The Association Between Non-Financial Performance Measures in Executive Compensation Contracts and Earnings Management
Journal of Accounting and Public Policy
Place of Publication
Executive compensation, especially cash bonus compensation, has come under fire by the Securities and Exchange Commission (SEC), the U.S. Federal government, and the media for its role in the current economic crisis. Specifically, the SEC has argued that some compensation packages provide incentives for risk-taking that may undermine shareholder value over the long-term. Short-term incentive payments to executives in the form of cash bonuses are mostly contingent on reaching targets of accounting-related measures or financial performance measures (FPMs). However, the incentives from these payments may lead to accrual manipulation and earnings management. Alternative measures are non-financial performance measures (NFPMs). We expect that firms that employ NFPMs in bonus contracts will have a lower prevalence of earnings management, since these measures tend to focus executives on the long-term. In this paper, we examine the type of performance measures used by firms in the S&P 500 index in their cash bonus compensation. We find that firms that use both FPMs and NFPMs have lower discretionary accruals compared to firms that use only FPMs. These firms also have a slightly lower incidence of meeting or just beating earnings benchmarks. In additional tests on a subset of firms with equity offerings, in which incentives for income-increasing manipulation exist, we find that firms with NFPMs have lower discretionary accruals. The implication is that NFPMs can be used in compensation contracts to reduce earnings management behavior and mitigate erroneous executive compensation. This is important to investors as well as regulators, especially in light of the recent debate on compensation reform.
executive compensation, nonfinancial performance measures, earnings management, cash bonus, compensation reform, discretionary accruals
Accounting | Business Administration, Management, and Operations | Business Law, Public Responsibility, and Ethics
Cynthia Beatrice Lloyd PhD (2011).
The Association Between Non-Financial Performance Measures in Executive Compensation Contracts and Earnings Management. Journal of Accounting and Public Policy.30 (3), 256-274. USA: Elsevier.