Big Baths Around Turnovers: What Happens if the Former CEO Stays on Board?

Abstract

We examine whether retaining the former CEO as a board member has an impact on big bath accounting around CEO turnovers. Early evidence shows that when a CEO turnover occurs, the new CEO uses big bath to shift the responsibility for low earnings toward the previous management. However, the former CEO is often retained. This event may restrict the new CEO’s ability to take a big bath. Using a hand-collected sample of CEO turnover events in US firms, we find that CEO turnover increases the probability of a big bath. However, retaining the CEO acts as a monitoring mechanism by reducing the probability of big baths, especially opportunistic ones. Our findings indicate that CEO retention could be a useful corporate governance mechanism that restricts new CEO’s opportunistic practices.

Acknowledgements

We thank Beatriz Garcia Osma (editor), the anonymous referee, Gilad Livne, Bjorn Jorgensen, Marco Maria Mattei, Annalisa Prencipe, Hari Ramasubramanian (discussant), and the participants at the 2023 EAR annual conference for helpful comments and suggestions.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Supplemental Data and Research Materials

Supplemental data and research material are available in an online Supplement at the journal’s Taylor and Francis website, https://doi.org/ 10.1080/09638180.2024.2325992.

Table OA1 presents results examining the relation between big baths and the duration of CEO retention.

Table OA2 presents results for our main models including former CEO’s retirement as additional control.

Table OA3 presents results for our main models considering the timing of CEO turnover and retention.

Table OA4 presents results for our main models using entropy balancing.

Notes

1 We follow Haggard et al. (2015) in differentiating between big baths that are opportunistic (pursuing CEOs’ personal incentives) and non-opportunistic (to ‘clear the air’ and improve information environment).

2 Big baths are prevalent in reality. For instance, General Motors took a big bath in 2008, announcing a net loss of $15.5 billion in the second quarter. This event was preceded by poor performance, and the CEO was not retained post-resignation. Similarly, General Electric took a big bath in 2018 by writing down the value of some of its business units to $22 billion. In this case, despite the company’s positive performance, the firm did not retain the CEO. In another recent case, Samsung Electronics was accused of engaging in big bath accounting in 2019, reporting operating profit of $5.47 trillion instead of the expected $7 trillion, due to large write-offs. After announcing ‘unprecedented losses,’ the CEO resigned without taking any new role in the company. These examples demonstrate that companies engage in various forms of big baths, with the common goal of influencing the current year’s earnings such that future earnings look better.

3 We checked all turnover events manually to clearly identify the timing of CEO departure and the CEO responsible for the annual reports in the turnover year. We note that the Execucomp data does not always provide exact information on the year in which the turnover event occurs. Gentry et al. (2021) also identify this issue.

4 We find that in 87% of our cases, the former CEO is retained as the board Chairperson.

5 In the three models, we use different variables to control for the effect of performance, consistent with prior studies that have examined the three decisions independently. Our results are robust to the inclusion of different proxies.

6 We acknowledge that the effects of CEO turnover may be realized over longer timeframes surrounding the turnover event. Thus, in line with Haggard et al. (2015) and others, we consider the three-year window. In untabulated analyses we check the robustness of the results by varying the period from three years to one and two years, and find consistent results.

7 Special items are reported in Compustat as unusual and/or non-recurring items considered as special items by the firm, for example, bad debt expense when it is a non-recurring item or ‘restructuring/reorganization’ items, or non-recurring gains or losses from asset disposals.

8 Our BB_SPI and BB_ACC results are consistent with Hope and Wang (2018). BB_ACC has a lower percentage because this definition of big bath requires two criteria to be satisfied and hence is more restrictive.

9 The 9.85% statistic is not exactly the same as 9.71% (35.86% of 27.09%) because we construct the RETENTION variable using the three-year period surrounding the CEO turnover event.

10 Our overall results and conclusions remain the same when we use median ROA at each point in time, t-2 to t+2, instead of average ROA presented in Figures 1, 2a, and 2b. We prefer ROA over RET as ROA is an accounting-based measure of performance and is less influenced by market dynamics.

11 We report the findings for BB_SPI for the sake of brevity, but our inferences remain the same when we use BB_ACC.

12 We define internally promoted versus externally hired CEO subsamples by hand-collecting this information for each CEO turnover event from the firms’ annual reports and company websites. Notably, we find that new CEOs are more likely to be internally promoted when the former CEOs are retained and have performed well over their tenures.

13 We do not estimate the 3SLS for this additional analysis as this would result in a system of four equations, thus potentially overfitting the model to the data and complicating the interpretation of the results. Instead, we estimate big baths using 2SLS where the first and second stages are as in Eqs. (1) and (4), respectively

14 The fact that big baths do not worsen the information environment when the CEO is retained further supports the idea that big baths undertaken in this case can be considered non-opportunistic.

15 These results are consistent with the underlying descriptives concerning the percentage of big baths in the three years surrounding CEO retention and the turnover event. The frequency of big baths is steady across the three years, further validating our results.