Real Earnings Smoothing and Managerial Compensation Incentives

33 Pages Posted: 15 Jan 2019

See all articles by Changling Chen

Changling Chen

University of Waterloo - School of Accounting and Finance

Rachel Tang

University of Waterloo

Li Yao

Concordia University, Quebec

Date Written: January 14, 2019

Abstract

We provide empirical evidence that managers smooth earnings using discretionary R&D spending (i.e., real smoothing) when managerial compensation packages contain high risk-taking incentives. Specifically, we find that real smoothing is related to both the sensitivity of executive wealth to a unit change in stock price volatility (vega, capturing executives’ incentive of increasing R&D investment of high risk in nature) and the sensitivity of executive wealth to a unit change in stock price (delta, capturing executives’ incentive of preserving stock price possibly through reducing R&D investment). Given the empirical regularity of the extremely high correlation between vega and delta, we use Vega-to-Delta ratio to capture the net risk-taking incentive of executives, and find evidence supporting our hypothesis that the real smoothing is less for firms whose executives have high risk-taking incentives driven by their option compensations.

Keywords: Real earnings management; Executive compensation; Stock options; Risk taking

JEL Classification: M41; M52

Suggested Citation

Chen, Changling and Tang, Rachel and Yao, Li, Real Earnings Smoothing and Managerial Compensation Incentives (January 14, 2019). 2019 Canadian Academic Accounting Association (CAAA) Annual Conference. Available at SSRN: https://ssrn.com/abstract=3315652

Changling Chen (Contact Author)

University of Waterloo - School of Accounting and Finance ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1 N2L 3G1
Canada

Rachel Tang

University of Waterloo ( email )

200 University Avenue West
Waterloo, Ontario N2L 3G1
Canada

Li Yao

Concordia University, Quebec ( email )

1455 de Maisonneuve Blvd. W.
Montreal, Quebec H3G 1MB
Canada

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