Earnings management and asymmetric sensitivity of bonus compensation to earnings for high-growth firms

Abstract

In this paper, we examine whether high-IOS (investment opportunity set) firms vis-à-vis non-growth (low-IOS) firms will not reduce discretionary expenditures, such as advertising expenses, research and development, and SG&A (selling, general and administrative) expenses, to further sustain the firm growth in a more conservative reporting environment (the post-Sarbanes-Oxley (SOX) period). We also investigate, as an extension of a prior paper, the sensitivity of CEO bonuses to earnings in the cases of high-IOS and low-IOS firms. We find a stronger association between incentive compensation and asymmetric sensitivity of bonus to earnings for high-IOS firms in the pre-SOX period, and this asymmetric sensitivity disappears even for high-IOS in the post-SOX period. As in a prior study, we also look into whether accounting conservatism is stronger in the post-SOX period for both high-IOS and low-IOS firms than in the pre-SOX period. The findings are consistent with our hypotheses that high-IOS firms vis-à-vis low-IOS firms will not reduce discretionary expenditures, asymmetric sensitivity bonus to earnings disappears in the post-SOX period for both high-IOS and low-IOS firms, and that accounting conservatism for both high-IOS and low-IOS firms are stronger in the post-SOX period. The documented evidence in this study shows how regulatory changes affect both accrual and real earnings management behaviors, how those regulatory changes affect the sensitivity of bonus compensation to earnings, and how accounting conservatism affects bonus compensation changes in the post-SOX period in relation to the pre-SOX period for both high-IOS and low-IOS firms