Journal

of Accounting

and Economics

10 (1988) 3-36.

North-Holland

MANAGERIAL

COMPETITION, INFORMATION COSTS, AND

CORPORATE GOVERNANCE
The Use of Accounting Performance Measures in Proxy Contests*
Linda Elizabeth

DeANGELO

University of Rochester, Rochester, New York 14627, USA

Received April 1986, tinal version received June 1987
This paper reports evidence that dissident stockholders who wage a proxy contest for board seats
typically
cite poor earnings rather than poor stock price performance
as necessitating
the
proposed
hostile management
change. Consistent
with this finding, sample firms pre-contest
accounting
returns are systematically
below-market,
whereas their pre-contest
stock returns are
not. During an election campaign,
incumbent
managers
apparently
exercise their accounting
discretion to paint a favorable picture of their own performance
to voting stockholders.
If elected,
dissidents
tend to take an immediate earnings bath which they typically blame on the poor
decisions of prior management.

1. Introduction
A proxy contest is a political campaign in which stockholders who disagree
with managerial
policies seek election
to the firms board of directors.
Economists
view these contests
as the ultimate
corporate
governance
mechanism
that enables dissident
stockholders
of public corporations
to
replace inefficient
management
[Manne (1964,1965),
Alchian and Demsetz
(1972)]. Yet, as Jensen and Ruback (1983) emphasize, we know little about the
process through which alternative management
teams compete for the right to
direct corporate resources. For example, how do stockholders decide whether
incumbents
or dissidents would better manage the firm? Manne suggests that a
*Useful comments
were received from David Austen-Smith,
Ray Ball, Yoram Batzel, Gary
Biddle. Bob Bowen, Jennifer Burke, Nick Donuch, Mike Dugan, George Foster, Paul Healy, Cliff
Holdemess,
Mike Jensen, Susan Liberty, Ron Masulis, Maureen McNichols, Wayne Mikkelson,
Eric Noreen. Pat OBrien. Ed Rice. Roberta Romano. Rick Ruback. Dennis Sheehan. Terrv
Shevlin, Dee Shores, Mary Stone, Jake Thomas, Pete Wilson, Jerry Zimmerman,
the referee David
Larcker,
and participants
in accounting
workshops
at MIT, Ohio State, Stanford,
and the
University of Washington,
and in the law and economics workshop at UCLA. Special thanks are
due to Harry DeAngelo, Jerry Warner, and Ross Watts for especially helpful comments, and to
Gita Rao for her able research assistance. I am also grateful for the research assistance of Michael
Cannova,
Sanjay Malik, and Meenz Singh, for the manuscript
preparation
assistance of Gael
Roberts,
and for financial support from the Managerial
Economics
Research Center at the
University of Rochester and from the General Electric Foundation.

0165-4101/88/$3.500

1988, Elsevier Science Publishers

B.V. (North-Holland)

L. DeAngelo, Accounting measures in proxyjights

recent decline in stock prices will identify inefficient incumbents,

yet Dodd
and Warner (1983) find that stock prices typically increase before a proxy
contest. This empirical regularity limits dissidents ability to cite stock prices
as evidence of managerial inefficiency, and generates a demand for alternative
performance
measures - such as corporate earnings - that will help convince
voting stockholders
to change managers.
This study investigates the use of accounting performance
measures in 86
proxy contests
for board seats on listed corporations
during 1970-1983.
Dissident stockholders
of these firms typically cite poor earnings as necessitating the proposed management
change, while they infrequently
cite a stock
price decline for that purpose. Consistent
with this finding, sample firms
pre-contest
accounting returns are systematically
below-market,
whereas their
pre-contest
stock returns are not. During the election campaign, incumbent
managers apparently
exercise their accounting
discretion to portray a favorable earnings picture to voters. If elected, dissidents tend to take an immediate
earnings bath, which they typically blame on the poor decisions of prior
management
and which enables them to report an earnings turnaround
the
following
year. Viewed collectively,
these findings indicate that corporate
earnings performance
plays a role in the process through which alternative
managers compete for stockholder support.
These findings clarify the process of managerial competition
and hence bear
on theories of the firm that seek to explain how managerial
behavior is
governed in public corporations
[e.g., Alchian and Demsetz (1972) Jensen and
Meckling (1976)]. They also relate to prior studies which find that accounting
data play a role in other aspects of corporate contracting
[e.g., Smith and
Warner (1979), Smith and Watts (1982), Leftwich (1983)]. Finally, they add to
a growing body of research which posits that, because accounting data define
the terms of exchange
in various
contractual
settings,
managers
have
situation-specific
incentives
to manipulate
those data. Healy (1985) finds
evidence of income manipulation
by managers compensated by earnings-linked
bonus plans, while DeAngelo (1986a) and Liberty and Zimmerman
(1986) find
no such evidence for managers who propose a buyout of public stockholders,
or who face upcoming union negotiations.
These differing results raise an issue
to which I return in the empirical discussion below: namely, what factors
determine the variation in income manipulation
across contractual
settings?
Section 2 discusses the information
costs and free-rider problems in stockholder voting that underlie the use of alternative
performance
measures in
contested
board elections, and that generate the hypotheses
tested in the
paper. Section 3 contains sample selection procedures and descriptive statistics. Section 4 documents
the frequency with which dissidents cite earnings
and stock prices as evidence of managerial inefficiency, and describes sample
firms pre-contest
performance.
Sections 5 and 6 report evidence that, during
an election campaign, incumbents
typically report favorable earnings that can

L. DeAngelo, Accounting meusures in proxy

fghrs

reasonably be attributed to the exercise of their accounting discretion. Section

7 reports evidence that newly-elected dissident managers typically take an
earnings bath. Section 8 concludes with a brief summary.
2. The demand for accounting performance measures in proxy contests
In a contested board election, stockholders vote either for the slate of
directors proposed by management or for a rival slate proposed by the
dissidents who seek to replace them. The vote outcome determines which
group will manage the firm. This choice imposes costs of evaluating the
candidates on stockholders. They can, of course, avoid the choice by selling
their shares, but only at a cost, since buyers must be compensated for their
own (presumably lower, but positive) information costs. Stockholders can also
abstain from voting, but at the risk that the remaining sto&holders will
mistakenly elect an inefficient management team. Abstentions seem unimportant empirically since, on average, 84.5% of the shares outstanding are voted in
contested board elections [Dodd and Warner (1983, fn. 9)].
Stockholders who vote can limit their information costs by relying on the
candidates to provide information about their relative abilities/election platforms. Stockholders incentives to do so are reinforced by free-rider problems
in stockholder voting [see, e.g., Easterbrook and Fischel (1983)l.l These
problems both discourage outside stockholders from collecting information
and encourage the candidates to supply it, since they increase the likelihood
their information will be pivotal in the election. Dissidents and incumbents
also have incentives to publicize those facts that support their candidacy in a
format that is easily comprehended by the population of voting stockholders.
The candidates respond to these incentives by producing simplified, condensed
position statements which they make freely available, e.g., via paid advertisements in The Wall Street Journal. They also typically engage professional
proxy solicitors who contact stockholders to lobby for votes.
Dissidents communications to stockholders describe their identity, purpose,
complaints against incumbent management, and evidence in support of those

This free-rider problem, which is perpetuated

by the costs of coordinating
the actions of many
individuals,
is reduced when large blocks of voting stock are held, e.g., by institutions.
Street
wisdom, however, suggests that institutional
ownership does not eliminate the free-rider problem
because institutions
routinely vote with incumbent management
[see, e.g., Kolman (1985)]. They
allegedly do so because managers who become displeased with institutional
holders can punish
them by (i) influencing
the trustee of their own firms pension plan to withdraw plan assets from
institutional
management,
with the attendant loss of commissions,
and/or (ii) influencing managers of other public corporations
to do the same by convincing them that the institutional
holder
is disloyal to corporate
management.
Pound (1987) provides systematic evidence in support of
the argument that institutions
tend not to oppose management
in proxy contests. Consistent with
this argument
and as detailed in section 3 below, the current sample exhibits an unusually low
level of institutional
ownership.

L. DeAngelo, Accounting measures in proq

fights

complaints.
Incumbents
rebuttals cite evidence that contradicts the dissidents
claims, and incumbents
often question their opponents
intentions,
personal
integrity, suitability to manage a public corporation,
etc. Voters will recognize
dissidents incentives to publicize downward-biased
indicators of managerial
performance,
and incumbents
tendency to emphasize upward-biased
measures. Nonetheless,
given the information
costs and free-rider problems
in
stockholder voting, the potentially biased performance
measures advanced by
the candidates
can be voters least-cost means of deciding how to vote. If so,
candidates
who compete on the basis of these imperfect measures enhance
their chances of winning the election.
Dissident
stockholders
of firms whose stock price has declined materially
can use that fact to argue that the incumbents
are inefficient managers [Manne
(1964,1965)].
In an efficient market, however, stock prices anticipate the
potential benefits from removal of inefhcient incumbents,
hence they have a
tendency to increase as the capital market becomes aware of new avenues for
managerial
improvement.
As an empirical matter, stock prices typically do
is that the capital market
increase before a proxy contest. * One explanation
assesses an increased likelihood of either (i) replacement
of inefficient incumbents with a superior management
team or (ii) improved decision making by
incumbents
who perceive the increased threat of a challenge. In either case, a
recent stock price increase is of limited usefulness
to dissidents
who seek
evidence that will convince voters to change managers.
Dissidents
who do not have a stock price decline to attribute
to poor
management
may be able to use accounting
performance
measures for the
same purpose. While accounting
earnings are imperfect performance
indicators because they reflect managements
choice among numerous
accounting
estimates and techniques,
they are nonetheless
publicly-available,
and thus
readily verified. Moreover, because accounting numbers are calculated under
their direction, incumbents
cannot easily dismiss them as irrelevant or flawed
performance
measures. The evidence in section 4 indicates
that dissident
stockholders
typically cite poor earnings as evidence of managerial
inefficiency. This finding suggests the hypothesis
that firms involved in proxy
contests exhibit systematically
poor pre-contest accounting performance.
The
finding that sample firms pre-contest accounting returns, but not their stock
returns, are systematically
below-market
(section 4) suggests that dissidents
emphasize those numbers that support their cause.3

r Dodd and Warner (1983) document a statistically significant average stock price increase (net
of market effects) in the six months prior to and including the announcement
of a proxy contest,
and an immaterial
upward drift in stock prices over the five-year period before the contest. As
Dodd and Warner point out, stock price changes reflect only unanticipated
poor performance,
hence the absence of a dramatic stock price decline before a proxy contest does not imply that the
incumbents
are the best possible managers. This empirical regularity does, however, reduce the
usefulness of stock prices to dissidents who seek to persuade voters to change managers.
An alternative
explanation
earnings are more informative

for this finding is that dissidents typically cite earnings because

about incumbents performance
than are stock price changes.

L. DeAngelo, Accouniing measures in proxy fights

A related hypothesis
(tested in section 5) is that, once a campaign
is
underway,
managers respond to dissidents allegations by reporting increased
earnings. Incumbents
can use an earnings increase to argue that their policies
are starting to pay off, and to help convince voters that the dissidents are
simply opportunists
trying to expropriate these payoffs. For example, Twentieth
Century-Fox
management
claimed it is ironic an expensive proxy contest is
threatened just when their new production programs are about to generate a
turnaround
to a profitable position (The Wall Street Journal, March 10,
1971). In short, an earnings improvement
can influence
voters to retain
incumbents
who, if they cannot make a convincing
case that they are the
superior managers, stand to lose their jobs.
Incumbent
managers can achieve an earnings improvement
both via increases in real profitability
and via the exercise of their accounting discretion.
The latter is, of course, limited by the possibility that dissidents will uncover
evidence of income manipulation
and use it against them.4 But dissidents must
also convince voters, who will naturally suspect them of raising a non-issue
simply to cast doubt on incumbents
integrity. Even should voters suspect
income manipulation,
they cannot be sure incumbents
motivation
is opportunistic, i.e., to disguise their own inefficiencies from voters. Another possibility is that incumbents
window-dress
earnings in a good-faith
attempt to
under their
convey inside information
that the firms true profitability
management
is greater than current earnings would otherwise indicate. Both
managerial
objectives are consistent with the hypothesis (tested in section 5)
that incumbents
exercise their accounting
discretion
to portray a favorable
earnings picture during the campaign.
If incumbents
overstate earnings, victorious dissidents will have their own
future earnings
performance
penalized
by prior managements
accounting
choices (e.g., via increased amortization
charges). To improve future reported
profitability
(hence their salaries/ability
to maintain
control), newly-elected
dissident managers have incentives to take an earnings bath. They can blame
the resultant
substandard
earnings on prior management,
and these earnings
provide a low benchmark
for dissidents future earnings performance.
An
earnings
bath can also improve future earnings
by (i) reducing
future

4 For example,
the dissident stockholders
of Twentieth Century-Fox
filed suit alleging that
Foxs recent claim to have operated profitably during the first two months of 1971 is the result
of the use of a federal tax loss carryforward
and the result of a nonrecurring
gain from the transfer
of a substantial
asset. They claimed the two-month
profit of $2,975,000 results in part from
inclusion
of an item of over $10 million representing
income from the licensing of films for
television and
said $10 million figure represents th: licensing of a very substantial portion of
the tilm library of Fox for a substantial period of time (The Wull Street Journal, April 30, 1971).
5 In this view, managers have incentives to manipulate earnings because a failure to do so will be
incorrectly
viewed as a negative signal about future firm profitability.
Holthausen
and Leftwich
(1983. p. 112) discuss a variant of this signaling motivation,
which they label the information
theory of accounting
technique choice. Relatedly, Myers and Majluf (1984) and Miller and Rock
(1985) analyze corporate
financing and investment decisions in situations in which incumbent
managers have an information
advantage over outsiders.

L DeAngelo, Accounting measures in proxy fights

expenses, (ii) reducing the equity/asset

base for accounting
returns, and (iii)
providing dissidents greater scope to enhance reported profitability with gains
from asset sales at reduced book values. The section 7 finding that newlyelected dissidents tend to take an earnings bath suggests that new managers,
like the incumbents
they replace, view favorable earnings performance
as
an important
means of maintaining
stockholder support.
3. Sample selection procedures and descriptive statistics
I identified an initial sample of 102 proxy contests for board seats during
1970-1983
from the Weekly Bulletins of the New York and American Stock
Exchanges
and the NYSE log of proxy solicitations
by non-management
groups. For each contest, I read The Wall Street Journal Index (WSJI) and
relevant
articles for the five years around
the stockholder
meeting,
and
dropped 16 contests for the following reasons:
(1) The WSJI contained
no mention of the proxy contest in this five-year
period (6 contests).
(2) The proxy contest was an attempt to gain board seats by a labor or
consumer advocate group (5 contests).
(3) The proxy contest was an attempt to require or prevent open-ending
of a
closed-end mutual fund (4 contests).
(4) The proxy contest was a court-administered
open election after CEO
Robert Vesco fled the United States (1 contest).
This screening process was designed to identify significant (i.e., newsworthy)
proxy contests in which the primary reason insurgents sought board seats was
to correct the alleged inefficiencies of incumbent
management.
Table 1 reports the time distribution
of stockholder meeting dates for the 86
proxy contests in the final sample, of which 51 (59%) were for board seats on
NYSE firms and 35 (41%) were for board seats on ASE firms.6 In 71 (83%) of
these contests, the insurgents objective was to elect a majority of the firms
directors, while in the remaining 15 (17%) contests, their current objective was
minority
representation.
Six of the 80 firms in the final sample experienced
two separate proxy contests over the 1970-1983 sample period. (I considered a
second proxy contest as a separate campaign if at least two years intervened

6The current sample, like Dodd and Warners (1983) earlier one, contains highly-publicized
proxy contests for board seats on listed firms. The observed incidence of proxy contests that
reached
the countersolicitation
stage understates
the importance
of the proxy contest as a
corporate governance mechanism, since the threat of a proxy contest (that doesnt materialize) can
induce beneficial changes in managerial decisions. Dodd and Warner (1983, pp. 425-426) report
that about one-fifth of announced proxy contests are terminated
or settled before reaching the
countersolicitation
stage.

L. DeAngelo, Accounting measures in proxy fights

Table 1
The time distribution

of stockholder

meeting dates: 86 proxy

corporations
(1970-1983).

il)
Dissidents
obtained
no board
seats

1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
19x0
19x1
1982
19X3

5
11
3
5
2
6C
3
5
5
8
7
9b
7
10

Total
contests

86

Percent
of total

100%

for board

seats on listed

(2)
Sample partitioned

Total contests

Year

contests

2
6
2
3
0
1
2
2
1
3
3
2b
4
3h

by outcome

Dissidents
obtained
some seats,
but not controla

Dissidents
obtained
control of
the firm
1
1
0
0
1
2b

2
3
1

34

28

24

39%

33%

28%

A proxy contest was classified as resulting in a control change if the dissident stockholders
either (i) obtained a majority of the directorships,
or (ii) both installed a member of their own
group as Chief Executive Officer and obtained a near-majority
(one-half in one contest and 7 of 15
seats in two contests) of the board.
hIncludes
one subsequent
proxy contest. A subsequent
attempt
to gain board seats was
classified as a separate proxy contest if at least two years intervened between proxy contests and
the individuals
in the second dissident group differed from those in the first group. For the six
firms that experienced more than one proxy contest, the average time period between contests was
six years.
Includes two subsequent proxy contests, classified as above.

between contests and the second dissident group differed from the initial
group.) For these six firms, the average period between contests was six years
and the initial contests were evenly split into (i) two contests that resulted in a
control change, (ii) two contests in which dissidents elected a minority of the
board, and (iii) two contests in which the initial dissidents won no board seats.
Column
(2) of table 1 partitions
the time distribution
of stockholder
meetings by contest outcome - contests in which dissidents obtained no board
seats, contests in which they obtained some seats but not control, and contests
in which they acquired control. I classified a contest as resulting in a control
change if dissidents
either (i) obtained a majority of the board, or (ii) both

10

L. DeAngelo, Accounting measures in proxy$ghts

Table 2

Size, leverage.

Descriptive

and ownership measures: 80 listed corporations

whose
contest for board seats during 1970-1983.

statistic

Mean
(1) Size/leverage

Book value of
total assets (in $000~)
Total revenues
(in $OOVs)
Total market value
of equity (in $000s)
Number of
stockholders
Book value of long-term debt
as a percent of total assets

Median

managers

faced

Std. dev.

Range

proxy

measures

219,953

105,777

481,262

3,741 to 2,616,853

309,409

92,244

591,851

1,373 to 3656,321

82,578

35,488

140,105

1,873 to

8,439

5,887

12,163

22.6%

21.5%

16.6%

0.0% to 75.0%

11.1%

1.0% to 45.0%

652

to

828,291
83,319

(2) Ownership percentages

Percent of common stock
held by dissidents
Percent of common stock
held by management
Percent of common stock
held by institutions

14.5%

11.4%

11.7

8.3

11.6

0.1 to 48.2

6.1

3.2

8.5

0.0 to 50.6

Financial
data were obtained from corporate annual reports and Moodys Manuals, and are
for the fiscal year of the scheduled election, except for three firms for which prior-year data were
the most recent available (due to merger or bankruptcy).
The total market value of equity was
calculated
from (i) the number of shares outstanding
at year-end, and (ii) the average of the high
and low share prices for the year. Dissident and managerial ownership data were collected from
proxy statements or from articles in The WaN Street Journal, while data on institutional
ownership
were obtained from Standard & Poors Security Owners Stock Guide at the beginning of the year
in which the contested board election was scheduled.

installed a member of their own group as Chief Executive Officer (CEO) and
obtained a near-majority
(details below) of the board. Table 1 indicates that
sample contests
are approximately
uniformly
distributed
across the three
outcomes - in 39% of the contests the dissidents won no seats, they won some
seats but not control in another 3358, and they obtained control in 28% of the
contests. Of the 24 contests that resulted in a control change, dissidents elected
all directors in eight contests and a majority in 13 contests. In one contest, a
dissident became CEO after his group elected one-halfthe
board. In each of
the last two contests, a dissident became CEO after his group elected seven of
15 directors.
Table 2 reports descriptive
statistics, which include the mean, median,
standard deviation, and range of four corporate size measures and a leverage
measure (panel 1) and of three ownership measures (panel 2). By all size
measures - total assets, revenues, market value of equity, and number of

L.. DeAngelo,

Accounting

measures in proxy fights

11

stockholders
- sample firms are reasonably
large public corporations.
For
example, the median firm has 5,887 stockholders (versus 4,480 for the median
exchange-listed
firm on the 1983 Compustat
tape), although the average of
8,439 stockholders
falls below the 19,163 average for the latter group. These
relations suggest that the current sample contains fewer extremely large listed
corporations
than are on Compustat,
perhaps because the per-stockholder
costs make proxy contests uneconomic
for firms with a substantial
number of
stockholders
[see also Pound (1987)]. The last row of panel 1 reports a 22.6%
average (21.5% median) debt-to-assets
ratio, which is not markedly different
from the 20.6% average (17.3% median) for the Compustat firms.
The ownership data in panel 2 indicate that managers and dissidents tend to
hold reasonably
large voting blocks, while institutions
hold stakes of
considerably
smaller size. Dissidents holdings average 14.5% of the common
stock (median, 11.4%) and exceed incumbents
holdings by some 3% in the
typical case. Institutional
holdings average another 6.1% (median, 3.2%). While
institutional
holdings are slightly higher for the 47 NYSE-listed
companies
(average, 7.9%; median, 5.8%) they are nonetheless
quite low by NYSE
standards.
[The New York Stock Exchange Fact Book (1985) reports average
institutional
holdings of 35.4% in 1980.1 These relatively low institutional
holdings support street wisdom that dissidents are less likely to win (and
therefore to attempt) a proxy contest in firms with large institutional
holdings.
In this view, institutions
routinely support managers, who have various means
of punishing
institutions
that vote against them (see fn. 1).
The industry
affiliation of sample companies is of potential interest here,
since a high degree of industry concentration
would suggest that industry-wide
poor performance
might be an important
factor in proxy contests. Sample
companies,
however, exhibit a striking lack of industry concentration.
Standard & Poors Corporate Directory reports 64 separate primary 4-digit SIC
codes for the 80 sample firms. The largest number of firms in any one category
is four (two industries). There are two firms in each of ten industry categories,
and the remaining
52 sample firms are spread across 52 different industries.
Among the industries with more than one sample firm, in only one case did
two proxy contests for firms in the same industry occur in the same calendar
year. The absence of industry concentration
suggests that proxy contests for
firms in troubled industries may be more difficult to wage because incumbents
can more readily convince voters that their own firms poor performance
is
due to (industry-wide)
factors beyond their control.
4. Pre-contest

accounting and stock price performance

To determine the frequency with which contest participants

and stock price performance
as evidence for (or against)
change, I read the relevant WSJ articles and proxy statements

cite accounting
a management
available from

12

L. DeAngelo, Accounting measures in proxyJights

Disclosure. If these source documents do not exhaustively catalogue all issues

raised during the campaign, this procedure will understate the number of
contests in which the firms poor earnings record and/or stock price performance was an election issue. According to these materials, dissidents cited
poor earnings as necessitating the proposed management change in 61 (71%)
of the 86 proxy contests.7 They cited a recent stock price decline in only eleven
cases (13%) and, in each of these eleven cases, they also criticized earnings. I
found only one contest in which the incumbents claimed credit for a recent
stock price increase, and nine contests (10%) in which dissidents claimed the
companys stock price was too low relative to intrinsic value or to an
accounting benchmark such as book value.
The fact that dissidents typically flag poor earnings evidently indicates a
belief that these numbers will help their cause, since they would not expend
resources to publicize performance measures that have no chance of convincing voters to change managers. The role of accounting information in
effecting a hostile management change parallels its role in other corporate
contexts. Prior research finds that corporate debt contracts typically use
accounting data to define the permissible set of managerial decisions [Smith
and Warner (1979), Leftwich (1983)] and that managerial compensation is
often explicitly tied to earnings [Smith and Watts (1982) Healy (1985)]. The
current setting differs from these insofar as it involves the implicit use of
accounting data. It is similar insofar as a proxy contest is an extreme form of
managerial performance evaluation. Importantly, the current evidence indicates that, by serving as justification for a hostile management change, poor
earnings can affect managerial wealth/decisions in ways other than through
their explicit functional relation to periodic bonus compensation.
4.1. Pre-contest accounting performance
To assess sample firms pre-contest accounting and stock price performance,
I identified two announcement dates from reports in the WSJ. The first, the
inception of dissident activity, is the time at which the dissidents initially
expressed their dissatisfaction with managerial policies or management expressed its opposition to the dissidents attempts to influence those policies.
The second, the contest announcement, is the time at which the insurgents first
In
these 61 contests,
dissidents
criticized
,management
using a variety
of earnings
measures - presumably
those which in each case most convincingly portrayed the incumbents
as
poor managers, For example, some dissidents blamed incumbents for a current-period
loss, while
others criticized them for a negative earnings trend. The terms insurgents attached to corporate
earnings
are both pejorative and colorful - they called earnings sagging, sluggish, puny,
and referred to an earnings
collapse. Overall,
erratic,
anemic,
dismal, disappointing,
dissidents rely on simple earnings measures, presumably
because more complex statistical measures (such as negative forecast errors from time-series models) are too difficult for most outside
stockholders
to interpret.

L. DeAngelo, Accounting measures in proxy fights

13

Table 3
accounting
rates of return on equity and incidence of reported
contests for board seats on listed corporations
(1970-1983).

Pre-contest

(1)
Year relative to
inception of
dissident activity

Median
unadjusted
return on
equity

(2)
Median
return
on equity
adjusted for
market retumb

(3)
P-value for
Wilcoxon
signed-rank
testC

losses:

86 proxy

(4)
Percent of
sample
that reported
a loss

(1) Full sample (86 contests)

-3
-2
-1
Between inception of
dissident activity and
contest announcement
(27 firms)

9.2%
8.8
7.4

- 4.3%
- 4.4
-5.8

0.0028
0.0001
0.0001

11.6%
15.1
19.8

8.3

-4.8

0.0116

25.9

(2) Subsample in which dissidents criticized earnings (61 contests)

-3
-2
-1
Between inception of
dissident activity and
contest announcement
(19 firms)

8.0%
7.9
5.8

- 5.6%
-4.9
- 8.4

0.0072
0.0001
0.0001

9.8%
14.8
24.6

4.2

-9.8

0.0023

31.6

The inception of dissident activity was taken as the first Waif Street Journal announcement
that the ultimate dissident stockholder
group would seek board representation
or control of the
firm, or that management
opposed the groups attempts to influence corporate policy.
bThis figure was calculated by subtracting
the median return on equity for all listed companies
with data on Compustat
for the relevant year.
These significance levels are one-tailed, to test the prediction that sample companies median
market-adjusted
accounting
return is negative.

announced their intention to solicit proxies. The first date is meant to capture
the initiation of hostilities between dissidents and incumbents, whereas the
second is meant to capture the time at which they turned to outside stockholders to decide between them. For 37 of the 80 firms, the two announcement
dates coincide. For the remaining 43 firms, inception of dissident activity
precedes contest announcement by an average of 131 trading days (median, 93
trading days; range, 7-697 trading days).
Table 3 reports pre-contest accounting rates of return on equity and the
incidence of reported losses for the full sample of 86 contests (panel 1) and for
the subsample of 61 contests in which the dissidents criticized earnings (panel
2). These data cover the three years before inception of dissident activity for
all firms, and the period between inception of dissident activity and contest
announcement for the 27 sample firms (19 in the subrample) that released

14

L. DeAngelo, Accounting memures in proxy fghts

annual earnings during that period. The table reports the median unadjusted
return
on equity
[column
(l)], the median
return
adjusted
for the
contemporaneous
median return on equity for all listed firms on Compustat
[column (2)], P-values for Wilcoxon signed-rank
tests of the hypothesis that
the median market-adjusted
returns are negative [column (3)], and the incidence of reported losses [column (4)].
Columns (l)-(3) of table 3 indicate that sample firms pre-contest accounting returns are systematically
below-market.
For example, the median unadjusted return on equity for the full sample in the year before inception
of
dissident activity is 7.4% which, net of the overall market return, represents a
significantly
negative
-5.8% excess return. The same subpar performance
characterizes
the market-adjusted
accounting returns of the full sample in the
prior two years, and those of the 27 firms that released annual earnings
between inception of dissident activity and contest announcement.
Panel 2 of
table 3 portrays a similar, but consistently more negative picture of pre-contest
accounting
returns for the 61 contests in which dissidents criticized earnings.
Most dramatically,
it reports a -9.8% market-adjusted
return before contest
announcement
for the 19 firms that released annual earnings between the two
announcement
dates. Column (3) indicates that all market-adjusted
returns in
the table are significantly
negative under Wilcoxon signed-rank
tests, with
P-values that range from 0.0116 to 0.0001.9
Column (4) of table 3 reports the loss incidence in each of the three years
before inception of dissident activity, and in the period between inception of
dissident activity and contest announcement.
Of the full sample, 19.8% reported a loss before inception
of dissident activity, which increased to 25.9%
immediately
before contest announcement.
The numbers are more striking for
contests in which the firms poor earnings record was an election issue - 24.6%
reported a loss before inception of dissident activity, which increased to 31.6%
before contest announcement.
The loss incidence
for the current sample
exceeds the contemporaneous
loss incidence for all exchange-listed
firms on
Compustat
for 12 of the 16 calendar years with earnings observations.
This

I used the median market return to adjust the returns of the current sample because in some
years the average market return was sensitive to the inclusion of outliers. Specifically, for each
return for each sample firm, I subtracted
the contemporaneous
median return on equity for all
listed firms with data on Compustat,
a procedure
which assumes that sample firms have an
accounting
beta of one. Because sample firms average market beta is 1.23 [and to the extent that
accounting
and market betas are correlated as discussed in Watts and Zimmerman
(1986, pp.
120-125)],
this procedure
should understate
the degree to which sample companies experienced
below-market
accounting
returns in periods before the proxy con!est.
Sample
firms substandard
accounting
returns are relatively stable in periods before the
contest. An earlier draft of this paper [DeAngelo (1986b)] reports details of statistical tests which
indicate that sample firms did not experience a systematic pre-contest earnings decline.
Specifically,
I assigned the event-time data in column (4) to the relevant calendar
1966-1983,
and compared them to the contemporaneous
loss incidence for the Compustat
firms. The latter averages 9.2% (range, 4.7% to 17.0%) over the 1966-1983 period.

years,
listed

L. DeAngelo, Accouniing rnensures in proxy fights

15

Table 4
Pre-contest

stock price performance:

80 listed corporations
whose managers
for board seats during 1970-1983.

Month relative
to inception
of dissident
activity
- 60
~ 50
-40
-30
- 24
-23
-22
-21
-20
- 19
- 18
-17
- 16
-15
-14
-13
-12
-11
- 10
-9
-8
-7
-6
-5
-4
-3
-2
-1
0

(1)
Mean
unadjusted
return

0.017
0.037
0.003
0.019
0.011
0.012
0.006
0.015
0.014
0.006
0.014
0.024
0.015
0.047
0.015
0.031
0.003
0.012
0.009
0.013
0.001
0.017
0.028
0.001
0.020
0.018
0.022
0.041
0.093

(2)
Cumulative
unadjusted
return
0.017
0.153
0.283
0.476
0.538
0.549
0.556
0.571
0.557
0.563
0.577
0.601
0.616
0.663
0.648
0.679
0.682
0.670
0.661
0.648
0.649
0.666
0.695
0.694
0.714
0.731
0.753
0.794
0.887

faced a proxy contest

(3)
Mean
prediction
errorb

(4)
Cumulative
prediction
error

0.005
0.007
- 0.010
- 0.002
- 0.024
0.015
~ 0.008
0.007
- 0.024
0.006
0.009
0.019
- 0.010
0.029
- 0.022
0.022
0.015
-0.011
- 0.026
- 0.026
~ 0.004
0.006
- 0.004
- 0.017
- 0.006
~ 0.008
0.016
0.019
0.063

0.005
- 0.005
- 0.033
- 0.077
- 0.119
~ 0.104
- 0.112
- 0.105
- 0.129
- 0.123
-0.114
~ 0.095
-0.106
~ 0.076
- 0.098
- 0.076
- 0.061
- 0.072
- 0.098
-0.124
-0.128
-0.122
-0.126
-0.143
-0.149
-0.157
- 0.141
- 0.123
- 0.060

a The inception of dissident activity was taken as the initial Wall Street Journal announcement
that the ultimate dissident stockholder group would seek board representation
or control of the
firm, or that management
opposed the groups attempts to influence corporate policy.
Monthly
prediction errors were calculated using the procedure described in Dodd and Warner
(1983, fn. 25). In particular, market model parameters were estimated from monthly returns in the
4%month period consisting of months -84 through -61 and +13 through +36 relative to the
inception
of dissident
activity. In order to be included in the table, a security must have a
minimum of 24 monthly returns in the estimation period, a criterion which excluded two (2.5%) of
the 80 sample firms.

percent (75%) is significantly

greater than 50% at the 0.0401 level under a
binomial test.
Given this evidence, it is perhaps not surprising
that dissidents
tend to
emphasize
losses as necessitating
a management
change. For example, one
dissident claims The Condec Corporation
has an outstanding
record. It has
lost more than $90 million in the last three years, which is unmatched
by any

16

L. DeAngelo, Accounting measures in proxyjghts

its size (The New York Times, November

8, 1983). An evident
reason that dissidents focus on losses is that, while voters may disagree over
the appropriate
benchmark for positive income, they seem likely to view losses
as an indication
the firm is experiencing
serious difficulties. Hence, a track
record of losses may serve to encourage a proxy contest for board seats.

4.2. Pre-contest

stock price performance

Sample firms pre-contest stock price performance

exhibits little indication
of a systematic decline that insurgents could attribute to poor management.
Rather, sample firms experienced a systematic stock price increase in the six
months up to and including inception of dissident activity, as measured by the
market model procedure described by Dodd and Warner (1983, fn. 25). As
might be expected, dissidents who criticize a firms stock price performance
cite simple numbers such as raw returns rather than market model prediction
errors. Hence, I also ascertained
whether unadjusted
stock returns declined
materially before the dissidents intentions became public knowledge. Table 4
reports mean unadjusted
returns [column (l)] and mean cumulative unadjusted returns [column (2)] in the period from month - 60 to month 0 relative to
the initiation
of hostilities between dissidents and incumbents.
The overall
picture is one of positive unadjusted
stock returns in the months before the
dissidents intentions
were revealed.
Market model prediction
errors for the 60 months before inception
of
dissident activity [columns (3) and (4) of table 41 yield results similar to those
in Dodd and Warner (1983, pp. 415-416). In particular, there is evidence of
positive abnormal stock price performance
in the six months before inception
of dissident activity. Table 4 reports that the mean cumulative prediction error
(CPE) for months - 5 through 0 is 6.6%, with an associated Z-statistic of 2.60
[see Dodd and Warner (1983, pp. 436-437) for a description
of statistical
methodology].
For months - 2 through 0, the mean CPE is 9.7% (Z-statistic =
4.52) while the mean prediction
error in the announcement
month is 6.3%
(Z-statistic
= 4.54). This evidence indicates
that, on average, stock prices
increased significantly
in the six months before inception of dissident activity,
and that the increase occurred primarily in months - 2 through 0.
The CPE column in table 4 yields the visual impression
that, on average,
stock prices declined in periods before the initiation
of hostilities between
incumbent
management
and the dissidents. However, the negative prediction
errors are largely confined to months - 60 to - 24, and they are not statistically significant. The mean CPE for months -60 to - 24 is - 11.9%, with a
l1 The stock returns for the current sample do not exhibit the significant post-announcement
drift found by Dodd and Warner (1983). Specifically, the CPE for the 12-month period following
the inception of dissident activity (months + 1 to + 12 inclusive) is - 7.4%. with a Z-statistic of
- 0.95.

L. DeAngelo, Accounting measures in proxy jghts

17

Z-statistic of -0.16. The mean CPE in the eighteen months that preceded the
six months of positive abnormal performance described earlier, that is, the
mean CPE for months - 23 through -6 is an immaterial -0.7% (Z-statistic
= 0.19). These insignificant sample average prediction errors may help explain
why so few dissident groups cite poor stock price performance. On the other
hand, eleven groups did flag a stock price decline, which suggests that
dissidents will use such declines to support their cause when they find it
advantageous to do so.
5. Accounting

performance during the election campaign

This section reports tests of the predictions that (i) managers report increased earnings during an election campaign, and (ii) these earnings reflect
incumbents accounting discretion. I test the latter using the accrual approach
developed in Healy (1985) and DeAngelo (1986a). Specifically, I take the
year-earlier comparison period accrual as an estimate of the normal accrual
in the event period. The difference in accruals serves as a proxy for the
abnormal accrual, or the extent to which managers deliberately alter their
accounting choices to influence reported earnings. Formally, the accrual in the
event period, time t = 1, AC,, equals the difference between net income and
operating cash flows: AC, = NI, - CF,. * Similarly, the benchmark accrual is
taken from the year-earlier comparison period, time t = 0, and is defined as
AC, = NI, - CF,. With E denoting the expectations operator,
E( NI,) = NJ,,,
E( CF,) = CF,,
E(AC,)=AC,=(NI,-CFO),
which I label the random walk model because it assumes that, absent proxy
contest-induced changes in managerial decisions, all three variables would
follow a random walk.
Recent empirical evidence on the time series properties of alternative cash
flow measures [Bowen, Burgstahler and Daley (1986)] suggests that year-earlier
working capital from operations may be a superior predictor of operating cash
flows during the event period. With WK, = working capital from operations in
the year-earlier comparison period, this finding suggests an alternative model
*For most firms, the primary difference between net income and operating
cash flows is
probably the periodic depreciation
charge. Accruals also reflect managerial decisions to accelerate
or defer revenue recognition and to capitalize or expense costs such as repair expenditures,
as well
as gains/losses
from asset sales, non-cash writedowns and writeoffs, accounting estimates such as
bad debt expense, and changes in accounting principles.

L. DeAngelo, Accounting measures

18

for expected

operating

in proxyjghts

cash flows and accruals:

E(CF,)

= WK,,

E(AC,)

= @VI,,-

WK,).

The tables that follow report results for both models.

Unexpected
earnings are predicted
to be positive during the campaign
because managers
who report favorable
earnings
stand to increase their
chances of winning the election. Unexpected
accruals are predicted
to be
positive because managers have incentives to achieve an earnings improvement
via the exercise of their accounting
discretion.
Unexpected
cash flows are
predicted to be positive insofar as they proxy for the increase in real profitability that managers faced with a proxy contest have incentives
to effect.
While managers can also make cosmetic changes in operating cash flows (e.g.,
they can defer maintenance
and advertising expenditures),
managers ability to
do so is limited relative to their accounting discretion. Specifically, cash flow
adjustments
are constrained
to the remainder
of the current fiscal period,
while managers can make accounting
adjustments
until financial statements
are finalized.
The use of more than one expectations model reduces the likelihood that the
accrual results are driven by the choice of benchmark.13 Of particular concern
is the possibility
that accruals increased systematically
during the campaign
for some unspecified reason beyond incumbents
current control, so that the
benchmark
accrual is understated.
Such an increase might plausibly be induced by systematic changes in operating policy or asset/financial
structure
around the time of the proxy contest. The use of a prior-period
benchmark
(rather than one from a more extensive time-series
of data) reduces the
likelihood
that unexpected accruals reflect structural shifts that might occur
over longer intervals.14 Moreover, if sample firms experienced a material shift
in asset/financial
structure during the event period, then total assets and
operating cash flows might reasonably be expected to change as a result. Since
neither changed significantly, it seems unlikely that the accrual results can be
explained by a contemporaneous
structural change.

r3While the second expectations

model serves as a sensitivity check on the first, the best
benchmark
for expected accruals in random (and other) samples remains an unresolved empirical
issue. Two recent attempts to develop more complex models of expected accruals for non-random
samples are Liberty (1987) who takes a cross-sectional
approach, and Jones (1987) who takes a
time-series approach.
Empirical
support for the use of a prior-period
benchmark is provided in Bowen, Burgstahler
and Daley (1986, fn. 15) who employ more complex models on more extensive time-series of data,
and conclude
that these models do not provide better cash flow predictions
than the first
differences model I describe in the text.

L. DeAngelo, Accounting measures in proxy Jights

19

As an additional
sensitivity check on the accrual benchmarks,
I also conduct
cross-sectional
tests for within-sample
comparisons
of unexpected
accruals
across two different sample partitionings.
I chose to employ within-sample
comparisons
in preference to a matched-sample
approach because firms that
experience
a proxy contest likely differ in important,
but unspecified
ways
from other listed corporations.
Hence, any across-sample
differences in unexpected
accruals
might simply reflect other systematic
but uncontrolled
differences.
The within-sample
comparisons
indicate that the unexpected
accruals of firms that release earnings during the election campaign are significantly greater than the immediate post-election
unexpected
accruals of firms
that do not. I also find evidence that the relation between the accounting
returns of firms engaged in close proxy contests and the returns of other
sample firms reverses during the campaign. Taken together, these findings lend
empirical
support for the assumption
that unexpected
accruals measure the
effect of incumbents
accounting discretion.

5.1. Data
Quarterly reports on form lOQ, annual reports, forms lOK, and/or Moodys
Manuals are the source documents for earnings, accruals, and operating cash
flows. Operating
cash flows are calculated by adjusting working capital from
operations
for the changes in all current operating accounts [see DeAngelo
(1986a) and Drtina and Largay (1985) for computational
details]. In the
results reported
below, unexpected
earnings,
accruals, and cash flows are
standardized
by total assets as of the end of the year-earlier
comparison
period. I also standardized
the variables by end-of-period
total assets and by
total revenues,
and the results are consistently
invariant
to the choice of
standardization
procedure
(the one exception is reported and discussed in
section 6). Additionally,
binomial tests (which rely only on the direction of a
given observation,
hence are independent
of the choice of deflator) consistently support all parametric and non-parametric
results.
In 66 of the 86 sample contests, incumbent
managers released quarterly or
annual earnings between inception of dissident activity and the day before the
stockholder
meeting, as evidenced by a WSJ earnings announcement
in that
interval. If incumbents
released earnings more than once during this period, I
assumed that the last earnings released before the meeting were the most likely
to influence voters, hence the most attractive candidates for income manipulation. Of the 66 contests with at least one earnings release during the campaign,
43 contests
(42 firms) had sufficient funds statement
data available
from
Disclosure
to calculate both benchmark
and event period accruals. Funds
statements
were not routinely provided in forms 1OQ prior to late 1975, when
the Securities and Exchange Commission
(SEC) mandated their inclusion. As
a result, all but three of the 43 proxy contests occurred during 1976-1982.

20

L. DeAngelo, Accounting measures in proxy fights

The necessity to confine the empirical analysis primarily to post-1976 proxy

contests raises the issue of whether these 43 contests are clustered in time, so
that unspecified time-specific factors might plausibly induce the results. Such
time-clustering does not seem to be an important factor in the current sample.
Specifically, financial statements for the three proxy contests from the pre-1976
period are dated 1971, 1972, and 1973. For the remaining 40 contests, the time
distribution of financial statement dates is: two in 1976, two in 1977, three in
1978, seven in 1979, six in 1980, five in 1981, six in 1982, and nine in 1983.15
Nor is there any apparent clustering by industry, since the 42 firms involved in
these 43 proxy contests are spread across 38 separate four-digit SIC codes,
with no more than two firms to any one industry.

5.2. Empirical results

Column (1) of table 5 summarizes the standardized difference between the
earnings that incumbent managers released during the election campaign and
those from the year-earlier comparison period. Columns (2) and (3) of the
table contain the standardized measures of unexpected accruals and operating
cash flows. The first set of numbers in each column is the mean, t-statistic, and
significance level for a t-test that the mean is zero (versus the alternative
hypothesis that the mean is positive). The second set is the median, the percent
positive, and one-tailed significance level for a Wilcoxon signed-rank test. The
Wilcoxon test is probably more reliable than the t-test since Shapiro-Wilk
W-tests [Shapiro, Wilk and Chen (1968)] indicate significant non-normality in
the data.16 Panel 1 reports results for the random walk model, and panel 2
reports results for the alternative model.
The unexpected earnings in column (1) indicate that, during the election
campaign, managers of the typical sample company reported earnings that
materially exceeded those they had reported in the year-earlier comparison
period. This earnings increase averages about 1% of total assets, and is
significantly positive, at the 0.0023 level under a standard t-test. The median
earnings increase of 0.41% of total assets is also significantly positive, at the
0.0011 level under the Wilcoxon test. Finally, the proportion of positive

15As an additional check on whether the results reported below arc time-dependent,
I partitioned
the earnings, accrual, and cash flow changes into those for the 1970s (17 contests) and those for
the 1980s (26 contests) and compared
the means (medians) across the two subsamples.
This
comparison
yields no significant differences in any variable across the two time periods.
16Lehmann (1975, pp. 171-175) reports that the Wilcoxon test has an efficiency of about 95%
relative to a t-test for data that are normally distributed,
and that the Wilcoxon test can have an
efficiency that is considerably
greater than that of the t-test for non-normal
distributions.
He also
recommends
the Wilcoxon test over tests based on sign alone (such as the binomial test), which
are relatively inefficient for distributions
whose central regions are close to normal.

L. DeAngelo, Accounting measures in proxy fights

21

Table 5
Unexpected

earnings, accruals, and operating cash flows during

contests for board seats on listed corporationsa

(1)

(2)

Unexpected
earnings
(I) Rundom
Mean
t-statistic
Significance

levelh

Median
Percent positive
Significance level
for Wilcoxon
signed-rank
testh

Unexpected
accruals
walk

levelh

Median
Percent positive
Significance level
for Wilcoxon
signed-rank
testh

43 proxy

(3)
Unexpected
cash flows

model

0.0100
2.9929
0.0023

0.0195
2.1641
0.0181

- 0.0095
- 1.1899
0.8796

0.0041
74.4%

0.0048
62.8%

- 0.0012
46.5%

0.0011

0.0365

0.7486

0.0229
3.4038
0.0007

- 0.0129
- 1.9062
0.9683

0.0122
79.1%

- 0.0038
37.28

0.0005

0.9714

(2) Alternative
Mean
f-statistic
Significance

an election campaign:
(1970-1983).

same
as
above

model

Data are for the subsample of 43 proxy contests in which managers released earnings during
the campaign
and for which complete data, including funds statements for the final accounting
period before the contested election and for the year-earlier
comparison
period, were available
from Disclosure.
The subsample contains 42 initial proxy contests and one subsequent
contest,
which followed the initial contest for that sample firm by four years. All variables are standardized by total assets.
hAll significance levels are one-tailed, to test the hypothesis that unexpected earnings, accruals,
and operating cash flows are positive during the election campaign.
This model employs working capital from operations in the comparison period as a benchmark
for operating
cash flows, and the difference between net income and working capital from
operations
in the comparison
period as a benchmark
for the normal level of accruals.

earnings changes is greater than 50% at the 0.0011 level of significance under a
binomial
test. In short, all test results support the hypothesis that incumbent
managers typically report increased earnings during an election campaign.7~s

Seventy
percent of the 23 sample firms with earnings releases during the contest for which
funds statements are unavailable reported an earnings increase during the campaign. This percent
is statistically
greater than 50% at the 0.0475 level under a binomial test.
sThirty-two
(74.4%) of the 43 observations
were taken from financial statements that covered
one fiscal quarter, while the other eleven observations came from financial statements that covered
longer periods. To check whether inclusion of the 11 cumulative observations
affects the results, I
reran the tests using only the remaining 32 observations
and the results are virtually identical to
those in table 5.

22

L. DeAngelo, Accounting measures in proxy fights

The unexpected
accruals in column (2) offer two measures of the extent to
which unexpected
earnings in column (1) reflect the exercise of incumbent
managers
accounting
discretion.
Panel 1 of column (2) reports an average
unexpected
accrual of some 2% of total assets (median, 0.48%) under the
random
walk model. Both mean and median are statistically
positive, at
respective
significance
levels of 0.0181 and 0.0365. Panel 2 of column (2)
reports an average unexpected accrual of about 2.3% of total assets (median,
1.22%) under the alternative
model. Again, both mean and median are
statistically
positive, at respective significance
levels of 0.0007 and 0.0005.
Finally, the proportion
of positive unexpected accruals is greater than 50% at
the 0.0630 level for the random walk model, and at the 0.0001 level for the
alternative model. This evidence is consistent with the hypothesis that managers
exercise their accounting
discretion to portray a favorable earnings picture
before a contested board election.
The cash flow figures in column (3) of table 5 indicate that the significant
earnings increase in column (1) was not accompanied
by a contemporaneous
increase in operating cash flows. Specifically, operating cash flows did not
increase under either expectations
model. This finding is somewhat puzzling
because one might reasonably expect a proxy contest to induce managers to
effect an immediate improvement
in real profitability.
However, to the extent
that unexpected
cash flows proxy for changes in real profitability,
the results
suggest that sample firms real profitability did not increase during the election
campaign, although their reported profitability
increased significantly.
The unexpected earnings and accruals reported in table 5 contrast markedly
with the immediate post-election
unexpected earnings and accruals of sample
firms whose managers did not release earnings during the campaign.
Table 6
reports that these latter firms experienced an immaterial post-contest
earnings
decline [column (l)]. It also indicates that the unexpected
accruals of these
firms are insignificantly
different from zero under both expectations
models
[column (2)], as are their unexpected cash flows [column (3)]. All measures of
unexpected
earnings
and accruals in table 6 differ significantly
from the
corresponding
figures in table 5, which themselves differ significantly
from
zero. These differences cannot be explained by cross-sectional
differences in
proxy contest outcomes or in pre-contest
earnings performance
(which are
insignificant).
Nor can they be explained by the tendency (documented
in
section 7) for newly-elected
dissident managers to take an earnings bath.
These
18 firms include four firms whose managers
released earnings at the stockholder
meeting or on the day before the meeting, for which it seems unlikely that stockholders
had
sufficient time to reconsider their voting decisions in response. Of the 86 total contests, 43 had
earnings releases during the election campaign,
18 Fmprise
the current sample, two contests
had missing earnings announcement
dates, and the remaining
23 firms had earnings releases
during the campaign for which funds statements are unavailable (see fn. 17).

L. DeAngelo, Accounting measures in proxy fights

23

Table 6
Unexpected

earnings,

accruals,

and operating cash flows after the election

release earnings during the campaign.a

(1)
Unexpected
earnings
(18 firms)

(2)
Unexpected
accruals
(11 lirms)d

for firms that did not

(3)
Unexpected
cash flows
(11 firms)d

(I) Random walk model

Mean
f-statistic
Significance

levelh

Median
Percent positive
Significance level
for Wilcoxon
signed-rank
testh

~ 0.0076
- 1.3481
0.9024

- 0.0137
- 0.7063
0.7520

0.0029
0.1834
0.4291

- 0.0007
38.9%

- 0.0030
45.5%

- 0.0023
45.5%

0.8846

0.6555

0.5178

- 0.0064
~ 0.3287
0.6254

~ 0.0043
- 0.2803
0.6075

- 0.0109
45.5%

- 0.0023
45.5%

0.7184

0.5531

(2) Alternative model

Mean
r-statistic
Significance

levelh

Median
Percent positive
Significance level
for Wilcoxon
signed-rank
testh

same
as
above

Data are for the first (quarterly or annual) earnings announced

after the election for the 18
proxy contests whose managers did not release earnings during the campaign. Complete funds
statement data were available from Disclosure for 11 of the 18 firms. All variables are standardized by total assets.
hAll significance
levels are one-tailed, to test whether the immediate post-election
unexpected
earnings, accruals, and operating cash flows are positive for firms whose managers did not release
earnings during the election campaign.
This
model
employs
working
capital from operations
in the comparison
period as a
benchmark
for operating cash flows, and the difference between net income and working capital
from operations
in the comparison period as a benchmark
for the normal level of accruals.
dExcludes
seven firms for which funds statement data are unavailable
due to pre-1976 data
constraints.

Specifically, the mean unexpected accrual for the four firms whose managers
both (i) lost the election and (ii) did not release earnings during the campaign
is positive under both expectations models.
The insignificant
results in table 6 are similar to those in DeAngelo (1986a)
for firms whose managers proposed a buyout of public stockholders.
One
possible reason the latter results differ from those in table 5 is that management
buyouts
provide
stockholders
with differentially
strong economic
incentives
to monitor managements
accounting
choices. Differential
extema1

24

L. DeAngelo, Accounting measures in proxy jghrs

monitoring
may also help explain Liberty and Zimmermans
(1986) insignificant findings,
since union leaders stand to lose their positions
(and the
perquisites/benefits
thereof) should their failure to discover income manipulation engender a less valuable wage package for their constituents.
Conversely,
Healys (1985) significant findings for earnings-linked
bonus plans may primarily reflect relatively weak incentives of compensation
committees to monitor managements
accounting choices, given their ability to alter managerial
wages and bonus plan parameters
over time. Directors might also simply
rubber stamp compensation
that can be justified by reported earnings (e.g.,
because their primary concern is protection from stockholder liability suits), so
that earnings
serve as an excuse for the current level of managerial
pay
[Watts and Zimmerman
(1979)].
Two additional
factors may help reconcile the mixed results of extant
income manipulation
studies - the magnitude of the direct managerial payoff,
and opportunities
for outsiders to learn about the available degree of accounting discretion.
In the current setting and those studied by Healy (1985) and
DeAngelo (1986a), managers stand to directly increase their personal wealth
via their accounting
choices, and all but the last study report evidence of
income manipulation.
In contrast, union negotiations
provide managers with
no obvious direct payoffs. Moreover, they are of a repeat-game
nature (as,
however, is the setting in Healy), so that outsiders have a chance to learn
about the scope of managements
available accounting discretion. In contrast,
proxy contests and management
buyouts are one-time occurrences
for most
public
corporations.
While these three factors - differential
monitoring,
managerial
payoffs, and learning opportunities
- potentially
affect the degree
of income manipulation,
further research on managements
accounting choices
across a broader spectrum of contractual
settings is required to assess their
overall empirical importance.
6. Accounting

performance tests: Potential biases and sensitivity checks

Because the table 5 data are standardized

by a measure of company size,
their magnitude
does not accurately reflect the materiality of the earnings and
accrual increases managers typically report during an election campaign. Table
7 contains some additional facts which portray a more comprehensive
picture
of that materiality.
Row (1) of the table indicates that managers of the 35
firms whose comparison-period
earnings were positive reported a median 53%
earnings increase during the campaign, which is significant at the 0.0007 level.
Row (3) indicates that the accrual change from the year-earlier
comparison
period represents a median 45% of current income for the 37 companies with
positive earnings during the campaign. Row (4) indicates that, had accounting
accruals remained constant at the prior-period
level, managers of the 35 firms
whose prior-period
earnings were positive would have reported a median 32%

L. DeAngelo, Accouniing measures in proxy fights

25

Table I
The materiality

of earnings and accrual increases during an election campaign:

for board seats on listed corporationsa
(1970-1983).
Percent
change

(1) Median percentage change in earnings

during the election campaign (time t),
for the 35 firms whose time I - 1 earnings
were positive
(2) Median percentage change in earnings
at time t - 1, for the 32 firms whose
time f - 2 earnings were positive
Spearman rank correlation
(1) and (2)

53%

43 proxy contests

P-valuesb

0.0007

-19%

0.2425

-0.14

0.4223

between

(3) Median accrual change during the

election campaign as a percent of
time t earnings, for the 37 firms
whose time t earnings were positive
(4) Median pro forma percentage change in
earnings during the election campaign
(holding accruals constant at the time
I - 1 level), for the 35 firms whose
time r - 1 earnings were positive

45%

-32%

0.0307

0.4762

(5) Number (percent) of companies for which the

accrual change during the election campaign
turned a net loss into positive income

15 firms (35%)

(6) Number (percent) of companies for which the

accrual change during the election campaign
turned positive income into a net loss

1 firm (2%)

P-value (one-tailed) for binomial test

of differences in these proportions

0.0006

Data are for the subsample of 43 proxy contests in which managers released earnings during
the contest and for which complete data, including funds statements
for the final accounting
period before the contested election and for the year-earlier
comparison
period, were available
from Disclosure.
The subsample contains 42 initial proxy contests and one subsequent contest,
which followed the initial contest for that sample firm by four years.
hExcept for the rank correlation
test, these P-values are for Wilcoxon signed-rank
tests, which
are one-tailed
for earnings (and accrual) changes during the election campaign and two-tailed
otherwise.

earnings
decrease during the campaign. Taken together, these facts suggest
that the systematically
positive unexpected
accrual documented
in table 5
represents a material shift in incumbents
accounting decisions.
Further
evidence
that managers
significantly
altered
their accounting
choices during the campaign is that, for 15 companies (35% of the 43 contests),
the higher accrual they chose during the contest converted a figure that would
have been a net loss (under the prior accrual) into positive income. In only one

26

L. DeAngelo, Accounting measures in proxyfights

case (2% of the sample) did the lower accrual chosen during the contest
convert a figure that would otherwise have been positive income into a loss.
The hypothesis that this pattern (fifteen versus one) reflects a 50-50 chance of
an accrual increase is rejected at the 0.0006 level under a binomial test [rows
(5) and (6) of table 71. This pattern is consistent
with the hypothesis
that
incumbents
exercise their accounting discretion to avoid reporting a net loss
during an election campaign, perhaps because of the emphasis that dissidents
accord these losses (see section 4).
An alternative
explanation
for the 53% earnings increase is that it primarily
reflects a mechanical
intertemporal
reversal of sample companies prior poor
earnings performance.
Brooks and Buckmaster (1980) document a tendency
for extreme earnings realizations
to be followed by such reversals. However,
row (2) of table 7 reports that the - 19% median percentage earnings change
in the comparison
period is not statistically
significant. Moreover, if sample
firms event-period
earnings changes do represent a mechanical
reversal of
their comparison-period
earnings changes, then the two sets of numbers
should be negatively
correlated,
and row (2) of table 7 indicates that the
Spearman
rank correlation
is an insignificant
-0.14.
This latter finding
suggests that the median 53% earnings
increase during the campaign
is
implausibly
viewed as a mechanical
reversal of prior poor earnings.
It is
perhaps not surprising,
since rational dissidents
seem unlikely to instigate
proxy contests in periods of poor earnings if poor earnings are routinely
followed by predictable reversals that could hurt their chances of winning the
election.
Another possible explanation
for the 53% earnings increase is that the data
reflect a material
selection bias - firms that report earnings
during the
campaign
tend to be superior performers
because managers systematically
delay the release of especially poor earnings until after the election. Managers
ability to postpone earnings releases is, of course, constrained
by the disclosure requirements
of the SEC and by dissidents ability to delay the meeting,
e.g., via stockholder
litigation.
Nonetheless,
I checked whether the sample
contains a material number of companies that did not report earnings between
the inception of dissident activity and the stockholder meeting but that would
have done so had incumbent
managers released earnings on the same date
they did in the prior year. I discovered only three such companies,
two of
which reported earnings increases at the delayed earnings release date. Since I
find no indication
that managers
systematically
postponed
the release of
unfavorable
earnings,
it seems correspondingly
implausible
that the 53%
earnings increase during the campaign reflects a material selection bias.*
Any potential bias in the accrual tests would seem to favor the null hypothesis, since managers
who anticipated
the proxy contest may have increased prior-period
accruals to slow an otherwise
more precipitous
earnings decline. In seven (168) of the 43 contests, dissidents were publicly
opposed to management
during the comparison period, which indicates an empirical bias against
observing an accrual increase during the proxy contest.

L. DeAngelo, Accounting measures in proxy jghts

21

6. I. Did income manipulation afSect the election outcome?

Ideally, one would like to know whether the earnings increases managers
report during an election campaign
convince voters to retain incumbents
of contest outcomes with
whom they would otherwise oust. * A correlation
unexpected
accruals will not provide an unambiguous
answer to this question,
since observed success rates also depend on managers (unobservable)
ex ante
success probabilities.
Hence, I use an independent
measure of managers
ex ante success likelihood to partition
the sample into (i) contests in which
dissidents
posed an especially serious threat to the incumbents
(the close
contests) and (ii) the remaining
contests. If managers believe that reported
earnings
can affect the election outcome (and if opportunities
for income
manipulation
are approximately
equal across firms), then the unexpected
accruals of firms engaged in close contests should exceed those of the remaining
firms. While this comparison
seems preferable to an approach that assumes
managers odds of success are equal across contests, cross-sectional
comparisons remain problematic
absent a complete theory that specifies all factors
that might affect the odds of winning a proxy contest.*
Under the assumption
that rational managers would recognize ex ante that
their odds of winning were low, I classified the 17 of 43 contests in which
dissidents
obtained
control as close contests in which the incumbents
had
especially strong marginal incentives to manipulate
earnings. In another 11
contests,
incumbents
maintained
control,
but caused the corporation
to
repurchase
substantially
all of the oppositions
stockholdings
(so-called
greenmail),
or caused management
allies to do so. These actions would seem
to indicate that managers of these firms believed that they faced an especially
serious threat to their tenure, and so I grouped them with the other 17,
bringing the total to 28 close contests. In the remaining 15 contests, dissidents
obtained no board seats in seven, and a minority of seats (ranging from 11% to
22% of the board) in the last eight contests.
The results of the cross-sectional
accrual tests are mixed - those for the
random walk model (reported in table 8) provide some indication
of signifiVoters
typically
did not have sufficient information
to separate
reported
earnings into
operating
cash flows and accruals. Specifically, voters of 53% of the 36 firms for which I could
identify the SEC receipt date [see Wilson (1987)] did not receive complete financial statements
before the election, while another 19% received them less than one week in advance. Naturally,
voters will estimate the extent to which reported profitability
reflects incumbents
accounting
discretion
even without financial statements.
Nonetheless,
a proxy contest is a one-time occurrence for most firms so that voters have little prior knowledge of the extent of managers available
accounting
discretion in this particular circumstance.
22 For example, since stockholders presumably
evaluate managers using a variety of accounting
and non-accounting
information,
some managers may have a greater ability to convince voters
that a given earnings improvement
is indicative
of improved performance.
Consequently,
I
checked for other cross-sectional
differences which, on an a priori basis, would seem to affect
managers
credibility
with voters/their
chances of winning the election - differences
in the
percent of common stock held by managers, by dissidents, and by institutions,
and the total
number of stockholders
- and found no material cross-sectional
differences.

L DeAngelo, Accounting measures in proxy fights

28

Table 8
Unexpected

earnings, accruals, and operating

campaign: 28 close contests

cash flows (random walk model) during

versus the remaining 15 contests.=

(1)
Unexpected
eamingsb

(2)
Unexpected
accrualsb

an election

(3)
Unexpected
cash flowsb

(I) 28 close contests

Mean
t-statistic
Significance

level

Median
Percent positive
Significance level
for Wilcoxon
signed-rank
test

0.0130
3.4421
0.0010

0.0323
2.5964
0.0075

- 0.0193
- 1.8598
0.9631

0.0065
82.1%

0.0089
67.9%

- 0.0035
42.9%

0.0003

0.0111

0.9009

0.0044
0.6875
0.2515

- 0.0045
- 0.5205
0.6946

0.0089
0.8265
0.7888

0.0010
60.0%

0.0017
53.3%

0.0020
53.3%

0.3146

0.4212

0.7432

(2) 15 remaining contests

Mean
t-statistic
Significance

level

Median
Percent positive
Significance level
for Wilcoxon
signed-rank
test

(3) Differences between the two subsamples

Difference in means
t-statistic
Significance level

0.0086
1.1497
0.1309

0.0368
2.4278
0.0099

- 0.0282
~ 1.8836
0.9662

Difference in medians
Z-statistic for Wilcoxon
rank sum test
Significance level

0.0055

0.0072

- 0.0055

1.5926
0.0556

1.7201
0.0427

- 1.3888
0.9176

The 28 close contests consist of 17 contests in which dissidents obtained control and 11
contests
in which the incumbents
retained control, but repurchased
substantially
all of the
opfositions
stockholdings
(or caused management
allies to do so).
All variables are standardized
by total assets. The significance levels are one-tailed, to test the
predictions
that earnings,
accruals, and operating
cash flows increased
during the election
campaign,
and that they increased differentially for the 28 close contests.

differences, while those for the alternative model do not. For the random
statistically
positive
unexwalk model,
panel
1 of table
8 reports
pected earnings and accruals for the 28 close contests (and essentially zero
unexpected
cash flows). In contrast, panel 2 reports that all three variables are
insignificantly
different from zero for the remaining 15 firms. Panel 3 indicates
significant
cross-sectional
differences in unexpected
accruals (although
the
non-parametric
significance level becomes 0.3465 when unexpected
accruals
are standardized
by total revenues). Under the alternative model, unexpected

cant

L. DeAngelo, Accounting measures in proxy fights

29

Table 9
Market-adjusted

accounting

Year relative
to inception
of dissident
activityC

rates of return on equity:

15 contests.c

28 close contests

(2)

(3)

28
close
contestsb

versus

the remaining

15
remaining
contests

Differences
between
(1) and (2)

(4)
P-values for
Wilcoxon
rank sum
testd

-3
-2
-1
Between inception of
dissident activity and
announcement
of proxy
contest (9 and 7 firms,
respectively)

- 5.4%
- 4.6
-6.3

-2.1%
-1.2
-3.8

- 3.3%
- 3.4
- 2.5

0.2568
0.1200
0.4220

-4.3

- 1.5

-2.8

0.3971

Pro forma annualized

return during the
election campaign

-2.9%

- 7.1%

+ 4.2%

0.0394

Year after the contest

(25 and 13 firms,
respectively)

- 14.4%

~ 4.7%

~ 9.7%

0.1096

Market-adjusted
accounting
returns were calculated
by subtracting
the median return on
equity for all listed companies on Compustat
for the relevant year.
hThe 28 close contests consist of 17 contests in which dissidents obtained control and 11
contests
in which the incumbents
retained control, but repurchased
substantially
all of the
oppositions
stockholdings
(or caused management
allies to do so).
The inception of dissident activity was taken as the first Wall Street Journal announcement
that the ultimate dissident stockholder
group would seek board representation
or control of the
firm, or that management
opposed the groups attempt to influence corporate policy.
dThese P-values are two-tailed except for the election year in which the P-vahte is one-tailed, to
test the hypothesis
that managers of the 28 firms involved in close proxy contests reported a
differential
earnings improvement
during the campaign.
The pro forma annualized
return during the contest was calculated
as four times the last
quarterly accounting
return before the contested board election. For 15 of the 25 firms in the first
subsample
and 9 of the 13 firms in the second, the year after the contest includes the quarter
which forms the basis for this pro forma annualized return.

accruals for the 28 close contests are virtually identical to those reported in
table 8, and those for the remaining
15 firms become significantly
positive.
Hence the cross-sectional
differences in unexpected
accruals are insignificant
under this model.
Table 9 reports additional evidence on the two subsamples which suggests
that the observed
figures reflect the exercise of incumbents
accounting
discretion.
Specifically, the table 9 data indicate that the relation between the
accounting
returns
of the two subsamples
reverses during
the election
campaign.
Columns (1) and (2) of the table contain median market-adjusted
accounting
returns for each subsample in periods before, during, and after the

30

L. DeAngelo, Accounting measures in proxy$ghts

proxy contest. Column (3) contains cross-sectional

differences in those returns,
while column (4) reports P-values for Wilcoxon rank sum tests. The marketadjusted
accounting
returns of the 28 firms involved in close contests are
insignificantly
lower than those of the 15 remaining
firms in the four years
before and one year after the proxy contest. In sharp contrast, the pro forma
annualized
accounting returns of the 28 close contests are significantly
higher
during the election campaign. A comparison of unadjusted accounting returns
across the two subsamples yields virtually identical results, and therefore also
supports the hypothesis that managers exercise their accounting discretion to
report favorable earnings to voters.

7. Earnings baths after a successful control contest

Moore (1973) finds evidence that management
changes are typically followed by an earnings bath, in which new management
reduces earnings via
discretionary
non-cash writeoffs (writedowns, writeoffs, or other loss provisions
not accompanied
by a transaction).
The 22 successful proxy contests for
corporate control exhibit a similar tendency. 23 Twelve (55%) of these firms had
writeoffs in the year of the control change. Moreover, three of the ten firms
with no writeoffs were subsequently
acquired in transactions
that were pending
at the date of the post-contest
financial statements. And new management
of
these firms had obvious incentives not to take substantial
writeoffs because of
their potential negative impact on the pending acquisition.
Finally, two of the
ten firms with no writeoffs in the year of the control change had writeoffs
the following year, bringing the total number of firms with writeoffs after the
control change to 14 (64%).
Newly-elected
dissident managers typically cite these writeoffs as indications
that the firm is in serious trouble when they take office, which they tend to
blame on the poor decisions of prior management.
All 14 companies reported
a net loss in the year of the writeoffs and, for 10 (71%) of them, the non-cash
charges converted a figure that would have been a reported profit into a net
loss. For example, GAF Corporations
$3.8 million loss in 1983 includes
provisions
of $29.6 million for plant shutdown and office relocation
costs.
Writeoffs constitute
125.4% of the loss reported by the median firm in this
group and, in absolute value terms, represent an earnings charge of $14.7
million (with a range of $1.2 to $62.4 million).
The incidence
of non-cash writeoffs in the year of a control change is
strikingly
greater than that for the 600 firms in Accounting
Trends and
23Two of the 24 firms in which insurgents obtained control were dropped for this analysis - one
because it had merged with another company, and the other because its financial statements were
not available from Disclosure. The latter firm apparently
took large writeoffs in the year of the
control change (see Technicolor
Reports Consolidated
Losses of $278,000 and Total Nonrecurtine Losses of $10.4 million for the Year Ended June 27. The Wall Street Journal, October 27,
19-Z).

L. DeAngelo, Accounting measures in proxy fights

31

Table 10
Incidence
of non-cash
writeoffs
dissidents obtained control

after a successful proxy contest: 22 sample firms in which

versus the 600 firms in Accounting Trends and Techniques.

Asset
writedowns

Discontinued
operations
(non-segment)

Discontinued
operations
(segment)

(1) Percent of _Zsumple firms in the year of the control change,b

36.4%
(2) Percent of the 6OOfirms in Accounting
1970
1971
1972
1973
1974
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
Annual average
for years shown

31.8%

36.4%

Trends and TechniquesC

17.5%
22.8
22.0
12.3
11.8

N/Cd
N/C
N/C
N/C
N/C
N/C
2.8%
3.2
2.0
3.0
3.0
5.0
6.2
5.4
7.0

N/C
N/C
N/C
N/C
N/C
N/C
N/C
N/C
N/C
N/C
8.3%
9.3
14.7
12.7
12.3

N/C
6.2
6.2
6.2
6.7
6.2
11.2
11.2
10.8
14.0

4.2%

11.5%

11.8%

A proxy contest was classified as resulting in a control change if the dissidents either (i)
obtained
a majority of the directorships,
or (ii) both obtained a near-majority
(one-half in one
contest and 7 of 15 seats in two contests) and installed a member of their own group as CEO.
These data were obtained from corporate annual reports or forms 10K. Of the 22 sample firms,
three had entries in all three categories, four had entries in two categories, and six had entries in
one category only. The total of 13 companies with at least one category of writeoff exceeds the
total of 12 companies
cited in the text because the table includes one company whose new
management
both planned and carried out the disposal of a segment in the year of the control
change.
These data were obtained from the volumes for 1971-1985.
d N/C = data not collected by ATT in specified year.

Techniques (ATT) over the 1970-1984 period. This publication contains three
categories that include writeoffs - asset writedowns and gains/losses from
discontinued operations (both for segments and non-segments).24 I sorted the
data for my 22 firms into these categories, using data from the year of the
control change only. Panel 1 of table 10 reports these data, while panel 2
24 The latter two categories contain actual (as well as
therefore overstate the incidence of discretionary
noncash
and Techniques is the only publication
of which I am
writeoffs.
Hence, although
these data are imperfect,
I
purposes, and I adjust the data for my sample accordingly.

estimated) losses and actual gains, and

writeoffs. However, Accounting Trends
aware that compiles data on non-cash
nonetheless
use them for comparison

L. DeAngelo, Accounting measures in proxyjights

32

Table 11
Unexpected

earnings,

accruals, and operating cash flows following a control

proxy contests for corporate control (1970-1983)
(1)
Unexpected
earnings

(2)
Unexpected
accruals

change:

22 successful

(3)
Unexpected
cash flows

(I) Random walk model

Mean
r-statistic
Significance

level

Median
Percent positive
Significance level for
Wilcoxon signed-rank

test

- 0.0236
- 1.1209
0.2750

- 0.0477
- 2.2344
0.0182b

0.0241
2.6124
0.0163

- 0.0228
31.8%

- 0.0335
18.2%

0.0218
68.2%

0.1353

0.0062b

0.0296

- 0.0447
- 2.3777
0.0135b

0.0211
1.7843
0.0888

- 0.0209
27.3%

0.0337
63.6%

(2) Alternative model

Mean
t-statistic
Significance

same
as
above

level

Median
Percent positive
Significance level for
Wilcoxon signed-rank

test

0.0097b

0.0978

Data are for the subset of 24 contests that resulted in a control change for which complete
post-contest
financial data were available. Of the two firms that were dropped for this analysis,
one had incomplete data due to merger and the other firms post-contest
financial statements were
not available from Disclosure. All variables are standardized
by total assets.
b One-tailed significance levels, to test the hypothesis that newly-elected dissident managers take
an earnings bath after a successful proxy contest for corporate control. All other significance
levels are two-tailed.
This model employs working capital from operations in the comparison period as a benchmark
for operating
cash flows, and the difference between net income and working capital from
operations
in the comparison period as a benchmark for the normal level of accruals.

reports data for the 600 ATT firms for the years they were published in the
1971-1985 period. In the year of the control change, 36.4% of the current
sample had asset writedowns, while 31.8% and 36.4%, respectively, had nonsegment and segment discontinued operations. The corresponding average
percentages for the 600 ATT firms are 4.2%, 11.5%, and 11.8%. These findings
suggest that firms with a control change report an unusual number of
writeoffs.
Table 11 contains results of accrual tests that corroborate the finding that
newly-elected dissident managers typically take an earnings bath.25 These
25The results of these accrual tests should be interpreted with caution, since it seems reasonable
to expect that companies
undergo major corporate
restructurings
following a control change.
Hence, the assumption
that accruals did not change systematically
over the event period for
reasons unrelated to managements
accounting discretion (see section 5) may be violated for the
tests whose results are reported in table 11.

L. DeAngelo, Accounting measures in proxy fights

33

accrual results are not, of course, independent of the earlier finding that new
managers take a material number of non-cash writeoffs, since accounting
accruals incorporate the effects of these discretionary writeoffs, as well as those
of other, more subtle accounting choices. The table 11 data indicate that
earnings tend to decline immaterially in the year of the control change. In
contrast, unexpected cash flows are positive and significantly different from
zero at better than the 5% level under the random walk model (but only at the
S-10% level under the alternative model). These findings provide some indication that firms with a control change typically experience an immediate
post-contest increase in real profitability that is not reflected in reported
profitability because of new managements tendency to take an earnings
bath.

Column (2) of table 11 indicates that the negative relation between unexpected earnings and unexpected cash flows reflects a significantly negative
unexpected accrual in the year of the control change. Unexpected accruals
average -4.77% of total assets (median, -3.35%) under the random walk
model, and -4.47% of total assets (median, - 2.09%) under the alternative
model. All measures of unexpected accruals are statistically negative (at
significance levels that range from 0.0182 to 0.0062). This finding is especially
noteworthy considering the fact that, for 10 (45%) of the 22 firms, the
post-contest annual accrual includes the quarterly accrual(s) chosen by the
incumbents during the election campaign. In other words, for a non-trivial
subset of the sample, the post-contest annual accrual chosen by new
management is sufficiently negative to more than offset the quarterly accrual(s)
chosen by incumbents earlier in the same fiscal year.26 [In only four cases
(18%) does the comparison-period benchmark accrual incorporate a quarterly
accrual chosen by incumbents during the campaign.]
Finally, the earnings decrease that new managers typically report in the year
of the control change tends to be followed by a material earnings turnaround
the following year. Only seven (32%) of the 22 companies with a control
change reported an earnings increase that year. In contrast, a full 72% of these
firms reported an earnings increase the following year.27 The proportion of
positive earnings changes in the latter period exceeds that in the former at the
0.0132 level of significance (Z-statistic = 2.22). This material earnings
turnaround suggests that one reason why newly-elected dissident managers
26An earlier draft of this paper [DeAngelo (1986b)] reports details of cross-sectional
tests which
indicate that the post-contest
accrual changes of firms in which dissidents obtained control are
significantly
more negative than those of firms whose management
won all board seats. These
results should be interpreted
with caution, however, since the ceteris paribus conditions
are
probably violated for these cross-sectional
tests. Specifically, it seems reasonable to conjecture that
newly-elected
dissident managers have greater scope to take an earnings bath than do incumbents who have just warded off an attempted hostile management
change.
27The 72% figure is based on the subset of 18 firms that reported public financial data the year
after the control change. Of the remaining four firms, one had merged, one had sold all its assets,
one had gone private, and one had filed for bankruptcy.

J.A.E.

34

L. DeAngelo, Accounting measures in proxy fights

take an earnings bath is to demonstrate

to the stockholders
who elect them.

an immediate

earnings

improvement

8. Summary and interpretation of the evidence

This study investigates
the use of accounting
performance
measures in 86
proxy contests for board representation
on exchange-listed
corporations
during 1970-1983.
The evidence indicates that dissident stockholders who wage
these contests typically cite poor corporate earnings, rather than poor stock
price performance,
as necessitating
the proposed hostile management
change.
Consistent
with this finding, sample firms pre-contest
accounting
rates of
return on equity are systematically
below-market,
whereas their pre-contest
stock returns are not. During the election campaign,
incumbent
managers
apparently
exercise their accounting discretion to portray a favorable picture
of their own performance
to voting stockholders.
Specifically, while reported
profitability
typically increases significantly during an election campaign, real
profitability
(as measured by operating
cash flows) typically does not. If
elected by the stockholders,
dissidents tend to take an immediate
earnings
bath, which they typically blame on the poor decisions of prior management
and which enables them to report an earnings turnaround
the following year.
Viewed collectively, these findings indicate that corporate earnings performance plays a role in the process through which alternative managers compete
for stockholder
support. When information
is costly, dispersed public stockholders who nominally hold the right to appoint corporate management
have
neither the specific knowledge to perfectly assess managerial abilities, nor the
private incentives
to acquire such knowledge. Hence, dissident stockholders
rely on readily communicated,
imperfect measures of corporate performance
to convince the other stockholders
to change managers. In this competitive
process,
alternative
managers
typically
use poor earnings
to argue for
replacement
of incumbents
who, in turn, apparently exercise their accounting
discretion
to present voters with a favorable earnings picture during the
campaign.
Newly-elected
dissident managers also apparently
use their accounting discretion to effect a demonstrable
earnings improvement
after they
take office.
These findings suggest that poor earnings performance
serves as visible
evidence of managerial
inefficiency that can cost managers stockholder support (and potentially
their jobs). They also raise several questions about the
overall importance
of financial accounting
information
in the governance
of
publicly-traded
corporations.
First, is poor earnings performance
a factor in
management
changes effected through a firms internal governance process? A
recent paper by Weisbach (1987) provides preliminary
evidence that poor
earnings can serve as justification
for a board-initiated
management
change,
but further research is required to determine what evidence directors actually

L. DeAngelo, Accounting mea.wres in proxy fights

35

use to instigate these changes. Second, do other external governance

mechanisms - e.g., hostile tender offers, open-market accumulation programs,
or negotiated control block trades - tend to follow periods of poor earnings?28
Do incumbents manipulate earnings in attempts to avert a control transfer via
these other disciplinary mechanisms? These questions would seem to present
especially fruitful avenues for future research into the role of financial accounting in the theory of the firm.
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