The Effects of Board Characteristics on Earnings Management around Australian CEO Changes

Abstract

Prior research has shown evidence of earnings management in financial reports of US and Australian firms changing chief executive officer (CEO). This paper examines whether corporate boards, with certain characteristics associated with strong corporate governance, are effective in controlling any earnings management in the financial reports of Australian firms that change CEOs. Since hiring, monitoring and replacing the CEO are key roles of the board of directors, research in this specific context is considered particularly appropriate. After controlling for contemporaneous and lagged profitability in the year of CEO change, we find evidence of negative unexpected accruals in our sub‐sample of firms where the CEO resigned. For this group, larger boards and a higher proportion of independent directors appear to limit observed negative earnings management. In the case of CEO retirements there is evidence of positive unexpected accruals in the period of CEO change. However, none of the board characteristics show any significant relationship with unexpected accruals. In the period after CEO change, we find no evidence of positive unexpected accruals for CEO resignations and none of the board characteristics show any significant relationship with unexpected accruals. For CEO retirements, our analysis indicates that a higher proportion of executive and affiliated director shareholding goes some way towards counteracting the observed positive unexpected accruals. When lagged unexpected accruals are included in the regression equation to control for accrual reversals, CEO duality significantly increases the already positive earnings management found in CEO retirements in the period following CEO change.