Learning Through a Smokescreen: Earnings Management and CEO Compensation over Tenure

Abstract

Career concerns imply that CEOs have an incentive to engage in earnings management to extend their tenure (Fudenberg and Tirole (1995)). These incentives are likely to be more acute in the early years of tenure when there is greater uncertainty about CEO ability. However, it is also during the early years, when there is more uncertainty about business strategy, that earnings management is informative about the CEO’s expectations regarding future business conditions. As boards learn about managerial ability from independent signals over the CEO’s tenure, they can distinguish strategic from informative earnings management, and CEOs who continue to aggressively manage earnings are penalized. Consistent with this argument, we find that compensation is positively associated with earnings management in the early years of a CEO’s tenure, but the relationship becomes less significant and eventually negative in later years. These results are robust to treating earnings management as endogenous using instrumental variables. The relationship between earnings management and compensation over tenure is stronger for firms with better governance and higher institutional ownership and for CEOs with greater career concerns.

Keywords: Executive Compensation, Tenure, Earnings Management, Career Concerns

JEL Classification: G3, G32, G38, J22, K22