CEO compensation and earnings management over tenure; an examination of the BHCS

Bank CEOs smooth income due to job security concerns during poor performance year as they borrow income from the future to reduce the threat of dismissal in the current quarter (Kanagaretnam, Lobo, & Mathieu, 2003). However, managerial discretion in the use of accruals may also be informative about underlying business conditions (Wahlen, 1994); (Liu & Ryan, 1995). Therefore, it is important to examine the effects of earnings management on CEO compensation over her tenure. In this thesis, I examine how boards set a CEO’s compensation over her tenure in the presence of performance distortions by the CEO that may confuse the signal that the board gets from reported performance. Using a sample of 263 bank holding companies from the US banking industry. I develop and test a model of CEO compensation for US banks from the period 2003-2014, using established discretionary loan loss provision models. The findings show that that total, cash and inside debt components of compensation are positively associated with earnings management in the early years of CEO’s tenure when less is known about ability, and the relationship becomes weaker over tenure with both statistical and economical significance. I also show that the relationship between reporting distortions and compensation varies based on CEO and bank characteristics that capture uncertainty about ability and career concerns. These results are robust to treating earnings management and tenure as endogenous and using a different model of discretionary loan loss provisions. This implies that boards adjust compensation in response to potential earnings distortions in the early years of a CEO’s tenure. This study depicts a broader picture for the benefit of regulators and policymakers by teasing out the relevance of the good and bad side of earnings management. These findings raise major implication for bank regulators, particularly, that the current regulatory approach may not be the best form of regulation since banks differ in the way that they manage their compensation structure