Board Committees, CEO Compensation, and Earnings Management

In our paper Board Committees, CEO Compensation, and Earnings Management which was recently accepted for publication in the Accounting Review, we develop a model to analyze the effect of committee formation on how corporate boards perform two main functions: setting CEO pay and overseeing the financial reporting process. Even though stock-based compensation schemes are designed to motivate the CEO to take value-enhancing actions, such pay also induces manipulative actions that boost the (short-term) stock price at the expense of long-term shareholder value. We model the interaction between these productive and manipulative activities as a multi-task agency problem. In particular, the CEO in our setting has an incentive to distort the earnings report upward in an attempt to mislead investors about future cash flows. Even though nobody is fooled in equilibrium, earnings manipulation is costly to shareholders because it consumes corporate resources (e.g., leads to distortions in the firm’s operating and investment decisions) and involves personal costs to the CEO for which he must be compensated in order to ensure his participation.

The board of directors is interested in the long-run net firm value and is able to reduce the CEO’s ability to bias the earnings report through costly monitoring. The bias introduced into the report therefore not only depends on the CEO’s choice of manipulation but also on the board’s choice of monitoring. Monitoring by the board is not contractible and not observable, which implies that the board is unable to commit to a certain level of oversight. Despite the lack of commitment, the board has an (ex post) incentive to engage in monitoring because oversight lowers the CEO’s excess compensation and hence increases the net terminal firm value.

The greater the amount of stock-based compensation for the CEO (i.e., the greater the pay-performance sensitivity), the higher is the board’s ex post incentive to engage in oversight. The board of directors is able to exploit this spillover effect as a tool to indirectly commit to oversight. That is, by choosing a high pay-performance sensitivity, the board can credibly signal to the CEO that it will take its oversight function seriously. Such indirect commitment to oversight is beneficial, as it curbs the CEO’s incentive to take manipulative actions. Our model shows that if the whole board is responsible for both functions, it is inclined to provide the CEO with a compensation scheme that is relatively insensitive to performance in order to reduce the burden of subsequent monitoring. When the functions are separated through the formation of committees, the compensation committee is willing to choose higher pay-performance sensitivity, as the increased cost of oversight is borne by the audit committee.

Our model also generates predictions relating the board committee structure to the pay-performance sensitivity of CEO compensation, the quality of board oversight, and the level of earnings management. The full paper is available for download here.