Managerial academic experience, external monitoring and financial reporting quality

• Date: 01 July 2019
• DOI: http://doi.org/10.1111/jbfa.12398
• Author: Kaitang Zhou,Kirill E. Novoselov,Yi Zhou,Zhiming Ma
• Published date: 01 July 2019

DOI: 10.1111/jbfa.12398

Managerial academic experience, external

monitoring and financial reporting quality

Zhiming Ma1Kirill E. Novoselov2Kaitang Zhou3

Yi Zhou4

1PekingUniversity, Beijing, China

2Shanghai University of Finance and Economics,

Shanghai, China

3Wuhan University,Hubei, China

4FudanUniversity, Shanghai, China

Correspondence

KirillE. Novoselov, Shanghai University of Finance

andEconomics, Shanghai, China.

Email:kirill.novoselov@mail.shufe.edu.cn

Fundinginformation

NationalNatural Science Foundation of China,

Grant/AwardNumber: NSFC-71602037; Fun-

damentalResearch Funds for the Central Uni-

versities,Grant/Award Number: 2018QN027;

Ministryof Education Humanities and Social Sci-

encesResearch Funding, Grant/Award Number:

19YJC630234

Abstract

Thisstudy examines the effect of managerial academic experience on

firms’ financial reporting quality.Using data from China, we find that

firms with top managers possessing academic experience exhibit

lower levels of both accrual and real earnings management, along

with a lower probability of future restatements. This effect is more

pronounced for firms with inefficient external monitoring, suggest-

ing that the higher financial reporting quality is mainly explained by

the managers’ intrinsic motivation to report truthfully. The results

hold when we use firm fixed-effect regressions, instrumental vari-

able two-stage regressions, and a propensity score matching (PSM)

approach to mitigate the omitted variable and endogeneity con-

cerns. Our study suggests that academic experience can serve as a

source of valuable expertise for corporateexecutives.

KEYWORDS

academic experience, earnings management, expertise, external

monitoring, financial reporting quality, imprinting, intrinsic motiva-

tion, top management team

JEL CLASSIFICATION

D83, J62, M41, M51

1INTRODUCTION

This study examines the association between academic experience of the top management team (TMT) members

and the financial reporting quality of the focus firm, as well as the strength of this association as a function of the

firm’s external monitoring environment.A growing body of research suggests that the characteristics of top managers

explain a large fraction of the variation in firm policies (e.g., Bamber,Jiang, & Wang, 2010; Bertrand & Schoar, 2003;

Graham, Harvey,& Puri, 2013), with a substantial degree of the reported policy heterogeneity attributed to top man-

agers’ individual life and career experiences (e.g., Benmelech & Frydman,2015; Dittmar & Duchin, 2016; Malmendier

& Tate,2005; Schoar & Zuo, 2017). A compelling explanation of this effect is that early formative experiencesshape the

J Bus Fin Acc. 2019;46:843–878. wileyonlinelibrary.com/journal/jbfa c

2019 John Wiley & Sons Ltd 843

844 MA ET AL.

belief systems that individuals develop to navigate complex environments while avoidinginformation overload (e.g.,

Bingham & Kahl, 2013; Calori, Johnson, & Sarnin, 1994). Once developed,these belief systems remain quite stable over

the course of the individuals’ careers (e.g., Barr,Stimpert, & Huff, 1992; Bartunek, 1984; Reger & Palmer, 1996; Reger,

Gustafson, Demarie, & Mullane, 1994) and thus can serve as reliable sources of intrinsic motivation in settings where

externalmonitoring is impracticable or ineffective (e.g., Akerlof & Kranton, 2000, 2010; Bowles & Polanía-Reyes,2012).

The literaturestudying the links between personal experience and managerial behavior has thoroughly investigated

the US and other developed economies, but the effects of executives’personal characteristics on firm policies in devel-

oping economies remain largely unexplored. Such an explorationis warranted for the following reason. In many devel-

oping economies – including China – the markets for professional executives are relativelyimmature and inefficient

(Khanna, Palepu,& Sinha, 2005; Yuan, Yuan, Deng, & Yuan,2008), with only a minority of TMT members having started

their career paths as professional managers and the majority recruited from other occupations. Further,in developing

economies, the standard governance mechanisms remain relativelyineffective, leading to low-quality financial report-

ing and a generally opaque information environment that undermines the effectiveness of external monitoring (e.g.,

Morck, Yeung, & Yu,2000). Studying the practice adopted in a large developing economy sheds light on the personal

characteristicsthat could serve as a source of intrinsic motivation for corporate executives to report truthfully, serving

as a substitute for the more familiar disciplining mechanisms, such as external monitoring.

The unusually high proportion of top managers with academic experience in Chinese firms suggests that China is

an apt setting to test our predictions. Over many years, China operated as a centrally planned economy, where the

labor marketfor professional executives was simply non-existent because top managers were appointed by the author-

ities. FollowingChina’s reforms and opening up, two parallel developments have been responsible for creating a robust

demand for corporate executives:the emergence of a myriad of new firms and the adoption of the Western corporate

governance practices(including the appointment of professional executives) by the existing corporations. The reforms

thus improved a nascent managerial labor marketsomewhat (Groves, Hong, McMillan, & Naughton, 1995; Liang, Mar-

ler, & Cui, 2012). On the supply side, many academic researchers found it appealing to pursue new – and often more

lucrative – careers bystarting up their own businesses or becoming professional managers.

We argue that academic careers help future executivesin developing characteristics that improve leadership effec-

tiveness – including conscientiousness and the habit of precise, honest communication. Once developed over the

course of the academic career, these characteristics are likely to remain in place long after the individual has left

academia. We, therefore, predict that the firms employing former academic researchers as members of their top man-

agement teams exhibit higher financial reporting quality and that the hypothesizedeffect is more pronounced in firms

with relatively inefficient externalmonitoring.

Our empirical findings are consistent with the theoretical predictions. Using a sample of 6,486 firm-year observa-

tions from China, we compare financial reporting quality of firms with and those without executives who have prior

academic experience. We use four commonly adopted proxies of financial reporting quality: namely,accrual quality

(Kothari, Leone, & Wasley, 2005), real earnings management measures (Roychowdhury,2006; Zang, 2012), the aggre-

gate of these two measures, and the probability of future restatements (Chen, Sun, & Wu, 2010; Gul, Wu, & Yang,

2013). In our sensitivity tests, we further use auditors’ modified opinions, going concern opinions, the occurrence of

small profit, and an alternative definition of abnormal accruals to proxy for financial reporting quality.We find consis-

tent results that firms with executives possessing academic experienceare associated with higher financial reporting

quality,compared to those without.

We further explore whether the effect of academic experiencevaries across different external monitoring mecha-

nisms. If the association between top manager’s academic experience and high reporting quality that we document is

caused by managers’ intrinsic motivation to report truthfully,we would expect the effect that we study to be more pro-

nounced in firms with weaker external monitoring. The literature has shown that being audited bya Big N auditor or

havinggreater analyst coverage serve as efficient external monitoring mechanisms that improve firms’ financial report-

ing quality (e.g., Chen, Chen, Lobo, & Wang,2011; Lobo, Song, & Stanford, 2012; Yu, 2008). We, therefore, expect the

effect of top managers’ academic experience on financial reporting quality to be stronger for firms audited by smaller

MA ET AL.845

auditors and those covered byfewer analysts. The results are consistent with our prediction that academic experience

matters more when external monitoring is weak or ineffective.

Weadopt several methodologies to address the possible endogeneity and omitted variable problems. First, we run a

two-stage regression using one-year-lagged industry proportion of executiveswith academic experience as our instru-

mental variable. Second, we use propensity score matching (PSM) to tackle the potential problems caused by the dif-

ferences in observable firm characteristics between firms with and those without top managers havingprior academic

experience. We further use the entropy rebalancing method to address concerns using PSM. Finally,we include firm

fixed effects to mitigate the potential omitted variable concerns. Our results continue to hold in all the specifications

and thus endogeneity is unlikely to be a major concern in our study.

Another concern is the possible biases brought by the two-step approach we adopt to measure accrual and real

earnings management. Chen, Hribar,and Melessa (2018) point out that using residuals from the first-step model as the

dependent variable in the second-step model leads to a biased estimator and incorrect inferences. Therefore, following

Chen et al. (2018), we use a one-stage approach to re-estimate our models. The results, which are reported in the online

Appendix, provide additional assurance that our inferences are robust to alternativespecifications.

We also conduct a battery of robustness tests. First, we restrict the TMT scope to the CEO and CFO only because

these executivesare usually the most influential figures on the executive team. The empirical results under this spec-

ification are stronger, as expected; therefore, our conclusions are unaffected. Second, our results are insensitive to

using alternative earnings quality measures, such as modified audit opinions, going concern opinions, reporting a small

profit, and an alternative definition of abnormal accruals. Third, our results hold when we use an alternative – contin-

uous – measure of academic experience or control for other characteristics of TMT or board members that are known

to be associated with financial reporting quality. Finally,we perform additional tests across different media coverage

levels, and our findings do not provide any support to the alternativeexplanation that the relatively high reputational

concerns of academic executivesserve as the primary factor responsible for high earnings quality.

Our study makes the following contributions. First, it contributes to the literature on the determinants of finan-

cial reporting quality,especially to the stream of research focusing on China. The literature has identified several TMT

members’ individual characteristics that influence financial reporting quality, such as tenure, age, educational back-

ground and overconfidence (e.g., Ahmed & Duellman, 2013; Aier,Comprix, Gunlock, & Lee, 2005; Huang, Rose-Green,

& Lee, 2012; Jiang, Zhu, & Huang, 2013; Matsunaga, Wang,& Yeung, 2013; Schrand & Zechman, 2012). Most of these

studies investigate US firms. There are, however, reasons to believethat the results reported for the US and other

developed economies do not always generalize to emerging economies: e.g., Ye,Zhang, and Rezaee (2010) document

that, in contrast to the US, where there is a positive association between the presence of female executiveswith earn-

ings quality, there is no such association in China. Our results suggest that desirablecharacteristics of TMT members

recruited from other professions can serve as a means of improving financial reporting quality and thereby substitute

for formal (and costly) governance mechanisms. Even though China differs from other developing countries in many

important respects, we believe that our results suggest a promising direction for future research focusing on those

countries where the markets for professional executivesare not well developed and the standard monitoring mecha-

nisms are relatively ineffective.

Second, we contribute to the literature in finance and accounting studying the influence of various managerial

career paths on firm performance (e.g., Benmelech & Frydman, 2015; Custódio & Metzger, 2014; Dittmar & Duchin,

2016; Graham & Narasimhan,2005; Lin, Ma, Officer, & Zou, 2014; Malmendier, Tate,& Yan, 2011; Schoar & Zuo, 2017)

and the growing management literature studying the competencies and skills that are conducive to effective leader-

ship (e.g., Day,Fleenor, Atwater, Sturm, & McKee, 2014; Dragoni, Tesluk,Rssell, & Oh, 2009; Hammond, Clapp-Smith,

& Palanski, 2017). We take advantage of the relatively high proportion of top managers with academic experience

in Chinese listed firms and examine how this specific career track influences management decisions. We report that

the experience as an academic researcher improves financial reporting quality,consistent with the prediction of the

theories of early-career formative experiences (e.g., Gibbons & Waldman, 2004, 2006) and imprinting (e.g.,Marquis

& Tilcsik, 2013). We thus answer to Hambrick’s (2007) call for more research on the upper echelons of the corporate