The impact of CFO equity based compensation on Real Earnings Management

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Amsterdam Business School

RSAC and MSc thesis template

The impact of CFO equity based compensation on Real Earnings

Management

Name: Ikram el Hachhouchi Student number: 10852042 Date: 25 July 2016

MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam

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Statement of Originality

This document is written by student Ikram el Hachhouchi who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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1. Introduction

The objective and general purpose of financial reporting is to provide financial information about the reporting entity that is useful to existing and potential investors, lenders and other creditors in making decisions about providing resources to the entity (IFRS, 2010b, §OB2). The information in the financial statements can also be seen as a reflection of the inside knowledge of the management. Decisions made by the management about the reporting method, accruals and disclosures that would fit the business economics can be based on management’s inside knowledge (Healy and Wahlen, 1999). This discretion provides the possibility for management to use earnings management by a selection of the accruals, reporting methods and disclosures that do not provide an accurate and timely reflection of the underlying economics of the business (Healy and Wahlen, 1999). Since different accounting scandals occurred, from Enron and Freddie Mac to Bernard Madoffs massive Ponzi scheme, the quality of financial reporting has been subject to much scrutiny. Companies provided invalid information to their stakeholders which consists of lender’s, investors and other creditors to mislead them. The scrutiny of regulators increased by implementing the Sarbanes-Oxley Act (SOX) in 2002 to enhance internal control and the transparency of the financial information with the objective to provide better quality of information.

“The use of flexible accounting principles that allows managers to influence reported earnings, thereby causing reported income to be larger or smaller than it would otherwise be” is defined as earnings management (henceforth known as “EM”) by Davidson, Jiraporn, Kim and Nemec (2004). The study of , Surroca and Tribó (2007) described EM as the situation in which managers can use some level of discretion in computing earnings, without violating generally accepted accounting principles (GAAP), to make the reported incomes greater or lesser than they are. EM consists of either accrual-based earnings management (AEM) or real earnings management (REM). Despite the slightly varying definitions of EM, they all indicate that the managers are the ones who create the incorrect financial information.

According to the study of Cohen et al.(2008) there has been a significant decline in the use of AEM since the passage of SOX. When applying AEM the accruals process is changed by the accounting method whilst the accounting standards are still complying. A manager can change the method of depreciation or the underlying accounting variables like the total estimated economic life of assets. The increase of the regulators’ scrutiny had a negative impact as well as firms continued to manage earnings via real manipulation activities, such as postponements of investments and cutting in research and development expenditures (Roychowdhury, 2006).

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This phenomenon which is defined as REM focuses on the deviation from normal and operational business activities or manipulating real activities. REM is not of influence on the auditors’ opinion or regulators’ action if properly disclosed in the financial statements (Kim, B., L.L. Lisic, and M. Pevzner (2010). This form of EM deals with lower probability of drawing auditor or regulatory scrutiny over AEM and is therefore of consideration for managers in their choice for using REM. According to Zang (2012). REM and AEM act as substitutes of each other. The managers base their choice between these two options on the costliness. If adoption cost of REM are higher than the cost of AEM, it’s more likely that manager choose for AEM and vice versa. REM is also influenced by the quality of the audit (Chi, W. Lisic, L., &Pevzner, M., 2011) since firms are more intended to adopt REM if management is constrained by auditors to manage accruals.

1.1 Motivation and contribution

Previous research has mostly focused on AEM instead of REM, whilst REM has been more considered since the implementation of SOX in 2002. The existing studies already stated that incentives of executives have a significant influence on the adoption of EM and are more focused on CEO functions. (Davidson, Xie, Xu and Ning, 2007. Malmendier and Tate (2005) conclude in their study that this results are not the same for a CFO. This study extends prior research by examining whether equity based compensation incentivizes CFOs to use REM. Like aforementioned REM deals with real activities manipulation, such as cutting in research and development expenditures and postponing investment projects. Managers often decide to adopt REM over AEM since REM has a lower chance of drawing regulatory or auditor scrutiny. When properly disclosed in the financial statements, REM cannot influence the auditors’ opinion or regulators’ action (Kim et al. 2010). Prior studies conclude that there is an increase in real earnings management after the implementation of SOX (Graham et al 2005, Cohen & Zarowin 2010). The study of (Cohen et al. 2008) shows a significant decline in the use of accrual-based earnings management, while real earnings management increased significantly following the passage of

SOX.

This study will investigate the relation between CFO and REM in the US since there is a strong regulatory oversight. Jiang et al. (2010) find that there is an increasing concern about equity-based compensation of CFOs which could motivate executives to use more EM. The study of Warfield and Cheng (2005) suggest that stock-based compensation and ownership can lead to incentives for earnings management. If earnings management can increase short-term stock, managers can benefit from doing so by increasing the value of the shares they are going to sell.

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of the increase in the equity component of executive pay. This study will differ by exploring the role of the CFO, the impact of CFO characteristics on Real Earnings Management within U.S. listed firms will be explored. Formally, I hypothesize that equity-based compensation is positive associated with the use of Real Earnings Management by the Chief Financial Officer. The results in this study can be of interest for shareholders, investors and regulators. It can inform shareholders about the (negative) impact of equity based compensation at the costs of the firm. Further, this research gives insight whether real earnings management is used by CFOs to increase their personal wealth.

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2. Literature review

2.1 Agency theory

The agency theory gives a description of the principal-agent relationship that exists between owners of a firm and the management team that runs the firm (Jensen & Meckling, 1972). It focuses on issues that can occur when cooperating parties have different goals (Jensen & Meckling, 1976). The focus is on the principal-agent problem that arises in such relationships. The agent acts on behalf of the principal by managing the business on a day-to-day basis. The agent has access to information that is superior to the information accessible to the principal which gives rise to information asymmetry (Jensen & Mecklin, 1972). The principal receives periodic updates while the agent is managing a business on a day-to-day basis which gives the agent a superior insight into the business. The principal-agent problem arises when the principal’s interests differ from those of the agent and the agent is incentivized to engage in behavior that is more beneficial for himself rather than the principal. The principal establishes appropriate incentives in order to reduce opportunistic actions and divergence by the agent. To align the interests of the agent with the principals interest, firms often use compensation schemes. (Schapiro, 2005). However, this compensation schemes can have an adverse effect on the managers behavior since it might lead to an incentive to manipulate earnings by the agent. In an attempt to limit the divergence, principals can implement the use of monitoring systems.

Jensen and Meckling (1976) mentioned in their study that audit is one type of monitoring activity and the other type is the board of directors as the important monitoring system that can increase the value of the firm. The monitoring system provides an ex post control system to the firm (Jensen et al. 1976). When principals have the ability to obtain information about the agents activities in a effective way, it will be more likely that the manager acts in the best interest of the stakeholders. Fewer resources will be needed to reduce the divergence through incentives (Eisenhardt 1989). The level of information asymmetry can be reduced by an audit since it provides reasonable assurance that the financial statements are free from material misstatements and omissions (Arens et al. 2011). Principals can obtain the needed information about management activity through an audit and keep oversight. The interests of stakeholders and potential stakeholders can be protected with an audit, however the monitoring system vary with the quality of the audit.

The development of the research question and the corresponding hypothesis stems from the theoretical aspects discussed above.

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The theory on executive compensation originates from the agency theory which prescribes that if the agent wants to align his interests with those of the principal he needs to be incentivized to do so (Jensen & Meckling, 1976). Using equity based compensation shareholders try to align the management’s interests with their own interests (Jensen & Murphy, 1990). But due to inconsistencies in the alignment of the interests and the agent’s incentives to maximize their own wealth at the cost of the principle, the agent might engage in earnings management in a way to maximize his compensation (Scott, 2009).

2.2 What is Earnings Management?

The link between CFOs future trading and equity based compensation is of importance since such trading might motivate CFOs to care about short-term stock prices. This can change their behavior and results in REM incentives. Graham, Harvey and Rajgopal (2005) found evidence in their research that at least 78% of the executives would gladly engage in earnings smoothing for giving up economic value. Different meanings of EM are given in the literature. The most commonly used definition derives from the quality of the audit. A higher level of audit quality improves the detection of possible material misstatements.

Healy & Wahlen (1999, p. 368) reported that:“ Earnings management occurs when managers use

judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.” This definition means that applying EM leads to financial

reports that do not reflect the true underlying economic performance of a company which could mislead stakeholders in making their decisions about the allocation of capital. The main objective of a firm is to maximize shareholders value by exploiting assets that were acquired by equity capital and debt. Shareholders would be only incentivized to invest if they expect a positive future firm performance. It’s therefore in the firm’s interest to report positive earnings, positive earnings growth and to meet analysts’ forecasts in order to acquire capital (Degeorge et al. 1999). It is unlikely that firms are able to meet these expectations all the time, as a result firms might choose to manage earnings to meet the shareholders expectations. The adoption of EM can have a positive or negative tone. Misleading stakeholders is not only with a negative intention, it can have either a positive intention as in providing inside information to the outside stakeholders.

The definition of Healy & Wahlen (1999) has a more negative tone, for this reason the definition of Scott (2009, p. 403) could be more helpful to analyze a more broader explanation of adopting EM.

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Scott (2009, p. 403) defines EM on a different way and is more broad in his definition: “Earnings

management is the choice by a manager of accounting policies, or actions affecting earnings, so as to achieve some specific reported earnings objective.” Scott (2009) suggests that EM is used to maximize income or to

minimize income. In order to meet certain earnings forecasts a manager could manage earnings upwards, but also downward EM is possible. A company in financial trouble might manage earnings downward to make an even bigger loss thereby already incorporating future losses. Scott (2009) also mentioned two different ways to manage earnings, either by AEM or REM whereby AEM is accomplished by changing the accrual process. This is possible due to the fact that a certain amount of discretion is needed in preparing the financial statement in the form of estimations and selection of accounting techniques (Masahiro, Fumihiko and Tomoyasu, 2013). REM is triggered by management’s motivation to mislead stakeholders by diverging from normal operations. As stated in the introduction, these could consist, for example, of manipulation investments or operational activities like R&D and marketing expenditures (Roychowdhury, 2006).

2.3 Real Earnings Management post SOX

Corporate governance raised failures about the integrity of the provided accounting information to investors and led to a drop in investors’ confidence (Jain et al. 2003; Jain and Rezaee 2006; Rezaee 2004). These failures led to the passage of the Sarbanes-Oxley Act (SOX, July 30, 2002). SOX is signed by President Bush as the Public Company Accounting Reform and Investor Protection Act of 2002, into law on July 30, 2002. SOX introduces new provisions for management, directors, auditors and analysts, and significantly raises criminal penalties for securities fraud, for destroying, altering or fabricating records in federal investigations or any scheme or attempt to defraud shareholders. The increased legal risk may discourage managers from engaging in aggressive accruals management. REM is less likely to result in criminal penalties since REM is an intervention into a firm’s internal operational process instead of a firm’s external financial reporting process.

Accountants must include a report in the financial statement, filed with the SEC, in which they verify that there has been no impairment of auditor independence. Therefore, the main focus on auditor independence gives rise to auditor scrutiny of questionable accounting choices. Since auditors are in the position to limit managers’ use of accruals management, the increased auditor independence increases the risk that auditors will reject accounting choices in order to increase earnings (i.e., accruals management). However, auditors have limited or no authority to challenge the operational choices of the managers.

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Thus, the increased risk of auditors limiting accrual management techniques may incentivize managers to apply REM practices. Prior studies suggest that there is an increase in real earnings management after the implementation of SOX (Graham et al 2005, Cohen & Zarowin 2010). The study of (Cohen et al. 2008) shows a significant decline in the use of accrual-based earnings management, while real earnings management increased significantly following the passage of SOX. The results of this study are consistent with the results of a recent survey by Graham et al. (2005). The authors suggest that firms switched to manage earnings using real methods, possibly because these techniques are likely to be harder to detect while these techniques are more costly. They found strong evidence that managers take real economic actions to maintain accounting appearances. “In particular, 80% of survey participants report that they would decrease discretionary spending on R&D, advertising, and maintenance to meet an earnings target. More than half (55.3%) state that they would delay starting a new project to meet an earnings target, even if such a delay entailed a small sacrifice in value (Graham et al. 2005). Moreover, consistent with the conjectures made by Graham et al. (2005) in his study Cohen et al. (2008) find evidence that in the post Sarbanes–Oxley Act (SOX) period managers have shifted away from accrual based earnings management to real earnings management. This evidence shows that the need to avoid detection of accrual-based earnings management is greater than in previous periods, inducing managers to shift from the use of accrual-based to real earnings management activities.

Real earnings management activities differ significantly from accrual based earnings management as they have direct effects on cash flows. It is possible that the shortfall between the desired threshold and unmanaged earnings exceeds the accruals that can be manipulated at the end of the fiscal period. At that point in time it’s not possible for managers to use REM activities if accrual based strategies are completely applied. Researchers found evidence of significant variations in R&D expenditures and asset sales when firms attempt to meet or beat earnings benchmarks. Dechow and Sloan (1991) reported that executives reduce R&D expenditures to increase short-term earnings near the end of their tenure. Bamber et al. (1991) found evidence that firms reduce R&D expenditures in an attempt to meet earnings benchmarks such as previous year’s earnings or positive earnings.

Real earnings management has gained more attention due to its more extensive application than before the enactment of Sarbanes-Oxley Act (SOX). One reason for the greater willingness to increase real earnings management is that accrual based earnings management is more likely to draw auditors and regulators scrutiny, compared to the real earnings management decisions, regarding marketing, R&D, production or pricing (Cohen &Zarowin 2010).

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A second reason to use real earnings management may be that relying on accrual based earnings management alone is too risky since the amount by which accruals can be legally manipulated is limited, therefore there is demand to do it in combination with real earnings management (Badertscher 2011). Although real earnings management may be more costly than accrual based earnings management, several papers suggest that managers’ preference for engaging in real earnings management increased.

A frequently applied definition of REM in literature comes from Roychowdhury (2006, p. 337): ‘… 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.’

Several methods derived from previous studies on how to manage earnings through deviations from normal operational practices. The methods combine deviations from operating and investment activities, as well as financing activities (Roychowdhury, 2006; Hribar, Jenkins & Johnson, 2006). The method of Roychowdhury (2006) actually encompasses three methods by which REM can be achieved. The size of abnormal production costs, abnormal cash flow from operations and abnormal discretionary expenses are the methods by which REM is acquired. By altering the level of discretionary expenditures, such as research and development expenditures (R&D) and selling, general and administrative expenditures (SG&A) firms could deviate from investing and operating activities. IFRS requires that research and advertising costs are expensed in the period in which they are incurred, the reduction of these costs affects reported income immediately. Costs of developments are expensed rather than capitalized due to reasons of uncertainty regarding the development of the product or service (IASB 1998, IAS No. 38, para. 57). Postponement of development projects increases earnings in the short term. Furthermore, operating and investing activities can be deviated from if firms are overproducing, providing price reductions to boost the sales volume and build up inventory to lower the cost of goods sold which has an influence on earnings (Rowchowdhury 2006). In case of overproduction, the fixed overhead costs will be spread over a larger number of products which leads to a decrease of the costs of goods sold per product. In order to manage earnings firms can sell fixed assets with a gain. Earnings could also be manipulated if firms choose to deviate from financial activities.

2.3.1 Abnormal production costs

Whilst applying this form of REM more goods are produced than normally, this is the first way to manage real earnings. Overproduction leads to lower cost of goods and provides higher operating margins. Overhead costs could be spread out over more units of products which automatically lowers the cost per unit.

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Management of the real earnings in this direction leads to higher operating margins because of lower costs of goods sold. The additional inventory costs of the overproduced units are not recovered in the future. This can lead to higher abnormal production costs since the operation cash flow will be lower (Roychowdhury, 2006).

2.3.2 Abnormal cash flow from operations

When applying this method the sales manipulation will occur with offering price discounts to increase sales or by lenient credit terms to customers. When the product price returns to normal there could be negative consequences as lower returns and lower firm value.

2.3.3 Abnormal discretionary expenses

Roychowdhury (2006) states that a change in the level of discretionary expenses could deviate a manager from investing and operating activities. Management could adjust the level of research and development expenditures (R&D) by postponing development projects. This action leads to an increase of revenues in the short term and postponement of future profits as a result of development projects. A second way is adjusting the level of selling, general and administrative expenditures (SG&A). This is possible by decreasing or increasing advertising costs (Dechow and Skinner, 2000). SG&A costs have to be expensed in the same period that costs have been incurred and affect immediately the revenue. These abnormal discretionary expenses are the sum of SG&A expenses and R&D expenses (Roychowdhury, 2006).

2.4 CFOs role in a firm

Most studies focus on the role of the CEO in earnings management. The person in charge of the organization, with the largest compensation package (including equity compensation) and the most influence on the policies of the firm (Jiang et al., 2010). The CEO is more penalized than the CFO when missing analysts forecast since there is a larger pay for the CEO for performance sensitivity in the CEO compensation plan (Mergenthaler et al., 2011). The agent engaging in earnings management is normally addressed as the firm’s CEO, who is the leading executive in the organization and is ultimately responsible for the firm’s operations. Recent studies show that not only the CEO has incentives to manage earnings, but also the CFO.

The Securities and Exchange Commission (SEC) expressed concerns over the CFOs compensation, echoing this concerns disclosure rules on executive compensation amended. Firms are required to disclose the payments of CFOs.

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The SEC argues that ‘‘compensation of the principal financial officer is important to shareholders because 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).

The responsibility of the CFO is the financial reporting and financial management in the organization, therefore the CFO has more influence on these processes, and might be more in the position to manage earnings (Mian, 2001). The study of Katz (2006) suggest that the CFO, who is in charge of “minding the cookie jar”, should not be compensated based on equity but based on a fixed pay (Katz, 2006). As evidence of CFOs’ important role in financial reporting, Geiger and North (2006) found evidence that discretionary accruals decrease significantly surrounding the appointment of a new CFO. They also demonstrate that this decrease is not driven by concurrent CEO appointments. Graham, Harvey, and Rajgopal (2005) show that CFOs are concerned with beating analysts’ earnings benchmarks and are likely to report smooth earnings. The findings in the study of Mergenthaler, Rajgopal, and Srinivasan (2008) is consistent with prior studies, they concluded that CFO turnover increases significant following the failure to meet earnings benchmarks. Recent corporate fraud cases also indicate that CFOs can affect accounting quality. 1

Individual manager’s style and background can be a good indicator of manager’s behavior. When looking at the manager’s background, managers with an accounting or finance background tend to be more conservative, opposed to for example managers with a M.B.A. (Master of Business Administrations) background (Bamber et al., 2010). According to the ‘upper echelons theory’ all managers have their own specific qualities, which makes them react differently in different situations, compared to each other (Hambrick & Mason, 1984).

2.5 CFO incentives and compensation

The purpose of financial reporting is to provide financial information about the reporting entity that is useful to investors, lenders and other creditors in making decisions about providing resources to the entity (IFRS, 2010b, §OB2). Separation of control and ownership leads to the agency problem. Scott (2009) stated in his study that the main interest of the management are their careers and income while resource providers would like to maximize their return (Scott, 2009).

1_{Evidence is found that CFOs are involved in the most aggressive forms of earnings management. A group of 53}

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The decisions that the agent (executive) makes do not affect the agent financially or in a direct way. The second problem is that its seems to be impossible to control fully the actions that the agent takes or to observe all these actions. This is the problem of information asymmetry which is better known as the moral hazard between the agent and principal.

The theory on CFO executive compensation originates from the agency theory that prescribes the interests of agent to align with those of the principal, the agent needs to be incentivized to do so (Jensen & Meckling, 1976). Shareholders attempt to align the management’s interests with their own interest with the use of equity based compensation (Jensen & Murphy, 1990). But there are inconsistencies in the alignment of the agent’s incentives and interest to maximize their personal wealth at the cost of the principle, the agent might use earnings management in order to maximize his compensation (Scott, 2009). This gives rise to the question what the main drive is from the executive to apply REM to influence earnings?

Different studies documented that the trend in earnings management over time indicates that the tendency to manage earnings increased significant over time (Brown, 2001; Bartov et. al., 2002; Lopez and Rees, 2001). According to the study of Fields et al. (2001) managers with higher stock- and option-based compensation are more sensitive to short-term stock prices, and can use their discretion to affect reported earnings if capital markets have difficulty detecting earnings management. Prior studies (e.g., Cheng and Warfield 2005; Philippon 2006) found consistent evidence that equity incentives derived from stock-options compensation are positively associated with managements likelihood to engage in earnings management activities. The CEOs appear to use earnings management aggressive to affect the reported firm performance. In addition, unusually large amounts of options are exercised by CEOs, and large quantities of their firms’ shares during the years in which accruals make up a significant large part of the reported earnings. These findings are documented in the study on the accruals anomaly by Collins and Hribar (2000) and Sloan (1996).

Managerial ownership is an important mechanism to align the incentives of managers with those of the shareholders (Jensen and Meckling 1976; Morck et al. 1988). The managerial ownership can be increased by stock-based compensation. If options are granted to a manager, these options are not immediately exercisable until three or four years after grant date. When options become exercisable, three or four years later after they are granted, managers have the possibility to hold exercisable options or to exercise the options and hold shares. Managers more often choose to sell the shares received from exercising options to finance option exercises.

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Another award for managers is restricted stock that do not vest and cannot be traded until after a period of three or four years. Shares could also be obtained through open market purchases, which is common in early career stages (Core and Larcker 2002).

2.6 Hypothesis development

There are different payment structures which are used by firms. It might be difficult to select the optimal payment structure in order to incentivize the agent (Scott, 2009). A lot of studies indicate that an significant effect exists between EM and management incentives. Bergstresser and Philippon (2005) conclude in their study that manipulating reported earnings is more pronounced at companies where CEO compensation is closely related to stock value. Cheng and Warfield (2005) find that CEOs are motivated by higher equity incentives in order to meet analyst forecasts. The study of Jiang et al. (2010) indicate that equity incentives of a CFO is an independent factor to the adoption of EM. In their findings they also state that equity incentives of the CFO are playing a bigger role than incentives of the CEO in relation to EM activities. Prior studies have therefore focused more on the relation between equity incentives and EM because of the increase of the equity component in executive pay. Jiang et al. (2010) find that there is an increasing concern about equity-based compensation of CFOs that might motivate executives to use more EM. The discussed methods of REM will lead to an increase in earnings and make the stock options more worth. The study of Warfield and Cheng (2005) suggest that stock-based compensation and ownership can lead to incentives for earnings management. If earnings management can increase short-term stock, managers can benefit from doing so by increasing the value of the shares they are going to sell.

In sum, prior studies suggest that managers awarded with equity based compensation are motivated to care about short-term stock prices and to manage earnings. Evidence implies that in the post-SOX period following accounting scandals, the need to avoid detection of accrual-based earnings management is greater than in previous periods, inducing managers to shift from accrual-based to real earnings management activities. Accrual-accrual-based earnings management includes the costs of auditor and regulators scrutiny and the potential litigation penalties (Graham et al., 2005; Zang, 2006). This implies that equity based compensation may have altered managers’ preference to use REM to increase the firms’ stock price. The development of the hypothesis stems from the theoretical aspects discussed in section 2. Formally, I hypothesize that: Equity-based compensation is

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3. Empirical methodology

This thesis will include an archival study to test the hypotheses to give an answer on the aforementioned research question. This paragraph will give a description of the research design and variable measurement.

3.1 Data and sample description

The initial sample includes all US listed firms for the fiscal years 2005 to 2015 using data from the Compustat Fundamentals database and Compustat Executive Compensation database. Annual data is used to conduct the tests and estimate the equity-based compensation and REM model. The sample is restricted to post-2005 data, because in 2005 the CFO identifier in the Executive Compensation database started to be collected. CFOs have been identified by using the data item ‘CFOANN’. The variables needed to control for the relation between REM and CFO equity based compensation and are combined by Stata. The initial sample consist of 14.000 firm observations, merging the sample dropped the observations to 13.000 firm years. Firms from the financial industry (SIC codes 6000-6700) and utility industry (SIC codes 4000-4900) have been excluded from the sample because different regulations apply to these segments and might affect the REM residuals (Roychowdhury, 2006). The models for real earnings management are estimated by every year and industry and require at least 15 observations for each industry year. The final sample consist of 7015 observations after cleaning the data, excluding these industries and dropping missing values.

3.2 Measurement for Real Earnings Management

To capture real earnings management and for the development of the proxies I follow Roychowdhury (2006). I consider three metrics to study the level of real activities manipulations: the abnormal levels of cash flow from operations, discretionary expenses, and production costs. I estimate each model for every firm year and every industry. Subsequent studies, Zang (2006) and Gunny (2005), provide evidence of the construct validity of these proxies. I focus on the following three manipulation methods and their impact on the three variables listed above. All data are gathered from the annual Compustat database.

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1. Cash flow from operations; price discounts and lenient credit terms.

Price discounts and lenient credit terms will temporarily increase sales volumes and will disappear once the firm reverts to old prices. Both price discounts and more lenient credit terms will result in lower cash flows in the current period, but current earnings will boost by the additional sales. Normal cash flow from operations is estimated by the following equations (Roychowdhury, 2006).

(1) _{Assets t}CashFO t −1 = β0 + β1 ( 1 Assets t1) + β2 ( Sales t Assets t1) + β3 ∆Sales t Assets t−1+ εt

Where: CashFO = cash flow from operations Sales t = sales during period t

∆Sales= change in sales compared to the previous year Assets: total assets

2. Reporting of lower cost of goods sold.

Managers can increase production in order to increase earnings. If more units are produced, the fixed overhead costs can be spread over a larger number of units which lowers fixed costs per unit. Because the decrease in costs of goods sold the firm is able to report higher operating margins. Production costs is estimated by the following regression model (Roychowdhury, 2006).

(2) _{Assets t−1}COGS = β0 + β1 (_{Assets t−1}1 ) + 𝛽2 (_{Assets t−1}Sales t ) + εt

(3) _{Assets t}∆ INVT t −1= β0 ( 1 Assets t−1) β1 ( ( ∆ Sales t Assets t−1) + β2 ( ∆ Sales t−1 Assets t−1) + εt

(4) _{Assets t−1}PROD t = β0 + β1 (_{Assets t−1}1 ) + β2 (_{Assets t−1}Sales t ) + β3 (_{Assets t−1}∆ Sales t ) +β4 (∆ Sales t−1_{Assets t−1})+ εt

Where: COGS = Cost of goods sold expense ΔINVt = inventory increase/decrease at time t PROD = COGS + ΔINV

Sales t = sales during period t

∆Sales= change in sales compared to the previous year Assets = total assets

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3. Decreases in discretionary expenses.

Reducing R&D and SG&A expenses will lower the firms costs and boost current period earnings. The decrease in these costs increases current period cash flows (at the risk of lower future cash flows) if the firm generally paid for such expenses in cash. The developed model of Dechow et al. (1998) will be used to generate the normal levels of discretionary expenses. This model is also implemented in the research of Roychowdhury (2006).

(5) _{𝐴𝑠𝑠𝑒𝑡𝑠 t−1}𝐷𝐼𝑆𝑋 t = 𝛽0 + 𝛽1 (_{𝐴𝑠𝑠𝑒𝑡𝑠 t−1}1 ) + 𝛽2 (_{𝐴𝑠𝑠𝑒𝑡𝑠 t−1}𝑆𝑎𝑙𝑒𝑠 t−1) + 𝜀𝑡 Where: DISX= sum of R&D expenses, SG&A expenses.

Assets: total assets Sales: sales during period t

In addition to the three separate real earnings management proxies, which include CFO_r, PROD_r, and DISX_r, one aggregate real earnings management measure is developed following the study of Cohen et al. (2008). If firms use the methods together, cash flow from operations will be lower due to more lenient credit terms and price discounts, postponements of investments and cutting in research and development expenditures lowers the discretionary expenses, and at the same time overproduction increases the abnormal production costs. Therefore, negative coefficients of cash flow from operations and abnormal discretionary expenses, positive coefficient of abnormal production costs, indicate upward REM. In this study the REM proxy represents the sum of the abnormal cash flow from operations, abnormal production costs and abnormal discretionary expenses. Therefore, cash flow from operations and discretionary expenses are multiplied by (-1) to present higher real earnings management when the REM measure increases. This research will also report the results of the individual real earnings management drivers to provide richer information (Chi et al. 2011).

In this research CFOs equity-based compensation is measured by the stock price times the amount of stock holdings and the stock price times the amount of options holdings. The information is directly retrieved from the Compustat Executive Compensation database (Stockprice * Stock holdings) + (Stockprice * Options holdings).

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3.3 Control variables

According to the study of Gunny (2010) large firms have a negative correlation with EM. Watts and Zimmerman (1990) indicated consistent results that larger firms bear greater political costs. It is therefore expected in this study that the size of a firm is negative related to REM. To estimate firm size the natural log of total assets is used following the method of Jiang et al. (2010).

Firms that are close to violating a debt covenant are more likely to engage in EM (DeFond and Jiambalvo, 1994). Managers could resort to REM in order to avoid violation. To measure financial distress of a company a control variable DIST is created by dividing the company’s total liabilities by its total assets. Companies with a high leverage variable could indicate a decrease in opportunities for company growth, this could be offset by decreasing the R&D spending (Osma, 2008). Therefore, in this study it is expected that the leverage variable is positive related to REM. Francis & Yu, 2009 stated that the more growth opportunities a company has, the more willing it is to engage in EM. Firms with more growth opportunities than other firms face a larger reaction of the stock market on missed earnings forecasts. (Skinner and Sloan, 2002). Therefore it is expected that sales growth is positively related to REM. Following the study of Roychowdhury (2006) market- to book ratio is the proxy for sales growth of the fiscal year. I created the control

variable MTB.

Cohen et al. (2008) stated that big-4 firm audits are of higher quality and that they make less AEM possible. The results in the study of Badertsche et al. (2010) are consistent with prior research, firms audited by the big-4 auditors engage less in earnings management since they have a higher financial reporting quality. Therefore, a negative relationship is expected. Firms audited by a big-4 auditor are coded as ‘1’, whereas the code ‘0’ is provided to firms which have been

audited by a non big-4 auditor.

Estes and Hosseini (2001) reported that women generally have a lower level of confidence in making business decisions. When the level of self-assurance is low due to a lower level of confidence, certain risks and opportunities are avoided by an executive. Therefore it’s expected that a female applies less real earnings management than a male. I expect a negative relationship. A dummy variable is constructed to identify a female ‘1’ or a male ‘0’.

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3.4 Empirical model

In this study I expect a positive relation between real earnings management and equity based compensation. The initial regression in table 1 tests for this relation. As control variables I included the return on asset, firm size, sales growth, firms in financial distress, the presence of a big-4 auditor, and whether the CFO is a female. I used the classifications based on the first two digits of the SIC code. The following regression model is used in this study to test the hypotheses:

REM = β0 +β1 EQ_BC +β2 ROA +β3 Size +β4 DIST + β5 Gender +β6 MTB +β7 BIG 4 + εt

Where: EQ_BC: ( Stockprice * Stock holdings) + ( Stockprice * Options holdings ) ROA: Return on Assets;

Size: natural log of total Assets;

DIST: leverage variable measured as total liabilities divided by total assets; Gender: female CFO (1) or male CFO (0);

MTB: market to book ratio;

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4. Empirical results

4.1 Descriptive statistics

Table 1 presents the descriptive statistics of the main variables used in the research design. The table consists of the mean, median, the standard deviation and the quartiles of the variables. The means for the REM proxy and for the variable CFO are negative -.0010414 and (-.0029022) respectively. The standard deviation is the largest for the REM proxy which is normal since the REM proxy is the aggregate of cash flow from operations, production costs and discretionary expenses. My study differs from prior research, due to the post-SOX sample, that makes it difficult to compare the statistics with similar prior research.

Table 1 Descriptive statistics

Obs Mean St.dv p25 Median p75 Min Max

Variables: CFO_r 7015 -0.0029022 0.0599883 -0.0361626 0.0005326 0.0334832 -0.2673483 0.2549682 PROD_r 7015 0.0000103 0.1202813 -0.0633275 0.0056758 0.069422 -0.7392269 0.531224 DISX_r 7015 0.0018505 0.123663 -0.055065 0.007486 0.0751041 -0.5197013 0.4081069 REM 7015 -0.0010414 -0.2557178 -0.1313895 0.0164007 0.1557138 -1.246445 0.9022872 ROA 7015 0.0565141 0.0813937 0.0257452 0.0568705 0.0947104 -0.8496588 0.570999 AT 7015 9155.396 21678.26 739.266 2188.639 7305 13.393 292829 DIST 7015 0.4806282 0.1939923 0.3339088 0.4954942 0.6346988 0.0325593 0.8742561 Gender 7015 0.0932288 0.2907735 0 0 0 0 1 MTB 7015 2.61624 1.941545 1.410442 2.096452 3.219919 4.970006 24.99929 EQ_BC 7015 11182.04 36916.6 1822.987 4617.23 11778.78 0 1611845

Table two presents correlations between various variables. The Pearson correlation matrix is applied to indicate both the sign and the significance of the relation between the main variables in this study. The reported coefficients are significant at the 1% level. Cash flow from operations, production costs and discretionary expenses are all positive related to each other. This indicates that they are used together when acting for real earnings management. Equity based compensation is significant negative -0.1863 related to the REM proxy.

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Table 2 Pearson correlation matrix

CFO_r PROD_r DISX_r REM ROA Size DIST Gender MTB EQ_BC

CFO_r 1.0000 PROD_r 0.5019* 1.0000 DISX_r 0.1557* 0.7556* 1.0000 REM 0.5460* 0.9535* 0.8755* 1.000 ROA -0.4205* -0.2921* -0.0705* -0.2701* 1.000 Size 0.0512** 0.0114 0.0683* 0.0264* 0.0418* 1.000 DIST 0.1738* 0.1130* 0.0950* 0.1399* -0.1658* 0.5363* 1.000 Gender -0.0084 0.0221 0.0315* 0.0237* 0.0305* -0.0224 -0.0229 1.000 MTB -0.3353* -0.3435* -0.2307* -03518* 0.4152* 0.0590* 0.0971* 0.0032 1.000 EQBC -0.1863* -0.1459* 0.0702* -0.1463* 0.2372* 0.4707* 0.1180* -0.0343* 0.3421* 1.000 *** p<0.01, ** p<0.05, * p<0.1 4.2 Results

In this paragraph the regression tests for the relation between real earnings management and equity based compensation, whereby a positive relationship is expected. The relation to the three separate real earnings management drivers are also tested.

The R2 for the initial REM regression reports a value of 0.174, the explanatory power of this regression is therefore adequate with 17,4%. The regressions for the individual REM drivers CFO_r, PROD_r, DISX_r report an R2 of 24,3%, 16,6%, 8,1% respectively. The explanatory power for the DISX_r regression is less adequate. I hypothesized that CFO equity-based compensation has a positive influence on the use of REM. The result in table 3 reports a negative coefficient (-0.00176) of the relation between real earnings management and equity based compensation. This finding is contrary to prior literature and not in the predicted sign. Based on the results, it is concluded that the hypothesis is not supported since the coefficient is negative and not significant.

To control for systematic variation in the regression I included five control variables: return on assets, firm size, firms in financial distress, gender, market-to-book ratio and if a firm is audited by a big-4 company. The results report a significant positive relation of the variable DIST

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This finding is consistent with the prediction in this research. The significant, positive relation indicate that firms with a decrease in opportunities for company growth tend to increase REM. Second, sales growth is described as the market-to-book ratio in this study and has a small negative relation (-0.0428) to REM. This is not in line with the expectations and indicates that companies with large sales growth use less REM. This unexpected result can be driven for other certain reasons. The results show a positive significant relation (0.0648) for firms controlled by a big-4 company, this is not in line with the prediction that big-4 firm audits are of higher quality and that they make less EM possible. But this finding supports prior literature that REM deals with lower probability of drawing auditor or regulatory scrutiny over AEM and is therefore of consideration for managers in their choice for using REM (Zang 2012). The result on gender (0.0274) is not in line with the prediction that female executives apply less EM. However, there is inconsistency in the findings in prior research. The results of Peni and Vähämaa (2010) report that gender of the CEO has no influence on earnings management.

The same regression is conducted for each separate driver of real earnings management. Negative coefficients of cash flow from operations and abnormal discretionary expenses indicate upward REM as a positive coefficient of abnormal production costs indicate upward REM. CFO_r is positive related (0.000154) to equity based compensation and therefore not in the predicted sign, the result indicates downward REM. PROD_r and DISX_r are both negative related to equity based compensation (-0.000707, -0.00121 resp.) whereas PROD_r indicates downward REM and DISX_r indicates upward REM. The results for the relation of each separate REM driver to equity based compensation are not significant. CFO_r is significant negative related to the control variable size (-0.00553). This result supports prior literature that larger firms apply less REM because they face more political costs.

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Table 3 Regression

(1) (2) (3) (4)

VARIABLES REM CFO_r PROD_r DISX_r

EQ_BC -0.00176 0.000154 -0.000707 -0.00121 (-0.713) (0.284) (-0.597) (-0.995) ROA -0.331 -0.207 -0.216 0.0914 (-7.065) (-13.70) (-9.274) (3.476) Size -0.00263 -0.00553*** -0.00110 0.00400*** (-1.038) (-9.856) (-0.921) (3.206) DIST 0.242*** 0.0717*** 0.0882*** 0.0818*** (13.10) (16.42) (10.35) (8.428) Gender 0.0274*** 0.000402 0.0125*** 0.0145*** (2.979) (0.185) (2.835) (3.120) MTB -0.0428*** -0.00725*** -0.0184*** -0.0171*** (-19.63) (-14.17) (-16.64) (-16.42) BIG 4 0.0648*** 0.00209 0.0234*** 0.0393*** (5.216) (0.745) (3.941) (5.973) Constant 0.0404** 0.0349*** 0.0292*** -0.0237** (2.049) (8.070) (3.158) (-2.368) Observations 6,931 6,931 6,931 6,931 R-squared 0.174 0.243 0.166 0.081

Robust t-statistics in parentheses *** p<0.01, ** p<0.05, * p<0.1

4.3 Robustness test

In this section a robustness test is conducted with controlling for year fixed effects, year industry fixed effects and firm year- fixed effects. The results are reported in table 5. The R2 increased compared to the normal regression from 17,4% to 24,3% when controlling for year fixed effects. The R2 for the year industry fixed effects decreased only slightly to a value of 16,6% compared to the normal regression. There is a major change in the firm year fixed effects model, a decrease from 17,4% to 8,1% is reported. Although the R2 changed the explanatory power is overall sufficient.

The result from the initial regression indicate that REM is significantly negatively related to equity based compensation. The results remain in the same negative direction when controlling for year fixed effects, year industry fixed effects and firm year fixed effects with coefficients of -0.00248, -0.0089, -0.00445 respectively. The coefficients are significant at the 1% level. The findings do not indicate upward REM and therefore the hypothesis is not supported. Changes in the level of the control variables did not result in any major changes compared to the results from

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It is concluded that the robustness test overall supports the main results. Summarized, the results indicate that equity incentives are not necessary related to REM. The theory on CFO executive compensation originates from the agency theory that prescribes the interests of the agent to align with those of the principal. There is no evidence found in CFO incentives and interest to maximize their personal wealth at the costs of the firm. The results indicate that equity based compensation incentivizes management to act in the best interest of the firm. This gives rise to the question what other factors drive executives to apply positive or negative real earnings management and gives room for further research about motives to engage in REM.

Table 4: Fixed effects analysis

VARIABLES REM

initial regression

REM year fixed effects

REM year industry fixed

effects

REM firm year fixed

effects EQ_BC -0.00176 -0.00248*** -0.0089*** -0.00445** (-0.713) (-1.01) (-3.53) (2.28) ROA -0.331 -0.336 -0.307 -0.044 (-7.065) (-7.22) (-6.35) (-10.96) Size -0.00263 -0.00381 -0.00439 0.054*** (-1.038) (-1.49) (-1.59) (6.14) DIST 0.242*** 0.247*** 0.341*** 0.0333 (13.10) (13.42) (16.40) (1.04) Gender 0.0274*** 0.0255*** 0.0239*** -0.00436 (2.979) (2.79) (2.62) (-0.37) MB -0.0428*** -0.0447*** -0.0512*** -0.0153*** (-19.63) (-20.09) (-20.97) (-8.14) BIG 4 0.0648*** 0.0629*** 0.0665*** (0.0047) (5.216) (5.07) (5.30) (0.26) Constant 0.0404** 0.0744*** 0.0012*** -0.0414*** (2.049) (3.44) (0.05) (-6.06) Observations 6,931 6,931 6,931 6,931 R-squared 0.174 0.182 0.217 0.123

Robust t-statistics in parentheses *** p<0.01, ** p<0.05, * p<0.1

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The second part of the robustness analysis shows which part of the CFO drives the negative relation between equity based compensation and real earnings management. To conduct this test dummy variables are created for the 10th, 25th, 50th, 75 and 90th percentile for CFOs that are rewarded by equity based compensation. The results are reported in table 5. It is interesting that for each subset the coefficients remain negative except for the CFOs that face the strongest equity based compensation. In the 5th_{rank the coefficient is positive with a value of 0.0000442, that is}

the group that is rewarded with the strongest equity based compensation. The result indicate that strong rewarded CFOs are more incentivized to apply REM. The finding is in line with the predictions in this study. The coefficient are not significant and for that reason it is not possible to analyze the results.

Table 5: Percentiles of equity incentives

Rankblock Coef. Std. Err. t p> |t|

1 -0.0084019 0,0111774 -0.75 0.452 2 -0.190358 0.0107243 -1.78 0.076 3 -0.0109616 0.0110973 -0.99 0.323 4 -0.0239939 0.0122531 -1.96 0.050 5 0.0000442 0.014737 0.00 0.998 Constant 0.0481811 0.0195575 2.46 0.014

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5. Conclusion

This study explores the relation between equity based compensation and real earnings management. Existing literature is consistent about the influence of executives on real earnings management and provide consistent evidence. Jiang et al. (2010) reported a significant relation between executives and earnings management and that not just CEOs but also CFOs have a significant impact on the application of earnings management. Evidence exists that there is an increase in real earnings management after the implementation of SOX (Graham et al 2005, Cohen & Zarowin 2010). Based on prior findings I conducted a test to examine the relation of CFOs equity based compensation and real earnings management.

The initial regression reports a negative insignificant relationship between real earnings management and equity based compensation. The significant results of the fixed effects regression models are in the same direction and indicate that real earnings management is negatively related to equity based compensation. Therefore, no support is found for the hypothesis. The results indicate that equity based compensation might incentivize management to act in the best interest of the firm. The findings contribute to prior literature about the effect of equity based compensation since the results in this study indicate that executive compensation aligns the interests of the executive with those of the principal. No evidence is found in this research about CFOs interest to maximize their personal wealth at the cost of the firm. This gives rise to the question what other factors drive the executive to apply REM and give room for further in depth research about the motives and intentions to engage in real earnings management. Future researchers can focus on a detailed analysis about other motivational drivers than equity based compensation to engage in real earnings management.

There are limitations in this study. The sample consist of U.S. listed firm. Therefore, it’s not possible to generalize to firms worldwide since there is a different regulation in other regions. Further researchers could apply this study to Asian or European firms. Finally, the control variables to measure the size, financial distress and growth opportunities are estimated based on prior research. Not all prior studies are consistent on the measurement of these control variables. The estimation of the control variables are inherent to little biases.

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Appendix: A Variable description

DISX_r Research & Development + Selling, General and Administrative expenses residual;

CFO_r Cash Flow from Operations residual; COGS_r Costs of Goods Sold residual;

Production costs Costs of Goods Sold + Change in inventory;

REM Real earnings management proxy consist of DIS_r + CFO_r + COGS;

AT Total Assets;

Sales Total Sales;

ROA Return on Assets (not significant in this study)

DIST Leverage measured by dividing total liabilities by total assets; Size Natural logarithm of total assets;

MTB Market to book ratio; proxy of sales growth;

BIG4 (1) if auditor code in Compustat is 04 (E&Y), 05 (Deloitte), 06 (KPMG), or 07 (PWC), (0) non- big four auditor; Gender (1) Female CFO, (0) Male CFO.

The impact of CFO equity based compensation on Real Earnings Management

RSAC and MSc thesis template