Earnings Management around Founder CEO Re-appointments and Successions in Family Firms

Earnings management consists of a firm’s insiders cooking the books, that is, manipulating reported earnings via discretionary accruals and/or taking real actions to affect the financial performance of the firm.  Discretionary accruals derive from different interpretations of accounting rules. For example, a firm wanting to inflate its reported earnings may choose to capitalise more of its costs rather than treating them as expenses. Alternatively, a firm could engage in real actions such as deferring investment in research and development and/or advertisement and as a result report higher earnings in a particular year.

In what follows, we define a family firm as a firm that is listed on the stock exchange, has a family as its main shareholder (holding at least 25% of the votes) and has a member of the controlling family holding the position of the CEO. Family firms may have specific incentives as well as disincentives to practise earnings management. On the one hand, family firms may be more likely to engage in earnings management as the latter can be seen as a private benefit of control. Given that the family has control over the firm, it may misuse this control by manipulating reported earnings. This is the so-called entrenchment effect. For example, inflated earnings may keep minority shareholders at bay and prevent them from questioning the family’s control over the firm. On the other hand, family firms may be less likely to engage in earnings management for at least two reasons. First, given that the family has most of its wealth sunk in the firm, it is in its interest to monitor the firm’s management and to ensure that the latter does not manipulate the earnings figures. In other words, family control may reduce agency problems, including earnings management. Second, the family may be reluctant to manipulate earnings as it is concerned about its reputation. Reputational concerns will be particularly important if the family intends to maintain control over the firm during successive generations. This is the so-called alignment effect.

While there is some isolated support from empirical studies of the entrenchment effect, most studies confirm the existence of the alignment effect: Family firms are less likely to engage in earnings management when compared to other, non-family-controlled firms. Nevertheless, we argue that there is a particular point in time when family firms may be tempted to manipulate earnings. This corresponds to the time when the family CEO is up for re-appointment or replacement. More specifically, we argue that founder CEOs who are up for re-appointment may be particularly tempted to cook the books. Why would this be the case? Given that founder CEOs have greater emotional attachment to their firm than later generations of the family, they are more likely to manipulate earnings to report good performance in the year preceding their re-appointment. This ensures that the minority shareholders are less likely to oppose the family’s ongoing control and management of the firm.

We study listed family firms (as defined above) from three countries, which are France, Germany and the UK. We find that on the whole family firms are less likely to engage in earnings management when compared to non-family firms, confirming the conclusions drawn from most existing studies about the existence of the alignment effect. Nevertheless, we also find confirmation for the above argument: Founder CEOs who are up for re-appointment engage in more upward earnings management when compared to other events in family firms as well as CEO replacements in non-family firms.

The results from our study suggest that investors should be cautious around the time of the re-appointment of the founder CEO in family firms when interpreting the financial statements of such firms. More generally, our study shows that there exist breaking points during which the incentives of otherwise well-behaved large shareholders may change substantially; hence, context and timing are important when assessing financial statements issued by firms with controlling shareholders.