CEO pay and earnings manipulation strongly linked

ANN ARBOR—Corporate boards and compensation committees are relatively ineffective safeguards against the use of manipulated earnings as a basis of CEO pay, a new University of Michigan Business School study finds.

According to a study by U-M accounting professor Eugene Imhoff, a strong link exists between executive incentive compensation and accounting performance measures among firms that likely manage—or distort—earnings.

"This is contrary to what might be expected if corporate boards and their compensation committees were able to identify the incidence of managed earnings," said Imhoff, the Ernst & Young Professor of Accounting at the Michigan Business School and director of Michigan’s Paton Accounting Center. "This also provides evidence that broader concern over manipulated earnings aimed at influencing incentive pay of key executives may be warranted."

In his study of more than 2,000 observations of CEO pay in 1998 and 1999, Imhoff examined the relationship between several accounting-based performance measures (e.g., operating income, net income, income before extraordinary items) and two separate measures of annual incentive pay: the annual cash bonus and total incentive pay (the annual cash bonus plus stock-based incentive compensation).

Using statistical models of earnings management and income smoothing, along with firm-specific data from 1990-1999, Imhoff found that the percentage change in each of the measures of accounting performance is significantly related to each of the two measures of CEO pay.

He says that for both measures of annual CEO incentive pay, the relationship between earnings and pay is strongest among firms with the greatest amount of "abnormal accruals" (i.e., earnings management). Moreover, the accounting performance measures appear to be the most important variable in explaining annual incentive pay for these firms.

"These results are consistent with the premise that extreme cases of abnormal accruals are effective at fooling compensation committees into granting annual cash bonuses based on managed measures of accounting ‘earnings,’" Imhoff said. "This holds for both cash-based incentive pay and for incentive pay that includes stock-based compensation."

In addition, Imhoff reports evidence that managers achieve superior cash bonuses by reporting smoothed "earnings" (i.e., presenting a smooth and somewhat increasing trend in earnings from year to year).

"Overall, the findings are consistent with the existence of broad-based earnings management and raise concerns regarding the inability of compensation committees to effectively evaluate managerial performance," Imhoff said. "The anecdotal evidence of accounting abuses from high-profile cases of earnings management may, in fact, be the tip of the iceberg."

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