The Relationship Between Compensation, Motivation, And Earnings Management

Regulators and investors remain concerned with earnings management and its effect on the reliability of accounting information. Agency literature suggests that a lack of compensation incentives (i.e., bonus payments) can decrease—but not completely eliminate--earnings management behavior, while theory from psychology suggests that individuals may be motivated to manage earnings, regardless of compensation. Consequently, we examine how compensation incentives and motivation (intrinsic versus extrinsic) affect earnings management behavior. We hypothesize and find that when compensation is linked to firm performance, managers make income increasing (decreasing) decisions when current earnings are below (above) analysts’ forecasts. We find that in the absence of compensation incentives, managers make earnings increasing decisions when current earnings are below analysts’ forecasts, but they do not make earnings decreasing decisions when current earnings are above analysts’ forecasts. Finally and most importantly we show that managers who possess strong extrinsic motivation are more likely to manage earnings upwards to reach targets – in the absence of compensation – possibly because it helps satisfy their competitive spirit and need for recognition. However when current earnings are above the target (analysts’ forecasts), managers are not compelled to manage earnings as this drive has already been satisfied