CEO Employment Contract Horizon and Financial Reporting Discretion

Abstract

We examine the effect of employment contract horizon on managers’ discretion in financial reporting. During the contract horizon, the board learns about a new CEO’s ability from realized firm performance and uses this information to determine whether to renew or terminate the CEO’s contract. Economic theory suggests that the informational value of firm performance to the board’s learning declines over time as the board’s estimate of the CEO’s ability becomes more precise; this motivates a CEO to overstate earnings more aggressively during the earlier stage of the contract horizon. Using a sample of initial employment contracts for the CEOs of S&P 500 firms, we find more (less) aggressive earnings overstatement during the earlier (later) stage of the first contract horizon. This finding is stronger for CEOs who have greater concerns over contract termination and for CEOs who have greater flexibility to manipulate earnings. This finding is robust after we account for alternative explanations. Firms that employ their CEOs without a contract horizon do not exhibit a similar trend in earning overstatement. Our evidence suggests that the CEO employment contract horizon has a significant impact on managerial discretion in financial reporting.

Keywords: CEO employment contract; Contract horizon; Earnings management

JEL Classification: G34; J41; M40; M41