Changes in bonus contracts in the post-Sarbanes–Oxley era

Abstract

We examine whether the relation between earnings and bonuses changes after Sarbanes-Oxley. Theory predicts that, as the financial reporting system reduces the discretion allowed managers, firms will put more weight on earnings in compensation contracts to encourage effort. However, the increased risk imposed by Sarbanes-Oxley on executives may cause firms to temper this contracting outcome. We examine and find support for the joint hypothesis that the implementation of Sarbanes-Oxley and related reforms led to a decrease in earnings management and that firms responded by placing more weight on earnings in bonus contracts. We find no evidence that firms changed compensation contracts to compensate executives for assuming more risk.

Chief Financial Officers’ Short‐ and Long‐term Incentive‐based Compensation and Earnings Management

“…Carter et al. () examine the relations between non‐discretionary and discretionary components of earnings and bonus compensation of CEOs. Their study finds that before SOX, both CEOs and CFOs had financial incentives to manage earnings upward and there were small penalties for managing earnings downward.…”

“…Executive compensation plans often include the stated objective of firm value maximisation and formally tie compensation to a measure of firm value such as earnings (Carter et al. ). Prior studies suggest that executives have an incentive to manage earnings to maximise bonus payments (e.g., Healy ; Holthausen et al.…”

“…Dowdell and Krishnan () and Carter et al. () argue that CFOs would have the greatest impact on reported earnings numbers and CFOs (and CEOs) have the primary responsibility for integrity of the financial statements. Carter et al.…”

The association between non-financial performance measures in executive compensation contracts and earnings management

“…Balsam (1998) finds a significant positive relation between discretionary accruals and cash bonus compensation. Carter et al (2009) report that changes in the executive bonus compensation structure are associated with changes in EM behavior. On the other hand, Burns and Kedia (2006) observe that the bonus component of CEO compensation does not impact the propensity to misreport.…”

Do firms manage earnings to meet dividend thresholds?

“…While our sample is not non-random, we nevertheless check whether our results are robust to estimating accruals using their methodology. Second, as suggested by Kothari et al (2005) and adopted in Carter et al (2007), we include ROA as an additional regressor in the Jones (1991) model and label this the ''modified KLW'' model. Third, we compute discretionary accruals using the modified Jones model introduced by Dechow et al (1995).…”