Earnings management and compensation: Do compensation committees distinguish between future prospect signaling and opportunistic discretionary accounting choices

Studies in the accounting literature suggest that managers conduct earnings management in an opportunistic (OEM) manner which enriches the CEO at the expense of shareholders. An alternative view is that earnings management signals the firms' future prospects (FSEM) which is consistent with shareholder value maximization. The current study uses a firm specific mapping of accruals into future cash flows to differentiate between FSEM and OEM and then investigates whether the CEO's FSEM and OEM choices map into their compensation mechanism. Using a fifteen-year panel data set of CEOs in the largest, publicly traded U.S. companies, I document that, after controlling for CEO and firm specific determinants of compensation, FSEM (OEM) CEOs receive a compensation incentive premium (discount). Second, I document a positive (negative) association between CEO compensation and total long term cumulative shareholder returns for the FSEM (OEM) portfolios. Finally, consistent with signaling theory, I document that, after controlling for all other effects, the group of FSEM firms have significantly higher annual abnormal returns than the group of OEM firms. My results also suggest that the relation between the FSEM signal and risk adjusted returns depends on the length of the horizon considered in calculating risk adjusted returns.