Learning Through a Smokescreen: Earnings Management and CEO Compensation over Tenure

54 Pages Posted: 2 Jan 2015 Last revised: 10 Apr 2017

See all articles by Cristina Cella

Cristina Cella

Stockholm School of Economics; Swedish House of Finance; Centre for Studies in Economics and Finance (CSEF); Sverige Riksbank

Andrew Ellul

Indiana University - Kelley School of Business - Department of Finance; Centre for Economic Policy Research (CEPR); European Corporate Governance Institute (ECGI); University of Naples Federico II - CSEF - Center for Studies in Economics and Finance

Nandini Gupta

Indiana University - Kelley School of Business - Department of Finance

Date Written: March 2017

Abstract

Career concerns imply that CEOs have an incentive to engage in earnings management to extend their tenure (Fudenberg and Tirole (1995)). These incentives are likely to be more acute in the early years of tenure when there is greater uncertainty about CEO ability. However, it is also during the early years, when there is more uncertainty about business strategy, that earnings management is informative about the CEO’s expectations regarding future business conditions. As boards learn about managerial ability from independent signals over the CEO’s tenure, they can distinguish strategic from informative earnings management, and CEOs who continue to aggressively manage earnings are penalized. Consistent with this argument, we find that compensation is positively associated with earnings management in the early years of a CEO’s tenure, but the relationship becomes less significant and eventually negative in later years. These results are robust to treating earnings management as endogenous using instrumental variables. The relationship between earnings management and compensation over tenure is stronger for firms with better governance and higher institutional ownership and for CEOs with greater career concerns.

Keywords: Executive Compensation, Tenure, Earnings Management, Career Concerns

JEL Classification: G3, G32, G38, J22, K22

Suggested Citation

Cella, Cristina and Ellul, Andrew and Gupta, Nandini, Learning Through a Smokescreen: Earnings Management and CEO Compensation over Tenure (March 2017). Riksbank Research Paper Series Forthcoming; Kelley School of Business Research Paper No. 15-18; Swedish House of Finance Research Paper No. 15-02. Available at SSRN: https://ssrn.com/abstract=2544262 or http://dx.doi.org/10.2139/ssrn.2544262

Cristina Cella (Contact Author)

Stockholm School of Economics ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

Swedish House of Finance ( email )

Drottninggatan 98
111 60 Stockholm
Sweden

Centre for Studies in Economics and Finance (CSEF) ( email )

84084 Fisciano, Salerno
Italy

Sverige Riksbank ( email )

Brunkebergstorg 11
SE-103 37 Stockholm
Sweden

Andrew Ellul

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

European Corporate Governance Institute (ECGI) ( email )

c/o ECARES ULB CP 114
B-1050 Brussels
Belgium

University of Naples Federico II - CSEF - Center for Studies in Economics and Finance ( email )

Via Cintia
Complesso Monte S. Angelo
Naples, Naples 80126
Italy

Nandini Gupta

Indiana University - Kelley School of Business - Department of Finance ( email )

1309 E. 10th St.
Bloomington, IN 47405
United States
812-855-3416 (Phone)
812-855-5875 (Fax)

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