In this chapter I will try to mention some general characteristics of the key-elements of my thesis, such as some definitions of earnings management or equity incentives, what impact had the implementation of SOX legislation to these two and also some useful theories that have been developed over the years and may be related to the central "meanings" of earnings management and equity incentives. The primary aim of this chapter will be to provide the reader of this study with a more clear and comprehensive overlook. More specific, Paragraph 2.1 refers to earnings management and the motives that drive it, Paragraph 2.2 discusses the general meaning of equity incentives, Paragraph 2.3 deals with the implementation of Sarbanes Oxley (SOX) Act in 2002 and finally, Paragraph 2.4 cites some basic theories around executives' compensation and earnings management.
2.1 Earnings Management
Generally, earnings are believed to be one of the most important information items provided in the financial statements of a company. According to Lev (1989), they are a quite reliable indicator to find out to what extent a firm has engaged in value-added activities. A majority of companies' stakeholders such as investors, employers and owners in their attempt to reach to the right and appropriate for the firm's performance decisions ask for and use this information together with all the other financial reports. Firms tend to pay a significant attention to the way they report their earnings and a reason for doing so is because earnings except for being important -for the operation of the firm as a whole, as it has already mentioned before- are quite useful as well.
Executives (CEOs - CFOs) and managers, as it is widely known, are primarily responsible for the company's performance. However, quite often, in order to achieve their personal goal and boost their individual compensations, they might influence the financial numbers -either upwards or downwards- and therefore these activities may also affect the reported earnings.
Earnings management is a much debated and largely treated, by the academic accounting society and literature, phenomenon. A neutral definition, leaving room for both good and bad interpretation, given by Scott (2009) presents earnings management as being "The choice by a manager of accounting policies, or actions affecting earnings, so as to achieve some specific reported earnings objective". Generally, we can say that it is the use of a specific accounting method to manipulate earnings number in a certain direction. However, there is a significant variety of different definitions given to earnings management by prior literature. Some of them present earnings management as a negative and misleading phenomenon, some others not.
One of the most frequently used in the literature definitions for earnings management is given by Healy and Wahlen (1999): "Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers". What can be easily concluded from the above definition is that earnings management is basically described as a negative phenomenon. The use of word "mislead" clearly drive as to usually illegal actions and opportunistic behaviors on behalf of the managers which have as main purpose the maximization of the executives' wealth instead of firm's well-performance. Furthermore, another well-known definition which also presents earnings management in a negative manner comes from Schipper (1989). "Earnings management is a purposeful intervention in the external financial reporting process, with the intent of obtaining some private gain."
However according to prior literature and as stated before, not all earnings management are opportunistic and misleading. Jirapon et al. (2008) claim that "earnings management may be beneficial, because it potentially improves the information value of earnings", while McKee (2005) cited by Grasso et al. (2009) agrees, defining earnings management as "reasonable and legal management decision making and reporting intended to achieve stable and predictable financial results". Moreover, according to Dechow and Skinner (2000), earnings management, in general terms, has a broader concept. They believed that it could also be used as a
useful vehicle in order to increase the informativeness of investors by the use of accruals in compliance with the accounting regulations and principles, such as the matching and the revenue recognition. Finally, a different perspective is given by Ronen and Yaari (2008) who classify the different definitions of earnings management as black, grey and white. Black refers to completely misrepresentation of financial reports, white pertains to the fact that the transparency of reports are enhanced by the earnings management and at the end, the grey, when reports are managed within the boundaries of compliance with bright-line standards, which could be either opportunistic or efficiency enhancing (Ronen and Yaari 2008).
It would be useful to mention that generally according to Cohen, Dey and Lys, (2007), there are two fundamental categories for earnings management. The first one is the Real Earnings Management, which can occur through the decrease of some specific discretionary expenses such as advertising, SG&A or R&D expenses and also the report of lower cost of goods sold through increased production, while the second is the Accrual-based Earnings Management.
2.1.1 Motives for Earnings Management
Despite the fact that it is a common secret that earnings management exists, it is quite difficult to prove it and detect it. Healy and Wahlen (1999) cited that the problem to prove that earnings management really exists "arises primarily because, to identify whether earnings have been managed, researchers first have to estimate earnings before the effects of earnings management, which is not an easy task". Thus, a way to make the detection of earnings management a more feasible task may be to know the incentives and the motivation which usually leads to it. The prior literature has used a variety of evidence of different incentives behind earnings management. However, we are going to be based on the segregation made by Healy and Wahlen (1999). As a consequence, the categorization of the three motives which trigger earnings management consists of:
The capital market motivations
The contracting motivations
The regulatory motivations
It would be good to mention that especially the first two categories seem to drive, more extensively, earnings management. More specific:
The first kind of motivations, the capital market, pertains to the incentives regarding the expectations of the market and other valuation issues. It is commonly known that investors, as well as all other interested parties (such as financial analysts) rely on all the available in the market information (and especially those that come from the firms through their accounting disclosures) in order to predict the future performance or the potential profitability of a firm and also to value its stocks. Taking under consideration this outsiders' power and influence and also the fact that the accounting disclosures published by the firms can be easily manipulated by the firms' top executives such as the Chief Executive Officers or Chief Financial Officers, we can logically conclude that organizations' management can easily be incentivized to manipulate earnings and accounting information to achieve specific objectives, like short-term stock price performance or to meet analyst's forecasts. Besides, it is proved from a large amount of previous studies and by Healy and Wahlen (1999), that either firms usually tend to manage earnings upwards (increasing their stock price), so as to become more attractive to investors and also executives obtain more personal benefits, or downwards (decreasing stock prices) just before they repurchase shares on the stock market. It is useful to mention that this category of motivations has become very important, especially during 1990s and later, after the all the more extensive use of equity incentive-based, depending on the stock prices, compensations of managers, and also the increased importance that stock market valuation started to have (Dechow and Skinner, 2000).
Second, the contracting motivations refer to incentives dealing with contracts created for executives' compensation and debt covenants issues. As far as the first one is concerned, it pertains to the developed bonus plan hypothesis, according to which managers is likely to be involved in earnings altering, in order to maximize their
bonus-based incentives through the accomplishment of the agreed bonus-terms in their compensation contracts. Regarding, now the later one, managements can usually turn to manage their earnings in a discretionary way, in cases where there are specific agreements in debt covenants and when these agreements are close to violation on behalf of the organization. Needless to say that it is obvious that there is a strong association between the first and the second kind of motivations, since over the last two decades, the CEOs' basically, and over the last years the CFOs' compensation plans and contracts are usually consisted of stock-based and option-based incentives. Besides, this relationship I will try to investigate later in this study.
Finally, the last kind of motivations, the regulatory motivations, includes incentives which have to do with anti-trust and other government regulations, usually regarding specific industries. Based on Watts and Zimmerman (1978), managers of firms which are more prone to anti-trust investigation, are encouraged to manage their earnings, usually downwards, so as to appear less profitable and avoid drawing attention. Also, it is a fact that some specific industries, such as insurance and banking industries, are more regulated and this leads to a more frequent and extensive earnings management in order to satisfy the regulators (Petroni, 1992).
2.2 Equity Incentives
Jensen and Meckling (1976) focused on the conflicting relationship between managers and shareholders/owners. They claimed that a linkage between the managers' compensation and shareholders' wealth should exist in order to reduce the agency costs. The implementation of equity-linked compensation was presented as a potential solution to this problem. Thus, equity incentives are created in order to align managers' interests with that of shareholders and motivate the first ones to increase the firms' value.
More specific, we can say that equity incentives is a kind of motivation which encourages managers to increase and improve the firm's share price. This motivation usually stems from the stock-based compensation and stock/option ownership, which are two commonly used kinds of equity incentives. Since the nineties, according to
Hall and Liebman (1998), "shares and options were a very common way to compensate firm's management". The last years, there is also a significant increase in the use of stocks and options, consisting nowadays a single largest component of the existing senior executives (CEOs-CFOs) pay.
Aggarwal & Samwick (1999) examined the importance of stocks and options on the wealth of the company. The results showed that changes in the value of the company's stock and options have a huge effect in the wealth of the company.Stock is the most usual way for executives to become part of the firm's ownership. Stocks are granted to executives either as normal stock grants or as restricted stock grants. "Restricted stock grants cannot be sold within a pre-determined time or before the firm reaches a standard performance goal" (Ronen and Yaari 2008). Stock options, on the other hand, are contracts that give the owner the "right", but not the "obligation", to buy or sell a stock at an agreed-upon (exercise) price within a certain period or on a specific date. Executives who own this kind of options are going to have profit only when the share price is higher than the exercise price -known as "in the money"-, otherwise not. Based on this, Murphy (1999) states that a reason that stock options do not give the same incentives compared to stock ownership is that option lose incentives when they are not "in the money". Also, according to Zhang et
al. (2008), "compared to stock options, stock ownership has a more direct effect on executives' current wealth, because executives actually own the stocks in the most real sense".
2.3 Sarbanes Oxley Act (SOX) Legislation
The burst of the high-tech bubble in the first quarter of 2000, followed by other fraud scandals such as Enron, Xerox, Arthur Andersen, Adelphia and other US corporations in the beginning of 20th century had started to raise great interest in the importance of corporate governance in disciplining firms and also questions regarding to what extent could the corporate financial reporting be characterized as reliable. The unreliability of corporate managers, monitors and the market in these cases raised arguments in favor of the need for government regulators to restore confidence in the
securities markets (Cohen, Dey and Lys, 2004). However, it was the public outrage following revelations of massive accounting fraud at WorldCom that spurred Congress to pass the Sarbanes-Oxley (SOX) Act of 2002 with unexpected swiftness (Li, Pincus and Rego, 2008). More specific, the Act combines the initiatives of the Representative Michael Oxley, chairman of the House Financial Services Committee, and Senator Paul Sarbanes, chairman of the senate Banking Committee (Ronen and Yaari 2008).
The Sarbanes-Oxley Act (SOX) of 2002 was the most important legislation affecting corporate financial reporting enacted in the United States since the 1930s. The stated purpose of the act was to "protect investors by improving the accuracy and reliability of corporate disclosures made pursuant to the securities laws" (Hamilton and Trautman 2002, p.87). Moreover, US President George W. Bush in 2002 described the legislation as incorporating the "most far-reaching reforms of American business practices" since the Great Depression.
Added to the aforementioned, the SOX legislation also set new procedures regarding the disclosures for companies in the United States and higher standards on the quality of financial information conducted in the market. Risks concerning the top executives like CEOs and CFOs also increased. SOX formally require that CFOs, as well as CEOs, provide personal certification on the accuracy and completeness of the financial information released by the company (Jiang et al. 2010). More specific, as far as the risks are concerned, they can be viewed in the Sections 404 and 302, which cope with the new responsibilities of executives. Under these parts of the SOX legislation:
"It is very important for managers to have an internal control system that will be effective when financial reports are to be prepared. This internal control system includes several controls when transactions take place inside a company and these transactions are of major importance in order to prepare the financial reports of a company. Specifically, in section 302 the internal controls of a company have to be certified periodically in a quarterly and annual basis by the managers. In section 404 managers of publicly held companies should provide an annual report which will represent how effective are the internal controls of the entity. This annual report should include: 1) a statement for establishing and maintaining adequate and
effective internal control from the management of the entity, 2) an assessment of how effective is the company's internal control system over financial reporting, 3) a statement from the external auditors of the company grading the managers work over the company's internal control system, 4) a written conclusion of how effective is the company's internal control system over financial reporting and 5) a statement which identifies what framework is used in the assessment of internal controls" (James A. Hall, p.131).
2.3.1 SOX and Equity-based Executives Compensation
Many prior studies tried to examine the effect of SOX on executives -the majority is referred to CEOs than to CFOs- compensations. Chang et al. (2011) examined the impact that SOX legislation had on the pay performance sensitivity of CEO's between regulated and unregulated industries. They concluded that a significant decrease in the stock ownership and the total pay performance sensitivity took place, especially in the unregulated industries, agreeing more or less with the results of other studies that after the implementation of SOX the incentives of shareholders are not so strictly connected with those of CEO, since CEOs started to possess more responsibilities and the regulation regarding the discipline measures and penalties was quite stricter than in the pre-SOX period. On the contrary, in the case of regulated industries, the results showed that the stock ownership and the total pay performance sensitivity did not change, meaning that the alignment between the incentives of CEOs and shareholders continued to exist and why not increased. Moreover, according to Banerjee et al. (2005) after the Enron crash and -subsequently- the appearance of SOX, there was a decrease in the amount of option-based compensation to CEOs, since the stock options granted to them also decreased.
Furthermore, in compliance with the aforementioned, the study of Cohen et al. (2004) stated that the compensations based on options decreased after SOX for CEOs, while at the same time the compensations based on standard salary and bonuses increased. That means that the nature of compensation changed, promoting more the fixed salary granted to CEOs, from the shareholders/owners, than the incentive based payment. This, actually, happened because of the considerably increased risk that
executives started to face. Another proof that SOX legislation changed the nature of executives way of payment is presented in the book of (James A. Hall, p.123), where "the compensation should be carefully determined by the compensation committee in order to provide executives with correct incentives that will be for the best of the firm and for shareholders". Finally Jiang et al. (2010) examining the association between -basically- CFOs and CEOs equity incentives and earnings management, they found that the combined total of both CEO and CFO equity compensation has declined during the post- SOX period.
2.3.2 SOX and Earnings Management
As it is stated prior in this study, SOX legislation was implemented, to improve the accuracy and reliability of corporate disclosures by modifying governance, reporting and disclosure rules for public companies (Cohen et al. 2004) and in general terms, to eliminate the earnings management, which in the beginning of this century started to become an all the more common phenomenon. SOX aimed to protect the interests of investors by restoring their descending confidence on the reliability and integrity of firms' financial reporting, through the timely, accurate and highly quality disclosures to the public. Moreover, through the development of this new legislation, regulators tried to make clear that Generally Accepted Accounting Principles (GAAP) could not be used as a defense against charges of malicious earnings management practices anymore and that it was expected from SOX to reduce those kind of practices (McEnroe, 2007). A considerable number of measures such as the increase of penalties for corporate frauds were implemented to improve both the quality and quantity of reliable information available to the public and enhance the transparency of corporate financial reporting (Chang et al. 2009). A step to this direction and, at the same time, to the avoidance of earnings management was the increase in the accountability of the board of directors and the modification in the relationships between them and the top executives, introducing the mandatory independence of the auditing committee and the financial literate of its members (Chang et al. 2009), in order to control the executives' tenures in specific hierarchical levels.
As it is mentioned before, according to Sections 302 and 404, both CEOs and CFOs are obligated to personally certify the corporation's financial reports -either quarterly or annually- which practically means that under SOX, and as far as the financial oversight of the firm is concerned, CFOs' responsibilities have also risen and started to align with these of CEOs. Moreover, the lack of compliance with the Section 404 and the non-certification of the financial reports may incur severe penalties for the firm and its top executives. As a consequence, the adoption of pernicious earnings management may become quite costly (Ronen and Yaari, 2008, p. 60) and that is also a main reason why it was expected that in the post-SOX period, a considerable decrease in earnings management practices may take place.
In addition, (Cohen, Dey and Lys, 2008) examined the relation between the use of earnings management -both real and accrual-based- before and after the implementation of SOX legislation in 2002. The results from their study showed that "accrual-based earnings management increased steadily from 1987 until the passage of the Sarbanes-Oxley Act (SOX) in 2002, followed by a significant decline after the passage of SOX. Conversely, the level of real earnings management activities declined prior to SOX and increased significantly after the pas-sage of SOX, suggesting that firms switched from accrual-based to real earnings management methods after the passage of SOX".
In the same line with Cohen et al. (2008), but some years before Graham et al. (2005) through their research claimed that "most earnings management is achieved via real actions instead of using accounting manipulations". Managers seemed to prefer to adopt real earnings management, instead of using accrual-based manipulation strategies in order to manage their earnings, despite the fact that the latter way of management it was likely cheaper than the first one. Always according to the authors, the implementation of SOX may be the main reason for this switch.
2.4 Theories
2.4.1 Positive Accounting Theory
Generally, theories' main aim is to explain and predict specific phenomena. The Positive Accounting Theory developed by Watts and Zimmerman in 1978 is an example of a particular positive theory of accounting. Demski (1988) states that Positive Accounting Theory is concerned with "the entire domain of financial reporting activities, ranging from choice of method through time, to audit arrangements, to political activities". According to Watts and Zimmerman (1978), Positive Accounting Theory (PAT) focuses on the behavior of managers and is concerned with describing, explaining and predicting actual accounting practices that they usually adopt. It also predicts that managers are rational and choose accounting policies that are in their own best interest (Watts and Zimmerman, 1986). Moreover, positive accounting theory is important because it provides those who must make decisions and choices on accounting policy (managers, accountants, investors, financial analysts, regulators) with predictions of, and explanations for, the consequences of their decisions (Watts and Zimmerman, 1986).
Watts and Zimmerman (1978) based their theory on two assumptions. According to the first one, individuals -in our case, top executives- usually tend to act in an opportunistic manner and regarding the second, individuals are self-interested and try to increase their personal profit and wealth. In plain words, referring to self-interested behaviors, we mean the cases under which CEOs and CFOs often try to find ways through the manipulation of the corporate financial statements in order to mislead the shareholders/owners/investors and boost the equity-linked parts of their compensation, usually ignoring the short or long-term prosperity of the firm.
Additionally, apart from the two aforementioned assumptions, Watts and Zimmerman developed three more hypotheses -variables-. "These variables represent the manager's incentives to choose accounting methods under bonus plans, debt contracts and the political process" (Watts and Zimmerman, 1990). These three hypotheses are:
The bonus plan hypothesis
The debt covenant hypothesis
The political cost hypothesis
According to the first one, managers with a bonus plan are incentivized to maximize their personal bonus by using all the appropriate accounting methods and practices to switch the reported earnings from future years to the current year. In that way, and more specific,"by reporting high net income, their utility will be maximized through bonuses and incentives" (Watts and Zimmerman, 1990). Of course, it would be of vital importance to be mentioned that managers, related with a bonus plan, are not always be incentivized to increase earnings. There are cases where manager would prefer incentives for decreasing earnings than increasing them. For instance, this may happen when the bonus compensation has already been maximized and there are no more margins for further increase.
As far as the second hypothesis is concerned, the executives' and consequently, the corporations' main target is to avoid, as much as possible, the probability of problems with creditors. This is often done through the establishment of debt covenants. These are a sort of "agreement" between the two sides ensuring, basically, that the borrower's side can repay the side of the lender. These are usually presented, for example, in the form of a specific level of debt to equity ratio. Thus, in cases where the firms tend to violate these debt covenants, managers have the incentive to select accounting procedures that shift reported earnings from future periods to the current period (Watts and Zimmerman, 1990).
Finally, the last hypothesis deals with political costs. These costs are basically imposed by outsiders and third-parties and may have, for example, the form of extra taxes in cases when firms perform higher than the expected or normal, or extra costs in order to comply with new environmental laws. Regarding the first case, the higher the profits or the prosperity a firm face, the more attractive may be shown in the stakeholders' and media attention. So, the questions that may appear in times of high profits may also create an increase in taxes and other regulations (Watts and Zimmerman, 1990). As a consequence, managers are incentivized to "manipulate" and defer the reported earnings usually by postponing, this time -and in contrast with
the two previous hypotheses-, the current earnings to the future. Generally, we could say that the higher the political costs to the firm, the more likely may be the use of these kinds of manipulation or of deferred accounting methods in the earnings disclosure.
2.4.2 Agency Theory
Another well-known and commonly used theory correlated with earnings management is the Agency Theory. Agency theory " is directed at the ubiquitous agency relationship, in which one party (the principal) delegates work to another (the agent), who performs that work" (Eisenhard, 1989). Jensen and Meckling (1976) define it as "a contract under which the principal engages the agent to perform some service on behalf which involves delegating some decision making authority to the agent". It attempts, more or less, to describe this "agency" relationship using the metaphor of a contract (Jensen & Meckling, 1976).
A basic problem that agency theory is concerned with resolving and occurs in agency relationships appears when shareholders hire top executives in their companies. This agency problem, as it is widely known, arises either when the desires or goals of the principal and agent conflict each other or when it is difficult or expensive for the principal to verify what the agent is actually doing (Eisenhardt, 1989). More specific, regarding the first one, in many cases the agent -in our study, the CEO/CFO executives- does not always act in the best interest of the principal -shareholders- (Jensen and Meckling, 1976), while in the second one, the problem is that the principal cannot verify that the agent has behaved appropriately (Eisenhardt, 1989).
A way to deal with this fundamental problem and try to eliminate its impact in the firms' performance was the implementation of equity incentives as an additional segment, in their fixed compensation package, for the top executive managers. It was in the shareholders' interest to align managements' incentives with their incentives, using executive compensation plans (Jensen and Murphy, 1990), creating however, an amount of other "problems", such as what it was mentioned in the positive accounting theory, when executives pay attention only to the increase of their individual wealth,
instead of the firm's actual performance and prosperity. Besides, this is going to be, more or less, the major issue of research in this study.
2.4.3 Other Theories
Apart from the two previously widely-known theories, there is also a large variety of other, more or less, relative to earnings management and executives' compensation theories.
First of all, the managerial power theory, states that managerial opportunism is what drives executives compensation and not the efficient contracting (Scott, 2009). According to Bedchuk et al, (2002), executives usually do not tend to act in the interest of their shareholders, and the reason for doing so is that it is a common fact that they have all the more influence in the decisions taken, regarding their compensation packages. So, by playing such an important role on the establishment of their own compensation, they usually facilitate their own personal wealth at the expense of their shareholders.
Secondly, is the tournament theory. Lazear & Rosen (1981) were the first who referred to this one. According to them, the basic factor for determining the executives' compensation should be their rank in the hierarchy of the organization and not their actual performance (Lazear & Rosen, 1981). Henderson & Frederickson (2001) also seemed to follow the same line suggesting that managers should not be paid according to their marginal output because it is more probable to decrease their effort and responsibilities.
Finally, Vroom (1964) introduced the expectancy theory, predicting 3 specific factors. First of all, he claims that the greater the degree that an individual values a job reward, the bigger the motivation on behalf of the individual to exert bigger effort, practically meaning that an executive increases his performance if his compensation is important to him. Secondly, the bigger the expectation of a strong and positive relationship between effort and performance, the higher the incentive to exert bigger effort. Finally, the higher the expectation that the compensation of the executive will be tied to his actual performance, the more motivated the executives will be to exert effort.
3. LITERATURE REVIEW
The previous chapter described the theoretical background over which this study is going to be based on. General characteristics and definitions for earnings management and equity incentives were given, together with details for the implementation of SOX legislation and what various studies on this subject has examined. Finally, some theories connected with executives' compensation and earnings management were also addressed in the last part. In this chapter, what earlier empirical literature has examined, related on this study, is going to be presented. First, there is a small introduction, followed by Paragraph 3.1, where some useful information on the executives' compensation plans/packages are given. Then, Paragraph 3.2 describes the relationship between these compensation plans/packages and Security and Exchange Commission (SEC), while Paragraph 3.3 provide a review over the equity-based compensation and the earnings management, the firm performance and the firm value. Next, Paragraph 3.4 explains the association between accruals and earnings management and in the end of this chapter, in Paragraph 3.5, the literature review, which relates the CEOs and CFOs equity incentives with earnings management and on which my study is going to be based, is developed.
Introduction
The separation of ownership and control is an unavoidable realty for large public corporations in the U.S. and abroad (Chava and Purnanandam, 2010). Based on the agency theory, which had dealt with this separation, and more specific, the agency problem that usually arises, as this was developed previously in this study, it can be easily understood that in past decades there was a fundamental problem between the shareholders and the managers of the firms. Usually, there was a serious conflict of interest between these two sides, often creating problems in the performance and prosperity of the firm as a whole. According to Jensen and Meckling (1976), who analyzed these conflicts between managers and shareholders, a possible solution to this agency problem and generally this agency costs would be an establishment of a linkage between the managers' compensation and shareholders' wealth. Equity-based incentives and compensations seemed to be an effective alternative.
As a result, over the last decades, a dramatic increase in the equity-linked (stock-based and option-based) compensations took place. Hall and Liebman (1998) documented that "the median exposure of CEO wealth to firm stock prices tripled between 1980 and 1994, and doubled again between 1994 and 2000". This was done, partly, in order to mitigate the concerns that managers were insulated from the firms' performance leading to value-destroying executive behavior, but basically, having as a primary purpose to incentivize the executives to behave in the shareholders' will. Furthermore, through equity incentives managers are "forced" to put effort in increasing company's value. All these changes in the payment-way of executives, as mentioned before, were set through the implementation of compensation plans.
3.1 Executives Compensation Plans / Packages
Scott (2009) in his book (p. 356), gives an interesting and very useful definition for the compensation plans. More specific, he states that "an executive compensation plan is an agency contract between the firm and its manager that attempts to align the interests of owners and manager by basing the manager's compensation on one or more measures of the manager's performance in operating the firm". It is a way to align firms' -and as a consequence, shareholders as well- goals with the effort exerted from executives.
Executives' compensation packages or plans consisted only of a fixed salary, without any further bonuses or "extras", raise significantly the probability of a high executives' risk-aversion regarding the firm-related decisions. This is done, because they do not have any further rewards and they do not want to be personally blamed of some unsuccessful risks they might have taken. Thus, according to a compensation plan, an executive's payment consists of two parts, a fixed part and a variable part. The first one contains his basic salary and the second one contains any kind of bonuses, shares or options. Shares and options were a very common way to compensate firm's management (Hall and Liebman, 1998). The variable part is in place to align specific incentives between manager and firm (Jensen & Murphy, 1990) and also, due to the fact that usually managers seem to be risk-averse, according to Gibbons (1998), the variable part incentivize managers to put more effort as well and as a result, take more risks because only through this way they will receive higher
bonuses. Moreover, for the same reason, while forming a compensation contract, it should become plain and sure that more effort results in higher payment to compensate the risk induced upon the manager (Indjejikian, 1999). In general terms we can say that the higher the incentives given to a manager, the larger the amount of risk the manager is exposed to. So, based again on Indjejikian (1999), managers want to be rewarded, by the means of a higher amount of pay for the risk taken.
However, despite the fact that these changes were triggered by a desire to relate managers' incentives with those of shareholders, recent researches showed us that also new problems have arisen. Armstrong et al, (2010) claims that "although equity holdings may alleviate certain agency problems between executives and shareholders, concerns have arisen among researchers, regulators, and the business press that "high-powered" equity incentives might also motivate executives to manipulate accounting information for personal gain". This view assumes that stock price is a function of reported earnings, and that executives manipulate accounting earnings to increase the value of their personal equity holdings (Armstrong et al, 2010).
According to Goldman and Slezak (2006)"stock-based compensation acts like a double edged sword". Connecting management incentives to the stock prices may force managers to act in a discretionary way in reporting earnings, in order to manipulate the stock prices of their companies. Levitt, (1998) had cited that investors and regulators have raised concerns that certain management incentives could lead to earnings management, reducing the informativeness of financial reporting and contributing to recent corporate scandals. Based on this Levitt's state, it is not much of a surprise the fact that just few years ago he came totally true. How else could be explained that the top executives of companies such as Xerox (2000), Enron (2001), WorldCom (2002) and more recently Lehman Brothers (2010) were accused of committing fraudulent activities and earnings management based on their discretionary power on financial reporting. Also Erickson et al, (2006) more or less agreed saying that "given the increased use of performance-based compensation over time and the theoretical and empirical arguments of its shortcomings, it is possible that the perceived increase in corporate fraud in the late 1990s and early 2000s was a predictable outcome of these changed incentives".
3.2 Executives Compensation packages and SEC
In contrast with the significant change in the top executives' compensation packages that took place over the last two decades, the alterations in the disclosure regulations over these compensations faced a little delay. During testimony before the Senate Finance Committee, Internal Revenue Service (IRS) Commissioner Mark Everson expressed that the temptations of stock appreciation demand "heroic" virtue to keep managers from wrongdoing (Katz, 2006 cited by Jiang et al, 2010). Moreover, various shareholders and investors started to put pressure on the Security and Exchange Commission (SEC) so as to set mandatory, detailed and clear information disclosures regarding their executives' payments and compensation plans. This was also promoted after the all the more increased influence that Chief Executive Officers (CFOs) started to have on the reporting of financial statements and also the increased trend which had the CFOs to start paid with shares and stock options included in their compensations.
Echoed by these concerns and pressures over the executives' and more specific the CFOs' growing compensations, the Security and Exchange Commission in 2006 established new disclosure regulations and rules by requiring the firms to disclose together with the CEOs pay, the CFOs payments as well. The SEC argued that "compensation of the principal financial officer is important to shareholders because along with the principal executive officer, the principal financial officer provides the certifications, required with the company's periodic reports and has important responsibility for the fair presentation of the company's financial statements and financial information" (Securities and Exchange Commission, 2006, p.117).
3.3 Equity incentives and earnings management
As it widely mentioned in this study, the major component of executives' equity incentives and of their compensation package, as a consequence, is the granting of shares, stocks and stock options to them for a better firm performance, higher incentive alignment between managers and shareholders and an increase in the firm's value. The positive effect of incentives from stock options on the propensity to misreport has important implications for the design of executive compensation plans
(Burns and Kedia, 2006). A lot of prior studies have examined the relationship between these incentives and the performance of the firm, the firm value as a whole or the earnings management.
Jensen and Meckling (1976) first and also Smith and Stulz (1985) later, documented in theoretical way that a possible greater linkage between CEO compensations and firm performance is connected with better incentive alignment -between the managers and the shareholders - and higher firm values, suggesting more or less that some option holdings may have a positive influence in the firm value. Usually the increase in the firm value and the improved firm performance could be achieved through the involvement in risky projects. According to Smith and Stulz (1985), stock options can be used to mitigate the effects of managerial risk aversion. As a result, stock options make managers to take on positive net present value, risky projects (Smith and Stulz, 1985). Added to that, Morgan and Poulsen (2001) also found some evidence supporting the positive impact that stock options have on firm value. Specifically, the documented in their study the market reacts in a positive way in the adoption of performance-sensitive compensation plans.
However, the excessive use of option may also have and unwanted results. Based on what Burns and Kedia (2006) claimed, "the use of stock options beyond some ''optimal'' level might be associated with an increase in the incentives for misreporting". More precisely, they found that restating firm-years are significantly associated with ''excessive'' option sensitivity. Moreover, this is also in the same line with what they had stated in a prior research few years ago (Burns and Kedia, 2003) saying that high pay for performance incentives arising from stock options significantly increase the probability of restatement. Gao and Shrieves (2002) argued that contrary to the basic salary of an executive, the bonuses and the amount of stock options are related in positive way to earnings management. This can become more comprehensive if we take under consideration the study from Core et al, (2003) who gave some quite remarkable evidence showing that the amount of money that come from the cash compensation, which in more case is the fixed part of a compensation plan, represents less than the 10% of the benefits that arise from the firm's stock options. Finally, Harris and Bromiley (2007), cited by Armstrong et al. (2010) suggested that the likelihood of managerial impropriety rises with "the strength of
inducements" and therefore test for a positive relationship between the probability of accounting misrepresentation and stock-option compensation.
The increased percentage of CEO compensation plan consisting of stock options and firm shares can incur great sensitivity between managers' personal wealth and firm's share price (Kedia, 2003). It is undoubted fact that after the connection of their compensation package with the movement of the firm's share price, managers may be "pushed" to exert more effort to increase both firm value and performance. Following one perspective, this can be done in the managers' attempt to satisfy and increase shareholders' wealth by driving the firm's share price upwards, but following another perspective, since in many cases they also own shares of the firm (as a significant part of their compensation plan), their incentives are also closely related to the maximization of firm's share price. Thus, this connection may also "push" them to alter some valuable resources and try to disclose the firm's performance in a more discretionary and beneficial for them manner. That's why Goldman and Slezak (2006) had claimed that stock-based compensation in many cases may act like a double edged sword.
Bergstresser and Philippon (2006) seemed to agree with the aforementioned stating that "equity incentives have the perverse effect of encouraging managers to exploit their discretion in reporting earnings, with an eye to manipulating the stock prices of their company". Furthermore, another interesting view of the connection of executives' compensation and firm's stock price was expressed by Ronen and Yaari (2008, p. 84) in their book. They tried to explain that equity-linked compensation may also induce conflicting incentives to earnings management. Specifically, they claim that instead of aiming only in a short-term-horizon management of earnings, by trying to increase all the more the firm's share price in order to gain more and more stock and option holdings, they should also pay attention to a longer-term-horizon through the implementation, sometimes, of an earnings smoothing. This is appropriate due to the fact that after the continuing increase in the firm's market price, through the increase of its share price, the probabilities and the margin for even more future gains, through further raise would be significantly limited.
Lots of prior studies also examined and found a positive relationship between earnings management and different components of executives' equity incentives. For instance, positive association between earnings management and option holdings [(Harris and Bromiley (2007), Burns and Kedia (2006)], earnings management and different equity components, such as unvested options and stock ownership (Cheng and Warfield, 2005), and earning management and the entire equity portfolio (Bergstresser and Philippon, 2006). Generally, it is quite understandable that earnings management and its relationship with equity incentives is much-debated and burning issue. This became clear from the variety of the aforementioned studies dealing with it and it is going to continue with additional references in accounting literature.
Finally, in contrast with all the previously mentioned studies referred to a positive relation, it would be of great importance to say that there are also some others which are not in compliance with them. Burns and Kedia (2006) and O'Connor et al. (2006) for example, expressed a different opinion. They claimed that equity incentives indeed, by aligning managers' and shareholders' interests managed to reduce management's desire to get involved in the manipulation of accounting and reporting numbers and to promote it.
3.4 Accruals and Earnings management
Managers who want to be involved in earnings management can usually do it using two different methods. The first one is through operational manipulation, or also widely-known as real-earnings management, and the second one, by implementing accrual-based earnings management.
Roychowdhury (2006) defines real earnings management as "departures from normal operational practices, motivated by managers' desire to mislead at least some stakeholders into believing certain financial reporting goals have been met in the normal course of operations". Furthermore, Cohen et al. (2008) focused their study, regarding real earnings management, on three manipulation methods, (1) the acceleration of the timing of sales through increased price discounts or more lenient credit terms, (2) the reporting of lower cost of goods sold through increased production and (3) the decrease in discretionary expenses that include advertising
expense, research and development, and SG&A expenses. However, in this study we are going to focus on earnings management which is mainly based on accrual accounting.
According to Dechow and Dichev (2002), accounting is usually based on discretion estimations and assumptions, which in most cases have to be corrected in future accruals or earnings. This can be one of the many reasons why accruals are often used as a way to manage earnings. Furthermore, since the determination of the accruals' size needs estimations and judgments from the side of the managers, and especially from the top levels of the firm's hierarchy such as CEOs and CFOs, it can be easily understood that accruals become highly vulnerable in manipulation. It is widely-known that usually there is an asymmetry in the information that stakeholders and other business outsiders receive from the side of the corporations. That practically means that a very common phenomenon appears, when there are difficulties to distinguish between honest estimation errors and opportunistic use of accruals, which usually aim to window-dress or mislead the external users of the financial statements (Dechow and Dichev, 2002).
Dechow et al. (2003) claim that the most popular way for companies to practice earnings management is through the manipulation of accruals. Accrual management is thought to be one of the most important discretionary tools available to managers so as to temporarily boost or reduce their firm's reported earnings (Chava and Purnanandam, 2010). Burgstahler and Dichev (1997) showed that accrual management is used to decrease the volatility of the firm's reported earnings, while Bergstresser and Philippon (2006) showed that CEOs with high equity-linked compensation manage their accruals more aggressively.
Healy (1985) defines accruals as "the difference between reported earnings and cash flow from operations". Since the cash flow cannot be manipulated by the method of accrual manipulation, the result can only be affected by adjustments to accruals. Generally, accruals occur when there is a difference in the time between the moment of the actual payment/receiving and the moment of the cost/revenue recognition. In other words, accrual accounting distinguishes between the recording of costs and benefits associated with economic activities and the actual payment and receipt of cash (Palepu et al. 2010, p.7). A reason why earnings management, based on accruals,
is so frequently used may also be the fact that firms prefer using accrual accounting for financial reports rather than cash accounting. Cheng et al. (1996) and Dechow (1994) state that the main purpose in using accrual accounting is that accrual accounting matches revenues and expenses better than pure cash flow accounting, implying that the use of accrual accounting could improve the evaluation the company's current performance as well as improving estimations regarding its future performance and future cash flows. According to Palepu et al (2010, p.7), "because cash accounting does not report the full economic consequence of the transactions undertaken in a given period, accrual accounting is designed to provide more complete information on a firm's periodic performance".
Total accruals can be decomposed into non-discretionary accrual and discretionary accruals. Non-discretionary accruals are accounting adjustments in firm's cash flows mandated by accounting standard-setting regulations and policies, while discretionary accruals are adjustments to cash flows selected by the managers. Since managers can exercise some control over the discretionary accruals, these are often used as the proxy for earnings management. Analysis of earnings management often focuses on management's use of discretionary accruals (Dechow et al. 1995). A variety of models has been developed and used in the finance and accounting literature in an attempt to detect earnings management by using accruals (either discretionary or non-discretionary) such as the Healy model (1985), the DeAngelo model (1986), the Jones model (1991) and the Modified Jones model (1995). However, these models are going to be examined further later in this study.
3.5 CEOs - CFOs Equity Incentives and Earnings Management
As it is stated previously, over the last two decades a dramatic increase regarding the use of equity-linked incentives that constitute the top executives' compensations plans took place. In an attempt to align interests between shareholders and managers, the implementation of stock-based and option-based compensations also raised another important and much-debated phenomenon. The increasing problem of earnings management. Usually, it is emphasized that executives use their personal impact and discretion on the financial reports generally, and more specific on earnings
to satisfy their own interests through more individual profits, often at the expense of the firm's prosperity. There is a large variety of prior literature studies examining the relation between earnings management and equity-based compensation.
The majority of them focus on the involvement of Chief Executive Officers (CEOs) on the manipulation of earnings as the top executive in an organization's hierarchy. However, during the last years, even in a more limited extent, the role of the Chief Financial Officer (CFO) started to draw all the more attention of the regulators and their relation with the financial reports and the disclosure of the earnings became a matter of further investigation. Based on Fuller and Jensen (2002), the increasing proportion of stock options in a manager's compensation package causes both CEOs and CFOs to focus on boosting short-term stock prices at the expense of long-run value creation. Moreover, Fuller and Jensen (2010) again, in later study, they argue that increasing the proportion of stock options in executive compensation makes the preservation and enhancement of short-term stock price a personal priority for both CEOs and CFOs.
3.5.1 CEOs Equity Incentives and Earnings Management
It is mentioned previously, that CEOs' involvement in the earnings management has been highly targeted and examined by the prior accounting literature. The reason for that is the fact that generally, it is believed that CEO is the executive who is in charge of the firm's operation as a whole, receiving in most cases the largest compensation packages (which are highly consisted of equity incentives) and also has the more influence on the decision making and the firm's policies (Jiang et al. 2010). If we also take under consideration that in many cases, especially in the U.S, the CEO possesses also the position of the chairman of the board of directors, which board often sets the CEOs compensation plan or contract, then it can become comprehensive the extent of power that this executive has on its own payment in association to the firm's administration.
Returning back to the previous literature, first Jensen and Murphy (1990) documented an association between CEOs incentives and shareholders wealth, saying that CEOs' incentives to raise shareholders' value and as a consequence the firm's value as well, was limited. More specific, they found that over the period 1974-1986, CEOs stock and option portfolios' value increased only by 3$ for every 1000$ increase in shareholders' wealth. However, it was until the 1990s when the direct exposure of CEOs wealth to the stock prices of their companies faced a dramatical boost. Hall and Liebman (1998) proved that during the period 1980-1994 when the median exposure of CEOs wealth to firm's value was tripled. Also, few years earlier, Mehran (1995) had found that there is a positive relation between the firm performance and the percentage of equity held by management, and to the percentage of their compensation that is equity-based.
As far as most recent studies are concerned, a variety of journals has documented the consequences of equity incentives, especially on earnings management. The maintained assumption of this line of research is that managers can successfully inflate share prices by manipulating financial statement bottom lines (Kim et al. (2011). [Cheng and Warfield (2005), Bergstresser and Philippon (2006), Burns and Kedia (2006), and Efendi, Srivastava, and Swanson, (2007)], among others, have provided evidence of a positive relation between CEOs equity incentives and earnings management. It is important to mention that on these 4 studies I am going to mainly base my own examination, of course, in accordance with all the aforementioned, by the accounting literature, evidences.
Cheng and Warfield (2005)
Cheng and Warfield (2005) examined the link between managers' equity incentives (arising from stock-based compensation and stock ownership) and earnings management. Specifically, they investigated the relationship of equity incentives and the selling of stocks by managers and also whether managers sell more shares after actual earnings management. They used stock-based compensation and stock ownership data over the time period 1993-2000 and as a general conclusion they found that equity incentives lead to incentives for earnings management. However, in order to reach on this result, they first documented that managers with high equity
incentives sell more shares in subsequent periods and that they are more likely to report earnings that meet or just beat analysts' forecasts. Moreover, a positive relation between equity incentives and manages' net future sales of their own firm's stocks was also found and finally, through additional analyses, they documented that managers with high equity incentives, especially those with consistently high equity incentives, are less likely to report large positive earnings surprises, consistent with earnings smoothing.
Bergstresser and Philippon (2006)
Bergstresser and Philippon (2006) examined also the relationship between CEOs equity incentives and earnings management, focusing almost in the same period 1993-2001 as Cheng and Warfield (2005) did. They found evidence that companies with more ''incentivized'' CEOs (those whose overall compensation is more sensitive to company share prices) have higher levels of earnings management, explaining that these CEOs appear to more aggressively use discretionary components of earnings to affect their firms' reported performance. In addition, they investigated the connection between CEO's option exercises and share sales and the high-accrual periods, claiming that these periods coincide with unusually significant option exercises by CEOs and unloading of shares by CEOs and other top executives. It is important to mention that in their attempt to detect the discretionary accruals, they used both a version of the Jones (1991) model and the Modified Jones model, finding the same results and they measured the CEOs incentives in the same way as other previous studies had done [(Core and Guay, 1999), (Erickson, Hanlon, and Maydew 2006), (Burns and Kedia 2006)] and as we are going to follow in this study. More specific, they assessed the relation between earnings manipulation and the power of CEO equity-based incentives, as measured by the dollar change in the value of a CEO's stock and options holdings that would come from a 1% point increase in the company stock price.
Burns and Kedia (2006)
Burns and Kedia (2006) examined the effect of CEO compensation contracts on misreporting. In fact, they were interested in the effect of stock options on the adoption of aggressive accounting practices and that's why they investigated whether and how management's incentives, through their compensation contracts, affect the likelihood of engaging in unusual accounting practices that result in a restatement of financial statements. They compared 1,500 firms from Standard and Poor's (S&P) database that announce a restatement of their financial statements over the period 1995 to 2002 with those firms that do not restate. Their results, more or less, were found consistent with the hypothesis they had set, which was saying that incentives from options encourage aggressive accounting practices that result in a restatement. This was concluded due to fact that (1) strong evidence that option sensitivity is positively associated with misreporting was found and (2) that the greater the convexity of CEO wealth to stock price, the greater is the propensity to misreport. On the other hand, as additional, but less important conclusions, they documented that other components of CEO compensation, namely, equity, restricted stock, long-term incentive payouts, and salary plus bonus, do not have a significant impact on the propensity to misreport, while at the same time, the possibility of restating firms is somewhat larger and that they have higher leverage than other non-restated firms in the S&P 1500.
Efendi, Srivastava, and Swanson (2007)
Efendi, Srivastava, and Swanson (2007) provided evidence on CEO opportunism during the 1990s market bubble, through restated financial statements at the end of this period and especially on restatements announced in 2000 and 2001, in an effort to support an overvalued stock price. More specific, their study it is a kind of extension of the previously-mentioned paper by Burns and Kedia (2006), since they focused their study on the association between accounting restatements and the intrinsic value of the CEO's in-the-money stock option holdings. Their results indicate that the likelihood of a misstated financial statement increases greatly when the CEO possess substantial amounts of in-the-money stock options. In cases of firms that are constrained by an interest-coverage debt covenant, that raise new debt or equity
capital, or that have a CEO who serves as board chair, the possibility for misstatements is also higher. Finally, as of a less importance but also quite remarkable investigation, they found that CEOs at restating firms benefit more from exercising options than CEOs at control firms.
An opposite view
In contrast to the aforementioned studies, there are also some scientific journals which do not seem to comply with them. Erickson, Hanlon and Maydew (2006) in general terms, found no significant positive relation between executive equity incentives and accounting irregularities. Added to this, Armstrong, Jagolinzer and Larcker (2010) not only did they not observe a positive relationship between CEO equity incentives and the incidence of accounting irregularities, but instead of that, their evidence suggested that the level of CEO equity incentives has a modest negative relation between executive equity incentives and accounting fraud. This result was more consistent with the notion that equity incentives reduce agency costs that arise with respect to financial reporting than was the interpretation that equity incentives cause managers to manipulate reported earnings (Armstrong, Jagolinzer and Larcker 2010).
3.5.2 CFOs Equity Incentives and Earnings Management
As it stated a lot previously in this study, the examination of CFOs' role in an organization and the effects that their equity-linked compensation may have on earnings management are quite limited in relation to the CEOs. "This is likely because CEO equity incentives are much bigger than those of CFO and therefore it is believed to be most influential" (Jiang et al. 2010). However, especially the last years, a switch in the importance of CFOs' role in the decision-making and the operation of the company has taken place. Just like CEOs, CFOs also receive equity-based payment, which can easily lead them to manage earnings. Taking under consideration also the
