Learning through a Smokescreen: Earnings Management and CEO Compensation over Tenure

Career concerns may lead CEOs to distort reported performance (Fudenberg and Tirole (1995)), particularly in the early years of tenure when there is greater uncertainty about the CEO’s ability. We investigate whether the presence of reporting distortions affects CEOs’ compensation over their tenure. Consistent with the view that career concerns are likely to be stronger in the early years of tenure, we find that earnings management is highest in the early years and decreases monotonically over the CEO’s tenure. The results show that compensation is positively associated with earnings management in the early years of a CEO’s tenure, but this relationship becomes negative over tenure, indicating that during the period of greatest uncertainty about a CEO’s ability, distorting earnings may pay off for some CEOs. Importantly, boards learn about CEOs’ ability over time, and do not reward those who continue to distort reported performance. These results are robust to treating tenure and earnings management as endogenous. We also show that the relationship between reporting distortions and compensation varies based on CEO characteristics that capture uncertainty about ability and career concerns: earnings management is more strongly correlated with the compensation of younger CEOs, and those without a fixed term employment contract who may be at higher risk of being fired. These results indicate that boards adjust compensation in response to potential earnings distortions in the early years of a CEO’s tenure.