The effects of global financial crisis on the relationship between CEO compensation and earnings management

• Date: 27 March 2020
• Published date: 27 March 2020
• Pages: 389-408
• DOI: https://doi.org/10.1108/IJAIM-08-2019-0101
• Author: Oheneba Assenso-Okofo,Muhammad Jahangir Ali,Kamran Ahmed
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

The effects of global financial

crisis on the relationship between

CEO compensation and

earnings management

Oheneba Assenso-Okofo

Department of Accounting, La Trobe University, Melbourne, Australia

Muhammad Jahangir Ali

Department of Accounting and Data Analytics,

La Trobe University, Melbourne, Australia, and

Kamran Ahmed

Department of Accounting, La Trobe University, Melbourne, Australia

Abstract

Purpose –This paper aimsto examine the effects of global financial crisis (GFC) on chief executiveofficers’

(CEO) compensation and earnings management relationship. Specifically, the authors examine whether the

recent financialcrisis had moderated the relationshipbetween CEO bonus and discretionary accruals.

Design/methodology/approach –The authors use panel datafor 1,800 firm-year observations (over a

period of six years from 2005 to 2010)and use univariate and multivariate tests to test their hypothesis.The

authors divide the period into pre-crisis, during-crisis and post-crisis periods to examine how the different

financialcrisis periods affect the relationship betweenCEO compensation and earnings management. Various

alternativetests including endogeneity test suggestthat the results are robust.

Findings –The authors’multivariateresults indicate that the relationshipbetween CEO’compensation and

earningsmanagement changes because of the GFC.

Practical implications –The findings, therefore, justify more monitoring and scrutiny to limit the

existence of opportunistic managerial behaviour and for the appropriate designing of CEO compensation

packagesduring abnormal economic circumstances.

Originality/value –So far as the authors’knowledge goes, this is the first study which examines the

relationshipbetween CEO compensation and earningsmanagement during GFC.

Keywords Global financial crisis, CEO compensation, Earnings management

Paper type Research paper

Erratum: It has come to the attention of the publisher that the article, Assenso-Okofo, O., Ali, J. and Ahmed, K.

(2020), “The effects of global financial crisis on the relationship between CEO compensation and

earnings management”,International Journal of Accounting & Information Management, Vol. 28

No. 2, contained an error in the author name and affiliation for Muhammad Jahangir Ali. These errors

were introduced in the production process and have now been corrected online.

The authors would like to acknowledge the comments and suggestions received from the

participants at the Asian-Pacific Conference on International Accounting Issues, November 6-9, 2016,

Maui, Hawaii, and at the seminar of Department of Accounting, La Trobe University, Melbourne,

Australia, on the earlier versions of the paper.

The effects of

global

financial crisis

389

Received22 August 2019

Revised15 December 2019

Accepted31 December 2019

InternationalJournal of

Accounting& Information

Management

Vol.28 No. 2, 2020

pp. 389-408

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-08-2019-0101

The current issue and full text archive of this journal is available on Emerald Insight at:

https://www.emerald.com/insight/1834-7649.htm

1. Introduction

In this study, we examine whether the relationship between chief executive officers’(CEOs)

compensation and earnings management varies across the economic cycle. In particular, we

investigate the link between CEO bonus compensation (BCOM) and earnings management and

whether the recent global financial crisis (GFC) has any impact on this relationship. The debate

on CEO compensation has received considerable attention from the media, regulators,

policymakers, academicians, researchers and the public, especially given the damaging effects of

the recent GFC (Chen et al.,2010;Core and Guay, 2010). Therefore, many countries enacted

legislations regarding excessive payment to CEOs so that shareholders voice their disagreement

on CEO remuneration plans at the AGMS (Atif et al., 2019). It is claimed that the GFC was caused

partly by executive compensation because the rewards for short-term earnings targets (e.g.

bonus) encourage excessive risk-taking by managers (Crotty, 2009). It is alleged that excessive

risk-taking behaviour –without due consideration for long-term susta inability of the organisation

–brought about the systematic financial crisis (Bebchuk and Fried, 2010;Fels, 2010).

Recent literature suggests strong links between the GFC and earnings management (Krauter

and Sousa, 2009;Habib et al., 2013). Prior studies link economic conditions with how earnings are

managed and that firms may be encouraged to engage in earnings management when a financial

crisis erupts (Dichev and Skinner, 2002;Charitou et al.,2007). This is because during the crisis

periods, firms are unable to achieve their targets and, therefore, have incentives to manipula te

earnings upward to meet predetermined targets, not only to win investors’confidence but also to

increase their chances of receiving a bonus. This, therefore, may suggest evidence of potential

effect of earnings management on CEO’s compensationduring the times of financial crisis.

Prior research also explores the association between CEO compensation and earnings

management (Gao and Shrieves, 2002;Bergstresser and Philippon, 2006). CEO compensation

policies are generally tied to an upfront earnings target rather than their actual performance. It is

claimed that because of compensation-maximising considerations, executives have several

choices to shift and boost their current earnings (Healy, 1985;Holthausen et al.,1995).

Consequently, BCOM is strongly linked with accounting measures, which can be manipulated

(earnings management) (Matolcsy, 2000). It is posited that the cash bonus component of the CEO

remuneration is likely to reduce agency problems so that managers can maximise shareholders

wealth. Nevertheless, performance-based cash bonus may motivate CEOs to manipulate

earnings. Furthermore, the difficulty in meeting targets during a financial crisis period is likely to

increase earnings management behaviour to present satisfactory performance (Masruki and

Azizan, 2012), thereby increasing compensation. Despite numerous studies on the relationship

between CEO compensation and earnings management, the extant literature has failed to

examine the sensitivity of this relationship to financial crisis. Our study aims to fill this gap.

The argument that CEO compensation increased during the financial crisis without a

corresponding increase in performance suggests a misalignment (Chen et al.,2010;

Wang et al.,2011). Moreover, the unexpected shock caused by the GFC creates an ideal

setting in which to examine the impact of the GFC on the relationship between executive

compensation and earnings management.Our study, therefore, focuses on the variations in

the relationship between CEO compensationand earnings management because of financial

crisis, rather thanexamining whether such a relationship exists.

Our study assumes certain caveats to put it in perspective. Firstly, the GFC was a

significant and major event which had the potentialto cause economic shocks to the system.

Our study focuses on compensationof Australian firms’CEOs rather than the compensation

of all executives. This is because the CEO is considered to be the main strategic decision

maker and therefore practitioners and academics pay much attention to the CEO’s

compensation. Moreover, the CEO’s position at the apex of the firm makes him or her the

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