Compensation Shifting from Salary to Dividends

Abstract

This paper examines whether owner-managers of small firms use their compensation strategically to change reported earnings. We identify an institutional setting, Denmark, in which the owner-manager has the discretion to shift compensation from salary to dividends and hence increase reported earnings at almost no direct cost due to approximate tax neutrality between the two income streams. Three findings emerge. First, owner-managers are twice as likely to decrease their salary when doing so can result in meeting or beating the zero earnings benchmark. Second, those decreasing their salaries to beat the benchmark are 45% more likely to increase dividends simultaneously than those who can beat the benchmark but do not. This indicates that reporting incentives shape compensation shifting. Third, owner-managed firms enjoy about 6% (EUR 1070) lower interest rates (interest expenses), than firms reporting losses, when they beat the benchmark by simultaneously decreasing salaries and increasing dividends. Our results highlight that owner-managers can manage reported earnings by altering their own compensation, which has economic consequences for the firm. This has implications for users of owner-managed firms’ financial reports because reported earnings would seem a poor contracting signal for these firms.