Do CEOs and Principal Financial Officers Take a "Bath" Separately or Together?: An Investigation of Discretionary Accruals Surrounding Appointments of New CEOS and PFOS

INTRODUCTION Personal certification requirements for Chief Executive Officers (CEOs) and Principal Financial Officers (PFOs) arrived in corporate America during the summer of 2002 in the form of an SEC Order and the watershed Sarbanes-Oxley Act (Sarbanes-Oxley Act 2002; SEC 2002b, 2002c). These legislative mandates were the first in the U.S. to require CEOs and PFOs to separately and personally file sworn statements with the SEC regarding the material accuracy and completeness of their companies' periodic financial filings. The Congressional investigations leading up to these mandates highlighted the significant influence of both the CEO and PFO on corporate financial reporting and led to the adoption of legislation to hold both of these individuals personally accountable for the release of accurate and complete corporate financial disclosures (SEC 2002a, Williams 2002; Geiger and Taylor 2003; Smith 2004). As implied by personal certification requirements, and argued by prior researchers (Pourciau 1993; Geiger and North 2006), individual CEOs and PFOs exert substantial influence on the reporting of their company's financial condition, and a personnel change at either of these two positions could lead to significant changes in financial reporting outcomes for the company. Prior researchers have paid particular attention to the effect of newly appointed CEOs on corporate financial reporting (Pourciau 1993; Murphy and Zimmerman 1993; Murphy 1999; Reitenga and Tearney 2003), and some research has begun investigation of the relationship between PFO appointments and a firm's reported financial information (Mian 2001; Aier et al. 2005; Geiger and North 2006). However, prior studies have focused on either CEO or on PFO turnover effects, and have not adequately considered turnover at both senior financial executive positions. While Mian (2001) finds that turnover at the CFO position is often accompanied by CEO turnover, we find no extant study that adequately examines concurrent turnover in both of these financial executive positions. In fact, no prior study examining changes in CEOs has considered concurrent turnover in PFOs, and, no extant PFO turnover study has adequately assessed or controlled for concurrent CEO turnover. In order to properly examine the effect of both CEO and PFO turnover on changes in corporate financial reporting, we identify a sample of large publicly traded firms appointing a new CEO, a new PFO, or concurrently appointing both a new CEO and PFO in the same year. If individual CEOs and PFOs have the ability to effect financial reporting, a likely outcome would be the reporting of unexpected financial results by the hiring firm. Thus, we examine changes in a company's discretionary accounting accruals surrounding the change in personnel at either of these two positions. Using the EXECUCOMP database we are able to identify a sample of 9,550 company reporting years from 1995-2002 for which we can obtain unambiguous information on the individuals appointed as CEO and PFO of the firm. We use these reporting year observations to examine the effect of CEO and PFO turnover on financial reporting for large U.S. public companies. Specifically, we examine changes in a firm's performance-adjusted total discretionary accruals surrounding CEO and PFO appointments. We assess total discretionary accruals in order to include all reported accruals and not only the current accruals that might be more easily managed by company reporting executives (DeFond and Jiambalvo 1994; Kothari et al. 2005). Further, we examine performance-adjusted accruals in order to provide better control for unidentified firm performance effects that might unwittingly affect our discretionary accruals measure (Kothari et al. 2005; Reynolds and Francis 2006). In addition, unlike most prior executive turnover studies, we employ a fixed-effects approach in our regression analyses that provides enhanced control for unspecified firm-specific factors by assigning each firm to serve as its own control. …