CEO Bonus Pay, Tax Policy, and Earnings Management

Abstract

In 1993, Congress passed Internal Revenue Code Section 162(m), which eliminated the tax deductibility of nonperformance-based executive compensation over $1 million. Recent research indicates that, as intended, Code Section 162(m) has strengthened the link between executive pay and firm performance. Although 162(m) apparently has changed executive compensation in a way desired by Congress, we hypothesize that 162(m) has indirectly influenced the financial-reporting process. Specifically, we hypothesize and find evidence to support the following: for numerous reasons associated with “qualifying” a compensation plan per Code Section 162(m), executives in firms that qualify their compensation plans receive relatively low pay when their firm's financial performance is extreme. Because these executives receive relatively low pay for extreme financial performance, an incentive exists to smooth reported earnings over time in order to maximize long-term compensation. The relatively smooth earnings patterns that we observe in qualified firms are related to the use of discretionary accruals. Our results appear robust to alternative sampling and modeling techniques. As such, our evidence suggests that a tax policy designed to curb allegedly excessive executive compensation has indirectly affected the quality of reported earnings.