Board Committees, CEO Compensation, and Earnings Management

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Board Committees, CEO Compensation, and Earnings Management

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Christian Laux ()
Volker Laux

Abstract

We analyze the effect of committee formation on how corporate boards perform two main functions: setting CEO pay and overseeing the financial reporting process. The use of performance-based pay schemes induces the CEO to manipulate earnings, which leads to an increased need for board oversight. If the whole board is responsible for both functions, it is inclined to provide the CEO with a compensation scheme that is relatively insensitive to performance in order to reduce the burden of subsequent monitoring. When the functions are separated through the formation of committees, the compensation committee is willing to choose a higher pay-performance sensitivity as the increased cost of oversight is borne by the audit committee. Our model generates predictions relating the board committee structure to the pay-performance sensitivity of CEO compensation, the quality of board oversight, and the level of earnings management.

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Paper provided by Department of Finance, Goethe University Frankfurt am Main in its series Working Paper Series: Finance and Accounting with number 181.

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Date of creation: Mar 2007
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Handle: RePEc:fra:franaf:181

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Find related papers by JEL classification:
M41 - Business Administration and Business Economics; Marketing; Accounting - - Accounting - - - Accounting
D23 - Microeconomics - - Production and Organizations - - - Organizational Behavior; Transaction Costs; Property Rights
D73 - Microeconomics - - Analysis of Collective Decision-Making - - - Bureaucracy; Administrative Processes in Public Organizations; Corruption
G34 - Financial Economics - - Corporate Finance and Governance - - - Mergers; Acquisitions; Restructuring; Corporate Governance
K22 - Law and Economics - - Regulation and Business Law - - - Corporation and Securities Law
L29 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Other

This paper has been announced in the following NEP Reports:

NEP-ACC-2007-09-09 (Accounting & Auditing)
NEP-ALL-2007-09-09 (All new papers)
NEP-BEC-2007-09-09 (Business Economics)
NEP-LAW-2007-09-09 (Law & Economics)

References listed on IDEAS
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:

Gutierrez, Maria, 2003. " An Economic Analysis of Corporate Directors' Fiduciary Duties," RAND Journal of Economics, The RAND Corporation, vol. 34(3), pages 516-35, Autumn.
K.V. Peasnell & P.F. Pope & S. Young, 2005. "Board Monitoring and Earnings Management: Do Outside Directors Influence Abnormal Accruals?," Journal of Business Finance & Accounting, Blackwell Publishing, vol. 32(7-8), pages 1311-1346. [Downloadable!] (restricted)
Sunil Dutta, 2002. "The Effect of Earnings Forecasts on Earnings Management," Journal of Accounting Research, Blackwell Publishing, vol. 40(3), pages 631-655, 06. [Downloadable!] (restricted)
Burns, Natasha & Kedia, Simi, 2006. "The impact of performance-based compensation on misreporting," Journal of Financial Economics, Elsevier, vol. 79(1), pages 35-67, January. [Downloadable!] (restricted)
Merle Erickson & Michelle Hanlon & Edward L. Maydew, 2006. "Is There a Link between Executive Equity Incentives and Accounting Fraud?," Journal of Accounting Research, Blackwell Publishing, vol. 44(1), pages 113-143, 03. [Downloadable!] (restricted)
Hermalin, Benjamin E & Weisbach, Michael S, 1998. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," American Economic Review, American Economic Association, vol. 88(1), pages 96-118, March. [Downloadable!] (restricted)
Other versions:
- Benjamin E. Hermalin & Michael S. Weisbach, 1996. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," Microeconomics 9602001, EconWPA, revised 09 Oct 1996. [Downloadable!]
- Benjamin Hermalin, 1995. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," Berkeley Olin Program in Law & Economics, Working Paper Series 1157, Berkeley Olin Program in Law & Economics. [Downloadable!]
- Benjamin E. Hermalin & Michael S. Weisbach, 1996. "Endogenously Chosen Boards of Directors and Their Monitoring of the CEO," Working Papers _004, University of California at Berkeley, Haas School of Business. [Downloadable!]
Benjamin E. Hermalin, 2005. "Trends in Corporate Governance," Journal of Finance, American Finance Association, vol. 60(5), pages 2351-2384, October. [Downloadable!] (restricted)
Andres Almazan & Javier Suarez, 2003. "Entrenchment and Severance Pay in Optimal Governance Structures," Journal of Finance, American Finance Association, vol. 58(2), pages 519-548, 04. [Downloadable!] (restricted)
Renée B. Adams & Daniel Ferreira, 2007. "A Theory of Friendly Boards," Journal of Finance, American Finance Association, vol. 62(1), pages 217-250, 02. [Downloadable!] (restricted)
Collins, Daniel W. & Hribar, Paul, 2000. "Earnings-based and accrual-based market anomalies: one effect or two?," Journal of Accounting and Economics, Elsevier, vol. 29(1), pages 101-123, February. [Downloadable!] (restricted)

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