Sensitivity of executive wealth to stock price, corporate governance and earnings management

Purpose - This paper seeks to investigate whether executive wealth sensitivity to stock price fluctuations serves as an incentive for earnings management. Design/methodology/approach - Using a sample of 475 chief executive officers (CEOs) from 410 randomly selected Standard and Poor's (S&P) 1500 firms, the relation between executive stock‐based compensation, corporate governance, and earnings management is empirically examined. Findings - CEO wealth sensitivity is positively associated with abnormal accrual usage and the relation is consistent with income‐smoothing. Also find that governance does not significantly influence the association between CEO stock‐based wealth sensitivity and earnings smoothing. Research limitations/implications - This study has several limitations. First, it is assumed that the accruals models used provide accurate measures of abnormal accruals. Several recent studies question the reliability of these models. Second, the wealth sensitivity measures in this paper are based on Black Scholes option pricing. A number of the assumptions underlying Black Scholes do not hold for executive options. Finally, governance factors that influence the examined relations may not be effectively captured by the measures in this paper. Practical implications - The findings have implications for compensation design. Unintended consequences of high CEO exposure to firm‐specific risk may not be effectively mitigated by governance. These results also have potential policy implications. In the wake of recent accounting scandals regulators tightened governance standards for corporate. The findings suggest that reliance on these standards as deterrents to earnings management may not be warranted. Originality/value - The study contributes to both the earnings management and corporate governance literatures. The results of this study suggest that CEO stock‐based wealth sensitivity is an earnings management incentive.