Managing Earnings Management: Compensation Committees’ Treatment of Earnings Components in CEOs’ Terminal Years*
Posted: 27 Aug 2009 Last revised: 27 Jan 2013
Date Written: August 26, 2009
The incentive to manipulate earnings to enhance earnings-based compensation increases in managers’ terminal years. We examine this horizon problem by considering the role of the compensation committee in setting terminal-year compensation. We predict that compensation committees are aware of the horizon problem and intervene when setting pay in terminal years. We find that the relation between changes in cash compensation and discretionary accruals changes is significantly reduced in the terminal years. This relation is symmetric for both positive and negative accrual changes. We also find weak evidence that the compensation committee views discretionary spending as less desirable as the CEO approaches retirement. Finally, we document that the relation between the level of option pay and the level of discretionary accruals is reduced in the terminal years. Our findings suggest that compensation committees do not act naively when setting CEO compensation in the terminal period and provide an explanation for the limited evidence of accounting manipulation in CEOs’ terminal years.
Keywords: horizon problem, compensation committee, discretionary accruals, real activity management
JEL Classification: M41, J33
Suggested Citation: Suggested Citation