Ceo Incentives and Earnings Management

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ARTICLE IN PRESS

Journal of Financial Economics 80 (2006) 511–529
www.elsevier.com/locate/jfec

CEO incentives and earnings management$
Daniel Bergstressera,Ã, Thomas Philipponb
a

Harvard Business School, Boston MA 02163,USA
NYU Stern School of Business, New York, NY 10012,USA

b

Received 25 September 2003; accepted 13 October 2004
Available online 22 December 2005

Abtract
We provide evidence that the use of discretionary accruals to manipulate reported earnings is more pronounced at firms where the CEO’s potential total compensation is more closely tied to the value of stock and option holdings. In addition, during years of high accruals, CEOs exercise unusually large numbers of options and CEOs and other insiders sell large quantities of shares.

r 2005 Elsevier B.V. All rights reserved.
JEL classification: G14; G34, M41
Keywords: Earnings management; Stock options; CEO compensation

1. Introduction
The past 15 years have seen an enormous increase in stock-based and optionbased executive compensation. The median exposure of CEO wealth to firm stock prices tripled between 1980 and 1994, and doubled again between 1994 and 2000 $

We are grateful for help from Mihir Desai, Wayne Guay, Brian Hall, Rema Hanna, Paul Gompers, Dirk Jenter, Erik Lie, Joshua Rauh, Eddie Riedl, David Scharfstein, Aamer Sheikh, Jeremy Stein, Luigi Zingales, and for helpful comments from participants in seminars at Harvard Business School, the College of William and Mary, the Federal Reserve Bank of Chicago, and the 2003 meetings of the Western Finance Association.

ÃCorresponding author.
E-mail address: dbergstresser@hbs.edu (D. Bergstresser).

0304-405X/$ - see front matter r 2005 Elsevier B.V. All rights reserved. doi:10.1016/j.jfineco.2004.10.011

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D. Bergstresser, T. Philippon / Journal of Financial Economics 80 (2006) 511–529

0.08

0.07

0.06

1990

1995

2000

Fig. 1. Average accurual ratios, size weighted.

(Hall and Liebman, 1998). Firms responsible for this change often described the increase in CEO exposure to stock prices as a way to align upper management incentives with the interests of shareholders. This strategy may, however, have had mixed results. In particular, it has recently been suggested that large option packages increase the incentives for managers to manipulate their firms’ reported earnings.1 The use of accruals to temporarily boost or reduce reported income is one mechanism for earnings management. Accruals are components of earnings that are not reflected in current cash flows, and a great deal of managerial discretion goes into their construction. As Fig. 1 shows, accruals (normalized by firm assets) have increased significantly over the past 20 years. This increase has been especially rapid since 1995. We examine cross-sectional data from the 1990s to assess whether the increasing use of accruals is related to the increase in stock-based CEO compensation.

Xerox is an example of a company whose executives appear to have manipulated reported income during the 1990s. During this period, the firm’s CEO was exercising large numbers of stock options and selling large numbers of shares. In April 2002, the SEC sued Xerox for manipulating reported earnings and revenues, and as part of the settlement with the SEC Xerox was forced to restate reported revenues for the period 1997–2001. This restatement reduced reported revenues by $2.1 billion and reduced reported net income by $1.4 billion. The SEC’s lawsuit accused Xerox of 1

See, for example, the 9 January, 2004 New York Times article by Gretchen Morgenson: ‘‘Options packages encourage executives to fiddle books.’’

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D. Bergstresser, T. Philippon / Journal of Financial Economics 80 (2006) 511–529

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using a variety of methods to inflate net income, including inappropriately allocating the revenue stream on their equipment leases. Xerox’s accounting choices were inconsistent with GAAP and...
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