Control Right, Compensation And Earning Management

Corporate governance, executive compensation and earning management have always been the classical problem in the study of corporate finance.The research of the relevance among corporate governance, executive compensation and earning management begin from the analysis frame of agency theory, Jensen and Meckling (1976) defined the firm as"a set of contracts cluster", which is a benefit mixture composed by owners of different elements aimed at getting reward, and linked by a group of visible of potential contracts; the contracting, performing and alternating of contracts bring"contract cost". Directed by the viewpoint, Watts and Zimmerman (1986) introduced contract theory to accounting research, and brought the assumption of"compensation plan", which laid a foundation of studying the relevance of executive compensation and earning management. In the late 20th century, the events of manager controlling and expropriation of large shareholders happened continually, which excitated the interest of scholar in the research of the correlativity among governance, compensation and earning management. In the first place, board governance and share rights structure will influence manager compensation (Hambrick&Finkelstein, 1995; Core etc., 1999; Fathi etc., 2001; Harvey etc., 2001; Cyert etc., 2002; Pornsit etc.. 2005; Ke Dagang, 2005); in the second place, corporate governance will remarkably influence earning management (Koh, 2003; Klein, 2002; Xie etc., 2003; Leuz etc., 2003; Park etc., 2004; Davidson etc., 2005; Li Changqing etc., 2004; Yu Minggui, 2004). Through literature study, we think the insufficiency in prior study mainly includes several aspects. First, the study of the relevance of executive compensation and earning management hasn't got accordant viewpoint. Second, the academe mainly examined the relevance of compensation-earning management, governance-compensation, and governance-earning management, but the internal relation and effect mechanism of three aspects was examined quite limitedly; meanwhile, the domestic study on motivation of earning management neglected executive compensation. Third, the pas studies mainly used regression analysis to test the relevance of subjective variables and examine the influence factors of earning management, which is so single that find different conclusion as a result of the difference of model setting, therefore they couldn't open out deep-seated effect mechanism.After summarizing literature, based on agency theory, this paper analyses the correlation between compensation and earning management, then introduce company's control right to examine its influence to compensation inducing earning management, which put governance, compensation and earning management into a model to reveal a causal relationship among the three.Starting from analyzing earning management motivation, and combining agency theory and incentive theory, we set up H1: there is earning management action for the purpose of high compensation, that is, executive compensation is positive to earning management. According to the operation attributes of ultimate controller of listed companies, the allocation of control right is divided into manager power and large shareholder control, which is introduced respectively, thereby we propose H2.1: for the listed companies with non-operating ultimate controller, executive compensation level will increase and the extent of earning management induced by compensation will decrease will increase at the effect of manager power; H2.2: for the listed companies with operating ultimate controller, large shareholder control is negative to executive compensation level, and enhances the significant level of positive relationship between executive compensation and earning management.We use the data of publicly listed companies in China, from 2001 to 2004, to examine hypotheses we set up. We control the influence of earning management with non-compensation motivation to our research when choosing samples. Based on the theory model, this paper sets up LISREL model using multi-indices to measure subjective variables, which both control the endogenesis and reveal the causality route of multi-variables. About the variables measurement, we use total salary of top three managers to represent manager compensation; the amount of underline items and modified Johns Model of Lu Jianqiao (1999) is used to measure earning management together; the effect of manager power in companies with non-operation ultimate controller is measured by while manager come from controlling shareholder or to be director dually; the effect of large shareholder control in companies with operation ultimate controller is measured by large shareholder's shareholding, ownership concentration and ownership balance. We set up three LISREL models respectively to examine our hypotheses, then use multi-regression model to examine the relevance between compensation and the direction of earning management, and distinguish the character from sample choice for designing sample lab directly, examine the relevance of compensation and performance before and after earning management to do robust test.From the empirical result we can see that there is earning management behavior of managers motivated by high compensation, but the allocation of control right significantly influences such behavior. After introducing the effect of manager power, executive compensation level will increase and the extent of earning management induced by compensation will decrease, which indicated that corporate incentive and restrictive mechanism fail while there is less control and restriction to manager, manager power will overrun, then the extent of earning management induced by compensation will decrease, this means earning management, which is high risk and cost, will be reduced in the way of maximizing manager personal benefit. By contraries, while the large shareholder have control right, in one hand, it restrain the power of executives on compensation contract so that executive compensation level decreases, in other hand, that the supervise incentive of large shareholder weaken even disappear will induce the collaboration between large shareholder and executives which benefit themselves by earning management (Xiao Yan, 2004), so large shareholder will indulge earning management behavior of managers, which significantly stimulates the extent of earning management induced by executive compensation. We can draw several implications from our study. First, further improve incentive system in listed companies, and set up relative rule of law and info-public regulation, realize incentive compatible of manager and shareholder, restrain manager's self-benefit behavior in order to make him concern sustain development of the corporation. Second, amend internal governance of the company, set up external manager market to create space for attorney competition, which can weaken manager power and is helpful to reduce agency cost. Third, improve external supervising mechanism, especially enhance the intendance to large shareholder's expropriation, and implement its value of supervising manager and reducing agency cost. We stress that it is very important to strengthen control right balance for improve the function of executive compensation and decrease earning management behavior drove by interest.Our study's contribution is that we use LISREL model and adopt multi-indices to measure subjective variables; in this way, we successfully put control right, compensation and earning management into one model to examine their internal relevance and causality route. Furthermore, we distinguish control right of listed companies from ultimate controller, from which we tell the story of Chinese listed companies'internal governance. Through our study, we give out new method and thinking for future further study on the relationship among corporate governance, compensation and earning management.