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2010

[EQUITY INCENTIVES AND EARNINGS MANAGEMENTIN THE UNITED KINGDOM]

Equity incentives

and earnings management

in the United Kingdom

Erasmus University RotterdamErasmus School of EconomicsRotterdam, 2010

Author L.J.P. (John) de Vos (315695)Coach Dr. Y. WangCo-reader Drs. R. van der Wal RA

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Equity incentives and earnings management in the U.K.

Preface

This thesis is written as the final assignment of my study Accounting, Auditing &

Control at the Erasmus University of Rotterdam. While writing this thesis earnings

management and the incentives for CEO’s to engage in earnings management were

of special interest to me. This period has come to an end with the conclusion of this

thesis. First of all I want to thank my family and friends for their support during my

master study. Secondly I would like to thank N. El-Haloush and R. van der Linden for

their support and comments on my thesis. Finally I would like to thank Dr. Y. Wang

for her support and critical review while writing this thesis.

John de Vos

Rotterdam, 2010

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Abstract

The past two decades have shown an enormous increase in stock-based

compensation. In the light of the credit crunch, the global financial crisis and the

following economic recession, variable compensation was a eyesore for a lot of

people. Some companies even asked their employees to hand in their bonuses. This

shows the importance of variable compensation in today’s world.

The use of stock-based compensation should make managers pay more attention to

share price and should provide better alignment between the stakeholders and the

managers of a company. However, recent studies (e.g. O’Connell and Brendan

2004) show that the incentives coming from variable compensation are not always

the right ones. A possible issue is their incentive to engage in earnings management.

This paper examines the relation between equity incentives and earnings

management in the United Kingdom (U.K.). Three types of compensation (i.e. fixed

salary, bonus and stock-based) are distinguished. Hypothesized is that fixed salary

has a negative relation and that bonus and stock-based compensation have a

positive relation with discretionary accruals as a tool for earnings management. To

test this, accrual and compensation data from FTSE listed firms is used. The accrual

approach will be used in measuring earnings management and the relative size of

the compensation types will be used to measure the compensation variables.

The results from this research show that fixed salary has a positive relationship with

discretionary accruals. For bonus compensation no linear relationship with

discretionary accruals is found and for stock-based compensation a negative

relationship with discretionary accruals is found. Moreover, this research has proven

that low equity incentive CEO’s have significant higher mean scores of discretionary

accruals than high equity incentive CEO’s. Therefore, the results seem to oppose the

results of studies from Bergstresser and Philippon (2006), Cheng and Warfield

(2005) and Gao and Shrieves (2002) who all found evidence that high equity

incentive CEO’s engage more in earnings management (through the use of

discretionary accruals) than low equity incentive CEO’s.

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Table of Contents

Preface........................................................................................................................3Abstract......................................................................................................................4

1 Introduction.........................................................................................................71.1 Problem statement..........................................................................................7

1.2 Research question..........................................................................................8

1.3 Contribution....................................................................................................9

1.4 Literature........................................................................................................9

1.5 Sample and methods....................................................................................10

1.6 Results..........................................................................................................11

2 Literature review...............................................................................................122.1 Earnings management..................................................................................13

2.1.1 What is earnings management?............................................................13

2.1.2 How are earnings managed?.................................................................14

2.1.3 Why do firms engage in earnings management?...................................16

2.1.4 How to detect earnings management?...................................................18

2.2 Compensation contracts...............................................................................23

2.2.1 Fixed salaries.........................................................................................24

2.2.2 Short-term incentives.............................................................................24

2.2.3 Long-term incentives..............................................................................25

2.2.4 Why do managers receive stock compensation?...................................25

2.3 Earnings management and equity compensation.........................................26

3 Hypotheses.......................................................................................................28

4 Research design...............................................................................................314.1 Data and sample...........................................................................................31

4.2 Dependant variable.......................................................................................32

4.3 Independent variable....................................................................................32

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5 Data analysis and results.................................................................................325.1 Discretionary accruals and descriptive statistics...........................................32

5.2 Results..........................................................................................................32

5.2.1 Correlation testing..................................................................................32

5.2.2 Independent-Samples T-Test.................................................................32

6 Conclusion, limitations and future research..................................................326.1 Research question........................................................................................32

6.2 Theoretical and empirical conclusions..........................................................32

6.3 Limitations and directions for future research...............................................32

References...............................................................................................................32

Appendix A...............................................................................................................32Appendix B...............................................................................................................32

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1 Introduction

1.1 Problem statement

Stock-based compensation, like stock options and shares for example, has been

frequently in the news the last couple of years. Despite the credit crunch, the global

financial crisis and the following economic recession, a lot of companies, also

financial institutions, gave their executives big bonuses. There were people who even

argued that executives should hand in their bonuses, because they thought

executives are responsible for the bad performances. Moreover here were

companies who asked their employees to hand in their bonuses, and in the United

States, the House passed legislation that significantly controls bonuses for

employees of financial institutions who received support from the government’s

financial rescue program1. For employees who earn more than $ 250,000, a 90%

surtax is granted on their bonuses. This example shows the importance of variable

compensation, and especially stock-based compensation, in today’s world.

The past two decades have shown an enormous increase in stock-based

compensation. The most important reason why managers nowadays have relatively

large stock-based compensation packages is that it should align managers’ aims with

the aims of stakeholders.

After two decades it seems however, that stock-based compensation has a short-

term perspective. Remuneration systems are working as they were designed to do.

Therefore they do not manage to align the interest of management with shareholders

(O’Connell and Brendan 2004). O’Connell and Brendan argue that, in a society

where CEO’s on average work four years for the same company, managers try to

appease the market through a variety of devices that ensure rising short-term stock

prices. With these devices they mean, among other thing, earnings management

practices to ensure steadily rising earnings that appease forecasts of the market.

On the other hand, Ronen and Yaari (2008) say it is difficult to make a profit in the

future when the market price is only rising. Therefore, Ronen and Yaari say long-term

1 http://online.wsj.com/article/SB123745823318182841.html[]

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earnings management should aim at deflating earnings. Although the opinions differ,

it is, in regard to this study, assumed that equity-based compensation creates short-

term incentives for managers to manage earnings.

Literature divides compensation contracts for managers into three categories; fixed

salaries, bonuses and stock-based compensation (Merchant and Van der Stede

2007). Gao and Shrieves (2002) say that, in contrast to salary, the size of stock

options and bonuses is positively related to the use discretionary accruals as a tool

for earnings management. According to Murphy (1999) in the eighties and nineties of

the last century the main development in executive compensation was stock-based

compensation.

1.2 Research question

The purpose of this thesis is to provide more insight into the relation between equity

incentives (stock-based compensation) and earnings management. Besides the

relation of stock-based compensation and earnings management, also the relation of

fixed salary and (cash) bonus with earnings management will be investigated.

While prior research on the relation between equity incentives and earnings

management, which will be elaborated on more in chapter 2, mostly used United

States (U.S.) data, this research investigates the situation in the European Union

(E.U.). Within the E.U. this study focuses on companies based in the United Kingdom

(U.K.). European countries require companies to disclose detailed information on

executive compensation practices in the disclosures of the annual report. The U.K.

was the first country within the E.U. where these duties were introduced (Praag

2005). Therefore, most data is available for the U.K. This leads to the following

research question:

What is the relation between equity incentives and earnings management in the U.K.?

1.3 Contribution

During the past years, compensation for managers and earnings management have

been important topics in many debates. This research and its results are interesting

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for two groups. First, for the Board of Directors of firms, because they provide the

compensation contracts to their top-managers. While stock-based compensation can

yield positive incentives effects, prior research has already shown that equity-

incentives have a negative effect on earnings management. Secondly, this study is

interesting for financial reporting regulators, because they criticize managers for their

focus on the short-term targets. It is expected that, with the results of this research,

financial reporting regulators can respond better to earnings management and its

incentives.

Moreover this thesis is a contribution to the knowledge on earnings management and

its relation with compensation for the academic world. It extends the growing

literature that examines the relation between equity incentives and earnings

management. Therefore this thesis may extent existing academic researches for

stock-based compensation outside the U.S.

1.4 Literature

This thesis is related to other papers on the subject of earnings management (e.g.

Daniel et al. 2008; Healy and Wahlen 1999; Stein 1989; Dechow et al. 1995). This

thesis is also related to studies on compensation contracts (e.g. Merchant and Van

der Stede 2007; Murphy 1999; Gao and Shrieves 2002). These studies have shown

what the different types of compensation are and how they are related to earnings

management.

Furthermore this thesis complements extant studies on the incentives for earnings

management (e.g. Cheng and Warfield 2005; Bergstresser and Philippon 2006;

Jensen and Murphy 1990; Bauman and Shaw 2006). These studies have shown that,

in general, the self-interest motivation of management is a great cause of earnings

management. Bergstresser and Philippon (2006) found evidence that earnings are

more manipulated through discretionary accruals when CEO’s total compensation is

more closely tied to the value of the shares. Cheng and Warfield (2005) examined

the relation between managers’ equity incentives and earnings management. They

found that high equity incentive managers are more likely to sell shares in the future.

This motivates these managers to engage in earnings management to increase the

value of the shares to be sold. Moreover, Gao and Shrieves (2002) examined how

the different types of compensation (i.e. fixed salary, bonuses, stock option, restricted

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stock, and long-term incentive plans) influence earnings management behaviour.

This research extends and complements those researches by examining the relation

between equity incentives and earnings management.

1.5 Sample and methods

As mentioned earlier, most research done until now, focuses on companies in the

U.S. This research will focus on companies based in the U.K. because that was the

first country in the E.U. where companies were required to disclose detailed

information on executive compensation. Therefore most data is available for the U.K.

As the sample for this thesis the FTSE 100 index is used. This is a share index of the

100 most highly capitalised U.K. companies, listed on the London Stock Exchange.

This data provides a sample of about 176 entries and is spread out over two years,

i.e. 2005 and 2006. Financial data that is needed of the earnings management

component, and compensation data from the CEO’s that is needed for the

compensation component, will be gathered from the annual reports of the

companies.

Like other studies (Dechow et al. 1995; Bergstresser and Philippon 2006; Gao and

Shrieves 2002) the accrual approach will be used in measuring earnings

management. To measure earnings management the Modified Jones Model

(Dechow et al. 1995) is selected.

As explained earlier, this research distinguishes three components in compensation

contracts; fixed salary, bonuses and stock-based compensation (e.g. stock-options,

shares). It focuses on the relation between equity incentives and earnings

management, but it also tests the relation of the other two components (i.e. fixed

salary and bonus) with earnings management. Because relative figures are better

comparable with each other, the relative size of the compensation type will be used

to measure compensation.

1.6 Results

The results from this research show that fixed salary has a positive relationship with

discretionary accruals. For bonus compensation no linear relationship with

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discretionary accruals is found and for stock-based compensation a negative

relationship with discretionary accruals is found.

Regarding the mean scores of discretionary accruals, no significant difference is

found for CEO’s with a relative high size and CEO’s with a relative low size of bonus

compensation. For fixed salary a small significant difference is found between the

mean scores of discretionary accruals for CEO’s with a relative high size and CEO’s

with a relative low size of fixed salary. Moreover, regarding stock-based

compensation, this research has proven that low equity incentive CEO’s have

significant higher mean scores of discretionary accruals than high equity incentive

CEO’s. Therefore, the results seem to oppose the results of studies from

Bergstresser and Philippon (2006), Cheng and Warfield (2005) and Gao and

Shrieves (2002) who all found evidence that high equity incentive CEO’s engage

more in earnings management (through the use of discretionary accruals) than low

equity incentive CEO’s.

Although the results in this thesis provide an indication on the relation between

earnings management and equity incentives additional research is needed to provide

a complete answer in the case of earnings management.

The thesis proceeds in five chapters. The next chapter provides background

information and the literature study. It describes the relevant academic literature on

earnings management, compensation contracts, and the link between these two

components. In chapter 3 the hypotheses are developed. The fourth chapter

discusses the research design. The research design describes the sample selection

and research method. In chapter 5 the results of the research are explained. In the

final chapter, chapter 6, the conclusions, limitations and directions for future research

are presented.

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2 Literature review

This section describes the background information and literature review on earnings

management and compensation contracts. Paragraph 2.1 elaborates on earnings

management. This paragraph will describe what earnings management is, how

earnings are managed, what activity manipulation is and why firms engage in

earnings management. The second paragraph will be about compensation contracts.

It describes fixed salaries, short-term incentives, and long-term incentives.

Furthermore it will elaborate on the fact why managers receive stock-based

compensation. In the last paragraph, paragraph 2.3, the link between earnings

management and equity compensation will be described.

Inefficient MarketThroughout this thesis, the asymmetric information gap between the principal and the

agent is discussed. This supports the notion that markets are not efficient in the

strong form2. According to the Efficient Market Theory (EMT) the strong form states

that all information (public and private) is included in the market price. This includes

that insider information (information known to management) is reflected in the share

price. If this is true, the reported information would not affect the stock price, because

the stock price already would reflect this information. In this scenario there would be

no incentive for management to manipulate earnings. If the market was efficient in

the strong form and managers reported manipulated earnings, the market would not

be fooled. Managers would therefore not be able to effect their compensation (Levy

and Post 2005).

2.1 Earnings management

In the light of past accounting scandals and the current world economics, the credit

crunch, the subject of earnings management has been receiving great attention. In

2 The three forms of the Efficient Market Theory (EMT) are: weak, semi-strong and strong. In the weak

form only historical data reflects the price of a share. In the semi-strong form all relevant public

information is reflected in the share price. The strong form states that all information (public and

private) is reflected in the stock prices.[]

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2001 the investment world was shocked when the smartest guys in the room3 were

caught manipulating accounts. The Enron affair bought to daylight the significant

effects of earnings manipulation. Unfortunately, the Enron affair does not stand on its

own. Since 2002 there has been a number of accounting scandal were earnings

have been manipulated (Royal Ahold, Parmalat and more recently Satyam Computer

Services4).

It is not always clear if firms operate outside the boundaries set by regulators. As Van

der Bauwhede (2003) sais the one form of earnings manipulation is considered fraud,

the other is misleading and based on misjudgements by managers. The corrupt view

on the issue is revealed by managers that operate outside the boundaries set by

regulators. However, earnings management operates more than often within the

guidelines set by the reporting authorities. This thesis will concentrate on the later

form of earnings management.

2.1.1 What is earnings management?

Healy and Wahlen (1999) state earnings management as follows:

“Earnings management occurs when managers use judgment in financial

reporting and in structuring transactions to alter financial reports to either

mislead some stakeholders about the underlying economic performance of the

company or to influence contractual outcomes that depend on reported

accounting numbers.” (Healy and Wahlen 1999, 368)

In this definition Healy and Wahlen use a judgement criterion, as well as the goal of

earnings management.

The judgement criterion implies that earnings management is an activity that is

purposely undertaken by management. This judgement criterion is cited in a number

of articles as moving within the boundaries set by regulators (e.g. Daniel et al. 2008;

Benish 2001). This criterion implies that management does not intentionally

manipulate accounts. However, it implies the use of professional discernment used

by management. This discernment addresses the main challenge researches face 3 A documentary about the Enron corporation, its faulty and corrupt business practices (source:

www.imdb.com)4 (Source: http://en.wikipedia.org/wiki/Accounting_fraud)

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(Beneish 2001). According to Bergstresser and Philoppon (2006) earnings

management occurs, when reported income includes cash flows and changes in firm

value. Cash flows are not difficult to establish, but changes in firm value requires a

greater deal of management discernment.

Healy and Wahlen also state the goal of earnings management. On the one hand

misleading stakeholders, and on the other hand influencing contractual outcomes. In

general earnings management is aimed at transferring wealth (Stolowy and Breton

2004).

2.1.2 How are earnings managed?

Financial reports convey earnings that have occurred throughout the past period.

These earnings are based on cash flow plus changes in firm value (Bergstresser and

Philippon 2006). Whilst cash flows are easily determined, changes in firm value are

more challenging. It is in determining this change in firm value that managers are

granted some freedom by regulators and standard setters. The accrual account,

designed by standard setters, is a common account used to manipulate earnings.

Benish (2001) states that it is like that earnings management takes place in the

accrual account. However the aim of standard setters was not to provide managers

with a possibility for earnings management. Accruals were designed to express

valuation changes that had not yet related in cash flows (Gao and Shrieves 2002).

This poses the problem that not all accruals are related to earnings management.

With regards to earnings management, only the discretionary component of accruals

is important (Benish 2001).

Based on their sales and value of assets, all firms are expected to have a certain

level of accruals (Van der Bauwhede 2003). However when these accruals exceed

non-discretionary levels, they could indicate to tend to manage earnings.

Over the years there have been a number of methods developed to detect earnings

management. Healy (1985) and DeAngelo (1986)5 developed methods that were

very dependent on years were no earnings management was suspected. This was

the biggest weakness for these models.

5 Cited from Van der Bauwheden (2003)[]

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The Jones model (Jones 1991) and the modified Jones model (Dechow et al. 1995)

were created to try to eliminate the discretionary element of the accruals, by taking

into consideration changes in the economic environment (Benish 2001). However like

most models these models have various limitations (read for further details on the

models paragraph 2.1.4). Studies have shown that changes in inventory, and

accounts receivables can resemble earnings manipulation (Roychowdhury 2006;

Stowley and Berton 2004).

Rational minds would suggest that investors, being able to detect earnings

management, would punish firms that violate the freedom granted to them by

standard setters. Studies carried out by Teoh et al. (1998a, b) and Teoh and Wong

(2002) suggest that investors are “naïve” in detecting earnings manipulations, due to

the asymmetric information gap. Although there are models that can predict the

possibilities of earnings management, an accurate forecast remains difficult.

It should be said that most researches that are carried out assume that the market is

not aware of the tendency by managers to alter earnings. However according to a

study by Stein (1989) investors rationally expect managers to manage earnings. As a

result, in pricing stock analysts’ expect managers to manipulate earnings. The market

knows it cannot prevent earnings manipulation from happening so it anticipates that

earnings have been managed (Cheng and Warfield 2005). This would be consistent

with the efficient market hypothesis. The share price reflexes all information, i.e.

public and private. The share price therefore portrays a true view of the firm, where

managed earnings are processed in the market price.

Coles et al. (2006) suggest that investors are well informed and sophisticated in there

awareness of earnings manipulation. Nevertheless, the transparency into incentives

and account manipulation is limited. Even though models might be available, these

models face limitations and can only indicate the possible use of earnings

management.

Activity manipulationMost studies carried out focus on account manipulation, however Roychowdhury

(2006) suggest that the effects of direct account manipulation are relatively lower in

comparison to activity manipulation. Activity manipulation can be characterized as a

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difference from normal operation with the objective to meet certain earnings targets

(Roychowdhury 2006). One might argue that activities that increase earnings are

only good for the firm. Roychowdhury mentions an increase in sales by means of

temporary discounts. This cannot harm the interest of a firm and investors might

even appreciate a certain degree of entrepreneurship to sell products that might have

not been sold without a discount. However earnings manipulation is known for its

short-term perspective. Therefore managers might mislead stakeholders (Stolowy

and Berton 2004). Activity manipulation doesn’t support this notion because it does

not mislead investors. Reported earnings by management are not incorrectly stated

and do not present an untrue view of the value of the company. Earnings

management through account manipulation does not always materialize and produce

cash flows, therefore not benefiting investors. Cash flows change the capacity of

firms to pay out dividend. DeAngelo and DeAngelo (2006) research suggests that

dividend payouts are important to investors. Further research has shown that

dividend cuts are punished at the stock market (Pettit 1972; Aharnoy and Swary

1980; Gullon et al. 2002). Therefore earnings that do not materialise into cash flow,

damage the cash position of the firm.

2.1.3 Why do firms engage in earnings management?

Although throughout the literature different forms of compensation are given for the

existence of earnings management, Stolowy and Berton (2004) state that the why

earnings management exist is to profit from the possibilities of wealth transfer.

Benish (2001) distinguished between four possible motives for earnings

management:

1. Debt contracts;

2. Compensation Agreements;

3. Equity Offerings;

4. Insider trading.

Firms’ performance are often regulated in debt covenants. Moreover dividend

restrictions are incorporated in them (Bradley and Roberts 2004). This is because the

position of the debt providers is weaken by dividends that exit the firm. Through

dividend payout, less cash remains in the firm to pay back the debt providers (Daniel

et al. 2008). Benish (2001) summarizes studies that reveal mixed results for the use

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of earnings management to avoid defaults on loans. Influence debt covenants by

using earnings management to avoid defaults, might have the opposite effect that

firms eventually default. Some firms profit from a relatively cheap form of capital,

although they may not default on their loans (Stolowy and Breton 2004). Due to

higher earnings, companies could seem more profitable than in reality.

Compensation contracts seem to provide more evidence for the existence of

earnings management than debt contract. Extensive studies (e.g. Healy 1985;

Bergstresser and Philippon 2006; Bauman and Shaw 2006; Ronen et al. 2006; Gao

and Shrieves 2002) have shown that in general that the greatest cause of earnings

management is the self-interest motivation of management. This subject will be

addressed more in depth in the next paragraph.

Equity offerings also offer a great opportunity to manage earnings. Managers are

known to inflate earnings to receive a better price for new equity (Benish 2001). This

is possible due to the information asymmetry and is consistent with the notion that

management aspire to receive a relatively low cost of capital.

Insider trading has also been documented (Benish 1999; Ronen et al. 2006). Benish6

even argues that it is expected for managers to use their insider information about

earnings overstatements, to trade for their own benefit. Ronen et al. (2006) study

supports recommendation to ban insider trading.

2.1.4 How to detect earnings management?

The accrual approach will be used in measuring the dependant variable, earnings

management (Dechow et al. 1995; Bergstresser and Philippon 2006; Gao and

Shrieves 2002). Like Dechow et al. (1995), five models will be described that are

used in the extant earnings management literature. These five models are the Healy

Model, the DeAngelo Model, the Jones Model, the Modified Jones Model and the

Industry Model. In this paragraph the models will be described.

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The models make use of accruals. Accruals are revenues and costs that make the

difference between the profit and the cash flow of a company. They depend on

accounting choices of managers, and it is therefore important to examine whether the

accruals are in line with expectations. Total accruals need to be decomposed into a

discretionary and a non-discretionary component. Discretionary accruals are those

which cannot be explained from normal activities. Managers can influence these

accruals. Non-discretionary accruals can be explained from normal activities of the

company and managers can not influence them.

The starting point of most models is the total accruals. The models then try to find the

non-discretionary element so they can divide the accruals in the non-discretionary

and the discretionary part.

1. The Healy ModelHealy (1985) uses total accruals to determine discretionary accruals. The

discretionary accruals are equal to the difference of total accruals in two successive

years. The assumptions Healy (1985) makes, is that non-discretionary accruals are

constant. Further is assumed that systematic earnings management is occurring in

every period. In this last assumptions it is that Healy’s study differs from most other

earnings management studies.

The sample is divided into three groups, in one is predicted that earnings are

managed upwards, and downward in the other two groups. Then a comparison of the

mean total accruals is made between the three groups.

The model Healy uses is:

NDA τ=∑t

❑TA t

T (2-1)

Where:

NDA Estimated non-discretionary accruals;

TA Total accruals scaled by lagged total assets;[]

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t 1,2,..T is a year subscript for years included in the estimation

period;

τ A year subscript indicating a year in the event period.

2. The DeAngelo ModelDeAngelo (1986) also uses total accruals to determine discretionary accruals. The

DeAngelo Model can be viewed as an expansion of the Healy Model, in which the

estimation period for non-discretionary accruals is restricted to the previous year’s

observation. In the DeAngelo Model first is assumed that differences in total accruals

have an expected value of zero under the null hypothesis of no earnings

management (Dechow et al 1985).

DeAngelo’s model further assumes that total accruals will move in the same direction

as the balance total of a company. For example, when a company invest in fixed

assets, this ultimately leads to an increase in total assets and therefore to an

increase in the balance total. The fixed asset (investment) has to be depreciated.

This will lead to an increase in (non-discretionary) accruals and therefore also to an

increase in total accruals. But if an increase in total accruals not directly comes from

an increase in assets then this increase is caused by discretionary accruals. This

could indicate earnings management.

DeAngelo’s Model is:

NDA τ=TA τ−1(2-2)

Where:

NDA Estimated non-discretionary accruals;

TA Last period total accruals (scaled by lagged total assets);

τ A year subscript indicating a year in the event period.

3. The Jones ModelIn comparison to Healy’s and DeAngelo’s Model, the non-discretionary accruals in

the Jones Model (Jones 1991) are assumed to be variable. An indication of the

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change in total accruals due to normal activities of a company is given by the change

in revenues with respect to the previous year and the value of the fixed assets. The

difference between the expected and the actual total accruals could indicate

discretionary accruals and therefore earnings management. The Jones model is

illustrated as (Ronin and Yaari 2008):

NDA t=α1( 1At−1 )+α2 (∆ REV t )+α3(PPE t)

(2-3)

Where:

NDAt Non-discretionary accruals in year t;

At-1 Total assets in year t-1;

∆REVt Changes in revenue in year t;

PPEt Property, Plant and Equipment in year t;

α1, α 2, α 3 Firm specific parameters.

The coefficients αχ are industry specific parameters. They estimate how different

industries, with difference in capital intensity, are influenced by the variables (Assets,

Revenue and PPT). Capital intensive industries, for example, will have a relatively

greater PPE element than knowledge based industries.

Firm specific parameters are generated using the following model, see next page, in

the estimation period (Dechow et al. 1995).

TAt=a1( 1A t−1 )+a2 (∆REV t )+a3(PPE t)+εt

(2-4)

Where:

TAt Total Accruals in year t;

a1, a2, a3 OLS estimates of α1, α 2, α 3.

There are, however, also weaknesses in the Jones Model. Because accruals are

deflated for changes in revenue the Jones Model does not take into account the

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ability of managers for sales-based manipulation. This is the greatest weakness of

the model (Peasnell et al. 2000). These changes are considered as changes in

economic activity. However Dechow et al. (1995) modified the original Jones Model

to incorporate the possible changes in revenue that are discretionary.

4. The Modified Jones ModelThe Modified Jones Model (Dechow et al. 1995) manages to incorporate the ability to

detect sales-based manipulations. In the modified Jones Model, non-discretionary

accruals are estimated during the event period as (Dechow et al. 1995):

NDA t=α1( 1At−1 )+α2 (∆ REV t−∆ AR t )+α 3(PPE t)

(2-5)

Where:

NDAt Non-Discretionary Accruals in year t;

At-1 Assets in year t-1;

∆REVt Changes in revenue in year t;

∆ARt Changes in accounts receivables in year t;

PPEt Property, Plant and Equipment in year t;

α1i, α 2i, α 3i Firm specific parameters.

Like the Jones model, the modified Jones model takes place in two stages. The first

stage is identical, where the estimated accruals are defined. It is important to note

that for estimating the NDA, equation 2-3 will be used (Bergstresser and Philippon

2006; Jones 1991). Dechow et al. (1995) adopted this approach from the original

Jones Model (1991). Equation 2-5 will be used when determining the actual NDA.

5. The Industry ModelThe last model which is discussed in this paragraph is the Industry Model used by

Dechow and Sloan (1991). Like in the Jones Model, the non-discretionary accruals

are assumed to be variable over time. Dechow and Sloan further assume that

variation in the determinants of non-discretionary accruals are common across firms

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in the same industry. The Industry Model for non-discretionary accruals is (Dechow

et al. 1995):

NDA t=γ1+γ2median I (TAt)

(2-6)

Where:

NDAt Non-Discretionary Accruals in year t;

y 1, y2 Firm specific parameters;

MedianI(TAt) Median value of total accruals scaled by lagged assets for all

non-sample firms in the same two-digit SIC code7.

The Industry Model has two disadvantages. First, the approach only considers

changes in the whole industry. It does not take firm specific circumstances into

account. Therefore these possible specific non-discretionary accruals are not

recognised by the Industry Model. As a result the model cannot distinguish

discretionary and non-discretionary accruals in the right way. Secondly, the model

only assumes a correlation between non-discretionary accruals from companies in

the same industry, but it does not take correlated discretionary accruals into account.

To which extent the earnings management stimulus is correlated across firms in the

same industry determines the severity of this problem (Dechow et al. 1995).

In this research the Modified Jones Model will be used for detecting earnings

management. There are a few reasons why the Modified version of the Jones Model

is used. First, as mentioned before, Dechow, Sloan, and Sweeny (1995) evaluated

the ability of the models described above to detect earnings management. Their most

important result was that the Modified version of the model developed by Jones

(1991) provides the best test to detect earnings management. It generated the fewest

type II errors, which represents cases in which earnings are managed, but are

identified as not. Guay et al. (1996) also evaluated the same five models. Their

findings suggest that the Jones Model and the Modified Jones Model are the most

effective models.

7 The use of two-digit SIC levels represents a trade-off between defining industry groupings narrowly

enough that the Industry Model captures the industry specific effects versus having enough firms in

each industry grouping so that the model can effectively diversify firm specific effects.[]

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Second, the most popular and best accepted model in the academic literature seems

to be the Modified Jones Model. Therefore the results of this research will be better

comparable to other studies when the Modified Jones Model is used.

2.2 Compensation contracts

As mentioned in the previous paragraph, compensation contracts are one of the main

reasons for earnings management. The contracts are derived from the issues around

the agency theory. The agency theory is concerned with two problems. The first

problem is that the aims of the agent (financial reporters of the company) are not in

line with those of the principal (stakeholder). Secondly, it is impracticable for the

principal to assess the work of the agent efficiently (Eisenhardt, 1989).

Both agent and principal want to increase their wealth. The principal’s wealth

increases when that of the firms increases. The wealth of the agent increases when it

receives the maximum return for its input (i.e. labour). The problem occurs when the

incentives for the agent to increase the value of the firm are absent, and the agent is

primarily aimed at increasing its value. However, the principal can alter this problem

by adding incentives to the agent in their compensation contract. These incentives

can better align the ambitions of agent and principal.

Before 1986 is was unusual for managers to receive stock-based compensation

(Bergstresser and Philippon 2006). Between 1974-1986 shareholders wealth

increased with $ 1,000 for every $ 3 increase in wealth for the CEO’s (Jensen and

Murphy 1990). During these years therefore, CEO’s had no incentive to increase the

wealth of the firm.

Incentive contracts are designed to eliminate this problem and to align the personal

interests of financial reporters (managers) with those of the stakeholders (investors).

Investors try to increase their return on investment, by increasing earnings within

their investment. Therefore financial reporters should also try to increase true

company earnings.

According to Murphy (1999) compensation contract are designed to align executive

interest with those of the shareholder. Literature divides compensation contracts for

managers into three categories (Merchant and Van der Stede 2007):

1. Fixed salaries;

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2. Short-term incentives; and

3. Long-term incentives

2.2.1 Fixed salaries

Although fixed salaries do not have much relation to management performance, most

incentives are based on fixed salary. Other elements within the compensation

contract increase when salary increases (Murphy 1999). Managers that are risk

obverse have a relatively larger part of fixed salary as part of their total remuneration

(Murphy 1999).

2.2.2 Short-term incentives

An example of a short-term incentive is the annual (cash) bonus. Although bonus

plan take many forms, most manager nowadays have a personal bonus plan that

contains a individual performance portion (Murphy 1999). These bonus then can be

achieved through predetermined targets and objectives, that can be both financial

and nonfinancial measurements. In a Towers Perrin survey, 65 of the 68 sample

companies using single performance measurement used accounting indicators as

performance measurement. 62% of companies using multiple performance

measurements used accounting indicators. Performance can be measured in a

number of ways from total earnings to growth rates.

2.2.3 Long-term incentives

Long term incentives are in particular stock options. These options are offered to

management as an incentive for long term earnings at the company. In most cases

these options can be exercised only over a period of time (Murphy 1999; Cheng and

Warfield 2005). More importantly executive options are non-tradable. Considering

these restrictions, managerial compensation contracts involve an increasingly higher

degree of stock compensation. Murphy (1999) even states that stock-based

compensation was most important development in executive compensation in the

1980s and 1990s.

Short-term and long-term compensation are the general compensation that is spoken

about when talking about earnings management. As proved in the Towers Perrin

survey, a large majority of companies (91% of the total sample of 177 companies)

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use accounting information to measure performance. Apart from stock-based

compensation managers can obtain shares by purchasing them on the open market.

Core and Larcker (2002) say that some firms expect managers to own a unknown

number of shares of their own company (Core and Larcker 2002).

2.2.4 Why do managers receive stock compensation?

As explained before, there is an information asymmetry between investors and

managers. Managers know the truth about the (financial) performance and the

situation of the company. Investors must rely on the information that is granted to

them by the managers. To add value to the publicized information audit reports are

designed. However, Ronen et al. (2006) claim that audit technology seems to be

imperfect and managers can move within the boundaries set by regulators. Because

regulators leave managers some space in the accounting rules, this creates an

incentive for managers to engage in earnings management.

In an extensive study on equity incentives, Cheng and Warfield (2005) examine the

actions of managers that are compensated through stock options. Due to the

increasing stock-based compensation in the last decades, a managers compensation

largely consists of shares. This is consistent with the incentive alignment investors

want to create. If stock-based compensation increase, a greater portion of manager’s

wealth is invested in a relatively risky asset, i.e. company shares. Managers will

adapt their remuneration package to their to an acceptable risk level, selling shares

at short-term prices. Under the capital asset pricing assumptions, returns on stocks

are positive and stock prices rise under normal economic circumstances. This

causes short-term trading because managers need to constantly adapt their risk

profile (Sivakumar and Waymire 1994; Noe 1999).

As managers have relatively short-term personal incentives and investors often have

a long-term incentive, this could lead financial reporter to report short-term high

earnings. This short-term view could damage long-term interest for the firm and

investors. This phenomenon has been researched in numerous studies (e.g. Jensen

and Meckling 1976; Rajgopal and Shevlin 2002).

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2.3 Earnings management and equity compensation

It is clear that extensive studies have been conducted on the subject earnings

management and compensation contracts. Compensation contract are often blamed

for their steer towards earnings management. However Gao and Shrieves (2002) say

that it is not the only incentive for managers to engage in earnings management. In

spite of the fact that there are more incentives, the incentive coming from

compensation contracts is the only form of earnings management that extracts

wealth from the company (Stolowy and Breton 2004).

Currently stock compensation is the biggest component in the executive

compensation package. The primary reason for the introduction of this form of

compensation was to eliminate the short-term orientation of executives. However in

eliminating this short-term awareness, does this form of compensation create a

greater incentive for managers to creatively report earnings? With managers

compensation coupled to firm performance – in a form of earnings –, and current

company earnings linked to stock prices, reporting managers have a seemingly

increased incentive to report colourful earnings.

Current earnings are based on past activities. Why are markets so possessed with

passed activities? Share prices are a reflection of the present value of future cash

flow. Therefore past earnings should have a very small impact on share prices.

Under normal economic situations share prices increase, because analysts’ expect

firms to increase their profit over the years. Put another way, if current earnings are

disappointing, future revenues will be lower than expected, effecting current share

prices. Therefore, current earnings give a good indication of future firm profits (Stein

1989).

Studies have shown that managers are more likely to report earnings greater than

the expectation of the market (investors and analyst’s), when they have a large

portion of stock-based compensation. (Bauman and Shaw 2006). Share prices

increase when firms beat the forecasts of analyst’s.This gives managers an incentive

to increase earnings. However this study does not imply earnings management as a

possible cause for these continuous surprises. Shaw nevertheless, does mention that

firms have even a greater incentive to beat analysts’ forecast by small amounts. This []

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could indicate a certain level of income smoothing. These small surprises are also

documented by Cheng and Warfield (2006). Their research has shown that

managers with high equity incentives, are less prone to show large positive earnings

surprises.

Gao and Shrieves (2002) note that income smoothing is a matter of timing. Managers

that receive Long Term Incentive Plans (LTIP) have no profit in managing earnings.

Gao and Shrieves found no positive nor negative relation between LTIP and earning

management. This is because firms cannot manage earnings upwards continuously.

This would result in exorbitant accruals, and could bring the firm into discredit.

However, ensuring that higher earnings (greater than analysts’ expect) come at an

optimal time for the manager, is a timing choice. Gao and Shrieves find that it is very

dependent on the forms of compensation in the contract.

Even though markets expect earnings to be managed, managers caught in the act,

are punished by investors. Palmrose et al. (2004) say that firms lost 10% of the share

price at the announcement of restatements of their earnings. Moreover, monetary

fines and reputation losses are also important risk factors for firms who engage in

earnings management (Karpoff et al. 2008). Disciplinary actions taken by the market

towards managers is not possible, due to limited ability to withdraw past

compensation. However post-restatement compensation plans are significantly lower

(Cheng and Farber 2008).

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3 Hypotheses

As explained in paragraph 2.2, this research considers that compensation contracts

nowadays consist of three elements; fixed salary, bonus and stock-based

compensation (e.g. stock options). However, the main focus will be on the relation

between equity incentives and earnings management. The relation of earnings

management with the other two components of compensation contracts (i.e. fixed

salary and bonuses) will also be tested. By testing the relation of earnings

management with all three elements of compensation data, the results for the

different elements can be compared among each other. Therefore the relation of

equity incentives and earnings management can be understand better.

In the extant literature there is already a lot of research done on the subject earnings

management. Some of these researches investigated the relation of earnings

management with equity incentives. Gao and Shrieves (2002) say in their study that

equity incentives gives managers an incentive that may lead to earnings

management strategies for maximizing their compensation.

CEO salaries are usually set on an annual basis. In a static setting, salary’s

sensitivity to price movement is zero. Therefore, it seems unlikely that salaries are

positively related to earnings management. Moreover, earnings management seems

to be costly. As explained in the last paragraph of Chapter 2, firms lost 10% of the

share price at the announcement of restatements of their earnings (Palmrose et al.

2004), and earnings management also may result in monetary fines and reputation

loss. Moreover, Gao and Shrieves (2002) find in their study that salaries are

negatively related to earnings management. Therefore, both logic and empirical

evidence suggest that earnings management is a costly activity. It therefore seems

reasonable that a manager with a relatively large amount of fixed salary, compared to

the other two components (i.e. bonus and stock-based), would have an incentive to

reduce the extent of earnings management, and so reduce the costs. This leads to

the following hypothesis:

H1: Fixed salary is negatively related to the use of

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discretionary accruals as a tool for earnings management.

Bonus compensation might also create incentives to engage in earnings

management, because some bonus plans might contain nonlinearities (Healy 1985;

Gaver 1995). Gao and Shrieves (2002) found in their study, that bonuses are

positively related to earnings management. On the other hand, bonus plans are

highly firm-specific, because of the structure and the pay-performance relation. This

makes it difficult to predict the magnitude of the relation between bonuses and

earnings management, but the expectation is a positive relation between bonus

compensation and discretionary accruals. This leads to the second hypothesis:

H2: Bonus compensation is positively related to the use of


Managerial compensation frequently contains stock-based compensation to align the

interest of managers and outside shareholders and reduce agency problems. The

results of Bergstresser and Philippon (2006) suggest that high equity incentive CEO’s

engage more in earnings management than low equity incentive CEO’s. They find

that CEO’s whose overall compensation is more sensitive to company share prices,

lead firms with higher levels of earnings management. Cheng and Warfield (2005)

examined the link between managers’ equity incentives, arising from stock-based

compensation, and earnings management. First they find high incentive managers

are more likely to sell shares a year after earnings announcements. Furthermore they

find that managers with high equity incentives are more likely to report earnings that

meet or just beat analysts’ forecasts. Their results indicate that equity incentives lead

to incentives for earnings management. Also, Gao and Shrieves (2002) find results

that indicate that the extent of stock-based compensation are positively related to

earnings management. Now that the incentives for managers are so closely tied to

the stock price of a firm it may have the perverse effect of stimulating managers to

manipulate their earnings (Bergstresser and Philippon 2006).

This thesis extends the previous cited studies by examining how stock-based

compensation relates to earnings management. The predicted linkage between

stock-based compensation and earnings management is as follows. Assume that a

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manager receives a large component of his/her remuneration in the form of stock-

based compensation. He/she can increase the value of that component of stock-

based compensation by taking actions to reduce the exercise price. This prediction

suggests an incentive for managers to engage in earnings management. If, for

example, a manager expects to receive stock options, he/she can reduce current

earnings through discretionary accruals. The effect could be a reduction in the

exercise price of the stock options on the award date. By doing this, the manager

increases the chance that the options are ‘in the money’. Therefore, the third

hypothesis is:

H3: Stock-based compensation is positively related to the use of


In the next chapter the research design is described.

4 Research design

In this chapter the variables used for this research will be discussed. The approach

will be similar to that of Bergstresser and Philippon (2006) and Gao and Shrieves

(2002). In conformity with other papers that investigate earnings management, this

research will make use of a field study. For this study four main variables will be

used. The expectation is that the relative size of stock-based compensation will

determine the extent of earnings management. Furthermore the relative size of

salary and bonus will be used to see whether these variables can also determine the

extent of earnings management. Therefore earnings management will be the

dependant variable, and stock-based compensation, salary, and bonus will be the

independent variables.

First the data and sample will be outlined in paragraph 4.1. In the second paragraph

the dependant variable will be described. Finally the independent variables will be

discussed in paragraph 4.3.

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4.1 Data and sample

As mentioned earlier in this thesis, most research done until now, focuses on

companies in the U.S. This research investigates the European situation. The U.K.

was one of the first countries in Europe where companies were required to report on

the remunerations of their directors. Therefore this research will focus on companies

based in the U.K.

Listed companies on the FTSE 100 index from the period 2005 - 2006 will be used as

the sample for this research. The FTSE 100 index from April 13 th 2009 is used as the

start of the sample selection. From the 100 listed firms on that date, 8 firms are

excluded because they did not exist in 2005 and/or 2006, or because they were not

listed in 2005 and/or 2006 on the FTSE 100 index. Furthermore 4 firms are excluded

because there is not enough information regarding the compensation data available

in the annual reports. Therefore the actual sample consists of 88 firms and 176

entries. Appendix B contains a list of all the listed firms on the FTSE that are taken

into account in this study.

This research focuses on 2005 and 2006 and not on more recent years because of

two main reasons. First of all because the global financial crisis started in 2007. So

the figures from 2007 until now are less comparable with those of 2005 and 2006.

Second, there is more data available for 2005 and 2006. When the writing process

regarding this thesis started, the annual reports for 2008 for most companies were

not available yet.

Because of these complications in more recent years, the data sample is from 2005

to 2006. All the financial data that is needed for the earnings management

component, and compensation data from the CEO’s that is needed for the

compensation component, will be gathered from the annual reports of the

companies.

4.2 Dependant variable

The dependant variable in this study is earnings management. An accruals model

(the Modified Jones Model) will be used as a measure of earnings management. The

Modified Jones Model takes place in two stages. The first stage of the Modified

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Jones Model is identical to the original Jones Model, therefore they both are

described in this paragraph.

The Jones ModelThe Jones model (Jones 1991) assumes that differences between cash flow and

earnings are caused by the accruals. First the total accruals must be separated into a

discretionary and a non-discretionary component (Bergstresser and Philippon 2006).

See equation 4-1 below:

DAi ,t=TA i ,t+NDA i ,t

(4-2)

Where:

DAi,t Discretionary Accruals for firm i in year t;

TAi,t Total Accruals for firm i in year t;

NDAi,t Non-Discretionary Accruals for firm i in year t.

Jones, in contradiction to prior research8, keeps into account that accruals might

change (increase of decrease) due to normal activities (non-discretionary accruals).

The Jones model is preformed in two stages. In the first stage the total accruals are

regressed against the changes in revenue and level of Property, Plant and

Equipment (PPE). This estimates the normal accruals. The next stage, stage two,

estimated regression is combined with the total accruals, changes in revenue and

PPE over the event year. Deviations from the estimated regression depict the non-

discretionary accruals9. The Jones model is illustrated as (Ronin and Yaari 2008):

NDA i , t

Ai ,t−1=

TAi , t

A i ,t−1=α1 i[ 1

Ai , t−1 ]+α 2i[ ∆ REV i , t

A i ,t−1 ]+α 3 i[ PPE i ,t

A i ,t−1 ]+εi ,t(4-3)

Where:

NDAi,t Non-Discretionary Accruals for firm i in year t;

Ai,t-1 Assets for firm i in year t-1;

TAi,t Total Accruals for firm i in year t;

8 See Ronin and Yaari (2008) Chapter 10 for historical overview of accrual based Methodology. 9 Total accrual = Normal Accruals (estimated in stage 1) + Discretionary accruals

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∆REVi,t Changes in revenue for firm i in year t;

PPEi,t Property, Plant and Equipment for firm i in year t;

εi,t Error term for firm i in year t;

α1i, α 2i, α 3i Coefficients for firm i.

Total accruals are calculated by the difference between earnings and operational

cash flow (Dechow et al. 1995):

TAi , t=Earningsi , t+CFOi , t

(4-4)

Where:

TAi,t Total Accruals for firms i period t;

Earningsi,t Earnings before extra ordinary income for firm i in year t;

CFOi,t Cash flow from operation for firm i in year t.

When measuring earnings management, | TA it | will be used. The Jones model

deflates all variables (ΔREV and PPT) with total assets from t-1 (beginning-of-the-

year). This overcomes hetroskedasticity10 (Ronin and Yaari 2008).

The coefficients αχ are industry specific parameters. They estimate how different

industries, with difference in capital intensity, are influenced by the variables (Assets,

Revenue and PPT). Capital intensive industries will have a relatively greater PPE

element than knowledge based industries.

Using only the standard Jones model would be short-sighted. The greatest weakness

lies in the fact that the Jones model does not take into account the ability of

managers for sales-based manipulation (Peasnell et al. 2000), because accruals are

deflated for changes in revenue. Jones considers these changes, as changes in

economic activity. Therefore Dechow et al. (1995) modified the original Jones model

to incorporate the possible changes in revenue that are discretionary.

The Modified Jones Model

10 “... when residuals at each end of the [dependant] variable(s) have unequal variances.” Therefore

the spread in the data is different. Source: Fields (2002)[]

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The model that will be used to determine the non-discretionary accruals is the

modified Jones model (Dechow et al. 1995). The model finds its origin in the

standard Jones Model. However, Dechow et al. (1995) have managed to incorporate

the ability to detect sales-based manipulations.

The modified Jones model is illustrated as (Ronin and Yaari 2008):

NDA¿

A¿−1=

TA¿

A¿−1=α1[ 1

A ¿−1 ]+α 2 i[ (∆ REV ¿−∆ AR¿ )A ¿−1 ]+α3 i[ PPE¿

A ¿−1 ]+ε¿

(4-5)

Where:NDAit Non-Discretionary Accruals for firm i in year t;

Ait-1 Assets for firm i in year t-1;

TAit Total Accruals for firm i in year t;

∆REVit Changes in revenue for firm i in year t;

∆ARit Changes in accounts Receivables for firm i in year t;

PPEit Property, Plant and Equipment for firm i in year t;

εit Error term for firm i in year t;


Like the Jones model, the modified Jones model takes place in two stages. The first

stage is identical, where the estimated accruals are defined. It is important to note

that for estimating the NDA, equation 4-2 will be used (Bergstresser and Philippon

2006; Jones 1991). Dechow et al. (1995) adopted this approach from the original

Jones Model (1991). Equation 4-4 will be used when determining the actual NDA.

4.3 Independent variable

The independent variables will be the type of compensation, for the different

hypotheses. For this research, the relative size of the compensation type will be used

to measure compensation. Relative figures are better comparable with each other. It

is generally accepted that absolute compensation differences between managers are

caused by firm characteristics.

To measure the relative power of the different compensation types (i.e. stock-based,

fixed salary, and bonus) an approach used by Bergstresser and Philippon (2006) will []

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be adopted.

EquityFirst the EQUITY_RATIOi,t will be constructed. This ratio measures the relative size

of stock-based compensation in the overall compensation of the CEO of firm i in year

t, as shown below:

EQUITY RATIOi ,t=STOCK i ,t

(STOCK i ,t+SALARY i ,t+BONUSi , t )(4-5)

Where:

STOCKi,t Stock-based compensation of the CEO of firm i in year t;

SALARYi,t Fixed salary of the CEO of firm i in year t;

BONUSi,t Bonus compensation of the CEO of firm i in year t.

SalarySecond, the salary element of compensation will be measured. This ratio measures

the relative size of fixed salary in the overall compensation of the CEO of firm i in

year t:

SALARY RATIOi ,t=SALARY i ,t

(STOCK i , t+SALARY i, t+BONUSi ,t ) (4-6)

BonusFinally, a measure for the bonus-incentives is constructed. This measure calculates

the relative size of bonus compensation in the overall compensation of the CEO of

firm i in year t:

BONUSRATIOi ,t=BONUSi ,t

(STOCK i , t+SALARY i ,t+BONUSi ,t ) (4-7)

When these equations are applied to the data, it defines for the different types of

compensation what their relative size is. Then the relative sizes can be compared

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with the results of the Modified Jones Model to see how the compensation types are

related discretionary accruals.

In chapter 5 the results are outlined.

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5 Data analysis and results

The previous chapter explained the selection procedures in constructing a sample to

test the hypotheses. The total collected sample consists of 88 FTSE 100 index listed

firms and contains data over 2005 and 2006.

In this chapter the results from the research will be described. Paragraph 5.1 will

elaborate on the descriptive statistics and how the discretionary accruals by means

of the Modified Jones Model are computed. Next the hypotheses will be tested using

correlation testing and the independent-samples t-test. The results of these tests will

be outlined in paragraph 5.2.

5.1 Discretionary accruals and descriptive statistics

This paragraph will elaborate on the discretionary accruals and descriptive statistics.

First the discretionary accruals are determined. In the Modified Jones Model, the

error term is the discretionary accrual for a firm. On page 34 the modified Jones

model is illustrated as:

NDA¿

A¿−1=

TA¿

A¿−1=α1[ 1

A ¿−1 ]+α 2 i[ (∆ REV ¿−∆ AR¿ )A ¿−1 ]+α3 i[ PPE¿

A ¿−1 ]+ε¿

(4-4)

Where:

NDAit Non-Discretionary Accruals for firm i in year t;

Ait-1 Assets for firm i in year t-1;

TAit Total Accruals for firm i in year t;

∆REVit Changes in revenue for firm i in year t;

∆ARit Changes in accounts Receivables for firm i in year t;

PPEit Property, Plant and Equipment for firm i in year t;

εit Error term for firm i in year t;


To calculate the error term (ε ¿), first the coefficients (α 1 , α 2 i∧α 3 i¿ have to be

calculated. By means of a linear regression model the coefficients are calculated with

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SPSS. See table 1 below for the coefficients collected from the output of the

regression model.

Coefficient Unstandardized coefficients (B)

α 1 1,23

α 2 i 0,03

α 3 i 0,34

Table 1 Coefficients

The unstandardized coefficients are used and not the standardized coefficients

because the standardized coefficients are converted to the same scale so that they

can be compared. This research does not compare the different variables so

therefore the unstandardized coefficients are used.

The output from SPSS further shows the adjusted R Square. The adjusted R Square

measures the proportion of the variation in the dependent variable (total accruals

scaled by assets) accounted for by the explanatory variables. For this model the

Adjusted R Square is 0,485 (48,5%), which is a reasonable percentage.

Now all variables are available, the error term (ε ¿) for each of the 176 companies is

determined. For the error terms (discretionary accruals) see appendix B on page 62.

The error terms in appendix B only concern absolute values. Even though earnings

management involves both positive and negative values of accruals, it does not

matter whether the value of the error term is positive or negative for this study. This is

because the magnitude of discretionary accruals is important, not whether the effect

is positive or negative. Now that the error terms (discretionary accruals) are

determined, the descriptive statistics over the data that is used in this research can

be computed.

From the 1st of January 2005 all listed European Union companies are required to

comply to the International Financial Reporting Standards (IFRS). Therefore the data

from 2005 and 2006, which is used in this research, is comparable. For this reason

the descriptive statistics for the data of 2005 and 2006 are calculated and presented

as one dataset.[]

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For the descriptive statistics the mean, median, standard deviation, minimum and

maximum for the years 2005 and 2006 together are computed. The descriptive

statistics are computed for the error term (discretionary accruals), the accrual data

and for the compensation data. The compensation data consist of three different

types of compensation; fixed salary, stock-based compensation and bonus. For the

descriptive statistics, see table 2 on the next page.

The statistics in table 2 show that, concerning the compensation data, fixed salary

has the highest mean (0,41) with respect to stock-based compensation (0,31) and

bonus compensation (0,28). Further stock-based compensation has the largest

standard deviation (0,23). See table 2 on the next page for detailed information about

the descriptive statistics.

5.2 Results

As described in Chapter 3, the hypotheses in this research is are:

1. Fixed salary is negatively related to the use of discretionary accruals as a tool for earnings management.

2. Bonus compensation is positively related to the use of discretionary accruals

as a tool for earnings management.

3. Stock-based compensation is positively related to the use of discretionary

accruals as a tool for earnings management.

To test the hypotheses, first a correlation test will be performed in paragraph 5.2.1 to

obtain understanding about the strength of the relationship between the different

types of compensation and discretionary accruals. Furthermore an independent-

samples t-test will be performed, see paragraph 5.2.2, to test whether there is a

significant difference in mean scores of discretionary accruals for each of the

compensation types.

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Statistics Error term Accrual data Compensation dataDiscretionary accruals (1) (2) (3) Fixed salary Stock-based Bonus

Mean 0,16 0,24 0,10 0,33 0,41 0,31 0,28

Median 0,11 0,19 0,06 0,20 0,37 0,35 0,26

Std. deviation 0,17 0,21 0,28 0,39 0,21 0,23 0,17

Minimum 0,01 -0,19 -0,45 0,00 0,04 0,00 0,00

Maximum 1,10 1,36 3,13 2,94 1,00 0,88 0,82

Table 2 Descriptive statistics

(1) = Total accruals (earnings before extraordinary income + cash flow from operation) divided by total assets

(2) = (Changes in revenue minus changes in accounts receivable) divided by total assets

(3) = Property, plant and equipment divided by total assets

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5.2.1 Correlation testing

Through correlation testing the strength and the direction of the linear relationship

between two variables can be determined. The Pearson Product-Moment Coefficient

(Pearson’s r) is used to determine the correlation. It can take on values from -1 to +1.

The sign out the front indicates whether there is a positive or a negative correlation.

A positive correlation means that as one variable increases, so does the other and a

negative correlation means that as one variable increases the other decreases. The

size of the absolute value provides an indication of the strength of the relationship.

Pearson’s r is +1 or -1 in the case of a perfect positive (increasing) or negative

(decreasing) linear relationship. If Pearson’s r is 0, then there is no linear relationship

(uncorrelated). Different authors suggest different interpretations for the outcome

from the correlations test. Cohen (1988) suggests the following guidelines:

Weak correlation: r = 0,10 to 0,29

Moderate correlation: r = 0,30 to 0,49

Strong correlation: r = 0,50 to 1,00

This rule of thumb is widely used in the extant literature. Therefore these guidelines

are used as a guidance for the interpretation of the results in this research. Caution

needs to be exercised in interpretation of the results from correlation testing. A

correlation test only determines the strength of the linear relationship, not whether

there is a causal relationship or not.

As explained in paragraph 4.3, the compensation variable consists of three types of

compensation; fixed salary, bonus compensation and stock-based compensation.

The different types of compensation are compared for their correlation with

discretionary accruals. For the 88 companies that are subject in this research, the

compensation data consists of these three types of compensation for the years 2005

and 2006. That means 176 data entries. See table 3 on the next page for an

overview of the results of the Pearson Product-Moment Correlations Test.

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Group Pearson’s r Sign. (1-tailed) N

Fixed salary 0,14 0,03 176

Bonus compensation 0,03 0,37 176

Stock-based compensation - 0,15 0,02 176

Table 3 Correlation test overall results

First, the Pearson’s r is analyzed. The results in table 3 show a positive weak

correlation (between 0,10 and 0,29) with discretionary accruals for fixed salary.

Regarding bonus compensation almost no linear relationship with discretionary

accruals is found. These two variables seem uncorrelated. Furthermore, table 3

shows a negative weak correlation with discretionary accruals for stock-based

compensation. This means that when stock-based compensation increases,

discretionary accruals decreases.

Next, the significance level (one-tailed) is assessed. The significance level indicates

how much confidence can be obtained from the results. As a cut-off for this research

results below 0,01 are considered highly significant, results between 0,01 and 0,05

are considered significant, results between 0,05 and 0,10 are considered less

significant and results above 0,10 are considered insignificant.

The correlation test is performed one-tailed, because the direction of the relationship

is predicted in the hypothesis (positive or negative relation). In this case therefore,

the results for fixed salary and stock-based compensation are statistical significant

because the p-values are below 0,05. The results for bonus compensation however

are insignificant (p-value of 0,37).

In summary, the results seem to make clear that there is a positive linear relationship

for fixed salary and a negative linear relationship for stock-based compensation. The

more CEO’s remuneration package consists of fixed salary, the larger (positive linear

relation) the discretionary accruals in the annual reports. Further, the more CEO’s

remuneration package consists of stock-based compensation, the smaller (negative

linear relation) the discretionary accruals in the annual reports. Yet, the strength of

both correlations is weak.

The results therefore reject H1 and H3 because it was suspected that fixed salary

would have a negative relation and stock-based compensation would have a positive

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relation with discretionary accruals. For bonus compensation a positive correlation

with discretionary accruals was hypothesized. However no linear relationship with

discretionary accruals is found, therefore H2 is also rejected.

Nevertheless, caution should be exercised in the interpretation of the results.

Correlation provides an indication that there is a linear relationship between two

variables. It does not indicate that one variable causes the other. The correlation

between two variables (A and B for example) could be due to the fact that A causes

B, that B causes A, or that an additional variable (C) causes both A and B. Even

when there seems to be a clear cause and effect relationship, a correlation alone is

not sufficient evidence for a causal relationship. So from the results in this paragraph

only conclusions about the strength and the direction of the correlation are justified.

5.2.2 Independent-Samples T-Test

The second test in this research about the relation between earnings management

and variable compensation is the t-test. A t-test is used to examine whether the

mean for two groups deviate from each other. There are two t-tests to compare the

group means:

1. Independent-Samples T-Test, for comparison of two independent groups;

2. Dependent-Samples T-Test, for comparison of two dependent groups.

In this research the independent-samples t-test is used because the research is

about two independent groups. For this purpose the data for each type of

compensation is subdivided into three groups. On the one hand group 1 (CEO’s with

a relative large size of fixed salary, bonus compensation or stock-based

compensation), and on the other hand group 2 (CEO’s with a relative small size of

fixed salary, bonus compensation or stock-based compensation). Group 1 and group

2 both consist of data for 60 CEO’s. For example group 1 from fixed salary consists

of the 60 CEO’s with the largest relative size of fixed salary, and group 2 of the 60

CEO’s with the smallest relative size of fixed salary. The 56 CEO’s in between those

2 groups are excluded for the independent-samples t-test. This group of CEO’s is

excluded because in this research the group with the highest relative size of the

different types of compensation is compared to the group with the lowest relative

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size. Therefore the ‘middle’ group has no function and it is excluded from this

research.

The independent-samples t-test will examine whether there is a statistically

significant difference in the mean scores of discretionary accruals between the two

groups. In this research this means whether there is a statistically significant

difference in the mean scores of discretionary accruals between group 1 and group 2

for each of the three different compensation types. For example the independent-

samples t-test examines whether there is a statistically significant difference in the

mean scores of discretionary accruals between group 1 and group 2 for fixed salary.

Two important assumptions are made regarding the results. The first assumption is

about the results of Levene’s test of equality of variances. This tests whether the

variance of scores for the two groups is the same. The outcome determines which of

the t-values SPSS provides is the correct one to use. If Levene’s p is above 0,05,

then equality of variance is assumed. The top row of the output from SPSS will be

used. If Levene’s p is below 0,05, then it is assumed there is not equality of variance.

In this case the results from the second row of the output will be used.

Secondly, SPSS’s output shows the significance level two-tailed. For this research

one-tailed significant levels should be determined because the direction of the

relationship is predicted in the hypotheses. Therefore the two-tailed significance level

from the output of SPSS is divided by two to compute the one-tailed significance

level. Like for the correlation test the same assumption about significance is being

made for the t-test. Results below 0,01 are considered highly significant, results

between 0,01 and 0,05 are considered significant, results between 0,05 and 0,10 are

considered less significant and above 0,10 results are considered insignificant.

In the next sections the results of the independent-samples t-test will be presented.

Independent-Samples T-Test for fixed salaryFirst the independent-samples t-test regarding fixed salary is conducted to compare

the mean scores of discretionary accruals for CEO’s in group 1 and CEO’s in group

2.

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The output from SPSS shows a significance level of 0,02 for the Levene’s test of

equality of variances. Because this is below the cut-off of 0,05, as explained on the

previous page, the results from the second line in the table, ‘equal variances not

assumed’, are used. For the results of the independent-samples t-test for fixed

salary, see table 4 below.

Fixed salary Results

Mean Group 1 (high) 0,17

Mean Group 2 (low) 0,13

Std. deviation group 1 (high) 0,20

Std. deviation group 2 (low) 0,10

T-value 1,351

Significance (1-tailed) 0,09

Table 4 T-test fixed salary

The results show there is a small significant difference in the mean scores for group

1 (median = 0,17, SD = 0,20) and group 2 (median = 0,13, SD = 0,10); t = 1,351, df

= 88, p = 0,09 (one-tailed). This is because the significance level (0,09) is between

the cut-off of 0,05 and 0,10, mentioned on the previous page.

This means a small significant difference is found in the mean scores of discretionary

accruals for CEO’s with the highest relative size of fixed salary and CEO’s with the

lowest relative size of fixed salary. In fact, the results make clear that for the

magnitude of discretionary accruals, it does matter to which proportion a CEO is

remunerated through fixed salary. The more a remuneration package consists of

fixed salary, the more discretionary accruals are distinguished in the annual report.

Independent-Samples T-Test for bonus compensationNext the t-test is conducted for bonus compensation. The significance level of

Levene’s test of equality of variances, showed in the output from SPSS, is 0,55. This

is above the cut-off of 0,05, mentioned on the previous page. This means the

assumption of equal variances has not been violated. Therefore, the results from the

first line of the table, ‘equal variances assumed’, are used. See table 5 on the next

page for the results.

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Bonus compensation Results





T-value 0,138


Table 5 T-test bonus compensation

The independent t-test shows no significant difference in the mean scores of

discretionary accruals between group 1 (median = 0,17, SD = 0,17) and group 2

(median = 0,17, SD = 0,19); t = 0,138, df = 118, p = 0,45 (one-tailed). This is because

the significance level (0,45) is well above the cut-off of 0,10 , explained on page 44.

Therefore, no significant difference in the mean scores for discretionary accruals

between CEO’s with the highest relative size of bonus compensation and CEO’s with

the lowest relative size of bonus compensation is ascertained. This means that for

the magnitude of discretionary accruals, it does not matter to which proportion a

CEO’s remuneration package consists of bonus compensation.

Independent-Samples T-Test for stock-based compensationFinally a t-test is conducted to compare the mean scores regarding discretionary

accruals for CEO’s in group 1 and group 2 of stock-based compensation. The output

from SPSS shows a significance level of 0,003 for the Levene’s test of equality of

variances. This is below the cut-off of 0,05, mentioned on page 44. It means the

variances for the two groups are not the same. Therefore the results from the second

line of the table, ‘equal variances not assumed’, are used. For the results of the t-test,

see table 6 on the next page.

The results in table 6 show a highly significant difference in the mean scores of

discretionary accruals between group 1 (median = 0,13, SD = 0,13) and group 2

(median = 0,20, SD = 0,22); t = -2,26, df = 98, p = 0,01 (one-tailed). In other words,

CEO’s from group 2 (low equity incentive CEO’s) have a statistically significant

higher mean score of discretionary accruals than CEO’s from group 1 (high equity

incentive CEO’s).

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Stock-based compensation Results





T-value -2,26


Table 6 T-test stock-based compensation

Because there is a highly significant difference in discretionary accruals between

CEO’s with the highest relative size (group 1) and the lowest relative size (group 2) of

stock-based compensation, the results seem to indicate that the extent of stock-

based compensation has impact on the magnitude of discretionary accruals.

In summary it appears that for fixed salary there is a small significant difference in the

mean scores of discretionary accruals between CEO’s from group 1 and CEO’s from

group 2. The more a remuneration package consists of fixed salary, the more

discretionary accruals are distinguished in the annual report. These results therefore

seem to reject H1 that fixed salary is negatively related to discretionary accruals.

Also for bonus compensation the results reject the hypothesis (H2). It was assumed

that bonus compensation is positively related to discretionary accruals. The results

however show no significant difference in the mean scores of discretionary accruals

for CEO’s with a relative high and CEO’s with a relative low bonus compensation

package. Therefore H2 is rejected.

Regarding stock-based compensated the results show that there is a highly

significant difference in the mean scores of discretionary accruals between CEO’s

from group 1 and CEO’s from group 2. However, the observed relation is negative.

Low equity incentive CEO’s have a significant higher mean score of discretionary

accruals than high equity incentive CEO’s. Therefore the hypothesis (H3) that stock-

based compensation is positively related to discretionary accruals is rejected.

In the next chapter the conclusion and the limitations from this research and

directions for future research are described.

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6 Conclusion, limitations and future research

In this final chapter the conclusions to the thesis are described. To provide an answer

to the research question as formulated in the introduction to this thesis, several

hypotheses were developed in chapter 3. In the first paragraph of this chapter the

research question is answered. Secondly, in paragraph 6.2 the theoretical and

empirical conclusions to the thesis are described. The final paragraph, paragraph

6.3, discusses the most important limitations of the methodology used and gives

directions for future research.

6.1 Research question

In this thesis the relative size of fixed salary, (cash) bonus compensation and stock-

based compensation on the use of discretionary accruals as a tool for earnings

management is examined. The purpose of this thesis is to give insight into the

relation between equity incentives (stock-based compensation) and earnings

management. The findings enhance the understanding of the relationship between

equity incentives and earnings management.

After introducing the topic, formulating the purpose of this research and the research

question, the relevant academic literature on earnings management, compensation

contracts and the relation between earnings management and stock-based

compensation is reviewed. Subsequently, three hypotheses were formulated, which

were empirically tested in order to come to an answer on the research question:

What is the relation between equity incentives and earnings management in the U.K.?

In summary, it can be concluded that, based on this research, evidence is found that

stock-based compensation has a negative relationship with discretionary accruals.

Further this research has proven that low equity incentive CEO’s have significant

higher mean scores of discretionary accruals than high equity incentive CEO’s. This

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rejects the hypothesis that stock-based compensation is positively related to

discretionary accruals.

6.2 Theoretical and empirical conclusions

There are three hypotheses, based on the review of the relevant academic literature,

which are tested in this research. Some results of this research support findings in

the academic literature, most findings however oppose the academic literature. The

first hypothesis states that fixed salary is negatively related to the use of discretionary

accruals as a tool for earnings management. Gao and Shrieves (2002) found in their

study that salary is significantly negatively associated with the absolute value of

discretionary accruals (scaled by asset size). The results in this research seem to be

oppose the findings of Gao and Shrieves. From the results it appears that fixed

salary has a weak positive relationship with discretionary accruals. Furthermore it

appears that there is a small significant difference in the mean scores of discretionary

accruals between CEO’s with a relative high and CEO’s with a relative low size of

fixed salary as part of their total remuneration package. The more a remuneration

package consists of fixed salary, the more discretionary accruals are distinguished in

the annual report. Therefore the first hypothesis is rejected.

The second hypothesis states that bonus compensation is positively related to the

use of discretionary accruals as a tool for earnings management. Healy (1985) and

Gaver (1995) found that bonus compensation might also create incentives to engage

in earnings management. Further Gao and Shrieves (2002) found that bonuses are

positively related to earnings management intensity. The results in this thesis oppose

the findings in the academic literature because no (or a very weak) positive

relationship between bonus compensation and discretionary accruals is found.

Moreover, no significant difference in the mean scores of discretionary accruals is

found for CEO’s with a relative high and CEO’s with a relative low size of bonus

compensation. Therefore the second hypothesis is also rejected.

The final hypothesis states that stock-based compensation is positively related to the

use of discretionary accruals as a tool for earnings management. The results show a

weak negative relationship between stock-based compensation and discretionary

accruals. Moreover, it appears from the results that low equity incentive CEO’s have

significant higher mean scores of discretionary accruals than high equity incentive

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CEO’s. Therefore, the results seem to oppose the results from studies from

Bergstresser and Philippon (2006), Cheng and Warfield (2005) and Gao and

Shrieves (2002). These studies all found evidence that high equity incentive CEO’s

engage more in earnings management (through the use of discretionary accruals)

than low equity incentive CEO’s. The findings in this research suggest the opposite

and therefore the third hypothesis is rejected as well.

Further research is needed to test to which extent fixed salary, bonus compensation,

stock-based compensation and the use of discretionary accruals are really related to

earnings management.

6.3 Limitations and directions for future research

There are various limitations to this research that should be taken into account. The

first limitation to this study lies in the use of the Modified Jones Model, which was

presented by Dechow et al. (1995). Some studies have criticized the predictive

accuracy of the modified Jones model (e.g. Guay et al. 1996). It is possible that the

model is misspecified and imperfectly distinguish discretionary from non-discretionary

accruals. The dependent variable can contain a non-discretionary component as a

possible consequence of this measurement error, although the approach seems to

be consistent with standard practice in the earnings management literature.

Secondly, the research focuses on listed firms in the United Kingdom. Non-listed

firms, which in general are smaller firms, have also incentives to manage earnings.

Therefore it is a limitation that the results might not be generalized to non-listed firms

and to other countries.

Finally the data that is used in this research is from 2005 and 2006. This could be a

limitation because it is a short period of time in which the firms are investigated. The

results could be influenced by other factors (e.g. changes in laws and regulations)

than earnings management only.

The limitations mentioned above form directions for future research. First, the study

could be extended by controlling for firm specific parameters (e.g. firm size, industry).

Secondly, this study focussed on the relationship between different types of

compensation and discretionary accruals. However, no assurance is provided on the

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extent of earnings management. Future research is needed to determine to which

extent the results in this study can be explained as a result of earnings management.

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Appendix A

Summarization of the empirical findings of prior research.

Author(s) Year Title paper Journal Object of study Sample (sample size, country, research

period)

Methodology Results

#1 Cheng Q., D.B. Farber

2008 Earnings restatements, changes in CEO compensation, and firm performance

The Accounting Review

Compensation contracts of CEO’s following an earnings restatement.

The sample size of this study is 289 restatements from the period of 1997 to 2001 from companies who are listed at the NYSE, the AMEX or the Nasdag.

For each restatement firm compensation data is collected. First the pre- and post-restatement levels of restatement firms' CEO option grants is compared to calculate the change in option grants around restatements. Then this change is compared to the change in option grants for control group over the same period. Furthermore, there is examined whether the reducting in option-based compensation leads to improved performance.

Restatement firms, compared to control firms, reduce the proportion of CEO’s total compensation that is option-based following a restatement. Thus, restatements firms are likely to view reducing option-based compensation as an important means of reducing their agency problems. Furthermore, the authors find evidence of improved operating performance following the reduction in option-based compensation.

#2 McAnally M.L., A. Srivastava, C.D. Weaver

2008 Executive stock options, missed earnings targets, and earnings management


Why managers miss earnings targets.

This paper uses two distinct samples: one with quarterly data and one with annual data. The quarterly dataset includes 54,934 firm-quarter observations from 1992 to 2005 and the annual

To test whether missed earnings targets are unassociated with subsequent stock-option grants, there is determined whether the value of option grants following a missed quarterly earnings target is different from the

Firms that miss earnings targets have larger and more valuable subsequent grants and firms are more likely to miss earnings targets just before large CEO option grants. Furthermore, the likelihood of missing earnings targets for firms that manage

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dataset includes 7,916 firm-years from the same period.

value of grants that follow no misses.

earnings downwards increases with stock-option grants.

#3 Cheng Q., T.D. Warfield

2005 Equity incentives and earnings management


The relation between equity incentives and earnings management.

All firm-years with data on CEO's stock-based compensation and ownership available from the Standard & Poor's ExecuComp database for the period 1993 to 2000.

First the relation between equity incentives and future trading is reported. Second results on the impact of equity incentives on the probability of meeting or just beating analysts' forecasts are investigated. Last, there is investigated whether managers sell more after earnings management.

High equity incentive managers are more likely to sell shares in the year after earnings announcements and have a higher incidence of meeting or just beating analysts' forecasts. Overall, the study suggest that stock-based compensation can lead to incentives for earnings management.

#4 Barton J. 2001 Does the use of financial derivatives affect earnings management decisions?


Assess the extent to which managers trade off derivatives and discretionary accruals to control earnings volatility.

The sample consists of 304 nonfinancial, nonregulated Fortune 500 firm's from 1994 to 1996.

A set of simultaneous equations that captures management’ incentives to maintain a desired level of earnings volatility through hedging and managing accruals are estimated. Derivatives are measured using notional amounts and discretionary accruals using the modified Jones model.

Firms holding derivative portfolios with large notional amounts have lower absolute level of discretionary accruals. The results suggest that the magnitude of notional amounts and discretionary accruals are endogenous. Managers smooth their firms’ earnings by adjusting the volatilities of cash flow and accruals.

#5 Daniel N.D., D.J. Denis, L. Naveen

2008 Do firms manage earnings to meet dividend thresholds?

Journal of Accounting and Economics

Whether firms manage earnings to meet dividend thresholds.

The sample consists of 1500 firm's listed in the Standard & Poor's ExecuComp database for the period 1992 to 2005.

First, the non-discretionary and discretionary components of total accruals are estimated. Second, regressions are estimated separately for each two-digit SIC industry for each year. Finally, the dollar valuesof discretionary and non-discretionary components

Dividend-paying firms tend to manage earnings upward when their earnings would otherwise fall short of expected dividend levels. This earnings management behavior appears to significantly impact the likelihood of a dividend cut. The findings imply that managers

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are obtained by multiplying the values calculated aboveby the firm’s lagged assets.

treat expected dividend levels as an important earnings threshold.

#6 Bartov E., P. Mohanram

2004 Private information, earnings manipulations, and executive stock-option exercises


To determine whether the ability of top-level executives to time stock-option exercises exist.

The sample consist of 1,322 firm-years (1,218 firms) over a period from 1992 to 2001 from the Standard & Poor's ExecuComp database.

The matched pair design is used to match a firm-year with abnormally high exercise with a firm that in the exercise year has normal exercises but is otherwise similar.

Abnormally positive stock price changes in the pre-exercise year turn abnormally negative after the exercise. Overall, the private information used by top-level executives to time abnormally large exercises follows from earnings management so as to increase the cash payout of exercises.

#7 Ashley A.S., S.S.M. Yang

2004 Executive Compensation and Earnings Persistence

Journal of Business Ethics

Investigates the effect of earnings persistence on the type or form of executive compensation

Firms followed in time from 1993-1998. In total 6,924 firm years. Additional control variables are size, tenure horizon, age and industry effects.

Total accruals scaled by total assets as a measure of earnings persistence. Firms with a high earnings persistence are expected to use earnings for management compensation. Firms with a low earnings persistence are expected to use cash flow from operations for management compensation.

Firms with high earnings persistence tend to be larger in size, report higher earnings, lower stock returns and use more cash compensation to reward executives. This in accordance with expectations. Reason, high earnings persistence firms are larger and therefore can afford to diversify activities, making them less vulnerable to market changes. Firms with smaller earnings persistence tend to reward management with equity -based compensation, i.e. stock options.

#8 Bauman M.P., K.W. Shaw

2006 Stock option compensation and the likelihood of meeting analysts'

Review of quantitative finance and accounting

The relation between stock options employed in a firm's executive pay plan and the

2,513 firms top 5 executives from the years 1992-2002.

Earnings per share is set off against analyst forecast (MEET) and if difference is between 0 and 1 cent per share (SHARE).

Firms that employ higher amounts of stock option compensation in their top executive pay schemes more frequently meet or beat analysts' quarterly earnings targets, and

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quarterly earnings targets

firm's propensity to meet or beat analysts' earnings forecasts.

more frequently report small earnings surprises, than firms with lower stock-based compensation.

#9 Roychowdhury,S.

2006 Earnings management through real activities manipulation

Journal for Accounting and Economics

Contributes to the literature on earnings management by presenting evidence on the management of operational activities. Prior literature focuses more on detecting abnormal accruals.

All firms in COMPUSTAT between 1987 and 2001 that have sufficient data available for the calculations needed. Data is analyzed is taken from annual figures. In total 17,338 firms year spread over 3,672 firms

Based on the model of Dechow, normal levels for CFO, production costs and discretionary expenses are attained for each firm. Deviations from normal levels are termed abnormal. These firms are stated suspect firms. The three different categories are to establish weather or not there in differences in the managerial decisions or operational activities, rather that reported activities.

The results complement existing literature on earnings management. Methods have been developed to detect real activity manipulation in large samples. The paper also detects activity manipulation around earnings threshold, particularly the zero threshold. Furthermore, insights are given into the factors of activity manipulation.

#10 Coles J.L., M. Hertzel, S. Kalpathy

2006 Earnings management around employee stock option reissues


Examines earnings management around the cancellation and subsequent reissue of executive (and other employee) stock options.

159 firms that undertook an option exchange program over the period 2001 through the second quarter of 2002. 54 made an public announcement of the exchange program.

To establish earnings management, the standard Jones model has been used. To ensure that earnings changes are not due to actual firm performance. Total accruals and discretionary accruals are examined prior to reset date.

Evidence of abnormally low discretionary accruals leading up to the option reissue date is evident. Thus, even in a setting where investors are aware of the incentives to manipulate stock price, it appears that managers still attempt to manage accruals to their own benefit. The market doesn't seem to respond to abnormally low discretionary accruals.

#11 Kothari S.P., A.J. Leone, C.E. Wasley

2005 Performance matched discretionary accrual measures


Test whether a performance-matcheddiscretionary-accrual approach

All firm-year observations from the COMPUSTAT Industrial Annual, and Research files from 1962 through 1999. All firms

Estimate for the performance-matched Jones model discretionary accrual is made. Similarly estimates for the performance-matched

Compared to the standard model used to find earnings management, the discretionary accrual approach seems to have a better effect. However the writes

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is well specified and powerful at estimating discretionary accruals.

that don't have sufficient data to compute the Jones model are excluded.

modified-Jones model discretionary accrual is done. Both estimates are compared.

do state that it is not possible to uses this method in all circumstances. This in mind the Jones and modified Jones model are easier and more practical.

#12 Balachandran B., K. Chalmers, J. Haman

2008 On-market share buybacks, exercisable share options and earnings management

Accounting and Finance

The association between earnings management and exercisable option holdings for buyback firms.

138 Australian on-market buy-back firms from 1996 to 2003.

Earnings management is analyzed using a variation of the cross-sectional modified Jones model. Discretionary current accruals is used as the measure for earnings management. Multiple regression analysis is used to test the association between discretionary current accruals and exercisable options and option exercises.

Findings suggest that firms’ motivations for announcing share buybacks are related to firms’ compensation policies. Overall, the evidence provides support for the proposition that earnings management and on-market buyback announcements are mechanisms to ‘drive up’ share prices to increase the cash payout of share option exercises.

#13 Ronen J., J. Tzur, V. Yaari

2006 The effect of directors’ equity incentives on earnings management

Journal of Accounting and Public Policy

Examines the effect of insider trading by directors on the likelihood of earnings management, on the value of the firm and on the stock price.

Not applicable Not applicable Incentive packages contribute to motivating directors to tailor incentives for effort-averse managers. At the same time, they also induce directors to tacitly collude with managers in pernicious earnings management.

#14 Erickson M., M. Hanon, E.L. Maydew

2006 Is There a Link between Executive Equity Incentives and Accounting Fraud?

Journal of Accounting Research

Examines whether the empirical evidence supports the claim that equity incentives are positively

50 firms that are both accused of fraud by the SEC and for which compensation data is available from 1996 to 2003. Further, 100 matched sample firms who

A variety of equity incentive measures is estimated to compare accused firms with matched and unmatched samples of firms that are not accused of fraud.

The analysis reveals no consistent evidence to support the conclusion that the probability of accounting fraud is increasing in the sensitivityof executives’ total equity or vested stock and stock option-

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associated with the probability of accounting fraud

are not accused of fraud and an unmatched sample which contains 13,033 firm-year observations on ExecuComp.

based wealth to changes in stock prices. Also, managerial exercises of stock options and managerial stock sales are not significantly higher for fraud firms than for nonfraud firms.

#15 Core, J.E., W.R. Guay, D.F. Larcker

2003 Executive equity compensation and incentives: a survey

Economic Policy Review

To synthesize the broad literature on equity compensation and executive incentives.

Not applicable - literature review



#16 Bergstresser D., T. Philippon

2006 CEO incentives and earnings management

Journal of Financial Economics

Examines whether firms with CEO's whose overall compensation is more sensitive to company share prices have higher levels of earnings management.

Data from the Compustat and and Compustat Executive Compensationdatasets.

Overall accruals measures is derived from the income statements of the firms. Both the Jones model and the Modified Jones model are used to estimate nondiscretionary accruals. Finally, the relation between earnings manipulation and the power of CEO equity-based incentives is calculated.

Managers whose overall compensation is more sensitive to company share prices lead companies with higher levels of earnings management. Periods of high accruals coincide with unusually significant option exercises by CEOs and unloading of shares by CEOs and other top executives.

#17 Baker T., D. Collins, A. Reitenga

2003 Stock Option Compensation and Earnings Management Incentives

Journal of Accounting, Auditing & Finance

Examines whether the use of stock options relative to other forms of pay influences discretionaryaccrual choices around option award dates.

168 firms with 1,100 firm-year observations from 1992 to 1998 from The Wall Street Journal annual compensation survey.

Earnings management is modeled as a function of relative option pay and several control variables. For the earnings management construct, discretionary accruals are computed using the modified Jones model on cross-sectional data. Finally, a number of control variables are included.

The analysis provides strong evidence that the discretionary accruals component of annual earnings is influenced by relative option compensation. Managers who receive large option awards appear to make income-decreasing accrual choices as a means of decreasing the exercise price of their awards.

#18 Gao, P., R.E. 2002 Earnings Journal of Identify firm The executive The authors use an estimate of The amounts of current year

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Shrieves Management and Executive Compensation: a Case of Overdose of Option and Underdose of Salary?

Financial Economics

specific factors that influence the extent of earnings management, with a focus on managerial contracts.

compensation information is obtained from the Standard and Poor’sExecuComp database, which reports components of compensation for CEOs of 1,500 U.S. firms from 1992 to 1999.

discretionary current accruals as a proxy for earnings management. A modified version of Jones model is used to distinguish between discretionary and nondiscretionary components. The role of eachof the major compensation components: salary, bonus, restricted stock, options and long-term incentive plans is considered in this study.

stock option grants are reliably positively related to earningsmanagement intensity. The most important result of this study is that compensation contract design does influence earnings management.

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Appendix B

A list of firms from the FTSE 100 index that are taken into account in this study and the

corresponding error-terms (discretionary accruals) for 2005 and 2006 for each company.

FTSE 100 index on April 9th, 2009:

# Company name Error-term 2005 Error-term 20061 Admiral Group 0,153588572 0,2425391312 Alliance Trust (The) 0,077352662 0,2125363113 Amec 0,021706024 0,0722938864 Amlin 0,088185772 0,038420775 Anglo American 0,023868141 0,1857964936 Antofagasta 0,651701382 1,1039862427 Associated British Foods 0,046576313 0,0217862328 AstraZeneca 0,422265554 0,5442855079 Autonomy Corporation 0,518379936 0,05469284310 Aviva 0,018656866 0,01648794611 BAE Systems 0,107622556 0,02361097112 BG Group 0,237446657 0,29910400713 BHP Billiton 0,283337719 0,33035317714 BP 0,142309623 0,14871040115 BT Group 0,102016036 0,07283499816 Balfour Beatty 0,039096635 0,04965089317 Barclays 0,014594324 0,01785802218 British Airways 0,106931328 0,07398714819 British American Tobacco 0,240256653 0,22106314620 British Land Co 0,105662168 0,12785502521 British Sky Broadcasting Group 0,546239425 0,55733224822 Bunzl 0,091257976 0,12764117123 Cable & Wireless 0,027285018 0,0970462524 Cadbury 0,132115182 0,05785243825 Cairn Energy 0,046835236 0,12963437526 Capita Group 0,169620679 0,19550731827 Centrica 0,157085556 0,05258705828 Cobham 0,070710615 0,09537228629 Compass Group 0,041058643 0,05361544730 Diageo 0,221764514 0,21072035131 Foreign & Col Invest Trust 0,188082363 0,07471096332 Friends Provident 0,015557684 0,03501509433 G4S PLC 0,020006356 0,04503237334 GlaxoSmithKline 0,448012639 0,35380675# Company name Error-term 2005 Error-term 2006

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5


35 HSBC Holdings plc 0,019042252 0,06885862336 Hammerson 0,246810151 0,26992234937 ICAP 0,152894216 0,09834313938 Imperial Tobacco Group 0,29398569 0,29727886539 InterContinental Hotels Group 0,00161693 0,01722486340 International Power 0,126861985 0,06568248441 Intertek Group 0,039790964 0,04051519742 Invensys 0,262918699 0,12003348243 Johnson Matthey 0,014812083 0,0431965544 Kazakhmys 0,286007199 0,83095786645 Kingfisher 0,022902267 0,09113368546 Land Securities Group 0,303457517 0,14164440347 Legal & General Group 0,011695923 0,01804968148 Liberty International 0,078909473 0,12271832349 Lonmin 0,069047894 0,3287410850 Man Group 0,150258697 0,10952416651 Marks & Spencer Group 0,135097396 0,10049411452 Morrison (Wm) Supermarkets 0,829662154 0,29319844253 National Grid 0,089179553 0,06752866554 Next 0,592417732 0,4194154255 Old Mutual 0,029271139 0,09535093256 Pearson 0,135523259 0,08778184257 Pennon Group 0,213585676 0,29345301758 Petrofac 0,018502204 0,29477696459 Prudential 0,008647134 0,01798581760 RSA Insurance Group 0,026024905 0,02029365261 Randgold Resources 0,441298937 0,13935255462 Reckitt Benckiser Group 0,364050363 0,38043864263 Reed Elsevier 0,173649396 0,16032606664 Rexam 0,052332637 0,02947811465 Rio Tinto 0,35214832 0,45726967166 Rolls-Royce Group 0,101023909 0,18839682467 Royal Bank Of Scotland Group 0,022516641 0,02866458668 Royal Dutch Shell A 0,236862307 0,18779994269 SABMiller 0,241859265 0,14086163570 Sage Group 0,210226131 0,16024175871 Sainsbury (J) 0,129359399 0,15479996672 Schroders 0,079701571 0,11169743273 Scottish & Southern Energy 0,00847627 0,0378820274 Serco Group 0,032983457 0,04189196175 Severn Trent 0,163763406 0,18863826276 Shire 0,01211122 0,08941547277 Smith & Nephew 0,094908016 0,19412701678 Smiths Group 0,118617784 0,053819397# Company name Error-term 2005 Error-term 2006

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79 Standard Chartered 0,090235298 0,05369454680 Tesco 0,02842635 0,0423909781 Tullow Oil 0,059856083 0,15156821182 Unilever 0,183367247 0,17786379783 United Utilities Group 0,191640713 0,18553255984 Vedanta Resources 0,091502944 0,09863646785 Vodafone Group 0,011150501 0,05368484486 WPP PLC 0,093395051 0,06712653387 Whitbread 0,187783051 0,20270675788 Xstrata 0,156310706 0,095739119

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