Substitution between Real and Accruals-Based Earnings Management after Voluntary Adoption of Compensation Clawback Provisions

47 Pages Posted: 13 Jun 2014

See all articles by Lilian H. Chan

Lilian H. Chan

The University of Hong Kong

Kevin C. W. Chen

Hong Kong University of Science and Technology

Tai-Yuan CHEN

Department of Accounting, HKUST Business School, Hong Kong University of Science & Technology

Yangxin Yu

City University of Hong Kong

Date Written: May 15, 2014

Abstract

To deter financial misstatements, many companies have recently adopted compensation recovery policies – commonly known as “clawbacks” – that authorize the board to recoup compensation paid to executives based on misstated financial reports. Clawbacks have been shown to reduce financial misstatements and increase investors’ confidence on earnings information. We show that the benefits come with an unintended consequence of certain firms substituting accruals management with real transactions management (e.g., reduce R&D expenditures), especially those with strong incentives to achieve short-term earnings targets (firms with high growth or high transient institutional ownership). As such, the total amount of earnings management does not decrease subsequent to clawback adoption. We further show that although real transactions management temporarily boosts those clawback adopters’ short-term profitability and stock performance, this trend reverses after three years. In summary, clawbacks may have unexpected effects for a subset of firms whose managers are under greater pressure to meet earnings goals.

Keywords: clawback provisions; real transactions management; accruals management

JEL Classification: G30; M41

Suggested Citation

Chan, Lilian H. and Chen, Kevin C.W. and Chen, Tai-Yuan and Yu, Yangxin, Substitution between Real and Accruals-Based Earnings Management after Voluntary Adoption of Compensation Clawback Provisions (May 15, 2014). Accounting Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2449102

Lilian H. Chan

The University of Hong Kong ( email )

Pokfulam Road
Hong Kong, Pokfulam HK
China

Kevin C.W. Chen

Hong Kong University of Science and Technology ( email )

Clear Water Bay
Kowloon
Hong Kong
+852 2358-7585 (Phone)
+852 2358-1693 (Fax)

Tai-Yuan Chen (Contact Author)

Department of Accounting, HKUST Business School, Hong Kong University of Science & Technology ( email )

Clear Water Bay
Kowloon
Hong Kong

Yangxin Yu

City University of Hong Kong ( email )

Hong Kong

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