Learning Through a Smokescreen: Earnings Management and CEO Compensation over Tenure

Abstract

We investigate how boards set a CEO’s compensation over her tenure in the presence of performance distortions by the CEO that may confuse the signal that the board gets from reported performance. Career concerns suggest that CEOs have an incentive to distort performance to extend their tenure (Fudenberg and Tirole (1995)), particularly in the early years when there is greater uncertainty about their ability. But managerial discretion in the use of accruals may also be informative about underlying business conditions (Teoh, Welch, and Wong, 1998). Over the CEO’s tenure, as more information is revealed about her ability, boards will place less weight on distorted performance in determining compensation. Consistent with this argument, we find that compensation is positively associated with earnings distortion in the early years of a CEO’s tenure, when less is known about ability, and the relationship becomes weaker and negative over tenure. We show that the relationship between reporting distortions and compensation varies based on CEO characteristics that capture uncertainty about ability and career concerns: earnings management is more strongly correlated with the compensation of younger CEOs; and, CEOs without a fixed-term employment contract. These results are robust to treating tenure and earnings management as endogenous and imply that boards adjust compensation in response to potential earnings distortions in the early years of a CEO’s tenure.