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Keeping top management in check

29 Jan 2018

SMU Assistant Professor Sterling Huang examines how corporate governance structure, the threat of litigation and other factors may impact a company’s decision to cook the books.

By Jeremy Chan

SMU Office of Research & Tech Transfer – Consider the situation of the remora fish as it latches onto a shark. It seeks to benefit by feeding off the shark’s meals, but it does not directly control the shark’s actions.

This relationship is analogous to the one between a company’s shareholders and its management team – shareholders leave the day-to-day operations of the company to a handful of individuals who presumably will work for the benefit of all who have a stake in the business. The spoils of profitable ventures are shared, and everyone is happy. Ideal as it may sound, this symbiosis sometimes does not play out in reality.

“In most large multinational corporations, the shareholders are numerous and scattered across many geographical locations, which means they are too diffused or uninformed to directly monitor the management team’s actions,” says Assistant Professor Sterling Huang of the Singapore Management University (SMU) School of Accountancy. “Left unchecked, the management team could derive private benefits at the expense of shareholders. This is the canonical agency problem between shareholders and managers.”

Hence, a system of rules and processes needs to be put in place to ensure that the interests of shareholders and managers are aligned. This is known as corporate governance, and Professor Huang has a profound interest in how it affects corporate decision making and firm valuation.

Faking progress

As stewards of the company, managers are responsible for keeping it profitable. At the end of the financial year, a rosy balance sheet reflecting strong earnings is the desired outcome, and based on these figures, bonuses are declared, and dividends paid out. Under pressure to perform, managers may be tempted to manipulate these numbers to avoid reporting annual losses, Professor Huang explains.

“Let’s say a company wishes to report higher earnings than it would be able to under its normal operations and its normal exercise of accounting principles,” he says. “It could, for example, offer price discounts to temporarily increase sales, overproduce to report the lower cost of goods sold, as well as reduce discretionary expenditures to improve reported margins. This is what we call real earnings management (REM).”

With REM, the company is stuck with higher inventory in the next period, which gives rise to real obsolescence risk, meaning that excess goods may lose market relevance. Long-term value is thus sacrificed for the sake of putting up a strong front in the short term.

Prior academic studies find that a staggering 78 percent of company executives admitted to engaging in some form of earnings manipulation at the expense of long-term gains. Managers often assert that they are exercising their “best judgement” when making such decisions, but this is a subjective statement that may not stand up to scrutiny, and may even be illegal in certain jurisdictions, Professor Huang said.

The litigation effect

Because claims of “best judgement” are difficult to prove false, REM is correspondingly difficult to detect, and so the academic literature has largely focused on ways to limit it. A commonly cited countermeasure is having a strong legal and institutional environment, says Professor Huang – one that provides shareholders with an avenue for recourse against errant management should REM be discovered after the fact.

In the event of litigation, companies that play fast and loose with their reporting of earnings run the risk of incurring direct costs in terms of out-of-court settlements, damages imposed by courts, or both. Additionally, indirect costs, such as the opportunity cost of management time and the loss of reputation, could have long-lasting negative repercussions on firm valuation.

To assess the effect of litigation on REM propensity, Professor Huang examined the accounting behaviour of firms in the US Ninth Circuit after its Court of Appeals passed a 1999 ruling that significantly increased the hurdle for successful litigation against corporations headquartered there. He found evidence of post-ruling increases in REM for Ninth Circuit firms, and more pronounced REM when institutional ownership was lower and managerial entrenchment higher.

Professor Huang’s findings, published in a 2017 working paper titled ‘Does Litigation Encourage or Deter REM?’ suggest that litigation does have a deterrent effect on REM, and that this deterrent effect is stronger for firms with a weak internal corporate governance structure.

Accounting for behaviour

Behaviour in response to rules or circumstances is a recurring theme in Professor Huang’s other research projects. In a 2016 Georgetown McDonough School of Business Research Paper, he and his collaborators uncovered an interesting association between CEOs’ marital status and their inclinations toward risky financial reporting, demonstrating that single CEOs are approximately five to ten percent more likely than their married counterparts to engage in earnings management of some form.

Another study going by the working title ‘The Economics of Managerial Taxes and Corporate Risk-Taking’ suggests that the personal tax rates of managers, in particular senior managers, affect their corporate investment and risk-taking decisions. Hence, while many perceive accounting as simply numbers on balance sheets, Professor Huang takes a more human-centric approach to the discipline.

A large part of Professor Huang’s research process involves collecting datasets from regulatory filings, which he then uses to gain novel insights into managerial decision making. “One of the biggest challenges I face in my research is identifying a unique dataset upon which an interesting research question can be framed,” he says.

One such research question he wants to explore in the future is the impact of machine learning on corporate risk-management and governance. “Given the rise of machine learning and the availability of big data, I am interested in understanding how artificial intelligence, coupled with big data, could help managers to make better business decisions,” he says. “It’s definitely an exciting time to be doing research in this field.”

Back to Research@SMU Issue 51

Last updated on 02 Feb 2018 .