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CEO incentive compensation and CEO incentive

compensation
earnings management
The implications of institutions and
governance systems 2447
Madi Almadi Received 9 May 2016
Graduate School of Business and Law, Revised 19 July 2016
Accepted 5 September 2016
RMIT University, Melbourne, Australia, and
Philip Lazic
PricewaterhouseCoopers International Ltd, Bielefeld, Germany

Abstract
Purpose – The purpose of this paper is to investigate the impact of CEO incentive-based
compensation on earnings management, taking into account the influence of institutional settings and
corporate governance systems.
Design/methodology/approach – Using archival data of 3,000 British, Australian, German, and
Austrian firm-years between 2005 and 2014, the study applies fixed-effect estimator to reduce risks of
endogeneity bias.
Findings – The findings reveal that institutional factors influence the relationship between CEO
incentive-based compensation and earnings management. Particularly, firms from countries within the
Anglo-American model (the UK and Australia), which provide greater protection for investor, stricter
legal enforcement, and higher quality of corporate governance, tend to have lower level of earnings
management. However, besides corporate governance quality, it is relevant to consider weaker
investor protection and legal enforcement to motivate earnings management in firms from countries
within the Euro-Continental model (Germany and Austria).
Originality/value – The study suggests that robust implementation of corporate governance,
derived from either model, helps in restraining CEO opportunistic behavior. Importantly, more
qualified institutions have higher impact on the relative adequacy of CEO incentive-based pay
formulas in mitigating earnings management concerns. This can be extended by future research
through comparative studies using other contexts or influential institutions.
Keywords Anglo-American corporate governance model, CEO incentive-based compensation,
Euro-Continental corporate governance model, Institutional factors, Earnings management
Paper type Research paper

1. Introduction
Several studies have shown, through various methodologies, the significant effect of
CEO incentives formulas on solving earnings management problems. Yet, they often
deliver contradictory results ( Jha, 2013; Nikolov and Whited, 2014). More importantly,
the majority of research has been conducted within a single country or corporate
governance context (mainly the USA or the Anglo-American model), thus unaccounted
for potential differences in institutional factors that could play a significant role in
influencing this pivotal and complex relationship between CEO incentives and
earnings (Chen et al., 2015; Lo, 2008; Pathak et al., 2014).
According to the generally adopted managerialist approach of agency theory, Management Decision
financial incentives are viewed as means whereby self-serving CEOs skim Vol. 54 No. 10, 2016
pp. 2447-2461
organizational profits and expropriate shareholders (Graham et al., 2012). © Emerald Group Publishing Limited
0025-1747
Self-serving occurs when firms largely rely on accounting-based performance DOI 10.1108/MD-05-2016-0292
MD measures during the evaluation of CEO performance. Indeed, accounting-based
54,10 performance measures are liable to manipulation as they are backward looking.
CEOs can in various ways influence their compensations and thus maximize their
personal gains at the expense of shareholders. Notably and according to Fu et al. (2015),
CEOs can expropriate shareholders by opportunistically managing pre-exercise
earnings to increase their cash payouts.
2448 By adopting the managerialist approach aligned with institutional factors in
different countries and governance systems, this paper aims to achieve two objectives.
The first is to highlight possible opportunistic managerial behavior manifested by
accounting earnings management and caused by CEOs incentive-based compensation.
The second is to investigate the impact of institutional factors on this behavior in four
advanced markets (the UK, Australia, Germany, and Austria) and with reference to the
Anglo-American and Euro-Continental models of corporate governance. These factors
relate to the level of investor protection (LIP), the degree of legal enforcement (DLE) and
the quality of corporate governance attributes.
Using archival panel data of 3,000 firm-years between 2005 and 2014 and controlling
for endogeneity, the findings reveal that CEOs of British and Australian firms
governed by the Anglo-American model have less tendency to engage in earnings
management so as to maximize their personal rewards. The paper joins these outcomes
to the strong investor protection, strict legal enforcement, and high quality of corporate
governance system that exist within this context, which appear to mitigate the risk of
CEOs opportunistic behavior. However, except for corporate governance quality, no
significant upward influence is found between CEO performance-based pay and
investor protection or legal enforcement on earnings management among German and
Austrian firms as adopters of the Euro-Continental model.
Correspondingly, the contributions of this study lie in the provision of a comparative
approach of CEO incentives and earnings, and within the statistical findings in
the context of different institutional factors and corporate governance models.
The remainder of this paper is organized as follows. Section 2 provides the theoretical
background and derivative hypotheses. Section 3 addresses the design of this study.
The paper then presents the results and robustness checks in Section 4. Lastly,
Section 5 draws conclusions by discussing the implications, recognizing the limitations
of the findings and providing avenues for future research.

2. Literature review and development of hypotheses

Research on CEOs financial incentives has witnessed a growth of interest in the last
two decades. Since then, studies have investigated whether financial incentives
contracts constitute for an effective motivation tool toward deviant behavior of CEOs.
Underpinned primarily by agency theory (Eisenhardt, 1989), the large extent of
literature exhibits two fundamental aspects. First, the majority of research has been
based on the Anglo-American model of corporate governance, whereas the
Euro-Continental model has received far less attention with regard to CEOs financial
incentives and their implications (Croci et al., 2012). Second, there are two competing
approaches in this regard. On one hand, the optimal contracting approach views CEOs
compensation via performance-based mechanism as an effective response to the
agency problem. On the other hand, the largely embraced managerialist approach
advocates that CEOs compensation and corporate governance practices in general are
the reflection of managerial power and rent-seeking behavior more than the provision
of efficient incentives (Van Essen et al., 2015).
 In consonance with the latter approach, Murphy (1999) indicates that, via the bonus- CEO incentive
maximization, CEOs can use discretionary accruals to maximize short-term compensation
compensation, notably stock options. Aboody and Kasznik (2000) uncover that CEOs
gain stock option award just before positive announcements and pause such awards until
after negative announcements. Healy and Palepu (2001) uphold this notion on strategic
disclosure behavior by which CEOs delay the disclosure of negative announcements until
they have obtained advantageous fringe benefits. In addition, Bebchuk and Fried (2003) 2449
report that the absence of large shareholders tends to facilitate CEOs abilities to control
the board of directors, thereby determining their own compensation that could be at the
cost of shareholders. Indeed, Bartov and Mohanram (2004) demonstrate that abnormal
selling by CEOs is related with less persistence of income positive accruals, which is
partly explained by opportunistic earnings management.
Moreover, Cheng and Warfield (2005) find that higher degree of earnings
management is usually characterized by greater sensitivity to the firm stock price.
Their findings imply that discretionary accruals increase in firms where CEO financial
incentives are closely linked to the value of stock. Artiach et al. (2010) further elaborate
that when the discretionary accruals are significantly higher, the earnings management
is less persistent, suggesting that positive operating performance can be explained by
the CEO stock option compensation. In this regard, it can be argued that such an effect
is an artifact of opportunistic earnings management. In fact, Kuang and Qin (2009) find
that some CEOs behave opportunistically by acting to decrease or increase stock prices
prior to option incentive awards and open market stock purchases.
Despite the lack of agreement among the underlying research, the results of studies
by Angel and McCabe (2008), Dechow et al. (2010), Duellman et al. (2013), and Li (2013)
are telling and all tend to reinforce the discretionary character of CEO behaviors on the
tendency of their deferred incentive compensation. This leads to the first hypothesis:
H1. CEOs Incentive-based compensation promotes earnings management behavior.
Nevertheless, there is a relatively rare discussion made on the effect of institutional
factors on the relationship between CEO incentives and earnings management behavior
and whether the same schemes of CEO incentive have the same influence on earnings
management behavior in the Anglo-American model as in the Euro-Continental model.
To our knowledge, research has yet to thoroughly address that across institutional
factors and particularly in different governance contexts. Despite some comparative
studies have unveiled findings that all of them are indirect or lack comprehensiveness,
they can be used to make predictions regarding this question. For instance, recent
research on CEO compensation (Pathak et al., 2014) and earnings management
(Chen et al., 2015) suggest that different institutional settings are likely to influence the
relationship between CEO incentive compensation and earnings management.
This paper reflects on the Anglo-American and Euro-Continental models of
corporate governance and arranges its debate along three main institutional elements.
The institutional traits of interest are related to the LIP, the DLE and the quality of
corporate governance. The focus therefore will be on whether or not these factors
influence CEO incentive-based compensation and earnings management behavior
within the context of the two governance models.
Prior research indicates that in countries with strong investor protection regimes
there is greater financial transparency and less earnings management, all of which can
be interpreted as evidence of higher accounting quality. Notably, Leuz et al. (2003)
report that strong country level investor protection gives rise to high quality
MD accounting information, and the interaction of these two variables is expected to
54,10 positively affect economic growth. Defond and Hung (2004) further investigate the
implications of the LIP on earnings management tendency across several advanced
economies adopting different governance models. Their findings show a lower trend of
earnings management among firms adopting the Euro-Continental model, where
shareholders are provided by a relatively stricter protection by their governance
2450 system, in comparison with companies implementing the Anglo-American model. In an
extension of the Defond and Hung study, Wright et al. (2006) examine whether board
structure (inside vs outside directors) explains the variation between the LIP and
earnings management within the context of an Anglo-American governance. Using a
sample of British and American firms, they find that earnings management occurs less
frequently given the similar investor protection provided by the same adopted
governance model. More recently, Enomoto et al. (2015) conclude that defensive
measures of earnings management practices are ineffective in the presence of large
CEO ownership that affects the level of protection given to minority shareholders.
Their empirical investigation, which bears on the context of Euro-Continental
governance, shows that the lack of effectiveness in these measures induces a negative
effect that favors the establishment and discretion of majority executives’ shareholders.
Consequently, this paper puts forward the second hypothesis as follows:
H2. CEOs incentive-based compensation promotes earnings management behavior
under weaker investor protection.
In addition, previous studies have indicated that the DLE affects informational content
and pertinence of corporate financial results. Tweedie and Seidenstein (2005) note that
a sound financial reporting infrastructure must consist of an enforcement legal
mechanism that ensures that the principles as laid out by the accounting and auditing
standards are followed. Lara et al. (2005) argue that earnings management practices
differ across countries, and that the divergences are linked to the level of legal
enforcement in each country. Burgstahler et al. (2006) document that earnings
management is more pronounced in countries with weaker legal enforcement.
More precisely, Ding et al. (2007) find that common law countries are relatively
stricter regarding these criteria than countries with a civil law system and
consequently, more conservative financial accounting practices. Kaserer and Klingler
(2008) extend the work of Ding et al. (2007) by demonstrating that firms in
commonwealth countries – where the Anglo-American model is applied – with stricter
legal enforcement, have lower earnings management magnitude compared to civil
law countries with less stricter legal enforcement. However, Acharya and Volpin (2010),
Bol (2011), Boyd et al. (2012) provide evidence that CEO pay tends to be substantially
larger in commonwealth countries, signaling potential engagement in earnings
management. Therefore, based on the notion that the DLE is likely to influence the
relationship between CEO compensation and earnings, combined with the lack of
existing empirical support of such an influence Bryan et al. (2015), this paper proposes
the following hypothesis:
H3. CEOs incentive-based compensation promotes earnings management behavior
under less stricter legal enforcement.
Moreover, weak corporate governance is seen as a culprit for excessive CEO rewards
and corporate collapse. The role of corporate governance mechanisms in relation to
financial reporting is fundamental in ensuring compliance with mandated reporting
requirements and maintaining the credibility of a firm’s financial statements (Brennan CEO incentive
and Solomon, 2008). While previous empirical research has generally established a compensation
negative relationship between governance mechanisms and fraudulent financial
reporting (Ali and Zhang, 2015), the evidence on the association between corporate
governance and earnings management remains inconsistent. For instance, Cornett et al.
(2008) report that the presence of CEO on the auditing and/or compensation committees
negatively impact corporate performance, given the influence of CEOs on dictating 2451
their employment contract would likely undermine the independence among other
board members. However, Liao and Hsu (2013) find little statistical support that the
composition of these committees influence earnings management practices. Similarly,
Lin and Hwang (2010) propose key aspects in other governance attributes in the
mitigation of earnings management that are induced by CEOs, including the size and
independence of the board of directors, the level of majority shareholders, and CEO
duality and ownership. Yet, Fernandes et al. (2012) fail to find significant relationships
between these variables and earnings management. Given such inconsistency in
empirical evidence on the relationships between earnings management and other
attributes related to board effectiveness in monitoring management in the financial
reporting process, this paper introduces the following hypothesis:
H4. CEOs incentive-based compensation promotes earnings management behavior
under lower quality of corporate governance.

3. Research design
3.1 Data and sample selection
To test the hypotheses of this paper, two groups of random samples of listed companies are
identified, representing the Anglo-American and Euro-Continental corporate governance
models respectively. The first group contains firms from the UK FTSE 100 index, as well
as the Australian ASX 200 index. The second is composed of German and Austrian
companies from the 100 FWB Prime Standard and from 100 Wiener Börse indices. The
chosen clustering’s are appropriate given each group closely parallels the three institutional
factors identified previously (Enomoto et al., 2015; Ferri and Maber, 2013). Further, for each
country, 75 companies were ultimately selected following the conduction of two filtering
procedures. First, firms were eliminated due to missing information needed for the period
under analyses covering the years from 2005 to 2014. Second, all firms from the financial
sector were excluded because they are subject to different regulations with regard to
corporate governance practices. All required data are archival based and collected from
firms’ annual reports, which are obtained from the databases of DataStream for the UK,
Connect4 for Australia, Amadeus for Germany, and Compass for Austria. Nevertheless,
data on the LIP is captured form the World Bank (2008) report.

3.2 Selection and definition of variables

This paper uses the methodology of Christensen et al. (2015), Enomoto et al. (2015),
Kothari et al. (2005) to define four proxies as measures that detect earnings
management and represent the dependent variable used in all the analyses of this
study. These proxies are EM1: the magnitude of discretionary accruals, EM2: the
practice of earnings smoothing, EM3: CEOs tendency to avoid minor losses, and EM4: a
cumulative measure of earnings management.
Further, the utilized independent variables come in two groups. The first captures
the latitude in which CEO incentive-based compensation reflects the CEO’s power.
MD In line with Cornett et al. (2008) approach, CEO incentive-based compensation is defined
54,10 as the difference between CEO pay and the next highest executive’s pay divided by the
CEO’s pay. The second group measures the effect of the institutional factors, these
being the LIP, the DLE, and the quality of corporate governance (CGQ).
In addition, this study includes several variables that control for potential
confounding influences on earnings management as documented by previous research
2452 (Duellman et al., 2013; Pathak et al., 2014). These are firm size (SIZE), firm growth
(GROWTH), Research and Development (R&D), and firm financial leverage (FINLEV).
Detailed descriptions for the measures of all the variables are provided in Table I.

Predicted
Variables Label effect Definition

Dependent variables
Earnings management proxies EM1a Discretionary accruals as a ratio of total assets
EM2 The firm Spearman correlation of the change
in accruals and the change in cash flow from
operation, both scaled by logged total assets
EM3 The number of minor profits divided by the
number of minor losses
EM4 Averaging the ranks of all EM1, EM2, and EM3b
Independent variables
CEO incentive-based CEOPAY + The difference between CEO pay and the next
compensation highest executive’s pay divided by the CEO’s pay
The level of investor LIP ± Investor Protection Index from the World
protection Bank (2008) report
The degree of legal DLE ± 1 for the common wealth system and 0 for the
enforcement civil law system
The quality of corporate CGQ ± Corporate governance qualityc
governance
Control variables
Firm size SIZE + Logged total assets
Firm growth GROWTH + Market to book ratio ((market value of equity
+book value of debt)/total assets)
R&D R&D + R&D expenditure
Firm financial leverage FINLEV + The ratio of total debt divided by total equity
Notes: aConforming to Kothari et al. (2005), EM1 is the firm’s standard deviations of operating income
and operating cash flow (both scaled by lagged total assets). The cash flow from operations is equal to
operating income minus accruals, where accruals are calculated as: (Δ total current assets−Δ cash)−
(Δ total current liabilities−Δ short-term debt−Δ taxes payable)−depreciation expense; ba firm-year
observation is classified as a “minor profit” if net earnings (scaled by lagged total assets) are in the
range [0, 0.01]. A firm-year observation is classified as a “minor loss” if net earnings (scaled by lagged
total assets) are in the range [0, −0.01). Net earnings are bottom-line reported income after interest,
taxes, special items, extraordinary items, reserves and any other items included in bottom-line net
income; cthe paper creates an index for measuring the quality of corporate governance composed of a
score of the value of 1 if the company satisfies the following attributes: the compensation and
Table I. nominating committees do not include executives, chairman and CEO positions are separated, the CEO
Variables definition has held his position for a minimum of three years, the board of directors meet at least twice per year,
and their predicted the CEO serves as a board member in at least one of other listed firms, more than 50 percent of the
effects on earnings board is composed by outside directors, institutional investors hold more than 10 pecent of the
management company stocks, and the company financial statement is certified by one of the big four auditing firms
4. Empirical results CEO incentive
4.1 Univariate analysis compensation
Table II offers descriptive statistics as well as a correlation matrix for all the
adopted variables. Panel A of Table II primarily informs that the average value of
accumulative earnings management (EM4) is 9.2 percent with variation of 6.7 percent
among the British and Australian firms. This is lower in Germany and Austria,
suggesting that firms in these markets engage in less earnings management. 2453
The rest of earnings management proxies (EM1, EM2, and EM3) indicate that
CEOs in the UK and Australia count more on earnings smoothing for earnings
management to obfuscate the company’s true financial performance. Conversely,
discretionary accruals and avoidance for minor losses are more prevalent
among German and Austrian companies. These dissimilarities can be the result of
pressures derived from analysts’ financial forecasting and capital market dynamics,
which are suggested to be more pervasive within the British and Australian markets
(Davidson et al., 2005; Lo, 2008).
Additionally, differences between the two groups can be seen in the specific
incentive from each related governance model. The statistics show that CEOs in the
UK and Australia are paid on average 14.5 percent higher than their next highest
paid executives, whereas this extent is 10.7 percent in Germany and Austria.
Given managerial power is being reflected via the extent of relative compensation, the
reported results on CEO incentive-based compensation indicate larger
management power among the British and Australian firms by comparison to
their German and Austrian counterparts. Moreover, the results of the institutional
factors demonstrate that the firms in countries adopting the Anglo-American
model have higher LIP, stricter legal enforcement, as well as having better
governance system. Indeed, the British and Australian firms scored on average
6.6 out of the eight nominated attributes, in comparison to just above 5.5 for the other
group. Besides, German and Austrian companies appear to be more leveraged than
British and Australian firms. Nevertheless, the latter are bigger in size and spend
more on R&D activities.
Furthermore, the correlation matrix presented in panel B of Table II reveals that
CEOPAY is significantly and positively correlated with the four proxies of earnings
management in both groups. These results provide initial support for the paper’s first
hypothesis, where CEOs incentive-based compensation is positively influencing
earnings management behavior. Further, the institutional factors appear to be
inversely correlated with the behavior of earnings management, as well as the relative
compensation of CEOs. However, the significance of these correlations is higher among
British and Australian companies. These observations support the notion proposed by
Bryan et al. (2015) that companies tend to use more CEOs incentive-based
compensation in an environment where shareholder rights are strongly protected,
laws are effectively enforced and firms are better governed. The results show that the
UK and Australian contexts satisfy these attributes. Similar to the findings of previous
research (Bhargava, 2013; Christensen et al., 2015; Lin and Hwang, 2010; Zeghal et al.,
2011), the correlation matrix confirms that variables controlling for firm economic
characteristics are overall positively and significantly correlated with the proxies of
earnings management. Statistically, no correlation is larger than the commonly
accepted level of 0.70, as well as variance inflation factors is 1.43, which is well below
the commonly accepted level of 10 (Wooldridge, 2015). This suggests that
multicollinearity should not to be a problem.
 MD

matrix
54,10

2454

Table II.

and correlation
Descriptive analysis
Panel A: descriptive statistics
British and Australian firms German and Austrian firms
Variables Mean Median Min. Max. Mean Median Min. Max.
EM1 0.083 0.101 −0.080 0.129 0.095 0.060 −0.001 0.127
EM2 0.112 0.056 −0.047 0.087 0.064 0.042 −0.012 0.081
EM3 0.081 0.044 0.064 0.055 0.090 0.041 0.018 0.079
EM4 0.092 0.067 0.048 0.116 0.083 0.047 −0.004 0.054
CEOPAY 0.145 0.129 0.093 0.019 0.107 0.080 0.000 0.164
LIP 9.13 9.13 9.13 9.13 6.64 6.42 5.83 8.80
DLE – – 0 1 – – 0 1
CGQ 6.60 5.62 5 7 5.56 5.74 4 6
SIZE 16.61 13.53 12.65 23.52 12.87 11.99 10.02 14.71
GROWTH 0.461 0.423 0.182 0.489 0.417 0.382 0.151 0.452
R&D 0.151 0.124 0.079 0.241 0.116 0.094 0.074 0.226
FINLEV 0.349 0.300 0.144 0.652 0.636 0.607 0.053 0.741
Panel B: 2-tailed Pearson correlation coefficients for British-Australian (German-Austrian) group are provided above (below) the matrix
Variables EM1 EM2 EM3 EM4 CEOPAY LIP DLE CGQ SIZE GROWTH R&D FINLEV
EM1 1 0.1419* 0.2343* 0.0231* 0.1507 −0.4687* −0.4621 −0.5765 0.0341 0.099 0.0121* 0.0264
EM2 0.1111* 1 0.0451 0.2541* 0.1551 −0.4621* −0.4687 −0.3688* 0.0209 0.0231 0.011 0.0209
EM3 0.099 0.0649* 1 0.011 0.3707 −0.2376 −0.1309* −0.3465 0.0132* 0.0121 0.1177 0.0308
EM4 0.3421* 0.1001 0.1914* 1 0.2519 −0.242 −0.2409* −0.5777 0.3707 0.1617* 0.1133 0.0275
CEOPAY 0.1991 0.2211* 0.5171* 0.3388* 1 −0.2431 −0.3454 −0.341* 0.121 −0.1199 −0.0165 0.0517*
LIP −0.2431 −0.3399 −0.2222 −0.2189* −0.11 1 0.1001 0.4633* 0.1111 0.0803 0.0121 0.0946
DLE −0.2981* −0.3707 −0.2497 −0.4213 −0.0253 0.1947 1 0.297 0.0066 0.0077 −0.055 0.011
CGQ −0.3377* −0.4081 −0.1551* −0.2255 −0.1111 0.3333* 0.1309 1 0.2321 0.0121 0.099 0.0946
SIZE 0.1309* 0.01166 0.4422 0.5303* 0.4081* 0.1166 0.2607 0.1023 1 −0.1188 0.341 0.2156
GROWTH 0.1121 0.2189 0.0407 0.2497 0.2387* 0.0715 0.0418 0.0231 0.2761 1 0.121 0.1001
R&D 0.1144 0.0913 0.044 0.1111* 0.0605 0.0341 0.0033 0.0187 0.3465* −0.1144 1 0.0121*
FINLEV 0.4103* 0.077 0.4103 0.4268 −0.1628 0.1001 0.066 0.066 0.2255 0.187 0.1144 1
Notes: n ¼ 1,500 for each group. *(italic) values are significant at 5 percent (1 percent) level
4.2 Multivariate analysis CEO incentive
To empirically test the impact of CEO incentive-based compensation on earnings compensation
management behavior, and to explore the moderating effects of the institutional
factors on any such impact, the paper applies the following form of fixed effect
regression model:
EM nit ¼ a0 þ a1  CEOPAY it þ a2  CEOPAY it  LIPit þ a3  CEOPAY it 2455
X
DLEit þ a4  CEOPAY it  CGQit þ ak
F ðSI Z E; GROW TH ; R&D; FINLEVÞþ X t þ Y i þ eit
where n ¼ 1, …, 4 is the earnings management proxy’s number; F the control variables;
Xt and Yi the dummies for year and industry fixed effect, respectively; εit the error term.
This paper employs fixed effect specification in order to remove unobserved time and
industry heterogeneities that may be associated with the earnings management
attributes of interest, thereby risk of endogeneity is being controlled.
Moreover, Table III provides the regression estimations for group 1 (British-
Australian firms) and group 2 (German-Austrian firms). Overall, the results of the
regression reveal that the goodness of fit of the tested models are strong, where the
adjusted R2 varies between 34.2 and 53.9 percent among the British-Australian group,
and between 32.5 and 41.2 percent in the other group. Fisher test further supports that,
having values that range from 6.7 to 9.7 at 1 percent significance level across the
models, thus indicating the effectiveness of the included variables in explaining the
variability in earnings management behavior.
With regard to the main variables of interest, the results show that CEO incentive-
based rewards positively influence the level of earnings management. These findings
provide evidence supporting the anticipated H1 that CEOs behave in a self-serving
manner, in which equity-linked compensation motivates their rent extraction through
earnings management practices. Despite its significance, the magnitude of the
relationship between CEOPAY and the proxies of earnings management slightly vary
between the two groups. The findings demonstrate that the German and Austrian
firms have larger figures than the British and Australian counterparts. Hence, rewards’
structure in the German and Austrian context appears to be more likely the subject of
potential earnings management as a reflection of greater CEO dominance.
Nevertheless, other elements may influence these results: precisely enhancement
caused by the control variables included the model that are significantly associated
with earnings management (SIZE, R&D, and FINLEV). Indeed, Artiach et al. (2010)
provide evidence that larger companies may face greater costs compared to smaller
ones due to higher analysts’ forecasts and shareholders scrutiny. Similarly, Jha (2013)
suggests that CEOs in highly leveraged companies tend to use more accrued income to
avoid debt covenant violation. Brown et al. (2011) also report that R&D expenditures
are positively associated with earnings management activities.
Additionally, the regression outcomes show that the joint effects of CEOPAY and
the institutional factors on earnings management vary between the two groups. On one
hand, the interaction terms are negatively and significantly impacting earnings
management proxies among the British and Australian firms. This indicates that
institutional settings put downward pressure on CEO incentive compensation that
likely to motivate earnings management. On the other hand, the moderators on
earnings management lose their statistical significance, apart from the quality’s score
 MD
54,10

2456

earnings
Table III.
Fixed effect
regression of

institutional traits
compensation and
management on CEO
Model (1) Model (2) Model (3) Model (4)
EM1 EM2 EM3 EM4
Predicted
Variables sign Group 1 Group 2 Group 1 Group 2 Group 1 Group 2 Group 1 Group 2

Constant na 0.047 (1.782)** 0.074 (2.065)** 0.027 (0.575)* 0.056 (1.062)** 0.016 (1.456)* 0.037 (1.701)* 0.041 (1.915)** 0.064 (2.107)**
CEOPAY +(H1) 0.379 (2.736)*** 0.397 (4.784)*** 0.347 (1.680)*** 0.370 (2.287)*** 0.279 (1.773)*** 0.385 (1.765)*** 0.244 (1.240)*** 0.369 (2.123)***
CEOPAY × LPI ±(H2) −0.106 (−3.190)*** 0.088 (1.601)* −0.075 (−2.783)*** 0.046 (1.210) −0.069 (−2.542)***−0.054 (−0.976) −0.098 (−3.366)*** 0.023 (1.692)*
CEOPAY × DLE ±(H3) −0.127 (−1.905)** 0.047 (0.915) −0.110 (−1.375)*** 0.030 (0.793) −0.075 (−3.047)*** 0.015 (1.273) −0.145 (−1.795)** 0.018 (1.111)
CEOPAY × CGQ ±(H4) −0.131 (−2.490)***−0.135 (−2.848)** −0.050 (−0.796)** −0.083 (−0.945)** −0.043 (−2.873)***−0.057 (−2.807)** −0.067 (−2.287)** −0.088 (−2.682)*
SIZE ± 0.090 (1.468)*** 0.305 (2.085)*** 0.010 (1.930)** 0.149 (1.982)** 0.388 (1.507)*** 0.367 (1.794)*** 0.560 (2.022)** 0.488 (1.923)**
GROWTH ± 0.001 (1.836)** 0.002 (1.716)** 0.039 (1.080)** 0.003 (0.714) 0.002 (1.689)* 0.001 (1.960)** 0.005 (1.434)* 0.002 (1.120)
R&D ± −0.006 (−1.485)* 0.002 (1.815)** −0.003 (1.511) 0.002 (1.884)** −0.002 (−1.197) 0.002 (1.251) −0.001 (−1.575)* 0.028 (2.332)**
FINLEV ± 0.012 (1.009) 0.080 (3.395)*** −0.002 (−0.753) 0.009 (3.420)*** −0.005 (−1.193) 0.008 (1.368)*** 0.010 (1.166) 0.006 (1.775)***
Adj R2 0.379 0.338 0.365 0.374 0.342 0.325 0.539 0.412
F-Fisher 6.724 (0.000) 8.457 (0.000) 7.065 (0.000) 9.528 (0.000) 9.157 (0.000) 8.555 (0.000) 9.379 (0.000) 9.742 (0.000)
( p-value)
ΔAdj R2 16.2% 7.4% 17.5% 3.8% 19.7% 8.6% – –
(vs model 4)
Notes: n ¼ 1,500 for each group. Group 1 represents the British and Australian companies, and group 2 represents the German and Austrian companies. Standard errors are in
parentheses. *,**,***Significant at 10, 5, and 1 percent levels, respectively
of corporate governance, when considering the German and Austrian contexts. CEO incentive
Therefore, the findings imply that higher investor protection and stricter legal compensation
enforcement reduce the risk of CEO behavior in managing earnings to get more
incentive compensation. More importantly, robust implementation of corporate
governance tools, derived from either the Anglo-American or Euro-Continental models,
helps in restraining CEO opportunistic behavior. Accordingly, this paper finds support
for H2 and H3 and some support for H4. 2457
4.3 Robustness tests
To further corroborate the reported findings and address potential bias of the results,
this paper conducts several robustness tests. First, in line with the suggestion of
Dechow et al. (2010) on the treatment of the error term for the estimation of
discretionary accruals, this paper repeats the regression analysis using two non-
financial measures (abnormal change in employees and abnormal change in order
backlog) to predict discretionary accruals manipulation. The regression outcomes
remain unaffected. Second, to ensure that CEO incentive-based compensation is
captured accurately, this paper further computes CEOPAY as the sum of newly
granted options and restricted stocks divided by total compensation. The regression
outcomes again remain unaffected. Thirdly, the natural logarithm of market
capitalization is used as an alternative of natural logarithm of total assets to proxy
for firm size, which did not change the results of the analyses as well. Lastly, the paper
conducts separate regression analyses by year to control for potential effects of the
global financial crisis. The reported empirical findings hold unchanged.

5. Conclusion
This paper examines potential opportunistic managerial behavior promoted by CEO
incentive-based compensation and manifested by accounting earnings management.
Importantly, it further investigates the potential impact of critical institutional
factors on this behavior with reference to the Anglo-American and Euro-Continental
models of corporate governance. These factors relate to investor protection, legal
enforcement, and corporate governance. Using archival panel data of 3,000 firm-years
between 2005 and 2014 and controlling for endogeneity, the findings reveal that CEOs
of British and Australian firms governed by the Anglo-American model have less
tendency to engage in earnings management in order to maximize their personal
rewards. The paper joins these outcomes to the strong investor protection, strict legal
enforcement, and high quality of corporate governance system that exist within this
institutional context, which appear to mitigate the risk of CEOs opportunistic behavior.
However, except for corporate governance quality, no significant upward influence is
found between CEO performance-based pay and investor protection or legal
enforcement on earnings management among German and Austrian firms as
adopters of the Euro-Continental model.
These findings contribute to the earnings management literature by providing
further empirical support to the current debate about the impact of CEO incentives-
based compensation on earnings manipulation. They show that this relationship is
positively correlated, implying the occurrence of opportunistic managerial behavior is
reflected by accounting earnings management and caused by CEOs incentive-based
compensation. To mitigate the risk of this behavior, strong investor protection, strict
legal enforcement, and corporate governance system are influential in inversing the
relationship between the CEO incentives and earnings management. Therefore, it is
MD evident that institutional factors have a significant influence on CEO incentive-based
54,10 reward’s potential to motivate accounting choices. This impact is not one standard for
all, but depends on the institutional factors and context of the country.
The results of the present study have implications for regulators who are concerned
to minimize opportunities for earnings management and to improve financial reporting
quality. There are also implications for companies seeking to strengthen their corporate
2458 governance with respect to financial reporting. In particular, there would appear to
be scope for strengthening the effectiveness of either the Anglo-American or the
Euro-Continental corporate governance practices and making greater use of
governance attributes as mechanisms to reduce earnings management.
The empirical findings are subject to several caveats. First, earnings management is
difficult to measure, especially as it manifests itself in different forms. This paper
attempts to address this issue by computing several proxies for earnings management,
which led to obtain consistent results across all measures. Second, the paper
acknowledges that other institutional factors may influence the association between
CEO compensation and earnings management. Since institutional factors are often
complementary, it is difficult to fully control for potential impact of other factors and to
disentangle them from the effect of this association. Moreover, the existence of
complementarities raises concerns about endogeneity bias. The paper attempts to
address these concerns with fixed effect specification. However, as the relations among
the institutional factors are difficult to model, the paper acknowledges that other
endogenous interactions may still exist.
With the above limitations in mind, the revelations of this study could be extended
by future research through comparative studies using other institutional factors or by
investigating the influence of social, cultural, political, and other country-specific
elements on CEO compensation to better perceive and recognize their discretion in
dealing with earnings management. Future comparable studies are also encouraged to
use a variety of other proxies to capture earnings management as well as institutional
factors, along with larger sample size and different analytical modeling’s than
implemented by this study. Diverse and robust analyses would undoubtedly enhance
the understanding of earnings management and its impact on firm operations, and
could allow for new and important patterns to be uncovered.

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About the authors

Madi Almadi worked in the banking sector for six years as an Analyst and Planning Manager at
the Citigroup. He holds an MSc from the Manchester Metropolitan University in International
Management, and recently completed PhD in Business and Strategy from the RMIT University.
Madi Almadi is the corresponding author and can be contacted at: madi.almadi@rmit.edu.au
Philip Lazic worked as an Accountant at the Mazars for three years, and is currently a
PricewaterhouseCoopers Auditing Consultant. He holds an MSc in Accounting and Finance from
the University of Münster and Swinburne University of Technology.

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