Earnings Management by Changing R&D Expenditure: Evidence on the Role of CEO Stock Compensation

Abstract

This paper examines whether the payment of a higher portion of stock relative to cash compensation for CEOs mitigates earnings management through R&D expenditure. Results using a sample of 7,246 firm-year observations of US corporations during 1992-2001 show that CEOs are more likely to cut R&D expenditure to avoid decreases in reported earnings (i) when the cash portion of their compensation is greater than the stock portion and (ii) when the cash portion relative to the stock portion is increased over a period of time. Results also show that the positive association between cash-based compensation and R&D reduction is stronger in firms with CEOs who also serve as board chairman (CEO dominance).

Keywords: stock compensation, cash compensation, myopic R&D investments, earnings management, CEO dominance

JEL Classification: M41, M43, J33, G34