENURE.

Table 2: summary statistics

Mean S.D. Min .25 Mdn .75 Max

AGE 50.16 6.64 30.00 46.00 50.00 55.00 87.00

BOARD_SIZE 5.60 1.16 1.00 5.00 5.00 6.00 14.00

SOX_D 0.19 0.39 0.00 0.00 0.00 0.00 1.00

BIG4_D 0.88 0.32 0.00 1.00 1.00 1.00 1.00

LITIGATION_D 0.32 0.47 0.00 0.00 0.00 1.00 1.00

SALES_GROWTH 0.11 0.26 -0.52 -0.01 0.08 0.18 1.33

FIRM_SIZE 7.35 1.59 3.65 6.20 7.21 8.40 11.34

LEVERAGE 0.19 0.18 0.00 0.01 0.17 0.30 0.87

TENURE 4.19 3.01 1.00 2.00 3.00 5.00 15.00

RETURN 0.13 0.61 -0.86 -0.21 0.05 0.32 3.48

EPS 0.03 0.14 -0.99 0.03 0.05 0.08 0.26

MARKET_PERF 5957.65 15231.91 15.14 515.35 1349.92 4031.34 111079.1

DR 0.44 0.50 0.00 0.00 0.00 1.00 1.00

RETURN_x_DR -0.13 0.21 -0.86 -0.21 0.00 0.00 0.00

DR_x_TENURE 1.82 2.86 0.00 0.00 0.00 3.00 15.00

RETURN_x_TENURE 0.53 2.83 -12.92 -0.60 0.13 1.11 52.20

RETURN_x_DR_x_TENURE -0.51 1.03 -12.92 -0.60 0.00 0.00 0.00

17

Table 3: correlation table

AGE BOARD_ SOX_D BIG4_D LITIGATI SALES_G FIRM_S LEVERAG TENURE RETURN EPS MARKET DR

AGE 1.000

BOARD_SIZE 0.0098 1.000

SOX_D -0.0455*** 0.1754*** 1.000

BIG4_D 0.0397*** 0.0872*** -0.2125*** 1.000

LITIGATION_D -0.0960*** 0.0070 -0.0067 -0.0053 1.000

SALES_GROWTH -0.0688*** -0.0090 0.0923*** -0.0396*** 0.0622*** 1.000

FIRM_SIZE 0.1153*** 0.1388*** -0.1484*** 0.2929*** -0.1331*** -0.0137 1.000

LEVERAGE 0.0053 0.0696*** 0.0369*** 0.0968*** -0.2251*** -0.0418*** 0.2877*** 1.000

TENURE 0.3447*** -0.1115*** -0.1337*** 0.0328*** -0.0536*** -0.0549*** 0.1003*** 0.0007 1.000

RETURN 0.0016 -0.0625*** -0.0614*** -0.0092 0.0244* 0.0346*** -0.0404*** -0.0081 -0.0169 1.000

EPS 0.0375*** -0.0173 -0.0084 0.0400*** -0.0238* 0.1616*** 0.1496*** -0.0880*** 0.0738*** 0.0203* 1.000

MARKET_PERF 0.0752*** 0.0446*** -0.0724*** 0.1023*** 0.0664*** 0.0403*** 0.5801*** -0.0123 0.0266* 0.0081 0.0831*** 1.000

DR -0.0282* 0.0427*** 0.0687*** -0.0252* 0.0244* -0.0384*** -0.0601*** 0.0187 -0.0246* -0.6218*** -0.1384*** -0.0772*** 1.000 * p < 0.05 (two-tailed) ** p < 0.005 (two-tailed) *** p < 0.001 (two-tailed)

18

Table 4: regression analysis

Source SS df MS

Number of obs = 9575

Model 24.422135 15 1.62814233

F ( 15, 9559) = 103.46

Residual 150.423047 9559 .015736274

Prob > F = 0.0000

Total 174.845182 9574 .018262501

R-squared = 0.1397

Adj R-squared = 0.1383

Root MSE = .12544

EPS Coef. Std. Err. t P>|t| [95% Conf. Interval]

DR -.0022479 .0066848 -0.34 0.737 -.0153516 .0108558

RETURN -.0672878 .0044764 -15.03 0.000 -.0760626 -.058513

RETURN_x_DR .2738219 .0152322 17.98 0.000 .2439636 .3036801

TENURE -.0015847 .0007424 -2.13 0.033 -.00304 -.0001293

DR_x_TENURE .0001439 .0012796 0.11 0.910 -.0023644 .0026521

RETURN_x_TENURE .0085331 .0009836 8.68 0.000 .0066051 .010461

RETURN_x_DR_x_TENURE -.0199 .0031425 -6.33 0.000 -.0260599 -.0137401

AGE -.0000281 .0002079 -0.13 0.893 -.0004356 .0003794

BOARD_SIZE -.002402 .0011557 -2.08 0.038 -.0046673 -.0001366

SOX_D .0103182 .0034871 2.96 0.003 .0034828 .0171537

BIG4_D .0027648 .0042323 0.65 0.514 -.0055314 .011061

LITIGATION_D -.0065822 .002852 -2.31 0.021 -.0121728 -.0009916

SALES_GROWTH .0793994 .0050425 15.75 0.000 .0695149 .0892838

FIRM_SIZE .0125379 .0009112 13.76 0.000 .0107518 .0143239

LEVERAGE -.089918 .0078107 -11.51 0.000 -.1052286 -.0746074

_cons -.001262 .013154 -0.10 0.924 -.0270467 .0245227

4.2 Results and analysis Table 4 shows the results from the regression of the final sample which contains 9,575 observations

for the period 1992 – 2013. The adjusted R-squared results in 13.83%, which indicates that the

independent variables explain 13,83% of the dependent variable.

As explained in the research methodology before, the coefficient of the variable RETURN, ,

measures the sensitivity of earnings to good news. The coefficient of the variable RETURN_x_DR, ,

measures the sensitivity of earnings to bad news. A conservative accounting approach is expected

when the bad news has a greater impact on EPS and therefore a positive , indicates accounting

conservatism. The table shown above depicts that the coefficient of RETURN is significant negative

and the coefficient of RETURN_x_DR is significant positive. This is consistent with the study of Basu

(1997), where bad news is reported on a more timelier basis than good news. Based on the

outcomes of the t-values (that are above 2.58) the significant level is above 99%.

19

The effects of TENURE on the coefficients are on a confidence level of 99% signifcant for the

coefficients of RETURN_x_TENURE ( ) and RETURN_x_DR_x_TENURE ( ). The outcomes of the

coeffecients indicates that TENURE has a contrary effect on conservatism. The slope (measures

the sensitivity of good news) is positive an slope (measures the sensitivity of bad news) is

negative. That indicates that good news is reported on a more timelier basis than bed news. The

hypothesis that CFO’s tenure does not have an effect on financial reporting quality is rejected. There

is support that TENURE has a significant impact on accounting conservatism. This regression provides

evidence that TENURE has a negative impact on the accounting conservatism.

5 Conclusion This research investigates the relationship between Chief Financial Officer’s (CFO) tenure and the

financial reporting quality. In more detail, the effects of the tenure of the CFO on the accounting

conservatism has been investigated. This study contributes to prior literature, because there has no

research been done between the CFO tenure and the financial reporting quality, up to now. I

predicted that short-tenured CFOs would be less conservative then long-tenured CFOs. At the

beginning of his tenure, the CFO tries to gain reputation and would therefore account less

conservative. When the CFO gained reputation, he tries to avoid to lose it by accounting

restatements and would therefore account more conservative.

Using Basu’s model I investigated the effects of the tenure of the CFO on accounting

conservatism. I found that the tenure of the CFO has a contrary effect than my predictions. I found

no evidence that CFO tenure has a positive impact on accounting conservatism.

Using American stock listed firms, the impact of SOX as a moderator between the

relationship of CFO tenure and FRQ, could be a further recommendation for new research. This

paper used a sample from 1992 till 2013. The effects of SOX has been taken into account as a control

variable. The moderating effect of the SOX variable could be new possible research.

20

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25

Appendix

Variable definitions

Variable name Description

Dependent variable

EPS Earnings per share standardized by the beginning-of-year share price Independent variables

DR Dummy variable equal to one if returns are negative, zero otherwise

RETURN End-of-year share price minus beginning-of-year share price plus dividends, divided by the beginning-of-year share price

TENURE Tenure of the current CFO

Control variables

AGE Age of the current CFO

BIG4_D Dummy variable equal to one if auditor is one of the Big Four auditors, zero otherwise

BOARD_SIZE Number of directors on the board

FIRM_SIZE Natural log of total assets

LEVERAGE Long term debt, divided by total assets

LITIGATION_D Dummy variable equal to one if firm has high litigation risk, zero otherwise

MARKET_PERF Share price multiplied by the common outstanding shares

SALES_GROWTH Percentage of the annual sales growth in total sales

SOX_D Dummy variable equal to one if respective year is in post Sox period , zero otherwise