Performance Based Compensation and Direct Earnings Management
40 Pages Posted: 3 Dec 2007 Last revised: 13 Mar 2009
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
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