Performance Based Compensation and Direct Earnings Management

40 Pages Posted: 3 Dec 2007 Last revised: 13 Mar 2009

See all articles by Antonio Camara

Antonio Camara

Oklahoma State University, Stillwater - College of Business Administration

Vicky Henderson

University of Warwick

Date Written: March 3, 2009

Abstract

There is empirical evidence and supporting theory showing performance-based compensation can motivate accounting based earnings management. Less well studied is the link between such compensation and direct forms of earnings management. In this paper we provide a model demonstrating that performance-based options can encourage a risk averse manager to take decisions to increase the riskiness (or gamble with) of earnings, for example by altering credit sales policies. Such behavior has been bourne out by management in a number of companies recently.

The incentive to undertake direct earnings management is stronger when the options are further "out-of-the-money" with respect to the performance threshold. We find if the performance threshold is low, there may be no incentive to manage earnings, even if such behavior is not penalized. In practice, thresholds are observed to be low. Our model suggests a reason for this is that firms are avoiding managerial gambling with earnings and associated losses in terms of the efficiency of the option compensation.

Keywords: Compensation, stock price manipulation, earnings management, ESO

Suggested Citation

Camara, Antonio and Henderson, Vicky, Performance Based Compensation and Direct Earnings Management (March 3, 2009). Available at SSRN: https://ssrn.com/abstract=763325 or http://dx.doi.org/10.2139/ssrn.763325

Antonio Camara

Oklahoma State University, Stillwater - College of Business Administration ( email )

201 Business
Stillwater, OK 74078-0555
United States

Vicky Henderson (Contact Author)

University of Warwick ( email )

Gibbet Hill Rd.
Coventry, West Midlands CV4 8UW
United Kingdom
44 (0)2476 574811 (Phone)