However, a prior study by Weber (2006) also investigates the effects of governance on the relation between CEO wealth sensitivity and earnings management using a random sample of 410 S&P 1500 firms. Weber (2006) finds that CEO wealth sensitivity is positively related to abnormal accruals and that governance does not significantly affect this relation. Weber (2006) defines monitoring intensity by only using the factor that explains the most variance from the principle component analysis. However, this methodology could misclassify firms because monitoring has multiple dimensions and using only one factor ignores the presence of substitutive monitoring mechanisms. Furthermore, in contrast to Weber (2006), using two monitoring intensity factors, we find that monitoring intensity has a significant effect on the relation between equity incentives and earnings management. Additionally, our study uses a broader sample of firms, a longer sample period, and multiple proxies for earnings management.
In addition to our primary contribution, we add to the literature in two ways. First, while prior studies on equity incentives and accrual-based earnings management document that the results are dependent on controlling for operating cash flow volatility, we show that for firms with low monitoring, equity incentives are positively related to accrual-based earnings management even after controlling for operating cash flow volatility. Second, we add to the literature by providing evidence on the
effects of monitoring intensity on the relation between equity incentives and real earnings management. To our knowledge, the only other study that investigates the relation between equity incentives and real earnings management is Cohen et al. (2008).4However, Cohen et al. (2008) do not consider the mitigating effects of monitoring intensity on this relation.
An important limitation of our study (and other work in this area more generally) is that equity incentives and other governance mechanisms are likely to be chosen endogenously with the firm
’s other corporate policies,
structures, and features. Thus, while we attempt to mitigate the effects of endogeneity, we cannot definitively rule out the possibility that our results could be affected by endogeneity bias.
The
remainder
of
this
paper
is
organized
as
follows.
Section 2 presents a discussion of prior research and our hypothesis development. Section 3 presents our research design choices and their rationale. The evidence is presented in Section 4 and the conclusion in Section 5.
2. Prior research and hypothesis development 2.1. Prior research
Equity incentives are an important part of firmsstructures that are used to align managers
’’ governance
interests with shareholder
interests (Mirlees, 1976, Jensen and Meckling, 1976 and Holmstrom, 1979). However, recent studies suggest that they also motivate managers to
focus on boosting stock price in the short term (see for example, Bar-Gill and Bebchuk, 2003 and Goldman and Slezak, 2006).
Prior studies document mixed evidence on the effect of equity incentives on earnings management. On the one hand, Gao and Shrieves, 2002, Cheng
and
Warfield,
2005, Bergstresser
and
Philippon,
2006 and Weber, 2006, and Cornett et al. (2008) find that equity incentives are positively related to the absolute value of abnormal accruals. On the other hand, Hribar and Nichols (2007) demonstrate that findings of earnings management in studies that are based on absolute abnormal accruals no longer hold once controls for cash flow volatility are added. Furthermore, in contrast with studies documenting opportunistic effects of equity incentives, Cohen et al. (2008) find a negative relation between real earnings management methods and stock ownership, CEO bonuses, and unexercisable options consistent with incentive alignment effects dominating opportunistic effects. Armstrong et al. (2010a, 226) summarize the findings on the relation between equity incentives and accounting irregularities of all types (including accrual based earnings management) by stating that literature.
”“no conclusive results have emerged from the
Thus, whether equity incentives result in earnings
management remains an open question.
2.2. Equity incentives and other governance mechanisms
We view equity incentives as one element of a firm
’s overall governance
structure. Furthermore, we note that equity incentives have both an incentive alignment effect as well as an opportunistic financial reporting effect. The incentive alignment effect follows from agency theory which suggests that managerial stock ownership align their interests with shareholders (Jensen and Meckling, 1976). The opportunistic financial reporting effect arises because managers with high equity incentives are motivated to overstate accounting performance and boost stock prices in the short-run. For example, Bar-Gill and Bebchuk (2003) show that when managers can sell shares in the short-run, they will be motivated to misreport performance and misreporting will be an increasing function of the fraction of management-owned shares that could be sold (also see Goldman and Slezak, 2006 and Ronen et al., 2006).
If firms choose their governance structures to maximize value, and optimally use equity incentives in conjunction with other governance mechanisms, there will be either a negative relation or no relation between equity incentives and earnings management. Intuitively, any opportunistic effects of equity incentives would be exactly offset by other governance or monitoring mechanisms. However, adjusting governance structures is costly so it is unclear whether most firms end up with optimal equity incentives and monitoring mechanisms in a dynamic environment. Deviations from optimal monitoring raises the possibility that under some conditions the opportunistic effects of equity incentives may dominate or mitigate the