Equity incentives, earnings management and corporate governance: Empirical evidence using UK panel data

Abstract

Using a UK panel data set drawn from 1675 Chief Executive Officer (CEO) year observations and 1540 Chief Financial Officer (CFO) year observations, we examine the relationship between CEO and CFO equity incentives and earnings management. In addition, we examine the moderation effect of corporate governance mechanisms on the relationship between executives’ equity incentives and earnings management. We use multivariate regression models to test our hypotheses. We find that CEO equity incentives are related to higher absolute and income increasing earnings management. These results support the managerial power theory argument that CEOs exploit equity-linked compensation to obtain more personal benefits without causing public anger. Contrary to CEO equity incentives, we could not find any significant relationship between CFO equity incentives and any of the earnings management proxies. In addition, we find that corporate governance quality (measured by individual mechanisms and overall index) has no effect on the relationship between executives’ equity incentives and earnings management. This result indicates that whereas some corporate governance mechanisms can reduce earnings management in general, they do not affect wealth driven incentives to manipulate accruals. In total, results question the effectiveness of the corporate governance system in mitigating opportunistic behavior motivated by executives’ compensation structures.