The association between earnings management and executive compensation - evidence from the FTSE350 Index of Companies

Tahir, Muhammad (2016) The association between earnings management and executive compensation - evidence from the FTSE350 Index of Companies. (PhD thesis), Kingston University, .


This study investigates the association between earnings management and executive compensation by examining evidence from firms in the FTSE350 Index. It questions whether CEOs manipulate earnings, particularly with regard to bonus entitlement and discusses the possible reasons for their actions. It explores whther earnings are manipulated in self-interest to reach pre-specified bonus levels and increase compensation. It also examines the extent of manipulation when bonuses are deffered or when long-term compensation is offered, The effect of non-financial measures in assessing performance is also examined, when they are used alongisde financial meaures and when giving equal or more weight. There are many studies concerning earnings management (hereafter, EM) and executive compensation, particularly in the US, but accruals management has mostly been used to determine the extent of manipulation and real activities management has received comparatively little attention. The present study uses both discretionary accruals (hereafter, DAC) and real activities management (hereafter, RAM) which gives wider understanding of the issue. The findings reveal that executives indulge in income-increasing earnings management through DAC and adjusting sales when company earnings approach their pre-specified minimum and target bonus levels. It is also found that executives employ income-decreasing earnings management by adjusting DAC and sales when earnings approach their pre-specified maximum bonus levels. When a deferred bonus is equal to or greater than the annual bonus, results reveal that firms engage in less income-increasing manipulation than those with less deffered bonus. In a situation where the proportion of long-term bonus is greater than short-term bonus, less income-increasing earnings management are exhibited in terms of both DAC and RAM. The use of non-financial performance measures in bonus contracts also can have a significant effect on constraining EM. The results of the present study reveal that when both financial and non-financial performance measures are used together, less income-increasing manipulation by DAC and expenses takes place. If equal or more weight is given to non-financial performance measure compared with financial measures, minimal EM takes place both in DAC and RAM. This study cotnrols for corporate governance variables particularly related to executive compensation to assess their influence on EM. Despit increasing regulation designed to restrict manipulation of company results, the results show that stronger corporate governance rules have a minimal effect in controlling earnings management. A major contribution of this study is that it concludes that although RAM is not widely used it has great importance in relation to executive compensation. DAC is relatively easily identified and executives may avoid detection by adopting RAM. This suggests that tests for RAM should be more extensively used. Another unique feature of this study is that the effectiveness of deferred bonus in controlling EM has not to the best of my knowledge been previously examined. Whilst other researchers have concentrated on the relationship between stock options and EM, this research additionally takes into account other forms of long-term incentive such as share incentive plan, company incentive plan etc. Another important consideration, largely unexplored by previous researchers, is the advantage of using non-financial performance measures as well as financial performance measures and the degree of weighting given to both when determining pay and bonuses. Shareholders and other stakeholders expect pay to be limked to performance by incentives relating reward to increased company earnings and the choice of performance measures is important to achieve this. The findings of this study will be of interest to shareholders and regulators because it will assis them in undertanding how compensation characteristics are related to EM.

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