Earnings Management and Abnormal Compensation

The literature examining the relation between CEOs’ total compensation and earnings management is inconclusive, likely due to unobserved determinants of executive compensation. Our study provides new conclusive evidence on this relation by exploring abnormal compensation, the proportion of pay that cannot be accurately determined by known factors such as experience, risk premium, etc. We find a negative relation, indicating that abnormal compensation decreases with increasing levels of earnings management indicating that CEOs involved in earnings management receive reduced excess compensation. We also find that the effect is more pronounced when CEOs engage in real rather than accruals earnings management activities. Although our evidence indicates that the current monitoring mechanisms in place at US firms are effective in penalizing CEOs’ compensation, we find that those CEOs who use accruals earnings management receive higher abnormal compensation via bonuses and stock options. This is an alert for firms aiming to curb such behavior