Earnings Management Methods and CEO Political Affiliation

This paper examines whether CEO risk aversion – proxied by their political affiliation – explains the method used to manage earnings. We argue that, even though real earnings management can have severe long-term consequences for firm performance, Republican managers are likely to prefer real over accruals-based earnings management because the former incurs significantly lower litigation risk costs than the latter and is relatively more difficult to detect. Based on a sample of more than 20,000 firm-year observations, we find that firms led by Republican (i.e. more risk averse) CEOs tend to manage their earnings through real activities manipulation, while those led by Democratic (i.e. more risk taking) CEOs tend to favor accruals-based earnings management. We also show that the positive (negative) relation between Republican-leaning managers and real (accruals-based) is more positive (less negative) for CEOs whose compensation is more oriented towards risk-taking.