Insider versus Outsider CEOs, Executive Compensation, and Accounting Manipulation

This paper examines the role of the financial reporting environment in selecting a new CEO from within versus outside the organization. We show that a CEO's ability to manipulate performance information renders it more difficult for the board to detect and replace poorly performing CEOs as well as aggravates incentive contracting, and these effects are stronger when the new leader is an outsider rather than an insider. The model generates several predictions. First, boards are more likely to recruit a CEO from the outside in firms in which performance measures are harder to manipulate. Second, CEOs recruited from the outside engage in greater accounting manipulation, receive steeper incentive pay, and obtain higher expected compensation (rents) than CEOs promoted from within. Third, outside CEOs have a shorter expected tenure relative to inside CEOs when performance measures are difficult to manipulate, and the opposite holds true when performance measures are easy to manipulate