The impact of COO incentives on real earnings management.

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The impact of COO incentives on real earnings management

Shanna Groen 10430687 18th_{June 2014}

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1. Introduction

One central tension in the corporate governance literature is the conflict of interest between firms’ owners and the managers hired to determine firms’ investment projects and payout decisions (Bergstresser & Philippon, 2006). Jensen and Murphy (1990) were among the first to examine the agency theoretic prediction that CEOs are only motivated to act in their shareholders’ best

interest if they are offered incentive contracts that ‘pay for performance’.

Another way to align managers’ incentives with those of shareholders is to make managers partly owners by granting them equity (Cheng & Warfield, 2005).

But there is an adverse effect of incentives; incentives may lead to earnings management. Earnings management occurs when a manager uses judgment in structuring transactions and in financial reporting to alter the financial reports to mislead stakeholders about the underlying economic performance of the company, or to influence the contractual outcomes that depend on reported accounting numbers. (Healy & Wahlen, 1999) (Bergstresser & Philippon, 2006). (Cheng & Warfield, 2005) (Graham, Harvey, & Rajgopal, 2005) (Gunny, The relation between earnings management using real activities manipulation and future performance: evidence from meeting earnings

benchmarks, 2010) However, managers may as well use earnings management to transmit private information to the market (Graham, Harvey, & Rajgopal, 2005).

This managing of earnings can be done in two ways: by means of accrual-based earnings management and by means of real earnings management. Accrual-based earnings management is achieved by changing the accounting methods or estimates used when presenting a transaction in the financial

statements. Real earnings management, on the other hand, is a purposeful action to alter reported earnings in a particular direction. This is achieved by changing the structuring or timing of a financial transaction, operation or investment, which may have suboptimal performance consequences. (Dechow & Skinner, 2000) (Zang, 2012) (Gunny, The relation between earnings management using real activities manipulation and future performance: evidence from meeting earnings benchmarks, 2010)

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Real earnings management may have real cash flow consequences and can therefore destroy firm value. This is not the case with accrual-based earnings management. (Walker, 2013) Most earnings management is achieved via real actions, as opposed to accounting manipulation. SOX might be a reason for the propensity to substitute real economic actions in place of accounting

manipulation. The reason for this is that real earnings management is harder to detect. (Cohen, Dey, & Lys, 2008) (Graham, Harvey, & Rajgopal, 2005)

Prior research largely examined the relation between CEO and CFO bonus and equity incentives on earnings management. There is for example evidence that the use of discretionary accruals to manipulate reported earnings is more pronounced at firms where the CEOs potential total compensation is more closely tied to the value of stock and option holdings. Other evidence shows that on average, CEOs saw only a $3 dollar increase in value of their option and stock portfolios for every $1.000 increase in shareholder wealth over the period 1974-1986, which suggests that CEOs had little incentive to maximize shareholder value. (Bergstresser & Philippon, 2006) (Jensen & Murphy, Performance Pay and Top-Management Incentives, 1990) Other authors (Jiang, Petroni, & Wang, 2010) (Fuller & Jensen, 2002) combine CEO and CFO incentives by investigating

whether CFO equity incentives play a stronger role than those of CEO in earnings management.

Though, little prior research about the role of the Chief Operations Officer (COO) is available, even though the COO is the main responsible of a wide range of firm’s operational decisions. The COO is typically the key individual

responsible for the delivery of results on a day-to-day, quarter-to-quarter basis. Therefore, the COO may have a larger or similar impact as the CEO. However, in the literature the role of the COO receives minimal attention (Bennett & Miles, 2006).

This thesis tries to close the gap in the literature and examines the impact of COO incentives on real earnings management. This research is motivated by the fact that much of the current research on earnings management focuses on detecting abnormal accruals (Roychowdhury, 2006), while there is not much prior literature about real earnings management. However, real earnings

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management increased significantly over the last years. (Cohen, Dey, & Lys, 2008) (Graham, Harvey, & Rajgopal, 2005)

Next to this can be concluded that a considerable amount of information about the influence of CEO and CFO incentives on earnings management is already available (Bergstresser & Philippon, 2006) (Jensen & Murphy, Performance Pay and Top-Management Incentives, 1990) (Hall & Liebman, 1998) (Jiang, Petroni, & Wang, 2010), while there is little prior research conducted about the role of the COO.

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2. Literature review and hypotheses

2.1 Incentives

The conflict of interest between firms’ owner-investors and the managers hired to determine firms’ investment projects and payout decision is a central tension in the corporate governance literature (Bergstresser & Philippon, 2006). The conflict of interest between managers and the shareholders of a corporation is a classic example of the agency theory.

Within agency theoretic view of management accounting it is usually assumed that there is a world of implicit and explicit two-person contracts between the employee and the owner in which both parties are motivated solely by self interest and therefore behave in a rational utilitarian fashion. It depicts the agency relationship as a contract under which the owner delegates decision-making authority to the manager, who then performs the services on behalf of the owner. Given that agents are utility maximizers, it seems the agent will not always take actions that are in the best interests of the principal. (Macintosh & Quattrone, 2011, p. 62) The owner, however, can limit such aberrant behavior by incurring monitoring, auditing, and accounting costs and by establishing, also at a cost, an appropriate incentive scheme. (Jensen & Meckling, 1976)

Like Jensen and Murphy (1990, p. 226) stated: ‘If shareholders had complete information regarding the CEOs activities and the firm’s investment opportunities, they could design a contract specifying and enforcing the

managerial action to be taken in each state of the world.’ But like they also say, the actions of the management and the investment opportunities that they face are not perfectly observable by shareholders. Therefore, the shareholders will unintentionally design compensation policies in order to give the managers

incentives that will increase the wealth of shareholders (Jensen & Murphy, 1990). Deci (1972) defines incentives as a way to tie a person’s financial rewards directly to his performance by paying him a set rate for each unit of output which he produces. He states that the motivational assumption underlying these

incentives is that a person will perform effectively to the extent that his rewards are made contingent upon effective performance. Incentive systems are

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areas and motivate employees to achieve and exceed the performance targets. (Merchant & Van der Stede, 2012, p. 367)

These incentives can arise from increases in the performance measures on which bonus is tied to, which are called bonus incentives (Indjejikian & Matejka, 2009), or they can arise from incentives in the appreciation of the stock prices, which increases wealth over equity holdings, which is referred to as equity incentives (Jensen & Meckling, 1976).

2.1.1 Bonus incentives

Indjejikian and Matejka (2009) find that annual bonuses are by far the most common incentive component of CFO compensation and that, on average, about 50% of CFO bonuses is based on accounting-based financial performance. Fox (1980) reports that in 1980 ninety percent of the one thousand largest US manufacturing corporations used a bonus plan based on accounting earnings to remunerate managers. Amato (2013) found that 58% of private company CFO bonuses was based on meeting financial performance goals, 13% was contingent on explicit nonfinancial targets such as safety targets or customer satisfaction, and 27% was awarded subjectively. The remaining small percentage was funded in other, unspecified ways.

The primary rationale for variable pay is, according to Merchant and Van der Stede (2012), to provide rewards in accordance with an employee’s

contributions to the organization, hence the notion of pay-for-performance of variable pay. Moreover, organizations aim to more effectively encourage outstanding performance by better recognizing employee contributions. Employees appreciate the opportunity to be rewarded for their performance, while their employer appreciates variable pay’s risk-sharing feature that makes compensation expense more variable with performance. (Merchant & Van der Stede, 2012) Jensen and Murphy (1990) examined that CEOs are only motivated to act in the best interest of their shareholders when they are motivated by incentive contracts that ‘pay for performance’.

Bonus incentives typically provide cash payments based on performance measured over a period of one year or less. The awards can be based on either performance of a single individual or that of the firm as a whole. (Merchant &

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Van der Stede, 2012) Bonus incentives can be non-financial, financial or

subjective measures. Research by Ittner et al. (1997a) indicates that 36 percent of U.S. firms use both financial and non-financial measures in their chief

executive officers’ annual bonus contracts. Traditionally, firms have measured and rewarded managerial performance using financial measures such as earnings, return on investment, or unit costs (Eccles, 1991). But according to Ittner et al. (1997a) there has recently been an increased emphasis on

nonfinancial measures such as customer satisfaction, productivity, employee satisfaction, market share and product quality, to evaluate and reward managerial performance. The primary reasons suggested for the use of nonfinancial performance measures are that these measures are valuable in motivating and evaluating managerial performance, and they are better

indicators of future financial performance than accounting measures. (Banker, Potter, & Srinivasan, 2000). Banker et al. (2000) add to this that the use of nonfinancial measures for performance evaluation is also consistent with theoretical work on compensation in agency settings. They say that because financial measures of performance may be imperfect, nonfinancial measures can add value by inducing long-run focused effort. But some studies indicate that subjective compensation plans can be superior to objective, formula-based plans because they allow the firm to exploit non-contractible information that

otherwise might be ignored in formula-based contracts (Ittner, Larcker, & Meyer, 1997b). Baker et al. (1994) indicates that the use of subjective weights on

objective performance measures allow the employer to mitigate distortions in performance measures. This is done by backing out unintended dysfunctional behavior or gaming induced by the incomplete objective performance measures.

Merchant and Van der Stede (2012) indicate that employers prefer bonus incentives instead of salary increases. The reason they give for this is because bonus payments are one-time payments. Because salary increases are not just one-time payments, they have considerable value; they provide an annuity that typically lasts for many years because employees’ salaries are rarely reduced. (Merchant & Van der Stede, 2012) Compensation arrangements run the range from a flat salary with no direct performance-based bonus to rewards based only

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some combination of a performance-based bonus and salary. The motivation for having some performance-based bonus and some salary in compensation

arrangements is to balance the benefits of incentives against the extra costs of imposing uncontrollable risk on the manager. (Bhimani, Horngren, Datar, & Rajan, 2012) Gibbons and Murphy (1990) find that CEO salary and bonus is

positively related to stock return, but negatively related to industry performance.

2.1.2 Equity incentives

The other way to align managers’ incentives with those of shareholders is by managerial ownership, which makes managers partly owners by granting them equity (Jensen & Meckling, 1976). Hall and Liebman (1998) mention that the median exposure of CEO wealth to firm stock prices tripled between 1980 and 1994, and doubled again between 1994 and 2000. Bergstresser and

Philippon (2006) describe the increase in CEO exposure to stock prices as a way to align the incentives of upper management with the interests of shareholders. Banker et al. (2011) suggest that the widespread use of these equity incentives is due to the fact that they motivate managers to take both revenue-increasing and expenditure-decreasing actions that directly contribute to the wealth of

shareholders.

Equity-based plans provide rewards based on changes in the value of the firm’s stock. Equity-based plans come in many forms, but most are variants of stock option, restricted stock or performance stock.

Stock option plans give employees the right to purchase a set number of shares of company’s stock at a set price during a specific period of time.

(Merchant & Van der Stede, 2012) Kalpathy (2009) states that corporate boards increasingly rely on stock options as a compensation tool and as a device for incentive alignment and managerial retention. She says that the growth in the use of stock options began in the late 1980s and gained in the 1990s a lot of momentum. According to Technology Associates, 15% to 20% of public companies offer stock options to employees as part of their compensation package (Cortese-Danile, Fitzsimons, & Latshaw, 2013) From an incentive perspective, employees only benefit when the stock price goes up, so therefore stock options motivate employees to increase their company’s stock price. This

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improves incentive alignment as employees only benefit when shareholders benefit. (Merchant & Van der Stede, 2012) Kalpathy (2009) confirms this by stating that when the stock price moves below the exercise price, the stock options begin to lose some of their ability to align managerial and shareholder incentives and to retain employees.

According to the ‘Stock compensation 2013 assumption and disclosure survey’ from PwC more conservative restricted stock units are replacing stock options in top executive compensation arrangements at larger, more mature companies. (Report on salary surveys, 2013) The reason for this is because restricted stocks also provide a reward for increases in stock price, but the stock itself also has value when the stock price is flat or even declines. With restricted stock plans, selling the stock that the employees are given is restricted for a specified period of time and is contingent upon continued employment.

(Merchant & Van der Stede, 2012) Irving et al. (2011) give two dimensions along which stock options and restricted stock grants differ, which affect their

incentive effects on employee performance. The first one is that restricted stocks are more valuable to employees because they will be in the money when vesting provisions are met, as long as the firm’s stock price is positive. Second, whereas stock options generally are not dividend protected, restricted stock is dividend protected as employees receive dividend on restricted stock and do not refund them even if they fail to vest or achieve other performance criteria.

Lastly, the performance stock makes the stock grants contingent on the achievement of stock or non-stock goals over a multiple-year performance period (Merchant & Van der Stede, 2012). Healy (1985) says performance plans award managers the value of performance units or shares in cash or stock if certain long-term earnings’ targets are attained. These earnings targets are typically written in terms of earnings per share, return on equity, or return on total assets. The key idea for these alternative stock option plans is to provide stronger incentives to maximize shareholder value. This is done by raising the bar for stock price improvements before the options become exercisable or by raising the bar on the conditions to vest, and, thus, earn the stock. (Merchant & Van der Stede, 2012)

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Mehran (1995) provides evidence that increasing managers’ equity-based incentives creates value. He finds that firm performance is positively related to the share of equity held by managers and the share of manager compensation that is equity-based. Also Murphy (1985) finds a significant relationship between total compensation level and stock performance. His result indicates that a firm realizing 10% rate of return will increase total remuneration of an executive by 2.1%.

2.2 Earnings management

Cheng and Warfield (2005) state that because the wealth of managers with higher equity incentives is sensitive to short-term prices, this sensitivity can lead to incentives to increase short-term prices and the value of the shares that managers are going to sell. Because of this, the managers can make value-increasing financing, investment and production decisions, and engage in earnings management. Also Jensen (1993) provides evidence that highly incentivized CEOs engage in higher levels of earnings management. Just like Bergstresser and Philippon (2006), who say that large option packages increase the incentives for managers to manipulate their firms’ reported earnings. This engaging in earnings management is the most important disadvantage of incentive compensation.

According to Healy and Wahlen (1999) earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports. This is done to either mislead some stakeholders about the underlying economic performance of the company, or to influence

contractual outcomes that depend on reported accounting numbers. Du and Li (2013) say that earnings management behavior exists universally in modern corporation and the nature of this behavior is distorting the financial position of the enterprise by using the rules of GAAP or accounting system to achieve the expected level of surplus. Schipper (1989) defines earnings management as a purposeful intervention in the external financial reporting process, with the intention of obtaining some private gain.

According to Zang (2012) earnings management is likely to occur when firms just beat or meet an important earnings benchmark. Graham et al. (2005)

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found that financial officers view earnings as the most important metric reported to outsiders. They state that the reasons for managers to want to either meet or beat earnings benchmark is to build credibility with the capital market, to improve the external reputation of the management team, to maintain or increase stock price and to convey future growth prospects. They state that failing to hit earnings benchmarks creates uncertainty about the prospects of a firm, and raises the possibility of hidden, deeper problems at the firm. The reasons that Healy and Wahlen (1999) found for earnings management to occur is to influence stock market perceptions, to reduce the likelihood of violating lending agreements, to increase management’s compensation, and to avoid regulatory intervention.

There are two ways in which earnings can be managed, namely: by accrual-based earnings management and by real earnings management.

2.2.1 Real earnings management

Gunny (2010) describes real earnings management as the way in which managers undertake actions that deviate from the first best practice to increase reported earnings. Zang (2012) says it is a purposeful action to alter reported earnings in a particular direction by changing the timing or structuring of an investment, operation, or financial transaction which may have suboptimal performance consequences. Roychowdhury (2006) defines real earnings management as management actions that deviate from normal business practices, undertaken with the primary objective of meeting certain earnings thresholds. According to Schipper (1989), real earnings management is

accomplished by timing of financing decisions or investments to alter reported earnings or some subset of this.

The types of earnings management that are discussed by Gunny (2010) include overproduction to decrease cost of goods sold expense and cutting desirable research and development investments to boost current-period earnings. Roychowdhury (2006) finds evidence suggesting overproduction to report lower cost of goods sold, price discounts to temporarily increase sales, and reduction of discretionary expenditures to improve reported margins.

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According to Roychowdhury (2006) managers engage in earnings

management either because they perceive private benefits to meet the reporting goals or because they act as agents in value-transfer amongst shareholders. Further, he finds evidence consistent with managers manipulating real activities to avoid reporting annual losses. Fuller and Jensen (2002) found that the

preservation of short-term stock value became a personal priority for many CEOs and CFOs as stock options became an increasing part of executive

compensation, and managers who made great fortunes on options became the stuff of legends. Further, managers were encouraged by overvalued equity currency to make acquisitions and other investments in the hope of sustaining growth, continuing to meet expectations, and buying real assets at a discount with their overvalued stock.

Graham et al. (2005) document the widespread use of real activities manipulation by surveying more than 400 executives. Eighty percent of the CFOs in their survey stated that, in order to meet an earnings target, they would

decrease expenditure on advertising, R&D, and maintenance, while fifty-five percent said they would postpone a new project, even if such delay caused a small loss in firm value. Real earnings management can reduce firm value because actions taken in the current period to increase earnings can have a negative effect on cash flows in the future periods (Roychowdhury, 2006). According to Walker (2013), real earnings management may have real cash flow consequences and can therefore destroy firm value. This is not the case with accruals-based earnings management.

Still, Gunny (2010) finds that firms that are engaging in real earnings management to just meet earnings benchmarks have relatively better subsequent performance than firms that do not engage in real earnings

management and miss or just meet the benchmarks. She says that these results suggest that engaging in real earnings management is not opportunistic, but consistent with the firm attaining current-period benefits that allow the firm to perform better in the future, or signaling it.

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2.2.2 Accrual based earnings management

The use of accruals to temporarily boost or reduce reported income is another mechanism of earnings management. Accruals are components of earnings that are not reflected in current cash flows, and a great deal of managerial discretion goes into their construction (Bergstresser & Philippon, 2006). Healy (1985) defines accruals as the difference between reported earnings and cash flows from operations.

Accrual-based earnings management involves adjusting net income by changing accounting estimates without changing actual operations

(Roychowdhury, 2006). It is achieved by changing the accounting methods or estimates used when presenting a transaction in the financial statements (Zang, 2012). Gunny (2010) says that accruals management involves within GAAP accounting choices that try to obscure or mask true economic performance. Algharaballi et al. (2008) state that accruals represent a favoured instrument for manipulation because of their relatively low cost and unobservable nature. But they also argue that managers have to realize that any accrual manipulation must be reversed in the future, and this is related to the reversible nature of accruals.

2.2.3 The trade of between accrual and real earnings management Most earnings management is achieved via real actions, as opposed to accounting manipulation. Graham et al. (2005) argue that managers prefer real earnings management because it is safer than accruals-based earnings

management. This is because it does not receive as much attention from

regulatory bodies and external auditors as accrual-based earnings management does. This is confirmed by Roychowdhury (2006), who argues that financial executives prefer to manipulate earnings through real activities rather than through accruals. This is because accrual manipulation is more likely to draw auditors or regulator scrutiny than real decisions about pricing and production, and relying on accrual manipulation alone entails a risk.

However, Goh et al. (2013) mention that real earnings management that is undertaken to increase current accounting numbers damages long-term firm

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management. Also, Walker (2013) says that real earnings management can destroy firm value. This is not the case with accruals-based earnings

management.

Zang (2012) finds that the trade-off decisions of managers are influenced by the costs and timing of earnings management activities. His first result is consistent with managers trading off earnings management methods based on their relative costliness. He finds that, when accrual-based earnings management is constrained because of a higher level of scrutiny of accounting practice in the post-SOX period, and limited accounting flexibility because of accrual

manipulation in prior years and shorter operating cycles, firms use real activities manipulation to a greater extent. The results also indicate that firms use more accrual-based earnings management and less real earnings management when the real earnings management is more costly to them, as a result of a less healthy financial condition, having a less competitive status in the industry, incurring greater tax expenses in the current period, and experiencing higher levels of monitoring from institutional investors.

His second results indicate a direct substitutive relation between real earnings management and accrual-based earnings management; the level of the accrual-based earnings management is negatively related to the unexpected amount of the real earnings management realized at the fiscal year-end. This suggests that, after the fiscal year-end, managers fine-tune their accrual accounts based on the outcomes of the real earnings management, consistent with the sequential decisions.

Cohen et al. (2008) document that there was a steady increase in accrual-based earnings management from 1987 until the passage of the SOX in 2002, followed by a significant decline after the passage of SOX. On the other hand, they also document that the level of real earnings management activities declined prior to SOX, followed by a significant increase after the passage of SOX,

suggesting that firms switched from accrual-based management to real earnings management methods after the passage of SOX. Also Ewert and Wagenhofer (2005) demonstrate that real earnings management increases when tightening accounting standards make accruals management more difficult. Just like

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management in place of accrual-based earnings management might be a consequence of the stigma attached to accounting fraud in the post-Enron and post-Sarbanes-Oxley world.

2.2.4 CEO and CFO bonus and equity incentives to manage earnings Most papers about earnings management focus mainly on earnings

management related to CEO and CFO. For example the paper of Bergstresser and Philippon (2006), who state that tying management incentives to the stock price may have had the perverse effect of encouraging managers to exploit their

discretion in reporting earnings, referring to the manipulation of the stock prices of their companies. They found evidence that the more incentivized CEOs lead companies with higher levels of earnings management. Also Cheng and Warfield (2005) tested whether high equity incentive managers engage in earnings management. They did this by examining whether these managers are more likely to report earnings that just meet or just beat analysts’ forecast. Their analysis indicate a significantly higher incidence of meeting or just beating analysts’ forecast for managers with high equity incentives. They further document that managers with high equity incentives are less likely to report large positive earnings surprises, consistent with earnings smoothing. Further, Healy (1985) finds that bonus schemes create incentives for managers to select accounting procedures and accruals to maximize the value of their bonus awards.

Although most of the literature discussed the CEO and earnings

management, Jiang et al. (2010) state that CFO incentives should play a stronger role than those of the CEO in earnings management, because CFOs primary responsibility is financial reporting. The result of their investigation on the possibility of the CFO equity incentives being associated with earnings management, confirms that CFO equity-based pay might create incentives to manipulate earnings.

Graham et al. (2005) report CFOs opinions and motives for earnings management and voluntary disclosure. They found that CFOs appears as keen in the post SOX environment as before to meet or beat earnings benchmarks, because they fear retribution from stock markets. Unless there is a fundamental change in the way in which stock markets perceive small misses from earnings

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earnings management or accrual-based earnings management, and influence analyst expectations, is unlikely to go away. Balsam et al. (2012) find that the CFOs are rewarded higher when there is evidence of earnings management that allowed the form to meet or just beat the earnings target. This result highlights the importance to firms of meeting analyst forecasts and the willingness of the compensation committee to incentivize CFOs for doing just that.

As a limitation to their study, Jiang et al. (2010) mention that they only considered the incentives of CEO and CFO, while it is likely that the incentives of other managers in the organization would also matter. They say that this is quite important because firms that provide their CFOs with strong equity incentives are more likely to provide strong equity incentives throughout the organization.

Therefore, this study will look further than the other studies. Where other studies only discuss the CEO or the CFO compensation, this research will focus on the compensation of COOs and on the influence it will have on earnings management.

2.3 Chief operating officer

Where the CEO is the highest-ranking executive in a firm, the number two position is for the COO. Bennett and Miles (2006) describe that the COO is

typically the key individual responsible for the delivery of results on a day-to-day basis. They say that COOs play a critical leadership role in executing the

strategies developed by the top management. According to Hambrick and Cannella (2004) the functions of COOs entail the allocation of resources, the handling of disturbances, the motivation and monitoring of employees and the communication and implementation of strategies. Hollander (2013) says that COOs have reason to see up, down, and throughout the entire business: every back-office function and line of business, all customer touch points and suppliers relationships. The COO may be in a better position to conduct real earnings management than the CEO or CFO because the COO has the advantage of being deeply involved in the firms operations. But like Bennett and Miles mentioned: ‘The COO role had not received much attention’. Therefore there is no research to the influence of COOs on earnings management.

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Based on this the following hypotheses are developed:

H1: COO equity incentives are associated with real earnings management. H2: COO bonus is associated with real earnings management.

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3. Method

3.1 Sample

The initial sample includes all S&P 1500 firm-years with data on COO compensation available from the ExecuComp database for the period 2002-2012. The sample is restricted to post-2001 data, so after the passage of SOX. The COO is identified based on managers’ titles in ExecuComp (TITLE) that include any of the following phrases: ‘oper’ and ‘Oper’. This sample is merged with a sample of Compustat, containing information from 2002 to 2012.

Merging these samples results in a total of 13.955 observations with

compensation data available for the COO. The observations of this sample with missing values for total assets (AT), R&D (XRD), SG&A (XSGA), and total

liabilities (LT) are excluded. Further, the sample is filtered to generate the R&D, SG&A and Production variables. Lastly, by dropping the cases with less than 10 firms available in an industry-year group, the final sample contains 1390 observations.

3.2 Real earnings management

Within real earnings management, there are different methods how managers can manage the earnings. This paper will examine three types of real earnings management also used by Gunny (2010), namely:

- Myopically investing in R&D to increase income. - Myopically investing in SG&A to increase income.

- Cutting prices to boost sales in the current period and/or overproducing to decrease COGS expense.

The following models, based on the paper of Gunny (2010), are used to calculate the different methods of how managers can manage the earnings. The missing values of variable ‘preferred stock at carrying value (UPSTK)’ are replaced by 0. The normal level of R&D expense is estimated using the following model:

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where:

RD = R&D expense A = total assets

MV = the natural log of market value Q = Tobin’s Q

INT = internal funds

The normal level of SG&A is estimated using the following model:

where: SGA = SG&A A = total assets

MV = the natural logarithm of market value Q = Tobin’s Q

INT = internal funds S = total sales

DD = indicator variable equal to 1 when total sales decrease between t – 1 and t, zero otherwise

The normal level of production cost is estimated using the following model:

where:

PROD = COGS plus change in inventory A = total assets

MV = the natural log of market value Q = Tobin’s Q

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3.3 Bonus and equity incentives

Incentives can arise from either increases in the performance measure on which bonus is tied to, which are called bonus incentives, or incentives in the appreciation of the stock prices, which increases wealth over equity holdings, which is referred to as equity incentives.

In order to measure the relation between earnings manipulation and the power of COO equity-based incentives, a model of the Bergstresser and Philippon paper (2006) is used. This is measured by the dollar change in value of a COO’s stock and option holdings that would come from a one-percentage point increase in the company stock price. This measure is constructed using the ExecuComp Executive Compensation data on COO stock and option holdings. The following model will be used:

where:

PRICE = the company share price

SHARES = the number of shares held by the COO. This will be measured by ExecuComps SHROWN_EXCL_OPTS.

OPTIONS = the number of options held by the COO. This will be measured by ExecuComps OPT_UNEX_EXER_NUM;OPTION_AWARDS_NUM;OPT_EXER_NUM. This ONEPCT is then used to calculate the variable INCENTIVE_RATIO. This measure of incentives is normalized in a way that captures the share of a

hypothetical COO’s total compensation that would come from a one-percentage point increase in the value of the equity of this COOs company. The following model will be used for this:

where:

SALARY = will be measured by ExecuComps SALARY. BONUS = will be measured by ExecuComps BONUS.

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In order to measure the relation between earnings manipulation and the power of COO bonus incentives, the bonus variable (BONUS) in ExecuComp is used.

3.4 Control variables

The first three control variables are based on the paper of Du and Li (2013). The first control variable is the natural logarithm of total assets, which stands for the company’s size (SIZE). The size of the company represents many of the missing variables, therefore it must be controlled to increase the accuracy of the model. The second control variable is operating income growth rate, which represents the company’s growth (GROWTH). Generally the company's research and development, advertising, personnel training and so on are beneficial to the company's future growth, but cannot be reflected in the real value of the

enterprise. In order to reflect the information to the investors, the company’s management is likely to manipulate earnings information to get investors’ attention. The third control variable is the asset-liability ratio, which is on behalf of the level of the company’s debt (DEBT). The higher the company’s debt ratio, the more the company will be inclined to gloss over the company’s financial situation. (Du & Li, 2013)

The fourth control variable, based upon the paper of Zang (2012), is market share (MKTSH), which is a firm’s market-leader status in the industry at the beginning of the year. Market share captures the inverse of the costs associated with real activities manipulation. It is measured by taking the revenue of the firm divided by the revenue of the 2-digit industry classification.

The fifth control variable controls whether or not the company has an auditor that is one of the big 4 (BIG4), which are Ernst & Young, Deloitte, KPMG and PricewaterhouseCoopers. This control variable will be used as the big 4 auditors are likely to be more experienced, to invest more resources in auditing, and to have more reputation at risk than the smaller audit firms (Zang, 2012).

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3.5 Empirical model

To test for the hypotheses, the following regressions are estimated for each year for the period 2002-2012. These regressions will both be made three times, with the first time the abnormal level of R&D as the level of real earnings management, the second time the abnormal level of SG&A will be used for this purpose, and the third time the abnormal level of Production. With this

regression the relation between equity incentives and COO earnings management (hypothesis 1) will be measured:

RM = α1 + α2 EQUI_INC + α3 SIZE + α4 GROWTH + α5 DEBT + α6 MKTSH + α7 BIG4 + ε

With this regression the relation between bonus incentives and COO earnings management (hypothesis 2) will be measured:

RM = α1 + α2 BONUS_INC + α3 SIZE + α4 GROWTH + α5 DEBT + α6 MKTSH + α7 BIG4 + ε

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4. Results

4.1 Descriptive statistics

The descriptive statistics of all the variables mentioned before are given in table 1. The final sample used for this entails 1390 observations.

Table 1: descriptive statistics

Variable N Mean Standard

deviation 25 th percentile Median 75 th percentile Abn. RD 1390 0.00 0.02 -0.01 0.00 0.01 Abn. SGA 1390 0.00 0.12 -0.07 -0.01 0.05 Abn. PROD 1390 0.00 0.12 -0.06 0.00 0.06 EQUI_INC 1352 0.16 0.13 0.06 0.13 0.23 BONUS 1390 69.29 183.35 0.00 0.00 25.00 SIZE 1390 3918.50 8513.21 369.57 936.98 3274.00 GROWTH 964 -0.03 5.13 -0.13 0.07 0.24 DEBT 1390 0.42 0.23 0.23 0.40 0.57 MKTSH 1390 0.03 0.11 0.00 0.00 0.01 BIG4 1390 0.90 0.30 0.00 1.00 1.00

Table 1 shows the descriptive statistics of the variables from the empirical model. The first three variables of table 1 show descriptive statistics related to the

residuals of the normal level of R&D, the normal level of SG&A and the normal level of Production. All three variables are winsorized at the 1st_{and 99}th

percentiles of their distributions to avoid the influence of outliers. The mean of the abnormal level of R&D is zero, also with a median of zero. These outcomes correspond to the outcomes of Gunny (2010). Also the outcomes of the abnormal level of SGA are quite the same. Both the means are again zero, and where table 1 shows a median of -0.01, Gunny had a median of -0.02. These outcomes are very close to each other. Also Cohen et al. (2008) make use of these two variables, with the difference of combining them in the variable discretionary expenditure together with advertising costs. Their descriptive statistics show a mean for this variable of 0.08, and a median of 0.01. This is quite higher than the mean in table 1, which can be explained by the different period Cohen et al. uses (1987-2005), because their sample is not filtered for only COOs, or because they included advertising costs. Though, the amounts of the two medians are closer to each other.

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Finally, also the outcomes of the abnormal level of Production are much alike to those of Gunny. There is a mean of zero, and where table 1 gives a

median of also zero, Gunny has a median of -0.01. Also this difference is minimal. But again the difference with the descriptive statistics of Cohen et al. is quite bigger. They show a mean of -0.06 and a median of 0.04. Again this difference could be explained by the difference in sample.

The fourth variable is the equity incentive ratio, which is based on the model of Bergstresser and Philippon (2006). In their paper they show an equity incentive ratio mean of 0.263, where table 1 shows a mean of 0.16. This

difference could be explained by the fact that the paper of Bergstresser and Philippon is based upon CEO incentives, and this paper is based upon COO incentives, which in that case means that the equity incentive ratio for COOs is lower than the ratio for CEOs. But the different time periods on which the investigations are based could also be a reason for this difference.

The fifth variable is the bonus variable, which shows that the mean of the bonus that COOs receive is $69.29. The median for this variable is 0, which means that there are also many COOs who do not receive any bonus.

The last five variables are the control variables. The size variable, which is also winsorized due to big outliers, shows that the mean level of total assets is $3,918.50 with a median of $936.98. Also Cohen et al. (2008) show this variable in their descriptive statistics, though their mean is a lot smaller, namely

$1401.43. This could indicate that in the period on which Cohen et al. based their research, the companies had smaller amounts of assets.

The growth variable shows that the operating income had an average decrease of 3%. Though, the median is positive, namely 7%. Also the debt variable, which entails the asset-liability ratio, is winsorized for outliers. This variable shows that the average debt ratio is 0.42, with a median of 0.40, which means that on average the companies have more than twice as much liability than they have assets. This variable entails the same as the leverage variable of Cohen et al. (2008), which has a mean that is almost the same, namely 0.41. Only the median of 0.21 is quite lower than the one of table 1.

Further, the market share variable gives a mean of 0.03, with a median of 0. The big 4 variable at last, showing the amount of companies that have an

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auditor which is one of the big 4, gives a mean of 0.90, which indicates that there are way more companies with a big 4 auditor than there are companies with another auditor.

Table 2 below shows the correlation between the variables. This table shows that there is a significant correlation between the R&D residual and the equity incentive variable. The correlation between the R&D and the bonus incentive is negative, only this one is just not significant at the 10 percent level. Also the correlations between the SG&A residual and the equity and bonus incentives are negative, but these two are by far not significant. Also the correlations between the production residual and both the incentives are not significant.

Though, there is a significant positive correlation between the R&D residual and the SG&A residual, and a significant negative correlation between the SG&A residual and the Production residual. This could indicate that

managers are inclined to engage in SG&A real earnings management when managers engage in R&D real earnings management, but when managers engage in SG&A real earnings management, they will engage less in Production real earnings management.

Table 2: Correlation table

Abn_RD Abn_SGA Abn_PR OD INC_RATI O BONUS SIZE GROWT H DEBT MKTSH Abn_SGA 0.0713*** Abn_PRO D 0.0050 -0.5091*** INC_RATI O 0.0503* -0.0086 0.0190 BONUS -0.0436 -0.0117 -0.0057 -0.0207 SIZE -0.0061 -0.0273 0.0150 0.2238*** 0.2405*** GROWTH -0.0185 -0.0382 -0.0170 -0.0039 0.0111 0.0166 DEBT 0.0006 0.1981*** 0.0370 0.0042 0.0499* 0.2361*** -0.0685* * MKTSH -0.0070 -0.0115 0.0019 0.0355 0.0750*** 0.2644*** 0.0057 0.1452*** BIG4 0.0196 0.0487* -0.0199 0.0693** 0.0321 0.1369*** 0.0419 0.0880*** 0.0831***

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4.2 Multivariate Analysis

4.2.1 Abnormal real earnings management and equity incentives To test the association between COO equity incentives and real earnings management (Hypothesis 1), the following equation will be used:

RM = α1 + α2 EQUI_INC + α3 SIZE + α4 GROWTH + α5 DEBT + α6 MKTSH + α7 BIG4 + ε

This equation is estimated using the three measures of abnormal real earnings management as the dependent variable: abnormal R&D expense (ERROR_RD), abnormal SG&A expense (ERROR_SGA), and abnormal production costs

(ERROR_PROD). In the case of the abnormal R&D and the abnormal SG&A expense, a negative error term implies that the firm has myopically under-invested in R&D and SG&A to increase income. In the case of abnormal

production costs, a positive error term implies that the firm is cutting prices to boost sales in the current period and/or overproducing to decrease COGS expense, which increases income.

Table 3 below shows the regression for the dependent variable abnormal R&D expense, abnormal SG&A and abnormal Production, with equity incentives.

Table 3: Abnormal R&D, SG&A and Production with equity incentives

Variable Abnormal R&D Abnormal SG&A

Abnormal Production Constant -0.0047 (0.034)** -0.0529 (0.000)*** -0.0078 (0.585) INC_RATIO 0.0036 (0.437) -0.0329 (0.261) 0.0442 (0.135) SIZE 0.0000 (0.450) 0.0000 (0.100) 0.0000 (0.391) GROWTH -0.0001 (0.362) -0.0007 (0.363) -0.0002 (0.755) DEBT -0.0028 (0.306) 0.0988 (0.000)*** 0.0308 (0.088)* MKTSH -0.0067 (0.213) -0.0196 (0.572) 0.0711 (0.043)** BIG4 0.0054 (0.008)*** 0.0250 (0.058)* -0.0157 (0.237) Adj. R-squared 0.0049 0.0350 0.0047 Number of obs 941 941 941 Notes:

*/**/*** represent statistical significance at 10 percent/ 5 percent/ 1 percent levels. Industry and year fixed effects not included.

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First of all, this table shows there is no significant correlation between the

abnormal level of R&D and the level of equity incentives, which can be concluded out of the p-value of 0.437. Though, there is a significant positive correlation between the abnormal level of R&D and the variable big4. This suggests that when a company has an auditor that is one of the big 4, there is a bigger change the COO will engage in R&D real earnings management.

Second, there is also no significant correlation between the abnormal level of SG&A and the level of equity incentives. Still, also this way of real earnings management has a positive correlation to the big 4 variable. So the COOs of companies with a big 4 auditor are more inclined to engage in both R&D and SG&A real earnings management. Further, there is also a significant

correlation between SG&A and the variable debt. This suggests that the higher the company’s liabilities are in comparison to its assets, the more the COO is inclined to engage in SG&A real earnings management. This is also the case with the abnormal level of production, which also has a significant positive

correlation to the debt variable.

Further, the abnormal Production also has a significant positive correlation with the market share variable. This means that the higher the revenue of a company is in comparison to its industry, the more the COO is inclined to engage in Production real earnings management. But also this way of real earnings management has no significant correlation with the level of equity incentives.

The conclusion based on only this table would be that hypothesis 1 should be rejected. But table 4 below, which shows the same variables as table 3 only this time controlled for year and industry effects, gives some other

information.

Table 4: Abnormal R&D, SG&A and Production with equity incentives controlled for year and industry

Abnormal Production Constant -0.0050 (0.109) -0.0532 (0.008)*** -0.0232 (0.255)

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SIZE 0.0000 (0.443) 0.000 (0.086)* 0.000 (0.488) GROWTH -0.0001 (0.348) -0.0006 (0.384) -0.0003 (0.713) DEBT -0.0032 (0.284) 0.1037 (0.000)*** 0.0424 (0.029)** MKTSH -0.0068 (0.214) -0.0168 (0.632) 0.0696 (0.050)* BIG4 0.0057 (0.006)*** 0.0250 (0.062)* -0.0184 (0.172) Adj. R-squared -0.0055 0.0252 -0.0034 Number of obs 941 941 941

Notes: */**/*** represent statistical significance at 10 percent/ 5 percent/ 1 percent levels. Industry and year fixed effects included.

This table shows that there is in fact a correlation between real earnings management and the level of equity incentives. Here, there is a positive correlation at the significance level of 10% between the abnormal Production and equity incentives. This result suggests that COOs in companies with a higher level of equity incentives actually are inclined to engage more in real earnings management. With this result the first hypothesis should not be rejected.

This table further shows the same significant correlation as table 4: both abnormal R&D and SG&A have a positive significant correlation with the variable big4, both abnormal SG&A and Production have a positive significant correlation to the variable debt, and there is a positive significant correlation between abnormal production and market share. Only this table adds to this that there also is a positive significant correlation between abnormal SG&A and the size of the company. This suggests that the higher the amount of assets in a company, the more the COO is inclined to engage in SG&A real earnings management.

4.2.2 Abnormal real earnings management and bonus incentives To test the association between COO bonus and real earnings management (Hypothesis 2), the following equation will be used:

RM = α1 + α2 BONUS + α3 SIZE + α4 GROWTH + α5 DEBT + α6 MKTSH + α7 BIG4 + ε

This equation is also estimated using the three measures of abnormal real earnings management as the dependent variable: abnormal R&D expense (ERROR_RD), abnormal SG&A expense (ERROR_SGA), and abnormal production costs (ERROR_PROD).

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Table 3 shows the regression for the dependent variable abnormal R&D expense, abnormal SG&A and abnormal Production, with bonus incentives.

Table 5: Abnormal R&D, SG&A and Production with bonus incentives

Abnormal Production Constant -0.0036 (0.085)* -0.0503 (0.000)*** -0.0062 (0.647) BONUS 0.0000 (0.650) 0.0001 (0.738) -0.0000 (0.667) SIZE 0.0000 (0.587) -0.0000 (0.037)** -0.0000 (0.685) GROWTH -0.0001 (0.493) -0.0006 (0.437) -0.0003 (0.700) DEBT -0.0013 (0.640) 0.1069 (0.000)*** 0.0280 (0.112) MKTSH -0.0076 (0.156) -0.0117 (0.737) 0.0663 (0.058)* BIG4 0.0041 (0.039)** 0.0131 (0.309) -0.0080 (0.533) Adj. R-squared 0.0010 0.0352 0.0010 Number of obs 964 964 964

Notes: */**/*** represent statistical significance at 10 percent/ 5 percent/ 1 percent levels. Industry and year fixed effects not included.

This table also shows a positive significant correlation between abnormal R&D and big4, between abnormal SG&A and debt and size, and between Production and market share. Though, the high p-values of bonus incentives (0.650, 0.738 and 0.667) indicate that there is no significant correlation between real earnings management and bonus incentives. Based on this table, hypothesis 2 should be rejected.

Even table 6 below does not change this conclusion. This table also shows the regression for the dependent variable abnormal R&D expense, abnormal SG&A and abnormal Production, with bonus incentives. Only this time the table is controlled for year and industry effects.

Table 6: Abnormal R&D, SG&A and Production with bonus incentives controlled for year and industry

Variable Abnormal R&D Abnormal SG&A Abnormal Production Constant -0.0050 (0.088)* -0.0608 (0.002)*** -0.0133 (0.491)

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SIZE -0.0000 (0.578) 0.0000 (0.030)** -0.0000 (0.855) GROWTH -0.0001 (0.453) -0.0006 (0.437) -0.0003 (0.678) DEBT -0.0014 (0.632) 0.1146 (0.000)*** .0368 (0.050)* MKTSH 0.0074 (0.174) -0.0104 (0.770) 0.0663 (0.062) BIG4 0.0043 (0.031)** 0.0127 (0.330) -0.0098 (0.449) Adj. R-squared -0.0091 0.0265 -0.0076 Number of obs 964 964 964

Notes: */**/*** represent statistical significance at 10 percent/ 5 percent/ 1 percent levels. Industry and year fixed effects included.

This table shows again the positive significant correlation between abnormal R&D and big4, and between abnormal SG&A and debt and size. Further this table also gives a positive significant correlation between abnormal production and the debt variable. But there is no significant correlation between the ways of real earnings management and the bonus incentive variable whatsoever.

Out of this can be concluded that hypothesis 2 should be rejected. These regression analyses show that there is no association between COO bonus and real earnings management.

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5. Conclusion

This paper examines three types of real earnings management: cutting discretionary investment of R&D to decrease expense, cutting discretionary investment of SG&A to decrease expense, and cutting prices or extending more lenient credit terms to boost sales and/or overproduction to decrease COGS expense. First, this research examines whether the measures of these types of real earnings management are associated with the equity incentives of COOs. Second, this research examines whether the measures of real earnings management are associated with the bonus incentives the COOs receive. The results indicate that, after controlling for growth, debt, market share and big 4, and after including industry and year fixed effects, the Production type of real earnings management is significantly related to COOs equity incentives. This suggests that when COOs are incentivized by equity, they are more inclined to cut the prices or to extent more lenient credit terms to boost sales and/or to overproduce in order to decrease COGS expense. Further, the results indicate that there is no significant relation between real earnings management and bonus incentives.

This paper makes the following contributions to prior literature. First, it contributes to the literature on earnings management. This paper extends research by undertaking a comprehensive analysis of the three types of earnings management and their relation with the COO. Most of the current research on earnings management focuses on detecting abnormal accruals, but there is not much prior literature about real earnings management. However, real earnings management increased significantly in the last years. Second, this paper

contributes to the literature on incentive compensation. This contribution is by providing information about the influence of COO incentives on earnings management. Where there is already a considerable amount of information available about the influence of CEO and CFO incentives on earnings

management, there is little information about the role of the COO.

Limitations of this study are first that it only focuses on the influence of COO incentives on earnings management, without taking the influence of the

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situation, this could be added in further research. Another area for further research is the timing of the real earnings manipulation. While they have to occur during the year, their intensity should increase towards the end of the year as managers form more reliable expectations of pre-managed earnings for the year. Finally, this study focuses on the COO incentives that are related to real earnings management. It will also be interesting to see how the COO incentives are related to the accrual-based earnings management.

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Appendix A: variable descriptions

Variable Explanation

RM Real earnings management. For this

variable the abnormal level of R&D (Abn_RD), the abnormal level of SG&A (Abn_SGA) and the abnormal level of Production (Abn_PROD) will be used.

EQUI_INC Equity incentives. For this the

incentive ratio is measured using ExecuComp executive compensation data on COO stock and option holdings

BONUS_INC Bonus incentives. For this the BONUS

variable in ExecuComp is used.

SIZE The company’s size. Based upon the

total assets (AT).

GROWTH The company’s growth. This is based

upon the operating income growth rate (OIBDP).

DEBT The level of the company’s debt. This is

based upon the asset-liability ratio (LT/AT).

MKTSH A firm’s market-leader status in the

industry at the beginning of the year. It is measured by taking the revenue of the firm divided by the revenue of the 2-digit industry classification. (REVT)

BIG4 Dummy variable which is 1 is a firm

has a big 4 auditor and zero otherwise. For this the auditor variable (AU) is used.

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The impact of COO incentives on real earnings management.