CEO incentive compensation and earnings management: The implications of institutions and governance systems

Abstract

Purpose: The purpose of this paper is to investigate the impact of CEO incentive-based compensation on earnings management, taking into account the influence of institutional settings and corporate governance systems. Design/methodology/approach: Using archival data of 3,000 British, Australian, German, and Austrian firm-years between 2005 and 2014, the study applies fixed-effect estimator to reduce risks of endogeneity bias. Findings: The findings reveal that institutional factors influence the relationship between CEO incentive-based compensation and earnings management. Particularly, firms from countries within the Anglo-American model (the UK and Australia), which provide greater protection for investor, stricter legal enforcement, and higher quality of corporate governance, tend to have lower level of earnings management. However, besides corporate governance quality, it is relevant to consider weaker investor protection and legal enforcement to motivate earnings management in firms from countries within the Euro-Continental model (Germany and Austria). Originality/value: The study suggests that robust implementation of corporate governance, derived from either model, helps in restraining CEO opportunistic behavior. Importantly, more qualified institutions have higher impact on the relative adequacy of CEO incentive-based pay formulas in mitigating earnings management concerns. This can be extended by future research through comparative studies using other contexts or influential institutions.