The Endogeneity of Executive Compensation and its Impact on Management Discretionary Behavior over Financial Reporting

35 Pages Posted: 8 Feb 2017

See all articles by Lan Sun

Lan Sun

CQUniversity (Australia)

Martin Hovey

UNE Business School

Date Written: February 6, 2017

Abstract

Extant literature has emerged testing the relationship between executive compensation and earnings management and many these studies have documented that compensation contracts create strong incentives for management discretionary behavior over financial reporting. Previous studies also pointed out that executive compensation could be simultaneously co-determined with earnings management, suggesting a potential endogeneity problem may exist between discretionary accruals and compensation structure. Using a sample of all Australian Securities Exchange (ASX) listed companies comprising 3,326 firm-year observations encompassing the periods from 2000 to 2006, this study examines the endogeneity of executive total compensation and its various components. Applying a 2SLS model the results show a significantly negative association between expected fixed compensation (particularly expected salary) and upwards earnings management and a significantly positive association between expected at-risk compensation (particularly expected bonuses) and upwards earnings management. These findings suggest endogeneity exists in that fixed compensation and salaries provide disincentives for managers to practice aggressive earnings management whereas at-risk compensation and bonuses induce managers to employ income-increasing discretionary accruals to inflate reported earnings. This study found that executive compensation plays a role in determining earnings management activities. Executives may distort financial reporting to maximize their personal wealth if their incentives are not fully aligned with those of shareholders. Compensation committees, therefore, may gain some insight in designing compensation structures that balance the incentive to improve a firm’s performance with the incentive to earnings manipulation.

Keywords: executive compensation, earnings management, discretionary accruals, compensation endogeneity, instrumental variables

JEL Classification: M41, M52, G34, J33, C26

Suggested Citation

Sun, Lan and Hovey, Martin T., The Endogeneity of Executive Compensation and its Impact on Management Discretionary Behavior over Financial Reporting (February 6, 2017). Available at SSRN: https://ssrn.com/abstract=2912640 or http://dx.doi.org/10.2139/ssrn.2912640

Lan Sun (Contact Author)

CQUniversity (Australia) ( email )

Australia

Martin T. Hovey

UNE Business School ( email )

TRAVENA ROAD
Armidale, NSW 2351
Australia

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