Managerial Ability and Earnings Quality

Managerial Ability and Earnings Quality*

Peter Demerjian

University of Michigan

Baruch Lev

New York University

Sarah McVay

New York University

November 20, 2006

Abstract:

We examine the relation between managerial ability and earnings quality. We

identify manager-specific effects by creating a measure of managerial ability

using frontier analysis and separating manager-specific from firm-specific effects

by following managers across firms. We find that earnings quality, measured by

the extent that accruals map into cash flows, is increasing with managerial ability.

This finding is consistent with the premise that more capable managers are better

able to estimate accruals.

*

We would like to thank Venky Nagar, Larry Seiford, Ram Venkataraman (AAA discussant), and workshop

participants at the 2006 AAA annual meeting, the University of California–Berkeley, and the University of Indiana

for their comments and suggestions.

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1. Introduction

We examine the relation between managerial ability and earnings quality. We anticipate

that superior managers will report higher quality accruals, all else equal, as they are more

knowledgeable of their business and therefore are better able to estimate accruals. While the

empirical literature in the area of earnings quality has largely focused on firm-specific

characteristics, such as size and board independence (Dechow and Dichev, 2002; Klein, 2002),

we examine manager-specific effects by creating a measure of managerial ability using frontier

analysis (e.g., Leverty and Grace, 2005). We further distinguish manager-specific from firm-

specific effects by following managers (specifically CFOs) across firms. Our study is in the vein

of Bertrand and Schoar (2003) who find that managers have an effect on firm choices, such as

acquisitions or research and development expenditures, and Francis et al. (2006) who document

that earnings quality varies inversely with CEO reputation.

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We find that earnings quality,

measured by the extent that accruals map into cash flows, is increasing with managerial ability;

this relation holds after including controls for innate characteristics of firms that make it more or

less difficult to estimate accruals (e.g., operating cycle and sales volatility) as well as structural

characteristics shown to affect the quality of earnings (e.g., board independence and internal

control quality). This finding is consistent with the premise that capable managers are better able

to estimate accruals resulting in a more precise measure of earnings. We also consider two

additional earnings quality measures: earnings persistence and a reduced frequency of

restatements. These results also support the notion that more able managers produce higher

quality earnings.

1

Francis et al. (2006) measure CEO reputation with the number of articles mentioning the executive. They find that

the number of news articles pertaining to the company’s CEO and earnings quality are negatively associated.

2

Our managerial ability measure is generated using Data Envelopment Analysis (or

frontier analysis), which assigns an efficiency score to each firm based on a vector of inputs

(e.g., capital and expenses) and outputs (e.g., revenue) of the company. We thus estimate the

relative efficiencies of firms in an industry and attribute these efficiencies to managerial ability.

We find that this efficiency score is positively associated with earnings quality, after controlling

for known determinants of earnings quality, such as firm size, cash flow volatility, and operating

cycle, and structural choices, such as board independence. We then triangulate our results to

verify that the efficiency score measures managerial ability rather than simply firm-specific

effects. For a sub-sample of our firms where we can track a manager across two firms, we

include both firm-specific and manager-specific indicator variables, interacted with the

efficiency score. We find that, after controlling for firm-specific effects, manager-specific

efficiency continues to be associated with earnings quality.

This paper is the first to examine the relation between earnings quality and managerial

ability. We examine a multi-dimensional measure of relative efficiency, and find that superior

managers report higher quality earnings. This finding contributes to both the earnings quality

literature and the managerial accounting literature. Although past anecdotal evidence suggests

that firms choose managers who can most efficiently operate the firm, these results apply a new

measure of managerial efficiency and find corroborating evidence.

In the next section, we develop our hypotheses with a review of the literature. Section 3

describes our managerial ability measure, obtained using Data Envelopment Analysis. In

Section 4, we describe our sample, test variables, and descriptive statistics. Section 5 presents

the results and the final section concludes the study.

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2. Prior Research and Hypothesis Development

To date, the bulk of the literature on earnings quality has examined firm-specific

characteristics. Dechow and Dichev (2002) define higher earnings quality to be when more

accruals are realized as cash (described in detail in Section 4.2.1). They document that earnings

quality is poorer for firms that are smaller, are experiencing losses, have greater sales and cash

flow volatility, and have longer operating cycles. Each of these innate characteristics makes

accruals more difficult to estimate.

In addition to these innate characteristics, earnings quality has been found to vary with

firm infrastructure. Klein (2002) finds that firms with more independent board members have

higher quality accruals, consistent with stronger governance constraining earnings management.

Ashbaugh-Skaife et al. (2006) and Doyle et al. (2006) find that earnings quality is poorer in firms

that have weaker internal controls over financial reporting, where it is less likely that errors or

intentional misstatements are discovered and corrected.

However, only Francis et al. (2006) examine whether earnings quality varies with

managerial characteristics. Their study examines the relation between earnings quality and CEO

reputation, measured by the number of business press articles mentioning each CEO. The

authors conduct their analysis for a sample of about 2,000 firm-year observations from the S&P

500 over 1992–2001 and find a negative relation between CEO reputation and earnings quality.

They conclude “boards of directors hire specific managers due to the reputation and expertise

these individuals bring to managing the more complex and volatile operating environments of

these firms.” In other words, it is the volatile operating environments or other innate

characteristics of the firm causing the lower earnings quality, not managerial actions.

In support of manager-specific effects, Bertrand and Schoar (2003) document that

managers have a real impact on the firms they manage—that firm decision-making reflects the

“style” of different managers. They follow managers in the Forbes 800 files, from 1969–1999.

As they examine an array of decisions, they follow CEOs, CFOs and COOs. Their final sample

has about 600 firms and just over 500 individuals. Bertrand and Schoar (2003) show that these

managers have an impact on the choices made by the firm as a whole. In a similar vein,