Earnings Management from the Bottom Up: An Analysis of Managerial Incentives Below the CEO

by Felix Oberholzer-Gee & Julie Wulf

Overview — Many studies as well as anecdotes document a link between the structure of chief executive officer (CEO) compensation and various measures of earnings manipulation. In this paper, HBS professors Oberholzer-Gee and Wulf analyze all components of compensation packages for CEOs and for managers at lower levels in a large sample of firms over more than 10 years, between 1986 and 1999. Results suggest that the effects of incentive pay on earnings management vary considerably by both type of incentive pay and position. Overall, it appears that the primary focus of compensation committees on equity incentives for CEOs overlooks a critical component in curbing earnings manipulation. If one wanted to weaken incentive pay to get more truthful reporting, diluting bonuses-particularly that of the chief financial officer (CFO)-would be the place to start. This may be the first study to analyze the relationship between CEO, division manager, and CFO compensation and earnings management. Key concepts include:

It is important to look at positions below the CEO because it is unclear if all or even most financial misreporting is decided at the top.
In addition to division managers, the importance of the CFO's role in financial reporting and the numerous recent corporate fraud cases suggest that CFOs can significantly affect accounting quality.
Companies report significantly higher discretionary accruals and excess sales and have a higher incidence of future lawsuits when CFOs are paid larger bonuses. Importantly, the magnitudes of these effects are much larger for CFOs in comparison to both CEOs and division managers.
Since the quality of financial reporting is difficult to assess, the researchers have used various measures of earnings manipulation in this study, including discretionary accounting accruals, end-of-year excess sales, and class action litigation.

Author Abstract

Performance-based pay is an important instrument to align the interests of managers with the interests of shareholders. However, recent evidence suggests that high-powered incentives also provide managers with incentives to manipulate the firm's reported earnings. The previous literature has focused primarily on Chief Executive Officers, but managers further down in the firm hierarchy-division managers and Chief Financial Officers-are likely to have similar incentives and perhaps even greater opportunity to influence reported earnings in a manner that maximizes these managers' personal income. Moreover, previous research focuses on equity incentives and largely ignores other elements of incentive pay. We contribute to this literature by analyzing all forms of incentive pay for several types of managerial positions and include additional measures of earnings manipulation-end-of-year excess sales and class action litigation-in addition to the standard measure of discretionary accounting accruals. We find that the association between high-powered incentives and earnings manipulation varies by both type of incentive pay and position. Our findings have important policy implications and suggest that compensation committees should review pay policies of other managerial positions in addition to CEOs. Importantly, if the committees wanted to weaken incentive pay to get more truthful reporting, diluting the CFO's bonus and stock options would be one place to start.