Executive equity incentives, earnings management and corporate governance

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Weber, Margaret Liebenow

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This paper investigates whether executive wealth sensitivity to stock price fluctuations or executive equity transactions serve as incentives for earnings management. I find that increasing wealth sensitivity, most notably the sensitivity arising from stock holdings, is associated with CEO abnormal accrual usage. Further, the relation between abnormal accruals and stock-based wealth sensitivity is consistent with incomesmoothing earnings management. Since smooth earnings are associated with higher stock valuations my findings suggest that wealth exposure arising from stock ownership is effective in aligning the interests of CEOs and shareholders. I also analyze whether governance quality influences the wealth sensitivityabnormal accrual relation. While strong governance is associated with lower overall levels of abnormal accruals, governance does not significantly influence the association between CEO stock-based wealth sensitivity and earnings smoothing. The failure of governance to curb earnings management supports the proposition that income smoothing is an expected outcome of efficient contracting consistent with incentive alignment. I also examine whether executives opportunistically manage earnings in order to maximize the value of their stock transactions. My findings suggest managers behave opportunistically. Specifically, I find an increase in income-decreasing accruals preceding large stock purchases by CEOs as well as an increase in income-increasing accruals following, but not preceding, large stock sales by CEOs; both suggest trading on private information. I also document that governance does not materially affect CEO use of abnormal accruals around transactions.