Managerial Ability and Earnings Management

We investigate how managerial ability affects the intentional distortion of financial statements (earnings management). On the one hand, better managers receive a compensation premium for their perceived ability, and to the extent that earnings management would tarnish their reputations, we expect them to manage earnings less. On the other hand, better managers may be more able to extract rents through earnings management, for example, by managing earnings to maximize the value of their stock options, while still offering shareholders superior returns over those of lower-quality managers. We investigate this empirically by examining the relation between managerial ability and both accruals management and real earnings management. We find that high-ability managers are more (less) likely to utilize accrual (real) earnings management, on average. We also expect and find that negative consequences following earnings management are mitigated among more able managers. In particular, we find evidence that better managers manage earnings more successfully, experiencing fewer negative outcomes such as lower sales or future financial restatements.