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Executive compensation and earnings management under moral hazard

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Abstract

This paper analyzes executive compensation in a setting where managers may take a costly action to manipulate corporate performance, and whether managers do so is stochastic. We examine how the opportunity to manipulate affects the optimal pay contract, and establish necessary and sufficient conditions under which earnings management occurs. Our model provides a set of implications on the role earnings management plays in driving the time-series and cross-sectional variation of executive compensation. In addition, the model's predictions regarding the changes of earnings management and executive pay in response to corporate governance legislation are consistent with empirical observations.

Suggested Citation

  • Bo Sun, 2009. "Executive compensation and earnings management under moral hazard," International Finance Discussion Papers 985, Board of Governors of the Federal Reserve System (U.S.).
    • Handle: RePEc:fip:fedgif:985
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    18. Lin Peng & Ailsa Roell, 2008. "Manipulation and Equity-Based Compensation," American Economic Review, American Economic Association, vol. 98(2), pages 285-290, May.
    19. Palmrose, Zoe-Vonna & Richardson, Vernon J. & Scholz, Susan, 2004. "Determinants of market reactions to restatement announcements," Journal of Accounting and Economics, Elsevier, vol. 37(1), pages 59-89, February.
    20. Holthausen, Robert W. & Larcker, David F. & Sloan, Richard G., 1995. "Annual bonus schemes and the manipulation of earnings," Journal of Accounting and Economics, Elsevier, vol. 19(1), pages 29-74, February.
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    Cited by:

    1. Liu, Qi & Sun, Bo, 2015. "Managerial compensation under privately-observed hedging and earnings management," Economics Letters, Elsevier, vol. 137(C), pages 1-4.
    2. Koch, Timothy W. & Waggoner, Daniel F. & Wall, Larry D., 2018. "Incentive compensation, accounting discretion and bank capital," Journal of Economics and Business, Elsevier, vol. 95(C), pages 119-140.
    3. McWay, Ryan & Saona, Paolo & Muro, Laura & Jara, Mauricio, 2019. "Contrasting Incentives for Earnings Management: Board Activity and Board Remuneration in Spanish Firms," OSF Preprints xgn3y, Center for Open Science.
    4. Jean-Gabriel Lauzier, 2021. "Ex-post moral hazard and manipulation-proof contracts," Papers 2112.06811, arXiv.org.
    5. Hani El-Chaarani, 2017. "The Mutual Impacts of Corporate Governance Dimensions and Legal Protection Systems on the Performance of European Banks: A Post-Crisis Study," European Research Studies Journal, European Research Studies Journal, vol. 0(2A), pages 538-567.
    6. Fouad Ben Abdelaziz & Souhir Neifar & Khamoussi Halioui, 2022. "Multilevel optimal managerial incentives and audit fees to limit earnings management practices," Annals of Operations Research, Springer, vol. 311(2), pages 587-610, April.
    7. Maria Kontesa & Rayenda Brahmana & Ashley Hui Hui Tong, 2021. "Narcissistic CEOs and their earnings management," Journal of Management & Governance, Springer;Accademia Italiana di Economia Aziendale (AIDEA), vol. 25(1), pages 223-249, March.
    8. Bo Sun, 2013. "The optimal shape of compensation contracts with earnings management," Applied Economics, Taylor & Francis Journals, vol. 45(21), pages 3102-3109, July.
    9. Titilope Esther Olorede & Segun Abogun & Johnson Kolawole Olowookere, 2022. "Executive Compensation, Corporate Governance and Financial Reporting Quality: Evidence from listed firms in Nigeria," Istanbul Management Journal, Istanbul University Business School, vol. 0(93), pages 1-19, December.
    10. Qi Liu & Bo Sun, 2016. "Managerial Compensation under Privately-Observed Hedging," International Finance Discussion Papers 1160, Board of Governors of the Federal Reserve System (U.S.).
    11. Mijoo Lee & In Tae Hwang, 2019. "The Effect of the Compensation System on Earnings Management and Sustainability: Evidence from Korea Banks," Sustainability, MDPI, vol. 11(11), pages 1-24, June.

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    More about this item

    Keywords

    Executives - Salaries;

    JEL classification:

    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D86 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Economics of Contract Law
    • G38 - Financial Economics - - Corporate Finance and Governance - - - Government Policy and Regulation
    • J31 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Wage Level and Structure; Wage Differentials

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