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The Effect of CEO Compensation on Real Earnings Management

Written by D. Grambo

Paper category

Master Thesis


Business Administration>Management




Thesis: Accrued Earnings Management Accrued Earnings Management is earnings management that only uses accruals. For example, companies change the classification of certain items to hide them from financial statements or change certain numbers and/or ratios. The actual company’s operations have not changed, but the methods they report on these operations have changed in order to achieve certain external goals, such as higher stock prices and increased investment. (Healy and Wahlen 1999). 2.8 Actual Earnings Management Actual Earnings Management is a form of earnings management, which involves a company changing its operations by changing its operating cash flow to affect various items in its financial statements (Healy and Wahlen, 1999). Earnings management is usually only used to try to meet certain benchmarks (Dichev et al., 2013). Then it can be assumed that the CEO will turn to earnings management when struggling to achieve short-term benchmarks and goals in order to obtain bonuses, in an attempt to achieve these benchmarks and goals in the short term to maximize their profits. It may even be worth the risk that actual revenue management harms the value of the company, as it has been theorized (Roychowdhury, 2006). This is because it is found that employees prefer short-term due to employee turnover, and they may not feel any long-term negative effects of their decisions (Palley, 1997). The next period may also be strong enough to offset any long-term losses caused by actual earnings management. In this case, the CEO will still receive the full bonus in the new period, which makes the use of actual earnings management a convincing choice for the CEO. In a study exploring the occurrence and nature of actual earnings management, Roychowdhury found evidence that managers used overproduction, price discounts, and reduced disposable expenditures to try to increase earnings for a period of time. (Roychowdhury, 2006) Roychowdhury, as predicted by Schipper (1989), found that such manipulations were not so common among sophisticated investors. Roychowdhury (2006) believes that this indicates that actual earnings management has failed to increase long-term company value, and theoretically, actual earnings management may have a negative impact on long-term company value, because earnings move in different periods at cost. Roychowdhury (2006) also believes that this fear of actual earnings management negatively affecting long-term performance makes actual earnings management a waste in front of experienced investors, which is why it is rarely used. Roychowdhury (2006) claimed that due to the split of incentives, managers use actual earnings management instead of accrued earnings management. 2.10 CEO compensation There are several different common methods for CEO compensation, and companies usually apply a combination of multiple methods in their compensation plan. Here we discuss some of the most common methods. The normal monthly cash salary is a predetermined monthly salary paid in cash. Cash salary has nothing to do with performance, except for being dismissed by the company, seeing your future salary reduced, or hoping to get a higher salary in the future. Salary cuts are very rare, so in addition to trying to keep the position, cash wages have little effect on motivating hard work and improving performance. (Larcker and Tayan, 2012) Bonuses are used to try to motivate the CEO in ways that strict cash wages cannot do. The bonus is basically an additional annual lump sum payment, if the performance is deemed sufficient, it is decided in advance. This performance can be measured by looking at experience such as profitability or stock performance, or the board of directors can make arbitrary decisions (Larcker and Tayan, 2012). Ideally, this kind of compensation method is conducive to motivate employees to perform better to ensure that they receive additional compensation, but it may also cause the CEO to try to obtain compensation through methods that do not increase the value of the company, but it does increase employee compensation. The ratio bonus depends on. It may also incentivize CEOs to over-prefer short-term gains and give up the company’s long-term gains, because when the long-term project starts to break even, they are unlikely to remain in the company, and before that, the project is only reducing their bonuses. Opportunity. (Larcker and Tayan, 2012) Stock options. This is a way for the CEO to have the opportunity to buy stocks at a fixed price, usually at the market price when the option is offered, and the buying opportunities are scattered over time. In theory, this should reward long-term growth because it takes several years to buy stocks, and you want the stocks to be of high value at the time. In reality, however, managers can benefit from high-risk decisions to raise stock prices. If these risks are not rewarded, they have almost no losses because they can simply avoid buying stocks if the price plummets. (Larker and Tayan, 2012) Stock ownership. The last method of CEO compensation we will discuss is equity. Stock ownership is different from stock options because the CEO does not have the option to buy stocks at a fixed price, but only gives the company stock. This gives the CEO the motivation to add value in the long-term, and it helps align the CEO's goals with investors, because the CEO is now an investor himself. However, this is not a perfect solution. The CEO can still try to drive short-term gains and sell when the value reaches its peak. Read Less