Do CEOs Get Penalized for Reporting Losses?
Click to Print This Page
The decision to replace a CEO is probably one of the most important decisions made by the board of directors. The decision has long-term implications for a firm’s investment, operating, and financing decisions. CEO turnover was around 10% per year during the 1970s and 1980s and 11% in the 1990s. However, between 1992 and 2005, annual CEO turnover jumped to 15%. In the more recent years since 1998, CEO turnover is around 16.5%, implying that the average CEO tenure is just over six years. More importantly, boards have become more sensitive to firm performance and are acting decisively in response to poor performance. Overall, the results suggest that the CEO’s job is more precarious than previously thought.
When firms report losses, the board is expected to become proactive in finding out the reasons for those losses. This may lead to a decision to dismiss the CEO for several reasons. First, shareholders might expect the board to dismiss the CEO when a firm reports a loss because of erosion in equity value and the board may act to placate shareholders. Second, boards have no assurance that CEOs would change their business strategy following losses, which suggests that current losses might persist into the future. Third, a newly appointed CEO is more likely to perform an objective and critical review of the firm’s business operations, to shut down poorly performing divisions, and to consider new strategies that allow the firm to become profitable again. In contrast, an incumbent CEO might have strong preferences for his/her prior investments.
The authors find that the probability of a CEO losing a job within two years of reporting a loss is about 30% higher than other CEOs. Also, when they use two other reported earnings measures (income before extraordinary items and operating income) in addition to the bottom-line number (net income) to define accounting losses, they find a positive relation between turnover and losses for all the three measures of losses. However, the sensitivity of CEO turnover to losses is strongest when losses are defined using the bottom-line net income number. Additionally, they find that the magnitude of accounting losses augments the sensitivity of CEO turnover to losses. Finally, an outsider CEO is more likely to be chosen to replace an incumbent CEO following the reporting of an accounting loss.
These results suggest that job protection might be a key consideration for CEOs confronting losses and may explain why CEOs manage earnings to avoid reporting a loss. Also, it appears that in addition to the traditional measures of firm performance used by boards to assess CEO productivity, boards also rely on accounting losses to assess CEO quality and to make CEO retention/dismissal decisions.2
–Al Ghosh is a professor of accountancy and the Stan Ross Scholar at the Zicklin School of Business, Baruch College (City University of New York).
1. “CEO Penalty for Reporting Losses” by Ghosh and Moon (2011), Working Paper, Zicklin School of Business, Baruch College, City University of New York, New York, NY 10010. E-mail: Aloke.Ghosh@baruch.cuny.edu; Ph. 646.312.3184.
1. We thank Dean John Elliott, Frank Fletcher, and Chris Koutsoutis for their comments and suggestions.