The dynamic relation between CEOs compensation and earnings management

Incentives and opportunities induce managers to manipulate earnings. While a growing body of research considered managers' compensation motives in explaining earnings management behavior, a gap still exists between academia and practice on the pervasiveness, form, and severity of earnings management. This study empirically examines how earnings management simultaneously interacts with the level and structure of managers' compensation. It is predicted that the level and mix of compensation will affect the extent and form of earnings management.; The objectives of this study are fourfold. First, the study investigates the magnitude of earnings management as explained by total compensation, including stock-based compensation. Second, the study examines whether the structure of compensation (bonus-based compensation versus stock-based compensation) provide different incentives for CEOs to manipulate earnings, thereby affecting the extent of earnings management. Third, I test whether earnings management takes the form of income-smoothing as the mix of compensation changes. Finally, the study considers the dynamic nature of the relation between earnings management and compensation.; Based on more relevant, recent, and large-scale compensation data to capture the levels and mix of compensation using continuous compensation variables, the study investigates both the form and the extent of earnings management and the possible, but yet untested, endogeneity between earnings management and compensation. In addition to ordinary least squares analysis, I develop a set of simultaneous equations that captures managers' incentives to manipulate earnings and to maximize compensation. The results of the two-stage least squares are consistent with the total and mix of compensation as significant determinants of the extent and form of compensation.; Using a sample of panel data of 3,938 firm-year observations covering the period 1992–1998, the study provides evidence consistent with the level and mix of compensation as determinants of the magnitude (in absolute value) of earnings management. The results provide strong evidence that CEOs have incentives to manage earnings to increase their total compensation and to maximize their bonus-based and stock-based compensation. Using a sample of 2,529 firm-year observations covering the period 1994–1998, the evidence is consistent with managers smoothing more (less) income as the bonus mix (stock-based compensation) increases (decreases). The evidence is consistent with managerial opportunism as opposed to efficient contracting.; I also find compelling evidence documenting the joint determination of earnings management and compensation. The Hausman specification test for endogeneity shows that the magnitude of earnings management and income-smoothing are endogenous to total compensation. Regarding the mix of compensation, the tests indicate that the extent of earnings management is endogenous to stock-based compensation while income-smoothing is endogenous to bonus-based compensation. Furthermore, the results of the same test indicate that total and mix of compensation are endogenous to the magnitude of earnings management whereas incentive compensation (bonus-based and stock-based) is endogenous to income-smoothing. This evidence indicates that earnings management behavior and compensation are endogenous and suggests the necessity to consider their endogenous nature in examining their relationship.