Top Management Team Incentive Dispersion and Earnings Quality*

Abstract

ABSTRACTThis paper examines the relation between the dispersion in pay‐performance sensitivities (PPS) among top management team (TMT) members and earnings quality. Prior research suggests that the PPS from executives' equity compensation induce earnings manipulation incentives. Most of this research, however, focuses on the PPS of individual executives, even though the financial reporting process requires the coordination among a broad range of executives. Focusing on the dispersion in PPS among TMTs, we develop a model that shows that, due to the coordination incentives embedded in compensation arrangements, managers with more closely aligned PPS will be more willing to work together to manipulate earnings as the rewards are shared more evenly among them. We empirically test the implications from our model and find a positive relation between PPS dispersion and earnings quality. We further find that the stock price reaction to firms' reported earnings relates to the earnings manipulation incentives based on PPS dispersion. Our results suggest that differences in PPS among TMT members hamper the coordination necessary to manipulate earnings and that investors are aware of this impact. Our study has important implications related to compensation‐related disclosures (e.g., those under section 953a of the Dodd‐Frank Act of 2010) and their potential impact on investors' understanding of earnings quality.