Managerial ability and revenue-expense matching: accrual estimation versus real business decision

ABSTRACT

We investigate the association between managerial ability and revenue-expense matching. We find that firms having more capable managers exhibit a better contemporaneous revenue-expense matching, partly attributable to their ability at accrual estimation. We also find that the association between current revenue and past expense is weaker for firms having more talented managers due to cash flow effects. These findings are robust to a battery of control variables and to alternative proxies of managerial ability. Our study indicates that the relation between managerial ability and earnings attribute could be a function of accrual estimation process as well as real business decision. JEL codes: G32.

KEYWORDS:

• Managerial ability
• revenue-expense matching
• accrual estimation
• real business decision

Notes

1. A lack of recent research on revenue-expense matching could be attributable to standard setters’ negative approach on revenue-expense matching. Particularly, Financial Accounting Standards Board abandoned matching by shifting their focus in earnings estimation from income-statement-based-model of earnings calculation to the balance-sheet-based-model. However, this does not mean that the comparison of revenue and expense is meaningless in earnings estimation. Rather, as shown above, Dichev et al. (2013) present that CFOs of U.S. firms believe that matching is still important in earnings estimation. Center for Excellence in Accounting and (2007) suggests that using matching in accounting is necessary because it reflects the inescapable reality of cost-benefit considerations and results that pervade every business. It also states, ‘Matching should be the cornerstone of financial reporting, and failing that, all these other concepts are deficient in content and utility.’

2. We note that this argument does not assume that accrual estimation ability is directly associated with revenue-expense matching. Rather, this argument is based on the presumption that a better accrual estimation leads to a better contemporaneous revenue-expense matching, implying that managerial ability could influence revenue-expense matching through accrual estimation. For instance, higher managerial ability on operating activities will be associated with better inventory management and less inventory manipulation (Huang and Sun 2017). This will lead to less inventory write-offs in future periods, which deteriorates future contemporaneous revenue-expense matching.

3. However, it is unlikely that managerial ability influences every aspects of corporate behaviors because papers documenting insignificant associations between managerial ability and corporate behaviors are less likely to be published than those with significant findings.

4. As we stated in the footnote 1, the recent shift from income-statement-based-model to balance-sheet-based-model in earnings estimation may damage the strength of our argument on the importance of revenue-expense matching. However, Center for Excellence in Accounting (2007) argue that focusing on asset-liability-comparison does not reduce the importance of revenue-expense matching to estimate bottom line item in the income statement.

5. The empirical data seems to support the ability matching theory’s view that managerial ability is time-invariant. Untabulated analysis indicates that the regression of managerial ability on one-year-lagged managerial ability yields the coefficient of 0.734 (t-stat.: 166.95) with R² of 54.56%. Thus, using one-year-lagged managerial ability reduces the possibility that our empirical analysis captures the potential bias arising from talented managers taking jobs on more successful firms, which would have better revenue-expense matching.

6. http://faculty.washington.edu/pdemerj/data.html Peter Demerjian updated managerial ability data of U.S. public firms from 1980 to 2016.

7. The negative coefficient on future expenses in Columns (1) and (2) may indicate that future expenses produce negative current revenues, drawing the question over the validity of revenue-expense matching estimation model. Note that Dichev and Tang (2008) suggest that the significantly positive coefficient on lagged expenses indicate that firms are conservative in recognizing earnings, meaning that firms tend to recognize expenses earlier than when they recognize related revenue. We conjecture that such a conservative reporting decision will generate insignificant or negative coefficients on future expenses. However, we are very cautious in drawing any interpretation on the coefficients on future expenses because the coefficient on future expenses flips when we control for additional control variables in Columns (3) and (4).

8. This interpretation is inconsistent with the positive association between managerial ability and accounting conservatism in García-Meca and García-Sánchez (2018) and Haider, Singh, and Sultana (2021). One possible explanation is the use of different observations. In untabulated result, we follow Haider et al. (2021) and find that the relation between managerial ability and CONS_ACC, average total accruals for 3 years multiplied by (−1), is significantly negative. This implies that our sample exhibits the negative association between managerial ability and conservatism, supporting our interpretation on the negative coefficient on past expense.

9. The negative coefficient on A_EXP_t+1*MA_t-1 would indicate that managers with better operating decision recognize fewer future expenses associated with current revenues. For instance, if managers with good understanding on the business are better at estimating the allowance loss for current noncash sales, firms having those managers will report less allowance loss related with current revenue in the future. Thus, the positive association between current revenue and future allowance loss will be weaker for firms having more talented managers.

10. We appreciate the anonymous reviewer who suggested this possibility and remedy.