Effect of earnings management on abnormal compensation of CEOs

Abstract

Agency theory suggests that monetary incentives are effective mechanisms to align managers’ and shareholders’ interests. Hence, value-maximising managerial decisions are positively related to their compensation levels, and vice versa. Several studies confirm that the practice of earnings management could be detrimental to a firm’s value; however, the literature examining the relation between CEOs’ total compensation and earnings management remains inconclusive. This may be due to the unobserved determinants of executive compensation. In line with the predictions of agency theory, this study provides conclusive evidence of this relation by documenting a negative relation between abnormal compensation (the proportion of pay that known factors cannot accurately determine) and earnings management. Thus, suggesting that CEOs involved in earnings management are penalised in the form of reduced excess compensation. Additionally, we find that the negative association between earnings management and abnormal compensation persists in both high and low-governance firms, and is robust to the presence of both internal and external corporate governance mechanisms as additional control variables. Since real earnings management is arguably more value-destructive in the long run, our results also confirm that CEOs involved in higher levels of real earnings management are penalised more severely than CEOs involved in higher levels of accrual earnings management.