Are CEOs Punished for Managing Earnings?

Abstract

Agency theory suggests that monetary incentives are effective mechanisms to align managers’ and shareholders’ interests. Hence, value-maximizing managerial decisions are positively related to their compensation levels, and vice versa. Several studies confirm that the practice of earnings management (EM) could be detrimental to a firm’s value, however, the literature examining the relation between CEOs’ total compensation and EM remains inconclusive. This may be due to the unobserved determinants of executive compensation. In line with the predictions of agency theory, this study provides conclusive evidence of this relation by documenting a negative relation between abnormal compensation (the proportion of pay that cannot be accurately determined by known factors) and EM. Thus, suggesting that CEOs involved in EM are penalized in the form of reduced excess compensation. Additionally, we find that the negative association between EM and ACOMP persists in both high and low-governance firms, and is robust to the presence of both internal and external corporate governance mechanisms as additional control variables. Since real earnings management (REM) is arguably more value-destructive in the long run, our results also confirm that CEOs involved in higher levels of REM are penalized more severely than CEOs involved in higher levels of accrual earnings management (AEM).

Keywords: Executive compensation; Abnormal compensation; Earnings management

JEL Classification: M12; M41; G34