The effect of long-term bonus plans on real based earnings management

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Amsterdam Business School

The effect of long-term bonus plans on real based earnings

management.

Name: Max Boon

Student number: 11134739 Thesis supervisor: S. W. Bissessur Date: 04 February 2018

Word count: 10.406

MSc Accountancy & Control, Accountancy

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Statement of Originality

This document is written by student Max Boon 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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Abstract

This thesis researches whether a long-term performance plan influences the real-based earnings management within American firms. Existing literature only researched whether long-term performance plans influence accrual-based earnings management. Therefore this research will contribute to the existing knowledge of the effect of a long-term performance plan. In this thesis several incentives for earnings manipulation are given, and which effect a long-term performance plan has on management.

The methodology which has been used relies on the previous study of Cohen and Zarowin (2010). The expectation was that real-based earnings management would decline when there is a long-term performance plan. The results show that long-term performance plan has a negative effect on real-based earnings management.

Key words: Earnings management, long-term performance plan, bonus compensation, United States.

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1 Introduction

Since the 1970’s, there is a development going on in firms which results in the raise of long-term performance plans according to prior research. After corporate and accounting scandals in the year 2002, the Sarbanes-Oxley Act was introduced to enhance the quality of financial reporting. According to prior research, the earnings management has shifted from accrual-based earnings management to real based earnings management after the Sarbanes-Oxley Act was introduced. The change from accrual-based earnings management to real-based earnings management gives an interesting topic, therefore this master thesis researches if there is a relationship between earnings management and long-term bonus plans. To be more precise, this master thesis researches if there is a difference between real based earnings management within firms in regards to the receiving of long-term bonus plans. In this paragraph, the relevance of this study, research question and an overview of the remainder of this paper will be described.

1.1 Relevance

In this thesis, I will examine the effect of having a long-term performance plan on real based earning management, and then, in particular, the effect of long-term performance plans on the real-based earnings management done by chief financial officers (CFO). Based on prior research there is an agency conflict between management and shareholders (Deangelo, 1986, p. 400), these conflicts are initiated by different interests within the firm. The different interests are for example management want to receive as much bonus as possible, and shareholders want value creation for the firm. To align the incentives between management and shareholders, the management will be given a long-term performance plan. The long-term performance plan will motivate management to not only look at short-term performance but also at the long-term performance of the firm. These differences between interests of the management and shareholder give an interesting basis for the research of the accounting environment.

The thesis has the focus on the CFOs of firms, according to Graham and Harvey (2001) CFOs merely act as chief executive officer (CEO) agents. The CFO’s primary focus is the design and implementation of a policy for the financial performance of the company (Mian, 2001), and therefore has a major influence on the management of earnings. There is empirical evidence that the incentives of a CFO for earnings management are independent of CEO incentives for earnings management (Jiang, Petroni and Wang, 2008). Jiang et al. also found that the incentives of CFO’s within earnings management are greater than the incentives of CEO’s.

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The performance plan is a big component of the executive compensation according to Holthausen, Larcker, and Sloan (1995). Management has, therefore, incentives to manage

earnings to cope with the demands to receive an executive compensation. The theory behind the management choices is called positive accounting theory, which defines management accounting choices. According to positive accounting theory, management use accounting standards for their own interest. Therefore firms want to influence the determination of accounting standards. The larger firms have more incentive to influence the accounting standards because the

government intervention at larger firms is higher (Watts & Zimmerman, 1986). Watts and Zimmerman (1986) would also expect that the earnings which are reported will be managed. The Sarbanes-Oxley Act has been introduced, a United States federal law which passed on July 30 2002, with the aim to restore the investors’ confidence in the United States capital market. The Sarbanes-Oxley act wanted to restore the confidence by improving corporate governance, the quality of audits, and the internal control of firms (Ugrin & Odom, 2010).

Companies have shifted from accrual-based earnings management to real based earnings management after the introducing of the Sarbanes-Oxley Act according to Graham, Campbell, and Harvey (2005) and Cohen, Dey and Lys (2008). The difference between both types of earnings management is that accrual-based earnings management involves adjusting how transactions are reported in the financial statements, whereas real based earnings management changes the economic activities (Vorst, 2016). Empirical evidence of the real-based earnings management method is found by Roychowdhury (2006). Roychowdhury (2006) found that firms use real based activities manipulation to avoid negative annual forecasts errors.

Based on prior research, I will examine real based earnings management through the abnormal cash flow operations, discretionary expenses and production costs (Cohen & Zarowin, 2010). I will test the hypotheses on firms which have a long-term performance plan and on firms which haven’t got long-term performance plans.

Management in contrast to bonuses has been researched extensively, but the majority of studies focus on accrual-based earnings management and management in total. In this research, there will be given more information about the existence of real based earnings management by CFO’s in reliance to long-term bonus plans within United States firms. This thesis contributes to

existing literature, because there has been a change from accrual-based earning management to real based earning management (Graham et al.,2005; Cohen et al., 2008) and there is a difference between the incentives of CEO’s and CFO’s for earnings management (Jiang et al., 2008), which isn’t researched before.

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1.2 Objective and research question

The objective of this paper is to get more insight into real based earnings management caused by long-term bonus plans. To accomplice the objective goal, there is a research question conceived. The research question is:

Does long-term performance plans affect the real-based earnings management?

1.3 Overview

This paper has the following structure. In the next chapter, there is a literature review performed. In this literature review, there will be an overview given of prior research about the relevant topics agency theory, earnings management, long-term performance plans and the link between the two. The relevant topics lead to the development of the hypotheses. Subsequently, in section three the research method will be described. The research method will highlight the hypotheses, the used sample, and the empirical model. The results of the empirical research will be presented and explained in chapter four. The final chapter will be the summary, where I will discuss my results in the conclusion and will explain the limitations of this research.

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2 Literature review

In this paragraph, the theoretical concepts will be described which will be used in the thesis. First, the agency theory will be explained, followed by earnings management. After earnings management, the issue of performance plans will be introduced. At last, the theory behind CFO will be discussed. After all the necessary theoretical concepts have been discussed, the

hypotheses will be developed and shown.

2.1 Agency theory

Based on prior research there has been determined that there is a misalignment between the incentives of management and shareholders. This misalignment is caused by different interest within the company (Deangelo, 1986). For example, the management wants to maximize their payment, and the shareholders want to create economic growth within the firm over the long term. The conflict of interest is named agency theory. An agency relationship is created whenever one or more parties are obligated to represent or act on behalf of another party. This agency relationship can cause an agency conflict within the relationship (Ross, 1973). There are two types of contracts which are important for the agency theory; these are the reward contracts of management and the contracts made with the debtholders (Walker, 2013). When a manager receives a long-term bonus plan based on earnings, the manager has the incentive to reach the maximum earnings for each year bonus. This incentive can misalign with the incentive of the shareholder which wants to create firm value over the years. To maximize the earnings, a manager could manage the earnings.

Agency theory assumes that there is information asymmetry which is caused by information asymmetries between executives who manage the firm and external investors. There are two types of information symmetry which will be highlighted: moral hazard and adverse selection. Moral hazard is information asymmetry between investors and managers when investors can’t determine which actions or decisions are made by the managers. Adverse selection arises when the managers have value-relevant information, which isn’t known outside the firm. Because of information asymmetry, it is possible for managers to use real earnings management.

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2.2 Earnings management

In this paragraph of the literature review, the theory behind earnings management will be discussed. At first, the definition and explanation of earnings management will be given. Second, the theory and reason for earnings management will be discussed. After that, the different forms of earnings management will be discussed. At last, the constraints for reducing earnings management will be discussed.

2.1.1 Definition of earnings management

Earnings management is in accordance to Healy and Wahlen (1999): “earnings management occurs when managers use judgement 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.” Another definition was given by Schipper (1989), she described earnings management as a disclosure management with the intent to intervene in the external financial reporting process, with the goal to obtain some private gain and not follow the neutral operation of the process.

The definition of Healy and Wahlen (1999) and Schipper (1989), which are stated above, both show that earnings management affects the transparency and truthfulness of financial reporting. Because of the earnings management, the earnings aren’t a reliable source for measurement of the company.

2.1.2 Theory behind earnings management and reasons for earnings management

Earnings management is done by making accounting choices. The theory behind accounting choices is called the positive accounting theory. In accordance to the research of Watts and Zimmerman (1978), the positive accounting theory is that you can explain and predict the actions of managers. For this theory, they used positive agency costs of debt and compensation contracts and positive information and lobbying costs to determine the accounting choices. The results of the research for the positive accounting theory, where that individuals act in their own self-interests (Watts and Zimmerman, 1978).

The theory of positive accounting theory is in line with the definition of earnings management that management will make accounting choices which are in their best interest. Therefore this will impact the reliability and transparency of the financial information.

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One of the reasons for earnings management in accordance to Richardson and Waegelein (2002) is to maximize management bonus. The management bonus is in most firms determined by a contract between the firm and its management. In the contract, there will be goals which need to be achieved to receive a reward. The performance plan is there to align the incentives of

management with the incentives of shareholders, because according to Deegan (2011) all individuals are driven by the desire of maximizing their own wealth. The opposite effect could happen when management receives a management bonus for their achieved goals. When the expectation is that goals aren’t achieved, it will give management an incentive to manage earnings which will result in the receiving of the management bonus. It is also possible that management will defer income by the management of earnings when the goals are already met, to have a buffer for next year. Both examples aren’t in the best interest of the company and its

shareholders. The defer of income has been confirmed by Healy’s (1985, p. 106) research, which showed that bonus structures create incentives for managers to use accounting choices to maximize their bonus rewards. The research of Schipper (1989) also confirms that earnings management is most likely to take place when managers have a direct stake in the reported numbers, and the financial statement users don’t have the incentive to undo the manipulation of the numbers.

Besides the previously discussed reason for earnings management, there is another reason for earnings management which is the capital market. The financial analysts use accounting information provided by the management of firms to make market predictions. The market predictions of the financial analysts influence the stock price, therefore it is important for

management that the market predictions show positive numbers. The research of Bartov, Givoly, and Hayn (2002) shows that when the analysts’ forecast has been met, the investors will reward the firms. Therefore management has an incentive to meet the analysts’ forecasts, which can lead to earnings management.

There is also another reason for earnings management with regard to the capital market. When there is, for example, a management buy-out or an equity offer, the management has an incentive to influence the (short-term) stock price (Healy and Wahlen, 1999). To influence the (short-term) stock price, the market predictions of financial analysts need to be influenced. The predictions of financial analysts can be influenced by accounting information provided by the management of the firm. If management presents higher earnings than previously predicted by the financial analysts, it is more likely than not that the stock price will raise, which will give the management more benefits when there is a management buy-out or an equity offer. The benefits will give management an incentive to manage earnings.

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2.1.3 Methods of earnings management

Earnings have six components: gross profits, general and administrative expenses, depreciation expenses, interest expenses, income taxes and other items (Lipe, 1986). These components can be managed for earnings by the manipulation of real activities or by accounting choices for estimates (Roychowdhury, 2006). Another way to manage the earnings is to shift the classification (Haw, Ho & Li, 2011). This thesis will focus on manipulation of real activities, therefore a short explanation of earnings management by making accounting choices for estimates and classification shifting will be given, after that, a detailed explanation over earnings management by manipulation of real activities will be given.

The management of earnings by accounting choices is called accrual-based earnings

management. Accrual accounting is an accounting method used to make financial performance consistent and comparable over a timeline (Dechow, 1994). For example, revenue can be recognized by accruals, if a project is in progress, but hasn’t been finished yet. Based on

accounting rules some of the revenue can be recognized, but this will be done based on the best estimate of the management. An example of costs is a service which has been provided in the current financial year, but hasn’t been billed yet by the supplier. Management should recognize an accrual for the costs, but the amount is based on the estimate of the management. Because most of the accruals are based on the estimates of management, there is an opportunity to manage earnings by manipulating the recognized accruals. The management of earnings by manipulating accruals can be done within the boundaries of generally accepted accounting principles (GAAP). The manipulation of accruals is within the boundaries, because GAAP states that judgement in financial reporting is allowed. Accruals need eventually to be reversed,

therefore the method is restricted. When eventually management reverse the accrual, the effect of the accrual is gone, therefore accrual-based earnings management has no cash flow impact. Classification shifting is the deliberate misclassification of core expenses as noncore special items within the income statement (Haw et al. , 2011). An example of classification shifting is

recognizing the cost of goods sold under the extraordinary expenses. The classification shifting will not influence the result, but will influence the gross profit, which is used for certain criteria. The effect is that the financial information isn’t reliable and transparent for the users of the financial information, this causes an information asymmetry between management and the users of the financial information. The result isn’t influenced by classification shifting, therefore it hasn’t got any impact on the cash flow.

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2.1.3.1 Real-based earnings management

Earnings management by the manipulation of real activities is called real-based earnings management. Real-based earnings management is done by manipulation of real activities, the manipulation of real activities can be done by either change the timing or structuring of an operation, investment, and financing transaction (Gunny, 2010). The manipulation of real activities done by the management should deviate from the normal operational practices. These actions will eventually influence the output of the accounting performance, which will mislead stakeholders that certain performance goals have been met in the normal course of business. An example of real-based earnings management is a reduction of discretionary expenditures. The cut in the costs is sometimes not done by management in the best interest of the firm, but to achieve the presentation goals which have been set. The cut in costs for achieving of goals is in accordance to the results which have been found by Graham et al. (2005) in their research. In their research they found that management is willing to perform real-based earnings management to achieve performance goals, even though the decisions weren’t in the best interest of the firm. Real-based earnings management in contrast to accrual-based earnings management has cash flow impact, because the decisions aren’t reversible in the next period. The decisions which are made for real-based earnings management aren’t made for optimal business operations, therefore it is possible that does decisions have a negative effect on the long-term value of the firm. The reasons for using this method is that the real-based management isn’t restricted and it is harder to detect. The detection is harder because the management has the authority to make decisions and regulators and auditors can’t form an opinion if it’s within the law.

The decision made by management between both types of earnings management will be made based on benefits, costs, and risks. The benefits can be for example the achieving of the performance goals. The loss of firm value can be an example of the costs. Eventually,

management will also look at the risk which will be taken by doing one of the options. A risk for accrual-based earnings management is the detection and communication of the managed

earnings. Eventually this will have an effect on the long-term firm value. As stated before the risk for real-based earnings management is that the decisions made will eventually have a negative effect on the firm's performance and its long-term firm value. According to Campa and Hajbaba (2016) manipulation of accruals and the manipulation of real activities are a trade-off from each other, because they have different impacts which is consistent with the theory stated above. The following methods of real-based earning management are used by management:

Acceleration of the timing of sales through increased price discounts or more lenient credit terms, reporting of the lower cost of goods sold through the increase of production and decrease

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of discretionary expenses including advertising, research and development, and selling, general and administrative expenses. (Roychowdhury, 2006)

2.1.4 Constraints for reducing earnings management

If a company has a poor financial performance or has a low industry market share, this will constrain the real-based earnings management and will increase the classification shifting method of earnings management (Abernathy, Beyer & Rapley, 2014). The real-based earnings management is limited because in a competitive market the earnings management is limited.

Based on research from Kinney and Mc Daniel (1989) there is a relation between a weak internal control system and material errors in the accounting disclosures. Based on those results the internal control system should constrain the possibilities of earnings management.

In 2002, after major scandals in the United States, the Sarbanes-Oxley Act was introduced by United States Congress. The Sarbanes-Oxley Act was introduced to improve accountability and transparency in the corporations and to prevent future scandals (Ugrin & Odom, 2010). The improvement of the quality of financial reporting should lead to more constraint of earnings management. Section 404 of the Sarbanes-Oxley act forces management to issue a report about the effectiveness of the internal controls. The auditor is also obligated to issue a report about the internal controls over the financial reporting. These rules should lead to an improvement in internal control, which will possibly lead to the decrease of earnings management.

The internal audit department of a firm is to test the financial reporting processes of their own firm. The internal audit department will lead to a better understanding and working of the internal control process. Therefore the internal audit department will constrain earnings management (Prawitt, Smith & Wood, 2009). Besides the internal auditor, the external auditor also has a constraining effect on earnings management. An auditor wants to have a good reputation, because their opinion has only value if they are trusted. Therefore an auditor doesn’t want any misstatements in the financial reporting, because this will lead to reputation damage (Becker, Defond, Jiambalvo & Subramanyam, 1998).

2.3 Performance plans

In this paragraph of the literature review, the theory behind performance plans will be discussed. At first, the definition and its goals of performance plans will be given. After that, the types of performance plans will be discussed. At last, the influence of management on their performance

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2.3.1 Definition and goals of performance plans

Performance plans are definite as compensations for accomplishing certain goals which are set in a plan, which will be achieved within a certain period (Healy, 1984). Examples of bonuses which are granted in a performance plan are stock options, salary raise, and bonus payment. The bonus compensation is on average 21% of the salary of management (Jackson, Lopez and Reitenga, 2008).

The goals of a performance plan is to align the incentives of the management with the stockholders (Richardson & Waegelein, 2002). Accounting numbers are used in managers performance plans and could, therefore affect the manager's wealth, as a result of the alignment of incentives it will minimize the agency costs (Watts & Zimmerman, 1986).

2.3.2 Type of performance plans

There are two types of performance plans: short-term performance plan and long-term performance plan. Around the 1970s there has been a shift from short-term performance plans to long-term performance plans (Richardson and Waegelelien, 2002). The differences between both plans are that short-term performance plans focus on the near future, and therefore the goals are set to be accomplished within a short period. Most of the long-term performance plans consist of performance targets over multiple years, a number of shares which are allocated to management at the begin of the period and number of shares or units which are rewarded when certain goals are achieved (Richardson and Waegelelien, 2002).

Richardson and Waegelelein (2002, p. 181) found empirical evidence that managers with a long-term performance plan are less likely to use earnings management than managers with a short-term bonus plan. The lower earnings-management is because managers will make decisions that are more long-term oriented. Because managers are more long-term oriented their incentives are more in line with the incentives of stockholders.

This thesis will focus on long-term performance plans, therefore the further literature review will be focused on that.

2.3.3 Effect of performance plans

The goal of performance plans is to align the incentives of management with the stockholders (Richardson & Waegelein, 2002), but performance plans have multiple effects.

One of the effects of a performance plan is that when is expected that certain goals aren’t met, the tactic of ‘taking a bath’ will be used. ‘taking a bath’ means that the performance will be even lower, to raise the performance of next year or to lower the expectation of next year (Healy, 1984). It is

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also possible that management will manipulate the earnings downwards when the maximum of the performance plan has been achieved. This will both influence the reliability and transparency of the financial information, therefore this isn’t aligning the interests of the management and the stockholders.

Performance plans also give management incentives to use accounting standards and accruals to maximize the payments from the performance plan (Healy, 1984). The actions of management have the effect that the financial information which is given to the stockholders isn’t reliable and transparent. These actions create an information asymmetry, which isn’t in line with the goal of aligning the incentives.

The effect of long-term performance plans on accrual-based earnings management is that it lowers the earnings management. The lowering of the accrual-based earnings management is caused because management is more focused on the long-run performance than on the short-term earnings (Richardson & Waegelein, 2002). This shows that the incentives between management and stockholders are more aligned by the long-term performance plan.

2.4 CFO

The role of a CFO is the design and implementation of a policy for the financial performance of the company (Mian, 2001). Based on the role of CFOs, CFOs have a major influence on the accounting choices and accounting adjustments which are made in the financial information of the company. Accounting choices and accounting adjustments are key-items for accrual-based earnings management. Because CFOs oversee the firm’s financial performance and make an analysis on the financial performance of the company, they have a major influence on the decisions which are made for capital management, capital budgeting and capital structure (Mian, 2001). These influences on the real operations of the firm are key-items for real-based earnings management.

The CFO is mostly seen as an agent of the CEO, because the CEO is the superior of the CFO. Besides that the CFO is the agent of the CEO, the CEO also has the power to replace a CFO, and by these reasons, the assumption is made that the CFO will not respond to their own incentives, but to the incentives of the CEO. Based on prior research performed by Graham, Harvey, and Rajgopal (2005) CFOs do respond to their own incentives and differ therefore from CEOs. In the research Graham et al. (2005) found that CFOs are concerned with beating earnings

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CFO did not make an earnings benchmark. These are all findings which suggest that the CFO does make own decisions and therefore is different from the CEO.

Based on the prior theory the research will focus on long-term performance plans of CFOs, because CFOs have a major influence on accrual-based earnings management and real-based earnings management. CFOs have also their own incentives which differ from CEOs.

2.5 Hypothesis

As discussed in the previous literature review, the long-term-performance plan has been introduced to align the incentives of management and stakeholders. Most of the long-term performance plans consist of performance targets over multiple years, a number of shares which are allocated to management at the begin of the period and number of shares or units which are rewarded when certain goals are achieved (Richardson and Waegelelien, 2002). Real based earnings management affects future cash flows, therefore it could have a negative effect on future results, and an effect on the achieving of the long-term goals of the performance plan. The bonus compensation of the manager is on average 21% of their income.

Based on prior research from Richardson and Wagelein (2002, p. 181) managers with long-term-performance plans are less likely to use accrual-based earnings management. Consistent with these findings, I predict that there is a negative relation between real-based earnings management and long-term performance plans. Therefore the following hypothesis is conceived and drafted: H1: Real-based earnings management is negatively related to CFO long-term performance plans.

As an addition to the previously explained hypothesis, there will also be a hypothesis about the trade-off between accrual-based earnings management and real-based earnings management. Based on prior research from Campa and Hajbaba (2016) manipulation of accruals and the manipulation of real activities are a trade-off from each other, because they have different impacts which is consistent with the theory stated in the paragraph about earnings management (§2.2). Based on the prior research, I predict that there is a larger trade-off between accrual-based earnings management and real-based earnings management. Therefore the following hypothesis is conceived and drafted:

H2: Trade-off between real-based earnings management and accrual-based earnings management is higher with a long-term performance plan for CFO’s.

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In the next chapters, the used mythology to answer the hypothesis will be explained. The model used to estimate the earnings management proxy will be explained, just as the regression model which will be used. Sample selection will be discussed and clarified.

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3 Research method

In this chapter the research methods will be described which will be used in the thesis. At first, the used variables will be described. After that, the used sample will be explained. At last the regression model of the measurement of real based earnings management will be described, and the model for hypothesis 1 will be explained.

3.1 Variables

In this paragraph the variables will be discussed. First, the dependent variable will be described. Secondly, the independent variable will be explained and described. At last the control variables will be discussed.

3.1.1 Dependent variable: Real-based earnings management

The measurement of earnings management has been used in different theses. The measurement of accrual-based earnings management is the most common, therefore this thesis has chosen for the measurement of real-based earnings management. The prior researches on real-based earnings management have used the proxies which have been set by Roychowdhury

(2006)(Zang, 2012; Leonidas, 2014; Cohen & Zarowin, 2010). The proxies which have been set by Roychowdhury (2006) are:

• Acceleration of the timing of sales through increased price discounts or more lenient credit terms;

• Reporting of lower cost of goods sold through increase of production

• Decrease of discretionary expenses including advertising, research and development, and selling, general and administrative expenses.

In this thesis, the chosen proxies will also be used to determine the real-based earnings

management, because it matches the theory of real-based earnings management which has been discussed in a previous paragraph. The regression model to determine the intensity of real-based earnings management will be discussed in paragraph 3.3.1.

3.1.2 Independent variable: Long-term performance plans

The independent variable for this thesis is long-term performance plans. Based on prior research the expectation is that there is a negative correlation between long-term performance plans and real-based earnings management. Therefore the independent variable will be used to answer, whether long-term performance plans and real-based earnings management have a negative

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correlation. The term performance plan will be measured as term pay focus, the long-term pay focus will be measured by dividing the dollar value of restricted stocks and stock options by the total dollar value of pay. The total dollar value of pay consist of salary, bonus and long-term income (Deckop, Merriman & Gupta, 2006).

3.1.3 Control variables

In this thesis there are also some control variables added which are related to the dependent variable real-based earnings management. The control variables are added to remove their effect from the regression. The following control variables are added to the regression: audit quality, firm growth, firm size, leverage and accrual-based earnings management. These control variables are described and explained below.

3.1.3.1 Audit quality

Deangelo (1981) defines audit quality as the probability that an existing material error is detected and reported by the auditor. Since earnings management is sometimes a material error in the financial information, the audit quality impacts the opportunity to manage earnings.

There is a direct relation between the size of the firm and the audit quality, because smaller firms have more incentive to be less independent in contrast to larger firms (Deangelo, 1981). The smaller firms are less independent, because the clients of smaller firms are a higher percentages of the total income, and therefore when a client leaves the audit firm, it has a bigger impact. The audit quality of bigger firms is also higher, because they have a higher incentive to protect their reputation. The insurance given by an auditors opinion is based on the reputation which the auditor has. Since the big auditor's firms are more publicly known, they want to protect their reputation more (Francis, 2004).

To eliminate the effect of audit quality on the regression model the control variable is added with the proxies: ‘Big 4’ (Deloitte, EY, KPMG en PWC) and ‘not Big 4’.

3.1.3.2 Firm growth

The growth of the firms is added as a control variable. Firm growth means the change in sales in comparison to last year. When there is a big growth of sales in a firm, this is associated with earnings management. The growth is associated with fraud, because when the growth stabilizes the managers still have the expectation of growth, and therefore they have an incentive to manage earnings (Summers and Sweeney, 1998). To eliminate the effect of firm growth on the regression

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3.1.3.3 Firm size

According to Lobo and Zhou (2006) the larger the firm, the more complexity in the firm. When the firm is more complex, it is easier to use earnings management, because it is difficult to detect. Therefore the control variable firm size is added to the regression. Firm size will be measured the natural logarithm of the market value of equity.

3.1.3.4 Leverage

The control variable leverage is added to eliminate the effect of debt-contracting motivations. Debt-contracting motivations are incentives to meet debt requirements for management (Francis and Wang, 2008). Management wants to meet debt requirements, because sometimes it is mandatory for the long-term bonus plan, the bank costs will raise, or it will impact the continuity of the firm. These requirements give incentives to manage earnings, therefore leverage is added as a control variable.

Leverage will be measured by the ratio of total liabilities defined by total assets. 3.1.3.5 Accrual-based earnings management

The control variable accrual-based earnings management is added to eliminate the trade-off effect between real-based earnings management and accrual-based earnings management. Based on prior research from Campa and Hajbaba (2016) manipulation of accruals and the manipulation of real activities are a trade-off from each other, because they have different impacts which is consistent with the theory stated in the paragraph about earnings management (§2.2).

Accrual-based earnings management will be measured using the modified Jones Model; this model is used in researches for accrual-based earnings management (Zang, 2012). The modified model is used because there is the possibility that discretionary accruals are measured with an error. The error is caused by not taken into account that there could be manipulations of revenue, and therefore the revenues should be corrected for accounts receivables (Dechow, Sloan, and Sweeney, 1995).

The modified Jones model uses the following cross-sectional formula: 𝑁𝑁𝑁𝑁𝑁𝑁𝑡𝑡 = α1 _𝐴𝐴_𝑡𝑡−11 + α2 (∆𝑅𝑅𝑅𝑅𝑅𝑅𝑡𝑡− ∆𝑅𝑅𝑅𝑅𝑅𝑅𝑡𝑡) + α3 (𝑃𝑃𝑃𝑃𝑅𝑅𝑡𝑡) + 𝜀𝜀𝑡𝑡 (1)

The formula above includes the following variables: 𝑁𝑁𝑁𝑁𝑁𝑁𝑡𝑡 which is measured by the following formula:

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𝑁𝑁𝑁𝑁𝑁𝑁 𝐼𝐼𝐼𝐼𝐼𝐼𝑡𝑡− 𝑅𝑅𝐶𝐶𝐶𝐶 𝐶𝐶𝑂𝑂𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑂𝑂𝑂𝑂𝐼𝐼𝑂𝑂𝑡𝑡

𝑁𝑁𝐴𝐴𝑁𝑁𝑂𝑂𝑂𝑂𝐴𝐴𝑁𝑁 𝑁𝑁𝑂𝑂𝑁𝑁𝑂𝑂𝑡𝑡 𝑂𝑂𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑡𝑡

𝑁𝑁𝑡𝑡−1 which is total assets from the previous period.

∆𝑅𝑅𝑅𝑅𝑅𝑅𝑡𝑡 which is the revenue of period t minus the revenue of period t-1.

∆𝑅𝑅𝑅𝑅𝑅𝑅𝑡𝑡 which is the net receivable of period t minus the net receivable of period t-1.

𝑃𝑃𝑃𝑃𝑅𝑅𝑡𝑡 which is the gross property plant and equipment in year t.

𝜀𝜀𝑡𝑡 which is the proxy for the level of discretionary accruals in year t.

α1, α2, and α3 are firm-specific parameters. Which are all set to 1, because in the dataset the non-financial companies are eliminated.

3.2 Sample selection

The data which has been used to answer the research question is collected from the Wharton Research Data Services (WRDS). The timeframe of the data was 2005 until 2014; this timeframe was taken because there was a change from accrual-based earnings management to real-based earnings management after the introduction of the Sarbanes-Oxley Act according to Graham et al. (2005) and Cohen et al. (2008). The economy started to go upwards after the financial crisis, therefore the data is limited to 2014, because the change could impact the results.

To retrieve the data, the following databases within Wharton Research Data services where used: Compustat and Execomp. The Compustat database was used for the financial statement related information, and the Execomp database was used for the executive compensation data. The data consists of all firms, except the data from financial services companies were excluded, because of the idiosyncratic and industry-specific financial reporting matters.

The initial database which was extracted from the Compustat database had 113,904 observations. After that the database Execomp was exported from Wharton Research Data Services, the database had 20,325 observations. These observations were added to the database of Compustat. After the databases were merged, the firm-year observations which weren’t complete where deleted. The final database consisted of 16,233 observations, which were used for the data research.

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3.3 Regression model 3.3.1 Real-based earnings management

The regression model is based on the model used by Cohen and Zarowin (2010). To measure the real based earnings management the abnormal cash flow operations, discretionary expenses and production costs are measured. First, the normal level of cash flow operations needs to be determined. The normal cash flow operations are determined by the following cross-sectional regression which has been introduced by Dechow, Kothari, and Watts (1998):

𝑅𝑅𝐶𝐶𝐶𝐶𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 = 𝑘𝑘1 1 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝑘𝑘2 𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝑘𝑘3 ∆𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝜀𝜀𝑖𝑖𝑡𝑡 (1)

After the normal cash flow operations are determined by the estimated coefficients from above, the actual cash flow operations are deducted from the normal cash flow to determine the abnormal cash flow operation.

The production costs are measured by the sum of the costs of goods sold and the change in inventory during the year. The following linear function will model the costs of goods sold:

𝑅𝑅𝐶𝐶𝐶𝐶𝑆𝑆𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 = 𝑘𝑘1 1 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝑘𝑘2 𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝜀𝜀𝑖𝑖𝑡𝑡 (2)

Besides the model of the costs of goods sold, the inventory growth needs to be determined. The inventory growth is determined by the simultaneous and lagged change in sales.

∆𝑂𝑂𝐼𝐼𝐴𝐴𝑁𝑁𝐼𝐼𝑁𝑁𝑂𝑂𝑂𝑂𝑖𝑖𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 = 𝑘𝑘1 1 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝑘𝑘2 𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝑘𝑘3 ∆𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝑘𝑘4 ∆𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 + 𝜀𝜀𝑖𝑖𝑡𝑡 (3)

Using the formulas 2 and 3, the normal level of production costs can be determined by the following formula: 𝑃𝑃𝑂𝑂𝑂𝑂𝑃𝑃𝑃𝑃𝐼𝐼𝑁𝑁𝑂𝑂𝑂𝑂𝐼𝐼𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 = 𝑘𝑘1 1 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝑘𝑘2 𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 + 𝑘𝑘3 ∆𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 + 𝑘𝑘4 ∆𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 + 𝜀𝜀𝑖𝑖𝑡𝑡 (4)

The normal level of discretionary expenses is determined by a linear function of sales shown below: 𝑁𝑁𝑂𝑂𝑂𝑂𝐷𝐷𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 = 𝑘𝑘1 1 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝑘𝑘2 ∆𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 + 𝑘𝑘3 𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,1−1 + 𝜀𝜀𝑖𝑖𝑡𝑡 (5)

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To determine the normal level of discretionary expenses by a function using the current sales, as used in formula 5, a mechanical problem will be created. The problem is caused by firms who will manage earnings upwards, of which the subsequent effect is that the residuals will

significantly lower. To resolve this problem, the normal level of discretionary expenses of lagged sales is determined by the following formula:

𝑁𝑁𝑂𝑂𝑂𝑂𝐷𝐷𝑖𝑖𝑡𝑡 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 = 𝑘𝑘1 1 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1+ 𝑘𝑘2 𝑆𝑆𝑂𝑂𝑡𝑡𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 𝑁𝑁𝑂𝑂𝑂𝑂𝑁𝑁𝑁𝑁𝑂𝑂𝑖𝑖,𝑡𝑡−1 + 𝜀𝜀𝑖𝑖𝑡𝑡 (5)

To determine the real earnings management, the three proxies will be combined into two measures. The first measure (RM_1) will consist of the abnormal discretionary expenses multiplied by minus one, plus the abnormal productions costs. The abnormal discretionary expenses are multiplied by minus one, because the sum of the both proxies will then show the most accurate measure of earnings management.

The second measure (RM_2) will consist of abnormal cash flows from operations plus discretionary expenses multiplied by minus one. The discretionary expenses are multiplied by minus one, because of the same reason mentioned above.

In the results, the variables RM_1 and RM_2 will be shown. Three individual real earnings management proxies acceleration of the timing of sales through increased price discounts, reports of lower costs of goods sold through increased production and decreases in discretionary expenses including advertising, R&D, and SG&A expenses will also be shown.

The study investigates the impact of long-term bonus plans on real earnings management, therefore the following regression has been made to measure the influence of long-term bonus plans.

3.3.2 The effect of long-term bonus plans on real-based earnings management

After the regressions for real earnings management have been performed, the regression analyses for the hypothesis “Real-based earnings management is performed lesser by CFO’s with a long-term

performance plan” can be performed. To determine what the impact of long-term performance plans are on real-based earnings management, the following equation will be used:

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As you can see the following variables are used:

REAL, which is real-based earnings management, what will be measured in accordance to the formulas stated above.

LONGTERM, which is long-term performance plan, what will be measured as the dollar value of restricted stocks and stock options defined by total dollar value of pay.

BIG 4, which is audit quality, what will be measured with the following dummies: if Big 4: 1; if Non-Big 4: 0.

GROWTH, which is the growth of the firm, what will be measured as the annual change in sales. SIZE, which is the size of the firm, what will be measured as the natural logarithm of the market value of equity.

LEVERAGE, which is the impact of debt requirements, what will be measured as the ratio of total liabilities defined by total assets.

AEM, which is accrual-based earnings management, what will be measured in accordance to the modified Jones model.

3.3.3 Trade-off between real-based earnings management and accrual-based earnings management

To determine the trade-off between real-based earnings management and accrual-based earnings management caused by long-term performance plans, the following equation will be used. 𝑅𝑅𝑅𝑅𝑁𝑁𝑅𝑅 = 𝛽𝛽0+ 𝛽𝛽1𝑅𝑅𝐶𝐶𝑁𝑁𝐶𝐶𝐿𝐿𝑅𝑅𝑅𝑅𝐿𝐿 + 𝛽𝛽2𝐵𝐵𝐼𝐼𝐶𝐶 4 + 𝛽𝛽3𝐶𝐶𝑅𝑅𝐶𝐶𝐺𝐺𝐿𝐿𝐺𝐺 + 𝛽𝛽4𝑆𝑆𝐼𝐼𝑆𝑆𝑅𝑅 + 𝛽𝛽5𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑁𝑁𝐶𝐶𝑅𝑅 +

𝛽𝛽6𝑁𝑁𝑅𝑅𝐿𝐿 + 𝛽𝛽7𝑁𝑁𝑅𝑅𝐿𝐿 ∗ 𝑅𝑅𝐶𝐶𝑁𝑁𝐶𝐶𝐿𝐿𝑅𝑅𝑅𝑅𝐿𝐿 𝜀𝜀𝑡𝑡 (1)

The variables are described above.

To determine the trade-off between real-based earnings management and accrual based earnings management, the variables accrual-based earnings management will be multiplied with the long-term performance plans. The trade-off than will be delong-termined by regression the variables with each other to determine the significance.

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4 Results

In this chapter, the research results will be presented and described. Regression is performed to examine whether the hypotheses can be proven. At first, the statics will be presented and explained. After that, the results of the regression will be presented and the explanation whether the hypotheses are proven.

4.1 Descriptive statics

The correlation between the different variables used in the regression is determined by a correlation matrix (table 1) and the variance inflation factor (table 2). Before these matrix’ were made some data in the variables have been dropped, because the descriptive statistics and regression coefficients can be influenced by extreme observations. The observations which had a fractional rank greater than 99.5% or a fractional rank smaller than 0.5% were dropped from the data. The number of observations decreased with 1.004 observations by the drop of the data.

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Table 1 – Correlation Pearson (linear) – independent, dependent and control variables. Re al-ea rni ng s m ana ge m ent Long -te rm pe rf or m anc e pl an A ud itor G rowt h of fi rm Si ze o f f irm Le ve ra ge o f f irm A cc rual -b as ed ea rni ng s m ana ge m ent A cc rual -ba se d e ar ni ng s m ana ge m ent * L on g-te rm pe rf or m anc e pl an s Real-earnings managemen t _1.000 N 16.233 Long-term performanc e plans _-0.33** _1.000 0.000 N 16.233 16.233 Auditor _{0.70** 0.064**} _1.000 0.000 0.000 16.233 16.233 16.233 Growth of firm _{0.094** 0.167** 0.021**} _1.000 0.000 0.000 0.008 N 16.233 16.233 16.233 16.233 Size of firm _{-0.108** 0.220**} _{0.014 0.379** 1.000} 0.000 0.000 0.065 0.000 N 16.233 16.233 16.233 16.233 16.233 Leverage of firm _{0.009 -0.018* 0.086** 0.018* 0.014 1.000} 0.245 0.025 0.000 0.024 0.082 N 16.233 16.233 16.233 16.233 16.233 16.233 Accrual-based earnings managemen t 0.034** -0.004 0.015 0.000 0.034** 0.022** 1.000 0.000 0.649 0.057 0.975 0.000 0.004 N 16.233 16.233 16.233 16.233 16.233 16.233 16.233 Accrual-based earnings managemen t * Long-term performanc e plans 0.024** 0.277** 0.033** 0.052** 0.101** 0.021** 0.897** 1.000 0.002 0.000 0.000 0.000 0.000 0.009 0.000 N 16.233 16.233 16.233 16.233 16.233 16.233 16.233 16.233

Table 1: Table 1 shows the correlation between the different variables. The variables which are used are the dependent variable real-earnings management which is measured by the model used by Cohen and Zarowin (2010). Besides the dependent variable the following independent variables are used long-term performance plan, accrual-based earnings management and accrual-based earnings management times long-term

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performance plan. There other variables are control variables, are added to remove their effect from the regression. ** means, correlation is significant at the 0.01 level. * means, correlation is significant at the 0.05 level. The matrix has been made based on the Pearson correlation, which evaluates the linear relation between two continuous variables.

The correlation matrix shows the correlation between all the different variables used for the regression model. As shown in the correlation matrix, real-earnings management is significant related to long-term performance plans, audit quality, the growth of the firm, size of the firm, accrual-based earnings management and accrual-based earnings management times long-term performance plan. Real-earnings management is positively correlated to audit quality, the growth of the firm and accrual-based earnings management, and is negatively correlated to long-term performance plans and size of the firm. This is conform the predications and prior research of Richardson and Waegelein (2002).

Table 2 – Correlation test – Variance inflation factor of dependent, independent and control variable.

V

IF

Long-term performance plans 1.064

Auditor 1.012 Growth of firm 1.178 Size of firm 1.204 Leverage of firm 1.009 Accrual-based earnings management 1.002 Accrual-based earnings management * long-term performance plan 1.176

Table 2: Table 2 shows the correlation between two or more independent variables. The VIF shows the correlation between two or more independent variables.

There is no high correlation between two or more independent variables based on the Variance Inflation Factor test as shown above. There is no high correlation, because the highest Variance Inflation Factor is 1.204, and the usual assumption of high correlation is a Variance Inflation Factor of four or higher. This is conform the predications and prior research of Richardson and Waegelein (2002).

Table 3 – Descriptive Statistics – independent, dependent and control variables.

V ar iab le s Me an Me di an Mi n Ma x St d. D ev .

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Auditor 0.6800 1.0000 0.0000 1.0000 0.4680 Growth of firm 244.7972 54.4000 -6079.8810 11871.0000 1085.0272 Size of firm 2325.6614 648.6660 2184.6000 74053.0000 5687.3645 Leverage of firm 0.5454 0.5306 0.0708 1.6892 0.2456 Accrual-based earnings management 31.3543 19.1851 0.1668 674.7962 39.2123 Accrual-based earnings management * long-term performance plan 18.7818 11.2685 -23.5469 561.7050 26.9840

Table 3: Table 3 shows the descriptive statistic of the variables used for the regression model. (N=16.233). The table shows the descriptive statistics of all the used variables in the regression. All the variables have the same amount of observations, because of the already explained cleaning process of the data.

As descript above the data has been adjusted for extreme values, this has been done by removing extreme values which are had a fractional rank greater than 99.5% or a fractional rank smaller than 0.5%. The mean of long-term performance plan in table 2 is 0.6265; this means that 62.65% of the firms have a payment structure which has components of long-term performance plan in it.

4.2 Regression result

To test the hypotheses “Real-based earnings management is performed lesser by CFO’s with a long-term performance plan” of the research, the following regression has been ran:

𝑅𝑅𝑅𝑅𝑁𝑁𝑅𝑅 = 𝛽𝛽0+ 𝛽𝛽1𝑅𝑅𝐶𝐶𝑁𝑁𝐶𝐶𝐿𝐿𝑅𝑅𝑅𝑅𝐿𝐿 + 𝛽𝛽2𝐵𝐵𝐼𝐼𝐶𝐶 4 + 𝛽𝛽3𝐶𝐶𝑅𝑅𝐶𝐶𝐺𝐺𝐿𝐿𝐺𝐺 + 𝛽𝛽4𝑆𝑆𝐼𝐼𝑆𝑆𝑅𝑅 + 𝛽𝛽5𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑁𝑁𝐶𝐶𝑅𝑅 +

𝜀𝜀𝑡𝑡

In this regression, the real-based earnings management variable will be regressed with the independent variable long-term performance plan. In this regression, the control variables audit quality, growth of the firm, size of the firm, leverage of firm and accrual-based earnings management are used to determine their effect on the variable long-term performance plan. Table 4 – Regression result real-based earnings management

ß Std. Error Coeffic. T-value P-value

(constante) 1.850 0.054 34.215 0.000***

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Auditor 0.277 0.031 0.070 9.031 0.000*** Growth of firm 0.000 0.000 0.159 19.043 0.000*** Size of firm 0.000 0.000 -0.164 -19.437 0.000*** Leverage of firm 0.010 0.058 0.001 0.165 0.869 Accrual-based earnings management 0.002 0.000 _0.014 5.008 0.000*** Accrual-based earnings mangagement * long-term performance 0.002 0.002 0.027 1.145 0.252 N 16.233 Adjusted R squar 0.039

Table 4: Table 4 shows the results of the linear regression. ** is significant on a 5% level, *** is significant on a 1% level. This table presents the relationship between the dependent variable real-based earnings management and the independent variable long-term performance plan. The results of the control variables are also added. The P-value shows the effect, if it’s above 0.05, there is no effect which can be recognized.

Table 5 – Regression result real-based earnings management Adjusted R square 0.039 F-value 95.952 P-value 0.000***

Table 5: Table 5 shows the results of the linear regression. ** is significant on a 5% level, *** is significant on a 1% level. This table presents the relationship between the dependent variable real-based earnings management and the total of the independent variables.

Table 5 shows that the independent variables long-term performance plan, auditors, growth of firm, size of firm and accrual-based earnings management have a significant effect on real-based earnings management ( P-value < 0.01).

The results of the regression (see table 4 and 5) show that there is a significant relation between long-term performance plans and real-based earnings, this is shown by the P-value of 0.001. Based on the results long-term performance plan has a negative effect on real-based earnings management. The control variables, except leverage, have a significant effect on the relationship between real-based earnings management and long-term performance plans. The results of the regression are in line with my predictions that there is a significant relation between real-based

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The adjusted R square of 0.039 shows that the independent variables only explain 3,9% of the real-based earnings management. The adjusted R square shows that there are more factors which influence real-based earnings management.

The F-value of 95.952 is significant based on the value of 0.000; the F-value shows that the independent variables have a significant impact on real-based earnings management. This is in line with the predications made for the hypotheses.

The following hypotheses were formulated for this research:

H1: Real-based earnings management is negatively related to CFO long-term performance plans.

Based on the results shown above, the H0 hypotheses can be rejected. There is a significant relation between long-term performance plans and real-based earnings management. This is conform the predications and prior research of Richardson and Waegelein (2002).

To test the hypotheses “Trade-off between real-based earnings management and accrual-based earnings management is higher with a long-term performance plan for CFO’s” of the research, the same regression will been ran:

𝑅𝑅𝑅𝑅𝑁𝑁𝑅𝑅 = 𝛽𝛽0+ 𝛽𝛽1𝑅𝑅𝐶𝐶𝑁𝑁𝐶𝐶𝐿𝐿𝑅𝑅𝑅𝑅𝐿𝐿 + 𝛽𝛽2𝐵𝐵𝐼𝐼𝐶𝐶 4 + 𝛽𝛽3𝐶𝐶𝑅𝑅𝐶𝐶𝐺𝐺𝐿𝐿𝐺𝐺 + 𝛽𝛽4𝑆𝑆𝐼𝐼𝑆𝑆𝑅𝑅 + 𝛽𝛽5𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑁𝑁𝐶𝐶𝑅𝑅 +

𝛽𝛽6𝑁𝑁𝑅𝑅𝐿𝐿 + 𝛽𝛽7𝑁𝑁𝑅𝑅𝐿𝐿 ∗ 𝑅𝑅𝑂𝑂𝐼𝐼𝐴𝐴𝑁𝑁𝑁𝑁𝑂𝑂𝐿𝐿 + 𝜀𝜀𝑡𝑡 (1)

In this regression, the real-based earnings management variable will be regressed with the independent variable accrual-based performance plan times long-term performance plan. In this regression, the control variables audit quality, growth of the firm, size of the firm, leverage of firm and real-based earnings management are used to determine their effect on the variable long-term performance plan. The results of this regression are equal to the regression results as in table 4 and table 5.

The results of the regression (see table 4 and 5) show that there is no significant relation between real-based earnings management and accrual-based earnings, this is shown by the P-value of 0.252. Based on the results there is no trade-off between real-based earnings management and accrual-based earnings management. This is conform the predications and prior research which stated that companies have shifted from accrual-based earnings management to real based earnings management after the introducing of the Sarbanes-Oxley Act according to Graham, Campbell, and Harvey (2005) and Cohen, Dey and Lys (2008).

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5. Summary and conclusion

In this chapter, the summary and conclusion will be given. The conclusion will be drawn based on the results which are presented in the previous chapter. At last, the limitations of the research will be discussed.

5.1 Summary

The purpose of this thesis is to answer the research question. The research question was: “Does long-term performance plans affect the real based earnings-management.”, so with this research, we want to determine whether long-term performance plans affect real-based earnings management. Prior research has shown that long-term performance plans affect accrual-based earnings

management (Richardson and Waegelelien, 2002), but after the Sarbanes-Oxley act in 2002, there has been a change from accrual-based earnings management to real-based earning management (Graham et al., 2005; Cohen et al., 2008). Based on the prior research I predict that after 2002 there is more real-based earnings management, but it is influenced by long-term performance plans.

Real-based earnings management is done by manipulation of real activities, the manipulation of real activities can be done by either change the timing or structuring of an operation, investment, and financing transaction (Gunny, 2010). In the research, there are several reasons identified why management uses earnings management based on prior research. These reasons are to maximize the bonus (Richardson and Waegelein, 2002), meet the analyst’ forecasts (Bartov, Givoly and Hayn, 2002) and to influence the stock price (Healy and Wahlen, 1999).

Performance plans are definite as compensations for accomplishing certain goals which are set in a plan, which will be achieved within a certain period (Healy, 1984). The goals of a performance plan is to align the incentives of the management with the stockholders (Richardson & Waegelein, 2002). Accounting numbers are used in managers performance plans and could, therefore, affect the manager's wealth, as a result of the alignment of incentives it will minimize the agency costs (Watts & Zimmerman, 1986).

To answer the research question, the following hypotheses have been made based on previous information and the combination between real-based earnings management and long-term performance plan:

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H2: Trade-off between real-based earnings management and accrual-based earnings management is higher with a long-term performance plan for CFO’s.

The real-based earnings management is determined by the method used in Roychowdhury’s research (2006). In this research the following proxies are used to determine real-based earnings management: Acceleration of the timing of sales through increased price discounts or more lenient credit terms, reporting of lower cost of goods sold through increase of production, and decrease of discretionary expenses including advertising, research and development, and selling, general and administrative expenses. The long-term performance plan is measured as long-term pay focus, the long-term pay focus is measured by dividing the dollar value of restricted stocks and stock options by the total dollar value of pay. The total dollar value of pay consist of salary, bonus and long-term income (Deckop, Merriman & Gupta, 2006).

The regression was performed with the dependent variable real-based earnings management, the independent variable long-term performance plan. The following control variables were used to remove their effect from the regression: audit quality, firm size, firm growth, the leverage of the firm and accrual-based earnings management.

5.2 Conclusion

To answer the research question “Does long-term performance plans affect the real based earnings-management.”, the research provides evidence for a negative relation between real-based earnings management and long-term performance plans. I find that firms with a long-term pay focus are associated with a lower real-based earnings management. Based on the results the H0 hypotheses can be rejected.

5.3 Limitations

The results of the research have a limitation, because the adjusted R square of the research is 0.038. This means that the variables explain 3.8% of the dependent variable ‘real-based earnings-management’. This limitation of a small explaining value of the variables should taking in to account when the results are interpreted.

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The effect of long-term bonus plans on real based earnings management