CEO employment contract horizon and earnings management

• Main Authors: WANG, Juan, GONG, Guojin, LEE, Hyun Jung
• Format: text
• Language: English
• Published: Institutional Knowledge at Singapore Management University 2011
• Subjects: Accounting; Corporate Finance; Human Resources Management
• Online Access: https://ink.library.smu.edu.sg/soa_research/852; http://aaahq.org/AM2011/abstract.cfm?submissionID=568
• Institution: Singapore Management University

This article examines the implications of CEO employment contract horizon for earnings management incentives. We postulate that, throughout the contract horizon, the board learns about the CEO’s ability through reported performance to determine contract renewal or termination. However, the informational value of reported performance declines over time as the board’s estimate of CEO ability becomes more precise, motivating the CEO to inflate earnings to a greater extent in the earlier stage of contract horizon to improve the board assessment and hence the contract renewal likelihood. Using the CEOs’ first employment contracts for S&P 500 firms, we find more aggressive income-increasing earnings management in the earlier stage of CEOs’ contract horizon. This finding is more pronounced when the CEO concerns more about contract termination. The evidence suggests that pre-specified contract horizon induces the CEO to manipulate performance to influence the board’s learning of his ability.