The Role of Non-Financial Performance Measures in Compensation Contracts in the Curtailment of Earnings Management

Abstract

Most executive compensation contracts (specifically bonuses) are based on accounting-related measures such as earnings per share (EPS), growth in revenue, return on stockholders' equity. However, the recent trend of account manipulation and earnings management documented in the literature may lead to inequitable bonus payments to the managers or executives. Alternative performance measures that may be used to motivate managers are stock prices or market returns and non-financial measures. In this paper, I examine firms in the S&P 500 index and examine the type of performance measures they use in their short-term compensation. I expect that firms that use non-financial performance measures will have a lower prevalence of earnings management, since these measures are harder to manipulate. The findings are opposite to expectations. The firms that use both financial and non-financial performance measures actually have higher discretionary accruals, specifically accounts receivable accruals, than the firms that only use financial performance measures. The interpretation of these results is that these firms suffer from low earning s quality which makes the accounting numbers less meaningful.