The Effects of Executive Compensation Contracts and Auditor Effort on Pro Forma Reporting Decisions

37 Pages Posted: 8 Dec 2008 Last revised: 14 Feb 2014

See all articles by Dirk E. Black

Dirk E. Black

University of Nebraska at Lincoln - School of Accountancy

Ervin L. Black

Steed School of Accounting

Theodore E. Christensen

University of Georgia - J.M. Tull School of Accounting; University of Georgia

Date Written: February 14, 2014

Abstract

We investigate two potential deterrents of aggressive pro forma reporting. First, the design of compensation contracts can encourage managers to adopt either a short- or a long-term focus. While it is difficult to observe whether compensation contracts are tied directly to pro forma earnings numbers, we posit that managers with a short-term horizon are more likely to make aggressive pro forma exclusions than managers with a long-term focus. Second, auditor effort can discourage potentially misleading pro forma earnings adjustments. Consistent with our predictions, we find that when compensation contracts include a long-term performance plan, managers are less likely to make potentially misleading pro forma earnings adjustments. Similarly, we find some evidence of a negative association between auditor effort (as proxied by higher-than-normal audit fees) and potentially misleading earnings adjustments. Taken together, this evidence is consistent with the notion that the design of compensation contracts and auditor effort can significantly influence managers’ pro forma reporting decisions. The results also suggest that investors discount earnings information when opportunism is likely to motivate managers’ earnings adjustments. Moreover, when managers make aggressive earnings exclusions in the presence of safeguards that limit opportunistic behavior, investors appear to react even more negatively.

Keywords: Pro forma earnings, compensation contracts, long-term performance plans, audit fees, earnings benchmarks, aggressive earnings management

JEL Classification: G14, G38, M40, M41, M43

Suggested Citation

Black, Dirk E. and Black, Ervin L. and Christensen, Theodore E., The Effects of Executive Compensation Contracts and Auditor Effort on Pro Forma Reporting Decisions (February 14, 2014). Available at SSRN: https://ssrn.com/abstract=1312562 or http://dx.doi.org/10.2139/ssrn.1312562

Dirk E. Black

University of Nebraska at Lincoln - School of Accountancy ( email )

307 College of Business Administration
Lincoln, NE 68588-0488
United States

Ervin L. Black

Steed School of Accounting ( email )

307 W Brooks
Norman, OK 73019
United States
405-325-2401 (Phone)

Theodore E. Christensen (Contact Author)

University of Georgia - J.M. Tull School of Accounting ( email )

Athens, GA 30602
United States

University of Georgia ( email )

Athens, GA
United States

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