Risk & Compliance

Interim CEOs Are Prone to Inflating Earnings

Not only that, they're more likely to be promoted to the top job permanently if they do.
David McCannNovember 18, 2015
Interim CEOs Are Prone to Inflating Earnings

Interim chief executives have been much in the news lately. Two events in October stood out: first, DuPont CEO Ellen Kullman abruptly retired and was temporarily replaced by board member Edward Breen. A week later, United Airlines chief Oscar Munoz had a heart attack, and general counsel Brett Hart was appointed as interim leader.

Ellen Kullman

Ellen Kullman

How these appointments will turn out is unknown, but management experts generally look askance at the appointment of interim chiefs, viewing it as succession-planning failure by corporate boards. Research has found the performance of companies led by interims to be inferior, due to the disruption in strategic decision-making and the fragmentation of top management teams.

Now some new research further darkens the picture. According to a study in the current issue of the Academy of Management Journal, interim CEOs engage in considerably more earnings manipulation than permanent successors. And it pays, enhancing the likelihood that they will be promoted to the top position on a permanent basis.

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“Little is known about how a motivated interim CEO goes about improving his or her chance of being promoted to the permanent position and how firms respond to such efforts,” the paper states. Acting chiefs, it reveals, are prone to “actively manage their impressions on key stakeholders by engaging in income-increasing earnings management, thereby improving their promotion prospects when the interim period ends.”

In sum, “firms should think very carefully before appointing an interim CEO,” warn the study’s authors, Guoli Chen of INSEAD, Shuqing Luo of the National University of Singapore, Yi Tang of Hong Kong Polytechnic University, and Jamie Y. Tong of the University of Western Australia.

However, a number of factors may mitigate the ill effects. Having several directors with finance or accounting backgrounds significantly reduces the amount of earnings inflation by acting CEOs as well as the likelihood that an interim chief who does inflate will get the job permanently. Coverage by many stock analysts achieves the same. And the presence of directors not stretched thin by more than three company-board memberships also militates against promotion of earnings-managing interims.

The study’s findings are based on an analysis of financial statements of 138 companies that appointed interim CEOs. Each was paired with a firm in the same industry that had a CEO departure at about the same time but selected a permanent replacement for the position. Firms were matched by the likelihood of appointing an interim CEO in a succession episode based on company size, age, and financial performance as well as on the succession environment — the departing CEOs’ tenure and age and whether the departure was planned or unplanned and due to dismissal, death, or poor health.

Interim CEOs in the study sample served in that position for between one and eleven quarters and for an average of three quarters, and about 23% were promoted to the corner office permanently. The professors gauged earnings management through a measure called “discretionary accruals.” These are non-cash accounting items that are particularly subject to manipulation because they typically entail some element of guesswork — for example, predictions of future write-offs for bad debts or estimates of inventory valuations. A positive value of discretionary accruals means they are above industry norms and suggests they are being used to inappropriately boost a firm’s accounting earnings.

The professors compared average discretionary accruals recorded during periods of interim CEO leadership with the average recorded in the eight quarters before and eight quarters after. When they compared that difference to the one recorded over the same time periods by firms with permanent successors, they found it to be almost 36% greater.

In other words, there was almost 36% more upwards earnings management by interim CEOs than by permanent successors.

And, as indicated above, this manipulation paid off for those who engaged in it. An interim CEO whose earnings management was one standard deviation (roughly 35 percentage points) above the mean had a 6% better chance to land the job permanently than someone at the mean. If that sounds modest, the edge rose to 15% if the number of stock analysts monitoring the company was low and to almost 20% if the board was lacking in accounting expertise.

Regarding the possibility that interims who managed earnings could simply be more capable than ones who did not, the professors examined firm performance one to three years after the interim CEO period, and found that the 23% of firms that promoted their interim chief performed no better than those that did not.

In conclusion, the authors note that “the last decade has witnessed an increasing number of interim successions, partially due to a growing number of CEO dismissals, the more challenging and turbulent external environment, and the limited amount of time a board has to find a corporate savior. A smooth CEO succession is important for a firm’s continued success, but … many firms do not have a CEO succession plan in place and so they must resort to a temporary succession arrangement when the occasion arises.”

The paper, “Passing Probation: Earnings Management by Interim CEOs and Its Effect on their Promotion Prospects,” is in the October/November issue of the Academy of Management Journal.

Picture of Ellen Kullman: Uploaded to Wikipedia by Mary Mark Ockerbloom, CC BY-SA 3.0