EuroMed Journal of Business

The association between CEO incentive rewards and earnings management: Do
institutional features matter?
Habib Jouber, Hamadi Fakhfakh,
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The association between CEO
incentive rewards and earnings
18 Do institutional features matter?
Received 14 November 2012
Revised 27 May 2013
Habib Jouber
24 August 2013 LARTIGE, Faculty of Economic Sciences & Management,
2 September 2013 University of Sfax, Sfax, Tunisia and Higher Institute of Management,
Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT)

Accepted 3 September 2013 University of Gabès, Gabès, Tunisia, and
Hamadi Fakhfakh
LARTIGE, Faculty of Economic Sciences & Management,
University of Sfax, Sfax, Tunisia and College of Business Administration,
Jazan University, Jazan, Saudi Arabia

Purpose – The purpose of this paper is to investigate whether or not there is a link between CEO
incentive-based compensation and earnings management and to examine how institutional
environment’s features influence such link.
Design/methodology/approach – To test the predictions, the authors use a panel of 1,500
American, Canadian, British, and French firm-year observation over the period 2004-2008.
Findings – The authors find a significant association between earnings management and CEO
incentive-based compensation. Moreover, the analysis provides evidence that institutional factors
are strong determinants of this association. Specifically, the results show that firms from countries
within the Anglo-American corporate governance model, which provides greater protection of
shareholder rights, ensures strict enforcement of law, and scores high on board oversight, tend to have
lower level of earnings management. The analysis shows however, that beside the formal corporate
governance quality, it is relevant to consider weaker shareholder protection and lower law enforcement
indexes to explain earnings management in firms from countries within the Euro-Continental corporate
governance model.
Originality/value – This paper is the first to provide insights regarding the extent to which CEO
incentive rewards imply management discretion and to indicate how much institutional features
matter. The analysis contributes to two distinct strands of research. It extends prior research on the
association between executive compensation and earnings management and adds to the literature
demonstrating a relationship between institutional factors and financial decisions.
Keywords Corporate governance, Earnings management,
Anglo-American corporate governance model, CEO incentive-based compensation,
Euro-Continental corporate governance model, Institutional factors
Paper type Research paper

The authors would like to thank the four anonymous reviewers, the Associate Editor Mike Useem
and Editor-In-Chief Bill Judge, for insightful and very helpful comments during the review process.
EuroMed Journal of Business
Vol. 9 No. 1, 2014 The authors are grateful for the comments from the participants at the Corporate Governance:
pp. 18-36 AIR 20th’s anniversary Conference on National Governance Bundles held at the Cambridge
r Emerald Group Publishing Limited
1450-2194 University Business School, September 28-29, 2012. The authors would like to thank their Institution,
DOI 10.1108/EMJB-11-2012-0019 Faculty of Economic Sciences and Management, University of Sfax, for funding support.

The remainder of this paper is organized as follows. qualified corporate governance. The managerial power view ensures that management compensation is regarded to be a means whereby self-serving executives Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) skim corporate profits and expropriate shareholders (Georgen and Renneboog. (2008). Background. related research. (EM3) small loss avoidance. The optimal contracting view asserts that management compensation is seen to be the result of a market-based mechanism which ensures that managers have adequate incentives to maximize shareholder value. Executives may proceed in various ways to influence over their pay. CEO incentive rewards have been blamed for encouraging some of the largest financial reporting scandals such as Enron and WorldCom. discuss the implications and limitations of our analysis. and the reversals of the pre-exercise overstatements negatively affect the post-exercise period. in Section 5. That is. we focus on the institutional determinants of such impacts. accounting-based performance measures are liable to manipulation as they are back-ward looking. there are two competing views 19 of CEO performance-based incentives: optimal contracting and managerial power. we provide evidence that. 2. 1. Introduction CEO incentive Incentive-compensation systems are unquestionably important because they and earnings presumably provide the primary mean by which organizations elicit and reinforce desired behaviors. In accordance with Cianci et al. and stricter law enforcement rules all reduce the retained dimensions (EM1-EM4) along which CEOs can exercise their discretion to manage earnings. Section 2 provides theoretical background and hypotheses for the study. In recent years. within the Anglo-American (but not Euro-Continental) setting. Baker et al. thereby expropriating the shareholders via excessive underpricing. 2011). They conclude that executives opportunistically manage pre-exercise earnings to increase their cash payouts. post-grant earnings announcements are found to be generally more favorable than pre-grant earnings announcements. and hence extract funds from the shareholders to their own benefit. In particular. Chahine and Goergen (2011) show that CEOs may grant themselves options at the initial public offering of their firm with an exercise price set equal to a deliberately low offer price. (EM2) income smoothing. higher outside investor rights protection. Particularly. (2011). Besides. The research design is presented in Section 3. we examine the association of CEO dominance with (EM1) discretionary accruals. we summarize our results. we aim at devoting an attention to the impacts of CEO pay-for- performance rewards on earnings management[1]. for example. In fact. we conceptualize CEO dominance as a measure of a CEO’s power and define it as the difference between CEO incentive pay and the next highest executive’s incentive pay divided by the CEO’s incentive pay. Concurrent with this growth there has been growing stream of research about the . and give suggestions for further research. Bartov and Mohanram (2004) show that large insider option exercises are preceded by abnormally positive earnings and followed by poor earnings performance. With this in mind. and (EM4) aggregate earnings management score. The results and robustness checks are discussed in Section 4. Self-serving occurs when companies rely much on performance measures when assessing their managers’ performance. and hypothesis Use of incentive-based compensation has undergone dramatic growth through the 1990s. document strategic disclosure to manage market expectations downwards prior to option grants. Our main result is that controlling for cross-national institutional features helps explain the potential of CEO incentive-based compensation to motivate manager’s earnings management behavior. due to its alleged role in the recent financial crisis. Theoretically. Finally. CEO pay has become the subject of unprecedented scrutiny.

finds that managers receive stock option grants shortly before good news announcements and delay such grants until after bad news announcements. Bergstresser and Philippon (2006) and Burns and Kedia (2006) find that the magnitude of discretionary accruals is greater at firms in which managers’ wealth is more closely tied to the value of stock. This motivates the first hypothesis: H1. Cheng and Warfield (2005) document a higher degree of earnings management to meet or beat the analyst forecast benchmark in firms with greater executive equity incentives. findings from international financial economics literature. and that this lower persistence is at least partly explained by opportunistic earnings management. (2007) find that the probability of a restatement is positively related to the size of in-the-money CEO option holdings and incentives to misreport are largely driven by needs to support overvalued equity. Moreover. Efendi et al. can be made to make definitive predictions regarding this question. Cohen and Zarowin (2010) find that increases in accrual-based earnings management in the period leading up to the Sarbanes-Oxley Act (SOX) are associated with increases in equity-based compensation. relatively little is known about how the institutional environment affects the potential of executives’ incentive rewards to motivate earnings management. Kuang (2008) documents that managers may behave opportunistically by taking actions to depress stock prices or avoid value increasing surprises prior to option incentive awards and open market stock purchases. However. focussed on management compensation in countries from the Euro-Continental corporate governance model. However. Incentive-based compensation motivates CEO’s earnings management behavior. Similarly. On the other hand. Beneish and Vargus (2002) show that abnormal selling by corporate executives is associated with a lower persistence of income-increasing accruals. Bertrand and Mullainathan (2001) find that in the absence of large shareholders. 2009.1 Jensen and Meckling (1976). Yermack (1997). Should we expect the same patterns of incentive compensation “costs” in Anglo-American firms as in Euro-Continental firms? No cross-national study has dealt with the institutional determinants of the association between CEOs incentive rewards and earnings management. the extant literature displays two interesting things. however. (2008) find that the previously documented positive impact of stock option compensation on operating performance is mainly an artifact of opportunistic earnings management. In line with the latter view. Sawicki and Shrestha (2008) provide evidence suggesting that managers use income-increasing earnings management while selling shares in the company and use income-decreasing earnings management while purchasing shares. The optimal contracting view considers shareholders’ use of performance-based 20 incentives as an efficient response to an agency problem. . there are two opposing viewpoints in this area. On one hand. for example. CEOs are able to capture the board and determine their own compensation at the expense of corporate profitability. Abody and Kasznik (2000) support the Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) hypothesis on strategic disclosure behavior whereby managers postpone the disclosure of bad news until after they have secured desirable fringe benefits. Utilizing primarily the seminal work of 9. all of them are indirect. Separate cross-country researches on management compensation ( Jansen et al. Additionally. EMJB effectiveness and cost of CEOs incentive rewards. Cornett et al.. The managerial power view holds that CEO compensation and other corporate governance practices reflect the exercise of managerial power and rent-seeking behavior more than the provision of efficient incentives. most research has concentrated on the Anglo-American world. Fewer studies have.

This leads to the following alternative hypotheses: H2a. legal enforcement strength. 2006. Wright et al. Wright et al. Leuz et al. Van Tendeloo and Vanstraelen (2005). and Nabar and Boonlert-U-Thai (2007) provide evidence that earnings management magnitude is on an average higher in code-law countries with less stricter law enforcement. Research design 3. 2003. 2010.’s (2006) results indicate that US managers are significantly more aggressive in managing earnings downward prior to an MBO than UK managers. 2011. (2010. Brenner and Schwalbach. as well as its potential to manage earnings with reference to each 21 framework. Wright et al. Weak governance structures have been implicated as a culprit for the corporate collapses and for excessive rewards to CEOs in spite of poor firm performance (Bekiris and Doukakis. They posit that earnings management occurs less frequently in outsider economies where shareholders are Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) provided more stringent protection by the country’s legal system and more frequently in insider economies where the legal protection provided to investors is weak. 2009.. Nabar and Boonlert-U-Thai. These factors rely to outside investor protection index. 2011) all find that CEO pay is more generous under greater protection of shareholder rights and stricter rule of law. compared to common-law countries with higher rule of law index. and corporate governance quality. (2003) have examined the occurrence of earnings management across 31 countries with different level of investor protection. . 3. Bryan et al. 2011).’s (2003) position that similarities in the UK and US legal environments result in similar and infrequent earnings management. (2006) extend the work of Leuz et al. and Bryan et al. H2b. In accordance with Cianci et al. Considering samples of UK and US[2] firms that were taken private in management buyout (MBO). 2011) and earnings management CEO incentive (Leuz et al. Moreover. Burgstahler et al. Cianci et al. Incentive-based compensation is more likely to motivate CEO’s earnings management behavior under weaker protection of shareholder rights. We consider the Anglo-American and Euro-Continental corporate governance settings and organize our discussion along three key institutional factors that might either coerce or motivate CEO incentive-based compensation. Jansen et al..1 Variable construction Our hypotheses call for two sets of variable to capture the extent to which CEOs’ incentive rewards imply management discretion. H2c. Incentive-based compensation is more likely to motivate CEO’s earnings management behavior under less qualified law enforcement rules. 2007) have recognized and earnings that institutional differences among countries causes differences in the use of incentive compensation and corporate earnings management. (2006). Incentive-based compensation is more likely to motivate CEO’s earnings management behavior under weaker corporate governance structure. (2009).. (2003) by question whether their country clusters (outsider vs insider countries) are broad in seeking to effectively explain the relation between earnings management and countries’ legal environment. Shareholder legal protection[3] and law enforcement quality are also seemed to affect the structure of management compensation. Brenner and Schwalbach (2009). they find evidence inconsistent with Leuz et al. Fahlenbrach (2009)..

Wright et al. Drawing on prior accounting research (e. R&D. LAGAL and GOV-Score measure respectively law enforcement and corporate governance qualities. 2006). The second set of variables captures firm’s economic features that previous researches have documented as might influence earnings management. Additional two sets of control variables are also constructed to capture factors explaining management use of discretion in a way to inflate economic performance. IPI measures outside investor rights’ protection Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) strength.’s (2003) country clusters. Variables included are SIZE. and all firms of SBF 120 index. Data on French observations are exhausted from various sources such as the Expansion magazine. we define a relative CEO incentive-based pay as the difference between CEO 9. 2003. All selected firms are shared out their corresponding industries using the Fama-French 12 industry classification except of financial industries in view of its specific regulation and because of the fundamental differences in their financial accounting relative to non-financial industries[6]. all UK listed firms of the FTSE 100 index.1 incentive pay[4] and the next highest executive’s incentive pay divided by the CEO’s incentive pay and we conceptualize it as to reflect CEO’s power. Leuz et al. and CEO characteristics are collected from DEF 14A proxy statement reports available on the SEC files and download from the EdgarScan’s web site (edgarscan. left us with 75 firms in each country. ownership and corporate governance are provided by the firms’ proxy circulars available from the System for Electronic Document Analysis and Retrieval database.. 2003). and GOV-Score. (EM3) the tendency of 22 managers to avoid small losses. (EM2) the smoothness of earnings. In fact. and the Euronext web sites. GROWTH. La Porta et al.g. Variables used are IPI. and Canada should be gathered together because in those countries common law traditions are largely spread. however. we compute four proxies detecting a range of earnings management activities. The discarding procedure.. For US firms. Investor right protection indices are provided by the World Bank Doing Business (2008)’s report. Needed information is hand collected from various sources. The second cluster groups UK and French firms considered as to represent the Euro-Continental corporate governance model. USA. that Leuz et al.. The first set captures expected institutional environment effects. LEGAL. UK. all Canadian companies of TSX100 index. Burgstahler et al. These clusters do not closely parallel simple code-law and common-law used in prior work (e. 25) claim. 1997. EMJB (2011).g.2 Data and sample selection Our starting target sample covers a random group of 120 US companies from S&P 500 index. ownership structure. For the Canadian firms set. either because of incomplete needed information for the period under analyses which covers years from 2004 to 2008. The first group gathers together US and Canadian firms labeled as representing the Anglo-American corporate governance model.. UK and France belong to two different families of law. Financial and accounting firm’s characteristics come from the 10 K annual reports contained in the same database. data on CEO pay. data on executives’ compensation. p. Leuz et al. We cluster the final sample under two The specific measures of all variables are described in Table I. (2006. Data on the UK firms are exclusively collected from their web sites[7]. 3. and LEVERAGE. Considering Leuz et al. the Financial Market Authority.’s (2003) country clusters are . board. These proxies are used as dependent variables in all regressions. or because of firm’s listing status[5]. (EM1) the magnitude of discretionary accruals. and (EM4) an aggregate measure of earnings management.

reserves.01] ( [0. taxes.01. EM2. c This index assigns a value of 1 if the firm meets the threshold level to each of these attributes. nominating and compensation committees are composed solely of independent outsiders. (2011) which focus on the cultural determinants of earnings management across 31 countries around the world cluster European countries (among them France and the UK) with Australia under the same group. board meet at least twice time annually. our per-country robustness checks reveal no highly significant differences between French and British firms[8]. and the firm is audited by at their predicted effects on least one of the big four companies earnings management overly broad in seeking to effectively explain the relation between countries legal environments and earnings management. and any other item.’s (2005) performance-matched discretionary accruals methodology. the audit function. composition of board of directors. Besides. extraordinary items. 0 otherwise Investor right protection IPI 7 Investor Protection Index from the world bank doing business (2008) report Corporate governance GOV-Score 7 Corporate governance Scorec quality Firm economic characteristics Firm size SIZE þ Total assets in logarithm Growth opportunities GROWTH þ Market to book ((market value of equity þ book value of debt)/total assets) Firm’s research and R&D 7 R&D expenses development expenses Leverage LEVERAGE þ The ratio of total debt over total equity a Notes: Discretionary accruals are computed using Kothari et al. Coffee.0] ).0. Table I. at least the CEO serves on the board of one of other public firms. nor in the compensation Variables definition and committee. etc. special items. Conyon et al. 2005. and EM3 Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) measures Independent variables CEO relative CEOPAY þ The difference between CEO’s incentive pay incentive-based pay and the next highest executive’s incentive pay divided by the CEO’s incentive pay Institutional factors Legal system’s origin LEGAL 7 Equal to 1 if common law. . 2010) note differences related to the use of equity compensation. institutional investors hold more than 10 percent of capital. chairman and CEO positions are separated. 2004. bA firm-year observation is classified as small profit (loss) if net earnings scaled by lagged total assets are in the range [0. Net earnings are bottom-line reported income after interest. CEO do not serves as a member neither in the nominating committee. board is controlled by more than 50 percent gray directors. A recent study by Desender et al. a number of studies (Monks and Minow.. between the UK and the USA. Predicted CEO incentive Variables Label effect Definition and earnings Dependent variables Earnings management EM1 Discretionary accrualsa as a percent of total proxies assets EM2 1 less the firm’s Spearman correlation between the change in accruals and the 23 change in cash flow from operation both scaled by lagged total assets EM3 The number of small profits divided by the number of small lossesb EM4 The average rank across EM1. Moreover.

2011. discretionary earnings management accruals and small losses avoidance are more pervasive among French and British firms. Burgstahler et al. US and Canadian frameworks satisfy these attributes. Comparative statistics from UK and French firms are less small indicating that those firms engage in less earnings management. The significant difference for debt to equity (T ¼ 1.37 percent (6. . 24 Panel A indicates that the mean (median) value of the aggregate earnings management proxy is 8. We can match these differences to strong financial analysts’ pressures and high capital market dynamism which are prominent within the US and Canadian economies. Jones and Wu. and SIZE. CEOPAY is highly (at 1 percent level) negatively correlated with each of the institutional features. US and Canadian CEOs are paid at 13.. Analysis of empirical results 9. we present the results of univariate analysis.71 percent for UK and French CEOs. These dissimilarities can also be matched to specific incentive from each related accounting model. 2012 among others). and GROWTH for the French and British observations).g.08 percent) among US and Canadian firms. SIZE and GROWTH for the American and Canadian observations. Similar results are already found by financial accounting researches (e. CEOPAY is significantly and positively correlated with all earnings management proxies in both subsamples. LEVERAGE.1 Before proceeding to the verification of our research hypotheses using multivariate statistical tests. These results closely corroborate those of Bryan et al. T-statistics for mean differences shows that the American and Canadian managers managed earnings significantly to a greater extent than their counterpart in the UK and French firms. Statistics on CEO incentive-based pay exhibit large management power among the Canadian and American settings by comparison to their French and British peers. US and Canadian firms are moreover well governed. Perols and Lougee. Panel B of Table II describes the univariate correlations among the dependent and independent variables. 4. 2006. (2010) who find that firms use relatively more equity-based compensation if in a legal environment where shareholder rights are more strong protected and where law are more effectively enforced. These correlations are hold only for the American and Canadian statistics. Interestingly. Ben Othman and Zeghal. Comparative figures on the Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) remainder individual earnings management measures (EM1 through EM3) display that US and Canadian managers rely more on earnings smoothing to obfuscate firm performance. T-statistics for mean differences and Wilcoxon z-scores for median differences confirm these findings. The latter are however larger and invest much more on R&D activities. EMJB 4. As expected. Those proxies are moreover highly correlated with many of firms’ economic characteristics and institutional environments’ attributes. The Pearson correlations between the four earnings management’s dimensions under study are positive and significant. On an average. CEOPAY is also significantly correlated with many of retained firms’ characteristics (namely. 2010.15 percent much larger than their next highest paid executives. 2006. In contrast.1 Univariate analysis Table II provides descriptive statistics for the variable used in the regression analysis. Jouber and Fakhfakh. Statistics on institutional features show that Canadian and American environments provide high degree of legal protection of investor rights and ensure strict enforcement of laws. These firms meet in average six among the eight corporate governance tools we have selected.96) indicates that British and French firms are large leveraged than Canadian and American firms do. This extent equal simply 9.

091 0.021 0.174 1 0.007 0.1372 0.000 5.0837 0. 8.0719 0.129 0.309 0.021 0.04** 2.104 0.073 0.615 0.000 2.371 0.083 0.371 0.1307 0.0971 0.0843 0.0739 0.0371 0.0492 2.033 5.36** EM2 0.383 0.103 0.119 0.10 0.000 1.108 0. CEOPAY.086 7 0. LEVERAGE. SIZE.04 0.07 0.0581 0.091 0.11 5.01 0.06 0.2055 2.18*** IPI 8.371 4.4195 0.177 0.0917 0. 3.1056 0.3 8.037 0.119 1 0.201 0.586*** 1.113 0.78* LEVERAGE 0.0859 0. LEGAL.000 1.205 0.16** 2.0437 0.05 0.603 0.016 0.003 0.0861 0.3473 0.028 4 0.01739 0.038 0.015 0. GOV-Score.517 0.031 0.006 0.227 0.0545 0.11** CEOPAY 0.011 0.231 0. 7.5929 0.227 0. R&D.137 0.217 0.011 0.722*** 3.0496 0.181 0.09** EM4 0.06 0.1016 0.315 0.141 0. 5.99** LEGAL – – 0.3791 0.27 0.**.141 0.148 0.086 8 0.0817 0.219 0.***Significant at 10.0793 0.093 1 0.104 0.31** GROWTH 0.01 9 0.0758 0. 9.511 0.101 1 0.31 0.251 0.31 0.031** – SIZE 15.7 10.96* EM3 0.98** 2.308 1 0.517 0.0402 0.337 0.573 0.3 8.05*** GOV-Score 6.1051 0.07** Panel B: Pearson correlation coefficients for US-Canadian (UK-French) sub-sample are represented above (below) the principal diagonal Variables 1 2 3 4 5 6 7 8 9 10 11 12 1 1 0.001 0.337 0.4442 0.0739 1.0482 0.09 0.9 9.5782 0.1315 0. 6.059 1 0.311 0.199 0.000 2.65*** R&D 0. GROWTH.101 0. Bold (italic) values are significant at 1 percent (5 percent) level.011 0.0672 0.315 0.073 0.707 0.025 5 0.199 0.511 0. and 1 percent level and earnings Descriptive statistics and 25 Pearson correlations Table II.22 4.05 5.105 13.373 0.109 0.314 0.196 10 0.6739 1.3 11.106 0.1175 0.1 12.211 0.0581 0.202 0.0106 0.101 0.344*** 1.221 0.1653 0.101 0.01 0.205 1 0.043 0.0431 0.041 0.2731 0.496 21.1 1 0. 10.11 1 Notes: 1.92* 1.09 0.011 12 0.1151 3. 11.023 0.1375 0.229 0.2194 0.091 0.381 11.000 3.104 1 0.3177 0. 5.388 0.000 0. EM3.337 0.3842 0.000 – – 0.0729 0.216 0.011 0.1173 0.09 0.065 0.0379 0.303 1 0.17 11 0.3 6.091 0.055 0. EM4.608 0. EM2. *.0753 0. 12.1493 3.221 0.119 0.0506 0.5515 0.011 0.307 0.4106 1.3 8.271 0.107 0.021 0.96** 2.024 2 0. IPI.012 0. 4.07183 1.031 0.000 7. Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) Panel A: descriptive statistics Sub-sample of US and Canadian firms Sub-sample of UK and French firms Variables Mean Median Min Max Mean Median Min Max T-student Wilcoxon z-scores EM1 0.019 0.0608 0. EM1.004 0. CEO incentive .06*** 2.3 8.88* 2.047 6 0.000 5.22 0.147 0.373 0.017 0.835 5.237 0.019 3 0.411*** 3.000 6.213 0.402 0.11 0. 2.561 0.

4. it appears that the associations between CEOPAY and earnings management proxies are not similar if we compare results from the two subsamples. British and French compensation structures seem to be more likely to file potential earnings management which reflects higher CEO dominance. GROWTH Þ þ X t þY i þeit where n ¼ 1. y. DeFond and Jiambalvo (1994) provide evidence suggesting that managers of highly leveraged firms have strong incentives to use income increasing accruals to avoid debt covenant violation. Therefore.8 which is the limit at which we begin to have a serious problem of multicollinearity). This result provides evidence that.707 (o0. as predicted in H1. We present the US-Canadian and UK-French per-sample estimation results. managers have significantly managed earnings in both settings. R&D.1 problems. We include industry and year-fixed effects to remove unobserved time and industry heterogeneities that may be correlated with the earnings management attributes of interest. According to the theoretical background and to the hypotheses outlined above. we present our research model and we present the main results.2 Test of hypotheses: regression analyses.7 and are significant ( p ¼ 0. EMJB Notably. .2 Multivariate analysis and verification of research hypotheses 26 In this section. R2s are moreover acceptable and show that at least 35. Osma (2008) finds a positive association between R&D expenditure and real earnings management. To test our hypotheses. Regarding the variable of interest.4 to 10. leverage. CEOs behave self-serving. the Fisher tests have values that range from 7. we can conclude that the models tested are generally significant. Y i the dummy industry fixed effect[9]. F the firm’s economic characteristic factor.000). 4.2. no one of all these correlations appear large enough to present collinearity 9. The possible explanation of this result is that the executive compensation “incentive effect” to manage earnings. LEVERAGE. The UK-French regressions’ outputs show larger figures than the US-Canadian ones. our conceptual model could be expressed as follows: EM nit ¼ a0 þ a1  CEOPAY it þ a2  CEOPAY it  IPI it Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) þ a3  CEOPAY it  GOV  Scoreit ð1Þ þ a4  CEOPAY it  LEGALit X þ ak  FðSIZE. and R&D expenses). 4. Furthermore. 4 is the earnings management proxy’s number. From Tables III and IV. may be. Xt the dummy year fixed effect. we estimate Model 1 which controls for year and industry-fixed effects.2. all specifications show that the relative CEO incentive-based compensation (CEOPAY) had a positive and very significant influence in the level of earnings management.8 percent of the probability that CEOs have managed their earnings over the considered period is explained by the eight variables in the model. That is performance-based rewards may incentivize them to extract rents from their firms via earnings management practices. Bekiris and Doukakis (2011) suggest that larger firms may face greater political costs relative to small firms because of higher analyst following and investor scrutiny. enhanced by other variables of the model which are highly significant (political costs. Hence. Indeed. eit the residual error. The largest correlation is between LEGAL and EM4 (US-Canadian case). which has a value of 0. In fact. respectively. in Tables III and IV.1 Research model.

001 (2.003 (1.160)*** 0.159 (1.6% 19.352)*** 0.082 (3.107)** CEOPAY þ (H1) 0.948)*** 0. and 1 percent levels US-Canadian per-sample and earnings Table III.796)*** 0.401 0.013 (1.002 (1.055 (1.976)** 0.121 (3.250)*** 0.509)*** 0.047 (3.076 (2.000) 7.000) DR2 (vs model 4) 17.011 (2.733)* 0.516)** SIZE þ 0.417 (3.288)** 0.396 (0.000) 10.0519 (1.317) 0.123)** 0.002 (1.061)*** 0.664)*** CEOPAY  IPI 7 (H2a) 0.007 (1.577)* R2 0.376 0.***Significant at 10.074 (2.144 (2. 5.739)*** 0.0455 (2.616 (2.108 (3.099 (3.140 (2.000) 10.**.858)* 0.312) 0.0001 (1.712)*** 0.96)** 0.771 (0.2% 21.043 (2. Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) Variables Model (1) Model (2) Model (3) Model (4) Dependent variables Predicted sign EM1 EM2 EM3 EM4 Intercept na 0.317 (0.083 (3.224)** LEVERAGE þ 0.815)*** 0.117 (3.732)* GROWTH þ 0.593 F-Fisher ( p-value) 7.307 (5.417 0.427 (3.011 (1.006 (1.858)*** 0.0301 (1.633)* 0.703)*** CEOPAY  LEGAL 7 (H2b) 0. 27 CEO incentive results . *.602)* 0.096)** 0.7% – Notes: For each variable.283) R&D 7 0.382 (2.002 (0.11) 0.010)*** 0.073 (0.0175 (1.020)** 0.662) 0.828) 0. standard errors are shown in parenthesis (n ¼ 750).974)** CEOPAY  GOV-Score 7 (H2c) 0.006 (1.268 (4.

785) 0.009 (4. 5.376) 0.059 (1.**.997)** 0.164 (2. and 1 percent levels .000) 10.0252 (1.358 0.693)*** 0.003 (0.2% 9.335 (6.262)*** 0. UK-French per-sample Variables Model (1) Model (2) Model (3) Model (4) Dependent variables Predicted sign EM1 EM2 EM3 EM4 Intercept na 0.0403 (1.861)* CEOPAY  LEGAL 7 (H2b) 0.091 (2.002 (1.565)** GROWTH þ 0.734)*** 0.153)*** R&D 7 0.271)** 0.02 (1.001 (2.063 (3.268)** 0. standard errors are shown in parenthesis (n ¼ 750).735)*** CEOPAY  IPI 7 (H2a) 0.537 (2.1 28 results EMJB Table IV.000) DR2 (vs model 4) 8.006) 0.871)* 0. Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) 9.805)*** 0.0615 (2.149 (3.5% – Notes: For each variable.950)*** SIZE þ 0.002 (1.404 (8.000) 9.453 F-Fisher ( p-value) 9.1% 4.331) 0.424 (5.002 (1.031 (2.481 (0.074) 0.002 (2.411 (0. *.007 (4.097 (2.232) R2 0.616)*** 0.4) 0.888)** 0.052 (1.115)** LEVERAGE þ 0.0817 (2.222) CEOPAY  GOV-Score 7 (H2c) 0.303 (0.716 (0.407 (3.088 (3.761)* 0.180)** 0.000) 10.051 (1.097 (1.017 (1.242)*** 0.002 (1.0706 (2.318)** CEOPAY þ (H1) 0.762)*** 0.372 0.***Significant at 10.072)** 0.156)** 0.411 0.010 (3.872) 0.437 (5.406 (6.573)*** 0.139)** 0.088)** 0.033 (0.133)*** 0.

we find support for H2c and some support for H2a and H2c. curbing management self-serving behavior. for example. that is high investor protection and strict 29 law enforcement. The significant main effects find evidence that strong legal environment forces. Tables III and IV show that company size has a significant and positive influence on the four earnings management levels. when we consider exclusively the French-British cluster of firms. the interaction terms’ impacts on earnings management loss their significance. In contrast. moreover. Interpreted collectively. these results support an overly restrict and complementary (substitutive) influence of the institutional Anglo-American (Euro-Continental) environment’s attributes on the CEO incentive compensation’s potential to manage earnings. Numerous earnings management studies have assumed directional income manipulation. Finally. We note.3 Sensitivity analyses. The results thus provide evidence that and earnings institutional features apply downward pressure to CEO incentive reward’s potential to motivate earnings management. Regarding the explanatory variables. besides.2. Dechow et al. This result confirms Watts and Zimmerman’s (1990) hypothesis sustaining that managers manage earnings to reduce political costs and market scrutiny. we tested for the robustness of our findings by splitting our EM1 proxy into positive (EM1 þ þ ) and negative (EM1) discretionary accruals in order to examine whether institutional features play a role in restricting CEOs’ incentive pays potential to motivate up-ward or down-ward earnings management. High-qualified corporate governance tools help moreover. Our basic estimation results display that the highest revealed association between the CEO based-incentive pay’s measure and earnings management’s proxies concern discretionary accruals earnings management. is the fact that the interaction terms’ magnitudes are presumably similar within the panel estimations which are performed using US and Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) Canadian observations. denote that CEOs are more likely to engage in income-increasing rather than income-decreasing behavior. that the interactions between CEOPAY and all institutional CEO incentive patterns are negative and highly significant. (2011) provide evidence that income-increasing adjustments are not filtered out of CEO compensation. Bekiris and Doukakis (2011) have already found that managers may use income increasing accruals when growth slows in order to maintain the appearance of sustainable growth. except for the corporate governance score. mitigate CEOs opportunities to manage earnings to get much incentive rewards. Thus. 4. result provides evidence that managers are well interested by income-increasing if their wealth became much tied to their firm’s performance. Tables III and IV display also a highly (marginally) positive association between the market-to-book ratio and all individual earnings management measures (discretionary accruals earnings management and small losses avoidance). but is statistically significant only in regressions ruled over the UK-French observations. Thus. It corroborates moreover. Most notably. that the coefficients of the interactions between corporate governance score and executive incentive pay (CEOPAY  GOV-Score) look larger-on absolute value than those obtained between IPI or LEGAL and CEOPAY. the R&D variable has a positive sign. that the compelling effect of the institutional determinants in both Anglo-American and Euro-Continental corporate governance environments matter significantly for . Our findings (reported in Table V) suggest that the hypothesized effect of CEO incentive pay on discretionary accruals earnings management loss significance when we consider negative discretionary accruals’ subgroups as the dependent variable. Ball and Shivakumar (2008). UK-French regressions show however. Lobo and Zhou (2006) suggestion that larger firms may be more inclined to manage their earnings because the complexity of their operations. Table III shows moreover. Hence.

117)** 0.963)** LEVERAGE 7 0.0441 (2. 5.8139 (0.0505 (1.877) 0.2551 (2.3078 (0. standard errors are shown in parenthesis.96)** 0.2713 (3.4371 F-Fisher ( p-value) 8.866)* 0.0739 (1.113) 0.0311 (1.037 (0.0733 (0.035) CEOPAY  GOV-Score 7 (H2c) 0.0901 (1.21 (1.067) 0. Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) 9.317 (2.1361 (2.017)*** R&D 7 0.171 (1.0000) Notes: For each variable.804)* 0.1934 (1.201)*** 0.008)** SIZE 7 0.106) 0.0000) 8.039 (1.219) 0.313) 0.171)** 0. *.***Significant at 10.495) CEOPAY  IPI 7 (H2a) 0.047 (0.1703 (1.217)*** 0.219)*** 0.917)* 0.4022 0.2106 (3.**.102)** 0.0303 (2.095) CEOPAY  LEGAL 7 (H2b) 0.0000) 7.0611 (1.025 (1.96)** 0.272 (2.4739 0. Robustness check results Variables US-Canadian sub-sample (n ¼ 750) UK-French sub-sample (n ¼ 750) Dependent variables Predicted sign EM1 þ þ EM1 EM1 þ þ EM1 Intercept na 0.1138 (1.011)** 0.4011 (2.2083 (1.896) 0.0191 (0.432) 0.2451 (1.211) 0.177)** 0.0000) 8.096)** 0.1 30 EMJB Table V.0917 (1.3017 (3. and 1 percent levels .199) GROWTH 7 0.672)* R2 0.202)** 0.788)* 0.5328 0.993) 0.1139 (3.096 (0.217)** 0.0407 (1.0505 (1.1022 (1.3307 (3.114 (2.881)* CEOPAY þ (H1) 0.4011 (1.1016 (1.

earnings-increasing but not earnings-decreasing. that the UK governance and pay institutional environments.500 firm-year observations from four countries between 2004 and 2008.” Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) Conyon and Murphy (2000) and Conyon et al. This check did not affect our results. (2010. we used an alternative measure of CEO incentive-based pay. That is. The empirical finding remained again the same. but not negative. The results of this test are reported in Table VI. Robustness checks display even that the economic determinants of up-ward and downward income adjustments are not unanimous. These results do not show significant differences by comparison to those reported above. we compute CEOPAY as (value of equity-based compensation/total compensation). when we considered the 2004-2006 and 2007-2008 panels separately (see footnote 8). USA and UK share the same legal system traditions. We consider a number of additional tests to further corroborate our results and address potential alternative explanations. legal enforcement. 31 On the other hand. R&D expenditures and growth opportunities enhance significantly positive. following Dechow et al. institutional features serve CEO incentive as curb on management discretion only when earnings adjustments are up-wards. To test for the sensitivity of our finding to the identification of the UK as a Euro-Continental corporate governance model. and earnings Thereby. accruals’ manipulations. Bryan et al. over 1. we can support an asymmetric character for the hypothesized institutional forces’ effects on the CEOs incentive pays’ potential to encourage discretional behavior. where value of equity-based compensation is the sum of newly granted options’ value and newly granted restricted stocks’ value and total compensation is (base salary þ bonus þ value of equity-based compensation). which are in many ways different to the USA. we repeat the whole analysis using Dechow et al. change in employees and change in order backlog. Conclusion This study examines the association between CEO incentive-based pay’s propensity to motivate earnings management and three institutional aspects of two international contexts: the Anglo-American and Euro-Continental corporate governance environments. Canada. to predict discretionary accruals manipulation. Specifically. On one hand. we rerun the analyses by considering the French and UK settings separately. we have ruled separate OLS regressions by year to control for the effects of the crisis.83) in the regression performed using income decreasing from US-Canadian subgroup as dependent variable. Both countries are member of the same legal environment where common law characteristics prevail. 5.’s (2011) two non-financial measures. We capture institutional settings by outside investor protection. That is. Our empirical finding remained unchanged. and corporate governance quality and we ran the fixed-effects model. and France . UK. have taken the UK closer to the stakeholder position. Third. in presence of interaction terms. the firm’s size and leverage influences are hold significant only for earnings-decreasing specifications. Countries under study are USA. The only difference being that the variable of pay (CEOPAY) gained marginal statistical significance (t-student ¼ 1. p. (2011) who presented evidence suggesting that conventional approaches of controlling for industry and performance induce considerable estimation error into the estimation of discretionary accruals. (2010) point out moreover. we used the natural logarithm of the market value of equity instead of the natural logarithm of total assets to proxy for company size. Obtained results are presumably the same. Second. First. They hold unchanged even when we split our sample into pre and post crisis subsamples. Finally. 393) dissert that “a global philosophy does not mean global homogeneity.

441 (1.451) 0. standard errors are shown in parenthesis.1056 (1.581) CEOPAY  GOV-Score 7 (H2c) 0.039 (1.011 (1.505) 0.013 (2.000) 8.566) 0.313)** SIZE 7 0.303 (0.572 (3.011 (3.392 (0.558 (1.303)*** R&D 7 0.966)** 0.51) 0.937)*** LEVERAGE 7 0.009)*** 0.695)* R2 0.033 (2.988)** 0.002 (1.117 (1.009 (1.121)** CEOPAY þ (H1) 0.339) 0. 5.048 (0.207)** 0.005 (1.1806 (1.173) 0.651)* CEOPAY  LEGAL 7 (H2b) 0.318)** 0. and 1 percent levels .002 (1.**.007 (1.107)*** 0.0283 (2.57 (1.358) 0.099 (1.571) 0.291)** 0.802)* 0.01 (2.527) GROWTH 7 0.424 0.491)*** 0.0386 (1.210 (0.645) 0.344 (3.0437 (1.503) 0.03 (1.933)* 0.0371 (2.511 F-Fisher ( p-value) 7. *.0407 (2.000) Notes: For each variable.303)** 0.491 0.501 0.479) 0. Additional robustness check results (French vs Variables French sub-sample (n ¼ 375) UK sub-sample (n ¼ 375) Dependent variables Predicted sign EM1 þ þ EM1 EM1 þ þ EM1 Intercept na 0.007 (2.3171 (1.057 (1.011 (2.0109 (1.1 32 EMJB UK cases) Table VI.177 (3.000) 8.531) 0.***Significant at 10.049)*** 0.117)** 0.039)** 0.5303 (2. Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) 9.021 (2.337) CEOPAY  IPI 7 (H2a) 0.0291 (2.000) 7.027 (1.301)** 0.

strong investor rights. . In fact. Consumer Durables. this potential is not “one-size-fits-all. and high corporate 33 governance structure values that prevail within this setting and mitigate the conflict of interest between firm’s insiders and outsiders. 6. 2. 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. strict law enforcement.french/Data Library/det_12_ind_port. Notes 1. Chemicals. 4. We join these results to the strong investor protection. socio-economic. Stock options are valued at the end of the fiscal year using Black and Scholes (1973) model adjusted for dividends. French’s web site: ken. Equity-based compensation is computed as (stock price)  (the member of newly granted shares) þ (stock price)  (option delta)  (the number of newly granted stock options).. 3. Our findings suggest that CEOs from the Anglo-American corporate governance setting express fewer propensities to engage in earnings management in the intention to gain more salary. Sensitivity analyses show however. Legal systems protect investors by conferring on them rights to discipline insiders.. Otherwise. Findings dissert moreover. which we split into two groups. hence. 1999). That is. The distribution of the sample firms by industry is available from the authors. 2003. these findings provide prominent evidence that cross-country differences on institutional values have significantly real impacts on CEOs performance-based pay’s potential to motivate deliberate accounting choices. The first group gathers together US and Canadian CEO incentive firms labeled as representing the Anglo-American corporate governance model. For policy making. CEO incentive pay is bonus þ equity-based compensation. (2003) in the cluster of outsider economies with large stock markets. political. that the institutional constraining effects are overly asymmetric. CEOs’ power to behave self-serving.” but depends on the country’s institutional context. Utilities. no up-ward significant interaction is revealed Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) between CEO incentive pay and investor protection or legal enforcement terms and earnings management dimensions. that institutional constraints on management discretion cease to exist among the Euro-Continental subgroup of firms. UK and USA are included by Leuz et al.html. Business Equipment. religious. Authors’ definitions for these groupings are accessible from Kenneth R. Future studies could extend our findings by focussing on other settings or by dealing with further cultural. as well as by enforcing contracts designed to limit insiders’ private control benefits (Leuz et al.dartmouth. The Fama/French 12 industry classification is: Consumer Non-Durables. Shops. dispersed ownership. Healthcare. 5. Manufacturing. Interpreted collectively. and strong legal enforcement. We screen out all firms that go public during the sample period. and Other. they matter only for restricting income-increasing but not income-decreasing adjustments. country-specific factors’ impacts on management compensation to better understanding its efficiency and/or costs. p. etc. Prior works show that those firms are subject to systematically higher levels of earnings management. and earnings The second cluster groups UK and French firms considered as to represent the Euro-Continental corporate governance model. 507). Telecommunications. apart from corporate governance quality. Energy. it will be important to consider formal and informal institutional features.

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A. (2006). 1.J.L. 2. Corporate Governance: An International Or visit our web site for further details: www. “Insider trading and earnings management”. G. J. 57-73. Vol. About the authors Habib Jouber is an Associate Professor in Finance. (1997). 3. pp. (2011). Accounting Horizons. Vol. 542pp. Vol. 449-476. (2006). and Shrestha. The Journal of Finance.A. 5th ed. “Good timing: CEO stock option awards and company news announcements”. investor protection.. and Vanstraelen. 69 . He has presented. Vol. Watts. Incorporating Advances in International Downloaded by Universitatea Alexandru Ioan Cuza At 06:58 30 March 2017 (PT) Accounting. 5 No. He has published many papers in several high-qualified journals and reviews. 1.L. D. 505-527. Perols. D. ISBN: 978-0-470-97259-5. pp. Journal of Financial Economics. Hamadi Fakhfakh is actually a Full Professor at the College of Business Administration. moreover. Advances in Accounting. pp. He has published many papers in several high-qualified journals and reviews. N.J. 131-156. C.B. and Guan. Osma. Shaw. He received his PhD in Finance from the University of Sfax. 155-180.. Wright. European Accounting Review. 20 No. K. Monks. Journal of International Accounting Hamadi Fakhfakh is a Professor of Finance and the Director of the LARTIGE Research Laboratory. pp. 65 No. J. S. G. The Accounting Review. Van Tendeloo. (2008). pp. and Minow. 1. (2007). J. pp. Habib Jouber is the corresponding author and can be contacted at: jouberhabib@yahoo.. J. Jazan University. and Wysocki. pp. Vol. (2008). pp. Journal of International Accounting Research. and Lougee.C. Sawicki. 9. 52 No. and Accounting. L. pp. “The relation between earnings management and financial statement fraud”. (1990). R. 116-131. Journal of Business Finance & Accounting. and Zhou. “Board independence and real earnings management: the case of R&D expenditure”. and Zimmerman. “Earnings management and investor protection: an international comparison”.L. and Boonlert-U-Thai. Vol. Vol. “Earnings management. 6 No.1 Lobo. 27 No. 331-346. 1. 25-40. Tunisia in 2002. 1. pp. Vol. Corporate Governance. P. 14 No. 39-53. “Positive accounting theory: a ten year perspective”. “Did conservatism in financial reporting increase after the Sarbanes Oxley Act? Initial evidence”. (2004). R. His main research interests are related to Corporate Finance.emeraldinsight. Vol. 35 Nos 3-4. University of Sfax where he received his PhD in Finance in 2012. He has presented at a number of international academic conferences. B. 2. Yermack. (2003). University of Gabès. K. Nanda. His research interests include issues related to Corporate Finance and Governance. 16 No. 2. many articles in several accounting and finance international conferences. and national culture”. Arabie Saoudite. Vol. Higher Institute of Management. He is also Member of the LARTIGE Research Laboratory in the Faculty of Economic Sciences and Management. Financial Theory. To purchase reprints of this article please e-mail: reprints@emeraldinsight. A. (2005). J. Tunisia. 35-54. “Corporate governance and investor protection: earnings management in the UK and USA”. Blackwell Publishing. B. EMJB Leuz. 36 Nabar. “Earnings management under German GAAP versus IFRS”.