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Tahir et al. (2019) – Getting compensation right – the choice of performance measures in
CEO bonus contracts and earnings management
Examines whether the choice of performance measures in CEO bonus compensation
contracts is associated with earnings management. They find less income-increasing
manipulation through discretionary accruals and expenses when non-financial performance
measures (NFPMs) are used alongside financial performance measures (FPMs) and when
the NFPMs are used to a larger extent than FPMs. Furthermore, they find less discretionary
accruals when long-term performance measures are used. This implies that non-financial
and long-term measures encourage executives to work toward the long-term success of the
company rather than their own short-term reward.
There has been much criticism that executive compensation is not linked to performance.
One possible explanation is that incentives provided through compensation contracts lead
to adverse effects on firm performance. Specifically, the inclusion of short-term focused,
earnings-based performance measures in executive compensation can lead to earnings
manipulation and therefore inaccurate firm performance.
Regulatory changes in the UK have encouraged the use of a diverse set of performance
measures in executive compensation.
When assessing reward-based compensation for executives, especially in bonus pay,
appropriate performance measures must be chosen. These may be related to financial
results of the company, non-financial factors, or a combination of both. These can be short-
term or long-term focused. The use of non-financial performance measures enables better
strategic planning, giving investors a more accurate picture of the company’s overall
performance. They also focus managers on the long-term and avoid the risk of managers
making short-term decisions to increase their pay, at the expense of the longer-term
success of the company.
Conclusion:
The paper examines the importance of the choice of performance measures in CEO bonus
contracts in constraining earnings management both through accruals and real activities
management. Performance measures are classified as financial and non-financial measures
with particular emphasis on the degree of weighting given to both FPMs and NFPMs. They
find that less income-increasing manipulation through discretionary accruals and expenses
takes place when FPMs and NFPMs are used together to assess executive performance. In
addition, they find that if equal or more weight is given to NFPMs the amount of earnings
management by discretionary accruals and real activities management through
discretionary expenses and overproduction is lower.
They also classify the performance measures using principal components analysis into two
factors which are interpreted as long-term and short-term factors. They find that the use of
long-term factors is associated with less income-increasing manipulation through
discretionary accruals. They present several robustness tests which provide similar results.
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