Nonfinancial Performance Measures and Earnings Management

Abstract

We examine the earnings management implications of using nonfinancial performance measures in executive compensation contracts. We argue and test that when a manager's compensation is based on financial and nonfinancial performance measures, he/she has less incentive to manipulate earnings to maximize the compensation. Using panel data covering the period 1992-2005, we compare earnings management behavior for a sample of firms that used both financial and nonfinancial measures to a matched sample of firms that based their performance measurement solely on financial measures. We consider the effect of the match between the use of nonfinancial measures and firm characteristics on earnings management behavior. The results are mainly consistent with a reduction in earnings management behavior for those firms that rely on nonfinancial performance measures in their compensation contracts.

Keywords: Nonfinancial, earnings management, artificial earnings management, real earnings management, compensation contract