Document Type

Dissertation

Degree Name

Doctor of Philosophy (PhD)

Department

Business

Program Name/Specialization

Accounting

Faculty/School

Lazaridis School of Business and Economics

First Advisor

Chima Mbagwu

Advisor Role

co-supervisor

Second Advisor

Darren Henderson

Advisor Role

co-supervisor

Third Advisor

Esther Maier

Advisor Role

committee member

Abstract

This dissertation examines the relationship between the perceived fairness in executive compensation and the level of earnings management on the one hand and the propensity for voluntary turnover on the other. Executive compensation has attracted significant academic attention for more than two decades. The ratcheting-up of executive pay raises questions about its determinants and whether the pay-setting process effectively promotes managerial behavior that aligns with the interests of shareholders. Alternatively, executives may simply extract rents at the expense of shareholders because of the informational advantage that they have and their influence over the board of directors, particularly the compensation committee (e.g., Daily et al. 1998; Newman and Mozes 1999; Anderson and Bizjak 2003). Because executives play a vital role in the success of their businesses, I argue that it is important to analyze whether the perceived fairness in their compensation affects their organizational behavior, particularly in areas that relate directly to the health of their firms.

The results of previous research on the relationship between executive compensation and earnings management have been inconclusive. Some studies have found that executive compensation is positively related to earnings management (e.g., Bergstresser and Philippon 2006; Burns and Kedia 2006; Efendi et al. 2007), while others have argued that this relationship is insignificant (e.g., Erickson et al. 2006; Armstrong et al. 2010).

While executives who perceive they are unfairly compensated may use earnings management to increase their performance-based pay, they may, alternatively, voluntarily quit a firm in order to find a position which they deem to give a fairer reward. With regard to voluntary turnover, some research finds that executive compensation, as a sign of managerial power, is negatively related to voluntary turnover (e.g., Song and Wan 2019); but Bloom and Michel (2002) disagree with this, arguing that although executive compensation is not related to executive turnover, it is positively related to the turnover of lower-level employees. Consequently, alternative theories offer the opportunity of complementarily explaining the nature of these relationships.

In summary, my dissertation is structured as follows: in Chapter 1 I present a structured review of the literature on the relationship between earnings management and executive compensation and describe how social comparison theory can provide a more nuanced understanding of this relationship; in Chapter 2, I develop an empirical measurement to capture perceived fairness in executive compensation and to analyze its effect on earnings management; and, in Chapter 3, I present the results of tests to determine whether perceived fairness influences voluntary turnover. Below, I describe each chapter in more detail.

In Chapter 1, I first provide a detailed review of the academic literature on the relationship between executive compensation and earning management. I then discuss the theoretical background of organizational justice theory (i.e., social comparison theory) and integrate this theory into agency theory to better explain the association between executive compensation and earnings management (e.g., Rupp et al 2017; Abernethy et al. 2017). I argue that by considering perceived fairness in executive compensation, certain opportunistic managerial behavior can be avoided. In empirical research, by incorporating perceived fairness in the regression explaining the relationship between executive compensation and certain managerial behavior, I can more accurately quantify the impact of executive compensation on these behaviors. Lastly, I identify potential research avenues that interested researchers could take to further our understanding of this topic. This chapter lays the foundation for my subsequent thesis chapters while also providing other avenues for future research.

In Chapter 2, I construct an empirical model that estimates the perceived fairness in executive compensation based on the factors that are likely to be considered when perceiving fairness, including firm fundamentals, the tenure and demographic characteristics of executives, and corporate governance. I then regress total compensation on these variables and take the residuals as the proxy for perceived fairness in executive compensation. According to social comparison theory, perceived fairness is formed based on the comparison between one’s ratio of inputs (e.g., efforts) over outcomes (e.g., compensation) and a comparison of this ratio to that of their referent(s): individuals would feel unfairly treated if their ratio is higher than that of their comparison base.

Next, I empirically examine whether perceived fairness in executive compensation is associated with the level of earnings management. I choose earnings management as the way to restore fairness to executives who perceive they are unfairly compensated, because the manipulation of earnings can increase the outcome of the ratio without significantly increasing the inputs, that is, without exerting significant efforts in increasing a firm’s fundamental performance. The empirical results are consistent with my expectation that executives who perceive they are unfairly compensated manipulate earnings upward to restore fairness.

In addition, I conduct several more analyses. Specifically, I test if perceived fairness also affects the level of real earnings management, the perceived fairness of which is the component of compensation executives value most, and, lastly, if chief executive officers (CEOs)[1] also use earnings management for the sake of fairness. In terms of robustness tests, I analyze if perceived fairness also affects the level of accruals management in the next period, if the incentive for earnings management only applies to executives who perceive they are under-compensated, and if the main result holds for an alternative measure of perceived fairness (Cooper et al. 2016).

This chapter contributes to the existing body of research on the relationship between executive compensation and earnings management (the literature) in three ways. Firstly, I develop a new measure for estimating the perceived fairness in executive compensation and use this measure to test if this measure of perceived fairness is related to the level of earnings management. I find the results consistent with my hypothesis. Secondly, by incorporating social comparison theory into this relationship, the mechanism of how executive compensation affects the level of earnings management can be further understood. I argue that, due to the mixed evidence in the literature on this topic, delving into explanations based on alternative theories, other than agency theory, could be fruitful. Thirdly, the findings demonstrate that the board of directors should consider fairness when determining compensation packages and should compare the level and structure of executive compensation in their own firm to that of firms with similar characteristics and individuals with similar demographics.

In Chapter 3, I examine whether perceived fairness in executive compensation affects the propensity for voluntary turnover. Since earnings management may not be the only avenue for executives to restore fairness, executives may take more extreme action. The results are consistent with my expectation that executives who are more unfairly compensated have a higher propensity for voluntary turnover. Further, my findings are robust when subjected to alternative definitions of voluntary turnover and to different model specifications. Voluntary turnover is driven by fairness in equity-based compensation rather than salary and bonus. The analysis in Chapter 3 provides insight into understanding the managerial labor market and how to retain scarce managerial talent, thus reducing costs associated with executive turnover.

[1] A chief executive officer (CEO) refers to the highest-ranked executive in a firm, and sometimes also serves on the board.

Convocation Year

2022

Convocation Season

Fall

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