The Relationship between CEO Compensation and Earnings Management: Evidence from Korea

Previous research has shown that CEOs have incentives to manage reported earnings in order to maximisetheir own levels of compensation, which are typically determined by firm performance. The present studyexamines whether CEO overcompensation reduces earnings management in classic principal–agent settingsby investigating the relationships between CEO compensation and upwards and downwards earningsmanagement. We analyse data on Korean-listed firms from a sample period of 2005 to 2007 in order toestimate the levels of CEO overcompensation put forward by previous studies. Discretionary accruals areestimated by the modified Jones model, while we adopt established proxies of real activity-based earningsmanagement. The presented findings show that earnings management significantly declines as CEOovercompensation increases. This negative relationship implies that managers reduce earnings management,when they receive overcompensation. We also find that CEO overcompensation has negative relationshipswith real earnings management under downwards earnings management and with discretionary accrualsunder upwards earnings management. These results suggest that that CEO overcompensation positivelyinfluences a firm’s long-term value considering when real earnings management could negatively influenceon firm value. Our findings therefore suggest that CEOs choose earnings management tools in order tomaximise their personal benefits and it has a positive effect by reducing opportunistic behaviour as well asthe firm’s long-term risk. The results of this study showed as counterevidence on common criticism aboutCEO overcompensation and could thus be used as a guideline for future compensation systems.