CEO Risk Incentives and Real Earnings Management

Previous research shows that companies use option compensation to motivate managers to accept risk (Jensen & Meckling, 1976). Indeed, risk adverse CEOs are likely to accept less risk than that accepted by diversified shareholders (Fama & French, 1992). Nonetheless, not all risks produce the expected benefits and risk has an intrinsic cost, such as potential large losses, that cannot be eliminated. Therefore, given CEO risk incentives, real earnings management can be viewed as a mechanism used to avoid the undesirable consequences of risk on reported earnings. However, engaging in real earnings management requires cutting investments, such as R&D, that have a well-documented association with firm’s future risk profile (Comin & Philippon, 2005). As a consequence, the use of real earnings management by CEOs with high-risk incentives as a tool for mitigating the intrinsic costs of risk is an empirical question that we tackle in this paper. Using a sample of quarterly observations from US firms over the period 2003-2010, and an instrumental variable approach to overcome endogeneity concerns, we show that CEOs with high risk-related incentives engage less in real activity manipulations that encompass cutting discretionary expenditures than do executives with low incentives. These findings are consistent with the idea that CEOs incentivized on risk avoid engaging in real management activities that can decrease firm’s future risk profile.