EuroMed Journal of Business

The association between CEO incentive rewards and earnings management: Do

institutional features matter?
Habib Jouber, Hamadi Fakhfakh,
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Habib Jouber, Hamadi Fakhfakh, (2014) "The association between CEO incentive rewards and earnings
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EMJB
9,1
The association between CEO
incentive rewards and earnings
management
18 Do institutional features matter?
Received 14 November 2012
Revised 27 May 2013
Habib Jouber
24 August 2013 LARTIGE, Faculty of Economic Sciences & Management,
2 September 2013 University of Sfax, Sfax, Tunisia and Higher Institute of Management,
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Accepted 3 September 2013 University of Gabes, Gabes, Tunisia, and

Hamadi Fakhfakh
LARTIGE, Faculty of Economic Sciences & Management,
University of Sfax, Sfax, Tunisia and College of Business Administration,
Jazan University, Jazan, Saudi Arabia

Abstract
Purpose The purpose of this paper is to investigate whether or not there is a link between CEO
incentive-based compensation and earnings management and to examine how institutional
environments features influence such link.
Design/methodology/approach To test the predictions, the authors use a panel of 1,500
American, Canadian, British, and French firm-year observation over the period 2004-2008.
Findings The authors find a significant association between earnings management and CEO
incentive-based compensation. Moreover, the analysis provides evidence that institutional factors
are strong determinants of this association. Specifically, the results show that firms from countries
within the Anglo-American corporate governance model, which provides greater protection of
shareholder rights, ensures strict enforcement of law, and scores high on board oversight, tend to have
lower level of earnings management. The analysis shows however, that beside the formal corporate
governance quality, it is relevant to consider weaker shareholder protection and lower law enforcement
indexes to explain earnings management in firms from countries within the Euro-Continental corporate
governance model.
Originality/value This paper is the first to provide insights regarding the extent to which CEO
incentive rewards imply management discretion and to indicate how much institutional features
matter. The analysis contributes to two distinct strands of research. It extends prior research on the
association between executive compensation and earnings management and adds to the literature
demonstrating a relationship between institutional factors and financial decisions.
Keywords Corporate governance, Earnings management,
Anglo-American corporate governance model, CEO incentive-based compensation,
Euro-Continental corporate governance model, Institutional factors
Paper type Research paper

EuroMed Journal of Business
Vol. 9 No. 1, 2014
pp. 18-36
r Emerald Group Publishing Limited
1450-2194
DOI 10.1108/EMJB-11-2012-0019
The authors would like to thank the four anonymous reviewers, the Associate Editor Mike Useem
and Editor-In-Chief Bill Judge, for insightful and very helpful comments during the review process.
The authors are grateful for the comments from the participants at the Corporate Governance:
AIR 20ths anniversary Conference on National Governance Bundles held at the Cambridge
University Business School, September 28-29, 2012. The authors would like to thank their Institution,
Faculty of Economic Sciences and Management, University of Sfax, for funding support.
 1. Introduction CEO incentive
Incentive-compensation systems are unquestionably important because they and earnings
presumably provide the primary mean by which organizations elicit and reinforce
desired behaviors. In recent years, CEO pay has become the subject of unprecedented
scrutiny, due to its alleged role in the recent financial crisis. That is, CEO incentive
rewards have been blamed for encouraging some of the largest financial reporting
scandals such as Enron and WorldCom. Theoretically, there are two competing views 19
of CEO performance-based incentives: optimal contracting and managerial power.
The optimal contracting view asserts that management compensation is seen to be the
result of a market-based mechanism which ensures that managers have adequate
incentives to maximize shareholder value. The managerial power view ensures that
management compensation is regarded to be a means whereby self-serving executives
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skim corporate profits and expropriate shareholders (Georgen and Renneboog, 2011).
Self-serving occurs when companies rely much on performance measures when assessing
their managers performance. In fact, accounting-based performance measures are liable to
manipulation as they are back-ward looking. Executives may proceed in various ways
to influence over their pay, and hence extract funds from the shareholders to their own
benefit. Baker et al. (2008), for example, document strategic disclosure to manage market
expectations downwards prior to option grants; post-grant earnings announcements are
found to be generally more favorable than pre-grant earnings announcements. Bartov and
Mohanram (2004) show that large insider option exercises are preceded by abnormally
positive earnings and followed by poor earnings performance. They conclude that
executives opportunistically manage pre-exercise earnings to increase their cash payouts,
and the reversals of the pre-exercise overstatements negatively affect the post-exercise
period. Chahine and Goergen (2011) show that CEOs may grant themselves options at the
initial public offering of their firm with an exercise price set equal to a deliberately low
offer price, thereby expropriating the shareholders via excessive underpricing.
With this in mind, we aim at devoting an attention to the impacts of CEO pay-for-
performance rewards on earnings management[1]. Besides, we focus on the institutional
determinants of such impacts. In particular, we examine the association of CEO dominance
with (EM1) discretionary accruals, (EM2) income smoothing, (EM3) small loss avoidance,
and (EM4) aggregate earnings management score. In accordance with Cianci et al. (2011),
we conceptualize CEO dominance as a measure of a CEOs power and define it as the
difference between CEO incentive pay and the next highest executives incentive pay divided
by the CEOs incentive pay. Our main result is that controlling for cross-national institutional
features helps explain the potential of CEO incentive-based compensation to motivate
managers earnings management behavior. Particularly, we provide evidence that, within the
Anglo-American (but not Euro-Continental) setting, qualified corporate governance, higher
outside investor rights protection, and stricter law enforcement rules all reduce the retained
dimensions (EM1-EM4) along which CEOs can exercise their discretion to manage earnings.
The remainder of this paper is organized as follows. Section 2 provides theoretical
background and hypotheses for the study. The research design is presented in Section 3.
The results and robustness checks are discussed in Section 4. Finally, in Section 5,
we summarize our results, discuss the implications and limitations of our analysis,
and give suggestions for further research.

2. Background, related research, and hypothesis

Use of incentive-based compensation has undergone dramatic growth through the 1990s.
Concurrent with this growth there has been growing stream of research about the
 EMJB effectiveness and cost of CEOs incentive rewards. Utilizing primarily the seminal work of
9,1 Jensen and Meckling (1976), the extant literature displays two interesting things. On one
hand, most research has concentrated on the Anglo-American world. Fewer studies have,
however, focussed on management compensation in countries from the Euro-Continental
corporate governance model. On the other hand, there are two opposing viewpoints in this
area. The optimal contracting view considers shareholders use of performance-based
20 incentives as an efficient response to an agency problem. The managerial power view
holds that CEO compensation and other corporate governance practices reflect the
exercise of managerial power and rent-seeking behavior more than the provision of
efficient incentives. In line with the latter view, Yermack (1997), for example, finds that
managers receive stock option grants shortly before good news announcements and delay
such grants until after bad news announcements. Abody and Kasznik (2000) support the
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hypothesis on strategic disclosure behavior whereby managers postpone the disclosure of

bad news until after they have secured desirable fringe benefits. Bertrand and
Mullainathan (2001) find that in the absence of large shareholders, CEOs are able to
capture the board and determine their own compensation at the expense of corporate
profitability. Beneish and Vargus (2002) show that abnormal selling by corporate
executives is associated with a lower persistence of income-increasing accruals, and that
this lower persistence is at least partly explained by opportunistic earnings management.
Moreover, Cheng and Warfield (2005) document a higher degree of earnings
management to meet or beat the analyst forecast benchmark in firms with greater
executive equity incentives. Bergstresser and Philippon (2006) and Burns and Kedia
(2006) find that the magnitude of discretionary accruals is greater at firms in which
managers wealth is more closely tied to the value of stock. Similarly, Cohen and
Zarowin (2010) find that increases in accrual-based earnings management in the
period leading up to the Sarbanes-Oxley Act (SOX) are associated with increases
in equity-based compensation. Efendi et al. (2007) find that the probability of a
restatement is positively related to the size of in-the-money CEO option holdings
and incentives to misreport are largely driven by needs to support overvalued equity.
Additionally, Cornett et al. (2008) find that the previously documented positive
impact of stock option compensation on operating performance is mainly an artifact
of opportunistic earnings management. Kuang (2008) documents that managers may
behave opportunistically by taking actions to depress stock prices or avoid value
increasing surprises prior to option incentive awards and open market stock
purchases. Sawicki and Shrestha (2008) provide evidence suggesting that managers
use income-increasing earnings management while selling shares in the company and
use income-decreasing earnings management while purchasing shares.
This motivates the first hypothesis:

H1. Incentive-based compensation motivates CEOs earnings management behavior.

However, relatively little is known about how the institutional environment affects the
potential of executives incentive rewards to motivate earnings management. Should we
expect the same patterns of incentive compensation costs in Anglo-American firms as
in Euro-Continental firms? No cross-national study has dealt with the institutional
determinants of the association between CEOs incentive rewards and earnings
management. However, findings from international financial economics literature, all of
them are indirect, can be made to make definitive predictions regarding this question.
Separate cross-country researches on management compensation ( Jansen et al., 2009;
 Brenner and Schwalbach, 2009; Bryan et al., 2010, 2011) and earnings management CEO incentive
(Leuz et al., 2003; Wright et al., 2006; Nabar and Boonlert-U-Thai, 2007) have recognized and earnings
that institutional differences among countries causes differences in the use of incentive
compensation and corporate earnings management. We consider the Anglo-American
and Euro-Continental corporate governance settings and organize our discussion along
three key institutional factors that might either coerce or motivate CEO incentive-based
compensation, as well as its potential to manage earnings with reference to each 21
framework. These factors rely to outside investor protection index, legal enforcement
strength, and corporate governance quality.
Leuz et al. (2003) have examined the occurrence of earnings management across
31 countries with different level of investor protection. They posit that earnings
management occurs less frequently in outsider economies where shareholders are
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provided more stringent protection by the countrys legal system and more frequently in
insider economies where the legal protection provided to investors is weak. Wright et al.
(2006) extend the work of Leuz et al. (2003) by question whether their country clusters
(outsider vs insider countries) are broad in seeking to effectively explain the relation
between earnings management and countries legal environment. Considering samples of
UK and US[2] firms that were taken private in management buyout (MBO), they find
evidence inconsistent with Leuz et al.s (2003) position that similarities in the UK and US
legal environments result in similar and infrequent earnings management. Wright et al.s
(2006) results indicate that US managers are significantly more aggressive in managing
earnings downward prior to an MBO than UK managers. Moreover, Van Tendeloo and
Vanstraelen (2005), Burgstahler et al. (2006), and Nabar and Boonlert-U-Thai (2007)
provide evidence that earnings management magnitude is on an average higher in
code-law countries with less stricter law enforcement, compared to common-law countries
with higher rule of law index.
Shareholder legal protection[3] and law enforcement quality are also seemed to affect
the structure of management compensation. Jansen et al. (2009), Brenner and Schwalbach
(2009), Fahlenbrach (2009), and Bryan et al. (2010, 2011) all find that CEO pay is more
generous under greater protection of shareholder rights and stricter rule of law.
Weak governance structures have been implicated as a culprit for the corporate
collapses and for excessive rewards to CEOs in spite of poor firm performance (Bekiris
and Doukakis, 2011; Cianci et al., 2011).
This leads to the following alternative hypotheses:

H2a. Incentive-based compensation is more likely to motivate CEOs earnings

management behavior under weaker protection of shareholder rights.

H2b. Incentive-based compensation is more likely to motivate CEOs earnings

management behavior under less qualified law enforcement rules.

H2c. Incentive-based compensation is more likely to motivate CEOs earnings

management behavior under weaker corporate governance structure.

3. Research design
3.1 Variable construction
Our hypotheses call for two sets of variable to capture the extent to which CEOs
incentive rewards imply management discretion. In accordance with Cianci et al.
 EMJB (2011), we define a relative CEO incentive-based pay as the difference between CEO
9,1 incentive pay[4] and the next highest executives incentive pay divided by the CEOs
incentive pay and we conceptualize it as to reflect CEOs power. Drawing on prior
accounting research (e.g. Leuz et al., 2003; Burgstahler et al., 2006), we compute four
proxies detecting a range of earnings management activities; (EM1) the magnitude
of discretionary accruals, (EM2) the smoothness of earnings, (EM3) the tendency of
22 managers to avoid small losses, and (EM4) an aggregate measure of earnings
management. These proxies are used as dependent variables in all regressions.
Additional two sets of control variables are also constructed to capture factors
explaining management use of discretion in a way to inflate economic performance.
The first set captures expected institutional environment effects. Variables used
are IPI, LEGAL, and GOV-Score. IPI measures outside investor rights protection
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strength. LAGAL and GOV-Score measure respectively law enforcement and corporate
governance qualities. The second set of variables captures firms economic features
that previous researches have documented as might influence earnings management.
Variables included are SIZE, GROWTH, R&D, and LEVERAGE. The specific measures
of all variables are described in Table I.

3.2 Data and sample selection

Our starting target sample covers a random group of 120 US companies from S&P 500
index, all UK listed firms of the FTSE 100 index, all Canadian companies of TSX100
index, and all firms of SBF 120 index. The discarding procedure, either because of
incomplete needed information for the period under analyses which covers years from
2004 to 2008, or because of firms listing status[5], left us with 75 firms in each country.
All selected firms are shared out their corresponding industries using the Fama-French
12 industry classification except of financial industries in view of its specific regulation
and because of the fundamental differences in their financial accounting relative to
non-financial industries[6].
Needed information is hand collected from various sources. For US firms, data on
executives compensation, ownership structure, board, and CEO characteristics are
collected from DEF 14A proxy statement reports available on the SEC files and
download from the EdgarScans web site (edgarscan.com). Financial and accounting
firms characteristics come from the 10 K annual reports contained in the same
database. For the Canadian firms set, data on CEO pay, ownership and corporate
governance are provided by the firms proxy circulars available from the System for
Electronic Document Analysis and Retrieval database. Data on French observations
are exhausted from various sources such as the Expansion magazine, the Financial
Market Authority, and the Euronext web sites. Data on the UK firms are exclusively
collected from their web sites[7]. Investor right protection indices are provided by the
World Bank Doing Business (2008)s report.
We cluster the final sample under two groups. The first group gathers together US
and Canadian firms labeled as representing the Anglo-American corporate governance
model. The second cluster groups UK and French firms considered as to represent
the Euro-Continental corporate governance model. These clusters do not closely
parallel simple code-law and common-law used in prior work (e.g. La Porta et al., 1997;
Leuz et al., 2003). In fact, UK and France belong to two different families of law.
Considering Leuz et al.s (2003) country clusters, USA, UK, and Canada should be
gathered together because in those countries common law traditions are largely spread.
Wright et al. (2006, p. 25) claim, however, that Leuz et al.s (2003) country clusters are
 Predicted
CEO incentive
Variables Label effect Definition and earnings
Dependent variables
Earnings management EM1 Discretionary accrualsa as a percent of total
proxies assets
EM2 1 less the firms Spearman correlation
between the change in accruals and the
23
change in cash flow from operation both
scaled by lagged total assets
EM3 The number of small profits divided by the
number of small lossesb
EM4 The average rank across EM1, EM2, and EM3
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measures
Independent variables
CEO relative CEOPAY The difference between CEOs incentive pay
incentive-based pay and the next highest executives incentive
pay divided by the CEOs incentive pay
Institutional factors
Legal systems origin LEGAL 7 Equal to 1 if common law, 0 otherwise
Investor right protection IPI 7 Investor Protection Index from the world
bank doing business (2008) report
Corporate governance GOV-Score 7 Corporate governance Scorec
quality
Firm economic characteristics
Firm size SIZE Total assets in logarithm
Growth opportunities GROWTH Market to book ((market value of
equity book value of debt)/total assets)
Firms research and R&D 7 R&D expenses
development expenses
Leverage LEVERAGE The ratio of total debt over total equity
a
Notes: Discretionary accruals are computed using Kothari et al.s (2005) performance-matched
discretionary accruals methodology. bA firm-year observation is classified as small profit (loss) if net
earnings scaled by lagged total assets are in the range [0,0.01] ( [0.01,0] ). Net earnings are bottom-line
reported income after interest, taxes, special items, extraordinary items, reserves, and any other item.
c
This index assigns a value of 1 if the firm meets the threshold level to each of these attributes;
chairman and CEO positions are separated, nominating and compensation committees are composed
solely of independent outsiders, board meet at least twice time annually, at least the CEO serves
on the board of one of other public firms, board is controlled by more than 50 percent gray directors, Table I.
CEO do not serves as a member neither in the nominating committee, nor in the compensation Variables definition and
committee, institutional investors hold more than 10 percent of capital, and the firm is audited by at their predicted effects on
least one of the big four companies earnings management

overly broad in seeking to effectively explain the relation between countries legal
environments and earnings management. Moreover, a number of studies (Monks and
Minow, 2004; Coffee, 2005; Conyon et al., 2010) note differences related to the use of equity
compensation, composition of board of directors, the audit function, etc. between the UK
and the USA. Besides, our per-country robustness checks reveal no highly significant
differences between French and British firms[8]. A recent study by Desender et al. (2011)
which focus on the cultural determinants of earnings management across 31 countries
around the world cluster European countries (among them France and the UK) with
Australia under the same group.
 EMJB 4. Analysis of empirical results
9,1 Before proceeding to the verification of our research hypotheses using multivariate
statistical tests, we present the results of univariate analysis.

4.1 Univariate analysis

Table II provides descriptive statistics for the variable used in the regression analysis.
24 Panel A indicates that the mean (median) value of the aggregate earnings management
proxy is 8.37 percent (6.08 percent) among US and Canadian firms. Comparative
statistics from UK and French firms are less small indicating that those firms engage
in less earnings management. T-statistics for mean differences shows that the
American and Canadian managers managed earnings significantly to a greater extent
than their counterpart in the UK and French firms. Comparative figures on the
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remainder individual earnings management measures (EM1 through EM3) display

that US and Canadian managers rely more on earnings smoothing to obfuscate firm
performance. In contrast, discretionary earnings management accruals and small
losses avoidance are more pervasive among French and British firms. We can match these
differences to strong financial analysts pressures and high capital market dynamism
which are prominent within the US and Canadian economies. These dissimilarities can
also be matched to specific incentive from each related accounting model. Statistics on
CEO incentive-based pay exhibit large management power among the Canadian and
American settings by comparison to their French and British peers. On an average,
US and Canadian CEOs are paid at 13.15 percent much larger than their next highest paid
executives. This extent equal simply 9.71 percent for UK and French CEOs. T-statistics
for mean differences and Wilcoxon z-scores for median differences confirm these findings.
Statistics on institutional features show that Canadian and American environments
provide high degree of legal protection of investor rights and ensure strict enforcement of
laws. US and Canadian firms are moreover well governed. These firms meet in average
six among the eight corporate governance tools we have selected. The significant
difference for debt to equity (T 1.96) indicates that British and French firms are large
leveraged than Canadian and American firms do. The latter are however larger and invest
much more on R&D activities.
Panel B of Table II describes the univariate correlations among the dependent
and independent variables. As expected, CEOPAY is significantly and positively
correlated with all earnings management proxies in both subsamples. CEOPAY is
also significantly correlated with many of retained firms characteristics (namely,
SIZE and GROWTH for the American and Canadian observations, and SIZE,
LEVERAGE, and GROWTH for the French and British observations). Interestingly,
CEOPAY is highly (at 1 percent level) negatively correlated with each of the institutional
features. These correlations are hold only for the American and Canadian statistics.
These results closely corroborate those of Bryan et al. (2010) who find that firms use
relatively more equity-based compensation if in a legal environment where shareholder
rights are more strong protected and where law are more effectively enforced.
US and Canadian frameworks satisfy these attributes. The Pearson correlations
between the four earnings managements dimensions under study are positive and
significant. Those proxies are moreover highly correlated with many of firms
economic characteristics and institutional environments attributes. Similar results are
already found by financial accounting researches (e.g. Ben Othman and Zeghal, 2006;
Burgstahler et al., 2006; Jones and Wu, 2010; Perols and Lougee, 2011; Jouber and
Fakhfakh, 2012 among others).
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Panel A: descriptive statistics

Sub-sample of US and Canadian firms Sub-sample of UK and French firms
Variables Mean Median Min Max Mean Median Min Max T-student Wilcoxon z-scores
EM1 0.0758 0.0917 0.073 0.1175 0.0861 0.0545 0.001 0.1151 3.06*** 2.36**
EM2 0.1016 0.0506 0.043 0.0793 0.0581 0.0379 0.011 0.0739 1.92* 1.96*
EM3 0.0739 0.0402 0.0581 0.0496 0.0817 0.0371 0.016 0.07183 1.98** 2.09**
EM4 0.0837 0.0608 0.0437 0.1051 0.0753 0.0431 0.004 0.0492 2.16** 2.11**
CEOPAY 0.1315 0.1173 0.0843 0.01739 0.0971 0.0729 0.000 0.1493 3.411*** 3.18***
IPI 8.3 8.3 8.3 8.3 6.033 5.835 5.3 8.000 3.722*** 3.05***
GOV-Score 6.000 5.11 5.000 7.000 5.05 5.22 4.000 6.000 2.586*** 1.99**
LEGAL 0.000 1.000 0.000 1.000 2.031**
SIZE 15.1 12.3 11.496 21.381 11.7 10.9 9.105 13.371 4.344*** 1.78*
LEVERAGE 0.3177 0.2731 0.1307 0.5929 0.5782 0.5515 0.0482 0.6739 1.96** 2.65***
R&D 0.1372 0.113 0.0719 0.2194 0.1056 0.0859 0.0672 0.2055 2.04** 2.31**
GROWTH 0.4195 0.3842 0.1653 0.4442 0.3791 0.3473 0.1375 0.4106 1.88* 2.07**
Panel B: Pearson correlation coefficients for US-Canadian (UK-French) sub-sample are represented above (below) the principal diagonal
Variables 1 2 3 4 5 6 7 8 9 10 11 12
1 1 0.129 0.213 0.021 0.137 0.517 0.511 0.615 0.031 0.09 0.011 0.024
2 0.101 1 0.041 0.231 0.141 0.511 0.517 0.608 0.019 0.021 0.01 0.019
3 0.09 0.059 1 0.01 0.337 0.216 0.119 0.315 0.012 0.011 0.107 0.028
4 0.311 0.091 0.174 1 0.229 0.22 0.219 0.707 0.337 0.147 0.103 0.025
5 0.181 0.201 0.561 0.308 1 0.221 0.314 0.31 0.11 0.109 0.015 0.047
6 0.221 0.309 0.202 0.199 0.1 1 0.091 0.603 0.101 0.073 0.011 0.086
7 0.307 0.371 0.141 0.205 0.101 0.303 1 0.27 0.211 0.011 0.09 0.086
8 0.271 0.337 0.227 0.383 0.023 0.177 0.119 1 0.006 0.007 0.05 0.01
9 0.119 0.0106 0.402 0.573 0.371 0.106 0.237 0.093 1 0.108 0.31 0.196
10 0.373 0.07 0.373 0.388 0.148 0.091 0.06 0.06 0.205 1 0.104 0.17
11 0.104 0.083 0.04 0.101 0.055 0.031 0.003 0.017 0.315 0.104 1 0.011
12 0.10 0.199 0.037 0.227 0.217 0.065 0.038 0.021 0.251 0.091 0.11 1
Notes: 1, EM1; 2, EM2; 3, EM3; 4, EM4; 5, CEOPAY; 6, IPI; 7, GOV-Score; 8, LEGAL; 9, SIZE; 10, LEVERAGE; 11, R&D; 12, GROWTH. Bold (italic) values are
significant at 1 percent (5 percent) level. *,**,***Significant at 10, 5, and 1 percent level
and earnings

Descriptive statistics and

25

Pearson correlations
Table II.
CEO incentive
 EMJB Notably, no one of all these correlations appear large enough to present collinearity
9,1 problems. The largest correlation is between LEGAL and EM4 (US-Canadian case),
which has a value of 0.707 (o0.8 which is the limit at which we begin to have
a serious problem of multicollinearity).

4.2 Multivariate analysis and verification of research hypotheses

26 In this section, we present our research model and we present the main results.
4.2.1 Research model. According to the theoretical background and to the hypotheses
outlined above, our conceptual model could be expressed as follows:

EM nit a0 a1  CEOPAY it a2  CEOPAY it  IPI it

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a3  CEOPAY it  GOV  Scoreit

1
a4  CEOPAY it  LEGALit
X
ak  FSIZE; LEVERAGE; R&D; GROWTH X t Y i eit

where n 1, y, 4 is the earnings management proxys number; F the firms economic

characteristic factor; Xt the dummy year fixed effect; Y i the dummy industry fixed
effect[9]; eit the residual error.
4.2.2 Test of hypotheses: regression analyses. To test our hypotheses, we estimate
Model 1 which controls for year and industry-fixed effects. We include industry and
year-fixed effects to remove unobserved time and industry heterogeneities that may
be correlated with the earnings management attributes of interest. We present the
US-Canadian and UK-French per-sample estimation results, respectively, in Tables III
and IV. From Tables III and IV, we can conclude that the models tested are generally
significant. Indeed, the Fisher tests have values that range from 7.4 to 10.7 and are
significant ( p 0.000). R2s are moreover acceptable and show that at least 35.8 percent
of the probability that CEOs have managed their earnings over the considered period is
explained by the eight variables in the model.
Regarding the variable of interest, all specifications show that the relative CEO
incentive-based compensation (CEOPAY) had a positive and very significant influence
in the level of earnings management. Hence, managers have significantly managed
earnings in both settings. This result provides evidence that, as predicted in H1, CEOs
behave self-serving. That is performance-based rewards may incentivize them to
extract rents from their firms via earnings management practices. Furthermore,
it appears that the associations between CEOPAY and earnings management proxies
are not similar if we compare results from the two subsamples. The UK-French
regressions outputs show larger figures than the US-Canadian ones. Therefore,
British and French compensation structures seem to be more likely to file potential
earnings management which reflects higher CEO dominance. The possible explanation of
this result is that the executive compensation incentive effect to manage earnings, may
be, enhanced by other variables of the model which are highly significant (political costs,
leverage, and R&D expenses). In fact, Bekiris and Doukakis (2011) suggest that larger
firms may face greater political costs relative to small firms because of higher analyst
following and investor scrutiny. DeFond and Jiambalvo (1994) provide evidence
suggesting that managers of highly leveraged firms have strong incentives to use income
increasing accruals to avoid debt covenant violation. Osma (2008) finds a positive
association between R&D expenditure and real earnings management.
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Variables Model (1) Model (2) Model (3) Model (4)

Dependent variables Predicted sign EM1 EM2 EM3 EM4

Intercept na 0.0519 (1.96)** 0.0301 (1.733)* 0.0175 (1.602)* 0.0455 (2.107)**

CEOPAY (H1) 0.417 (3.010)*** 0.382 (2.948)*** 0.307 (5.250)*** 0.268 (4.664)***
CEOPAY  IPI 7 (H2a) 0.117 (3.509)*** 0.082 (3.061)*** 0.076 (2.796)*** 0.108 (3.703)***
CEOPAY  LEGAL 7 (H2b) 0.140 (2.096)** 0.121 (3.712)*** 0.083 (3.352)*** 0.159 (1.974)**
CEOPAY  GOV-Score 7 (H2c) 0.144 (2.739)*** 0.055 (1.976)** 0.047 (3.160)*** 0.074 (2.516)**
SIZE 0.099 (3.815)*** 0.011 (2.123)** 0.427 (3.858)*** 0.616 (2.224)**
LEVERAGE 0.013 (1.11) 0.002 (0.828) 0.006 (1.312) 0.011 (1.283)
R&D 7 0.007 (1.633)* 0.003 (1.662) 0.002 (1.317) 0.0001 (1.732)*
GROWTH 0.001 (2.020)** 0.043 (2.288)** 0.002 (1.858)* 0.006 (1.577)*
R2 0.417 0.401 0.376 0.593
F-Fisher ( p-value) 7.396 (0.000) 7.771 (0.000) 10.073 (0.000) 10.317 (0.000)
DR2 (vs model 4) 17.6% 19.2% 21.7%
Notes: For each variable, standard errors are shown in parenthesis (n 750). *,**,***Significant at 10, 5, and 1 percent levels

US-Canadian per-sample
and earnings

Table III.
27
CEO incentive

results
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28

results
EMJB

Table IV.
UK-French per-sample
Variables Model (1) Model (2) Model (3) Model (4)
Dependent variables Predicted sign EM1 EM2 EM3 EM4

Intercept na 0.0817 (2.271)** 0.0615 (2.268)** 0.0403 (1.871)* 0.0706 (2.318)**

CEOPAY (H1) 0.437 (5.262)*** 0.407 (3.616)*** 0.424 (5.242)*** 0.406 (6.735)***
CEOPAY  IPI 7 (H2a) 0.097 (1.761)* 0.051 (1.331) 0.059 (1.074) 0.0252 (1.861)*
CEOPAY  LEGAL 7 (H2b) 0.052 (1.006) 0.033 (0.872) 0.017 (1.4) 0.02 (1.222)
CEOPAY  GOV-Score 7 (H2c) 0.149 (3.133)*** 0.091 (2.139)** 0.063 (3.088)** 0.097 (2.950)***
SIZE 0.335 (6.693)*** 0.164 (2.180)** 0.404 (8.573)*** 0.537 (2.115)**
LEVERAGE 0.088 (3.734)*** 0.010 (3.762)*** 0.009 (4.805)*** 0.007 (4.153)***
R&D 7 0.002 (1.997)** 0.002 (2.072)** 0.002 (1.376) 0.031 (2.565)**
GROWTH 0.002 (1.888)** 0.003 (0.785) 0.001 (2.156)** 0.002 (1.232)
R2 0.372 0.411 0.358 0.453
F-Fisher ( p-value) 9.303 (0.000) 10.481 (0.000) 9.411 (0.000) 10.716 (0.000)
DR2 (vs model 4) 8.1% 4.2% 9.5%
Notes: For each variable, standard errors are shown in parenthesis (n 750). *,**,***Significant at 10, 5, and 1 percent levels
 Table III shows moreover, that the interactions between CEOPAY and all institutional CEO incentive
patterns are negative and highly significant. The results thus provide evidence that and earnings
institutional features apply downward pressure to CEO incentive rewards potential to
motivate earnings management. In contrast, the interaction terms impacts on earnings
management loss their significance, except for the corporate governance score, when we
consider exclusively the French-British cluster of firms. The significant main effects find
evidence that strong legal environment forces, that is high investor protection and strict 29
law enforcement, mitigate CEOs opportunities to manage earnings to get much incentive
rewards. High-qualified corporate governance tools help moreover, curbing management
self-serving behavior. Thus, we find support for H2c and some support for H2a and H2c.
Most notably, besides, is the fact that the interaction terms magnitudes are
presumably similar within the panel estimations which are performed using US and
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Canadian observations. UK-French regressions show however, that the coefficients of the
interactions between corporate governance score and executive incentive pay
(CEOPAY  GOV-Score) look larger-on absolute value than those obtained between IPI
or LEGAL and CEOPAY. Interpreted collectively, these results support an overly restrict
and complementary (substitutive) influence of the institutional Anglo-American
(Euro-Continental) environments attributes on the CEO incentive compensations
potential to manage earnings.
Regarding the explanatory variables, Tables III and IV show that company size has
a significant and positive influence on the four earnings management levels.
This result confirms Watts and Zimmermans (1990) hypothesis sustaining that managers
manage earnings to reduce political costs and market scrutiny. It corroborates moreover,
Lobo and Zhou (2006) suggestion that larger firms may be more inclined to manage their
earnings because the complexity of their operations. Tables III and IV display also
a highly (marginally) positive association between the market-to-book ratio and all
individual earnings management measures (discretionary accruals earnings management
and small losses avoidance). Bekiris and Doukakis (2011) have already found that
managers may use income increasing accruals when growth slows in order to maintain
the appearance of sustainable growth. Finally, the R&D variable has a positive sign, but is
statistically significant only in regressions ruled over the UK-French observations.
4.2.3 Sensitivity analyses. Our basic estimation results display that the highest
revealed association between the CEO based-incentive pays measure and earnings
managements proxies concern discretionary accruals earnings management.
Numerous earnings management studies have assumed directional income
manipulation. Ball and Shivakumar (2008), for example, denote that CEOs are more
likely to engage in income-increasing rather than income-decreasing behavior. Dechow
et al. (2011) provide evidence that income-increasing adjustments are not filtered out of
CEO compensation. Hence, we tested for the robustness of our findings by splitting our
EM1 proxy into positive (EM1 ) and negative (EM1) discretionary accruals in
order to examine whether institutional features play a role in restricting CEOs
incentive pays potential to motivate up-ward or down-ward earnings management.
Our findings (reported in Table V) suggest that the hypothesized effect of CEO
incentive pay on discretionary accruals earnings management loss significance when
we consider negative discretionary accruals subgroups as the dependent variable.
Thus, result provides evidence that managers are well interested by income-increasing
if their wealth became much tied to their firms performance. We note, moreover, that
the compelling effect of the institutional determinants in both Anglo-American
and Euro-Continental corporate governance environments matter significantly for
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30
EMJB

Table V.
Robustness check results
Variables US-Canadian sub-sample (n 750) UK-French sub-sample (n 750)
Dependent variables Predicted sign EM1 EM1 EM1 EM1

Intercept na 0.0303 (2.102)** 0.025 (1.96)** 0.0441 (2.011)** 0.0407 (1.881)*

CEOPAY (H1) 0.317 (2.171)** 0.2083 (1.113) 0.4011 (2.202)** 0.171 (1.495)
CEOPAY  IPI 7 (H2a) 0.2713 (3.219)*** 0.2451 (1.917)* 0.0505 (1.211) 0.0311 (1.095)
CEOPAY  LEGAL 7 (H2b) 0.272 (2.117)** 0.1934 (1.432) 0.096 (0.877) 0.039 (1.035)
CEOPAY  GOV-Score 7 (H2c) 0.3307 (3.217)*** 0.21 (1.866)* 0.2551 (2.096)** 0.1361 (2.008)**
SIZE 7 0.1138 (1.313) 0.3017 (3.201)*** 0.0901 (1.106) 0.4011 (1.963)**
LEVERAGE 7 0.0733 (0.993) 0.1022 (1.788)* 0.1016 (1.067) 0.2106 (3.017)***
R&D 7 0.1139 (3.217)** 0.037 (0.896) 0.0611 (1.804)* 0.0505 (1.199)
GROWTH 7 0.1703 (1.96)** 0.0917 (1.219) 0.114 (2.177)** 0.0739 (1.672)*
R2 0.5328 0.4739 0.4022 0.4371
F-Fisher ( p-value) 8.3078 (0.0000) 8.047 (0.0000) 7.8139 (0.0000) 8.0191 (0.0000)
Notes: For each variable, standard errors are shown in parenthesis. *,**,***Significant at 10, 5, and 1 percent levels
 earnings-increasing but not earnings-decreasing. That is, institutional features serve CEO incentive
as curb on management discretion only when earnings adjustments are up-wards. and earnings
Thereby, we can support an asymmetric character for the hypothesized institutional
forces effects on the CEOs incentive pays potential to encourage discretional behavior.
Robustness checks display even that the economic determinants of up-ward and
downward income adjustments are not unanimous. On one hand, the firms size and
leverage influences are hold significant only for earnings-decreasing specifications. 31
On the other hand, R&D expenditures and growth opportunities enhance significantly
positive, but not negative, accruals manipulations.
USA and UK share the same legal system traditions. Both countries are member of
the same legal environment where common law characteristics prevail. Bryan et al.
(2010, p. 393) dissert that a global philosophy does not mean global homogeneity.
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Conyon and Murphy (2000) and Conyon et al. (2010) point out moreover, that the UK
governance and pay institutional environments, which are in many ways different to
the USA, have taken the UK closer to the stakeholder position. To test for the
sensitivity of our finding to the identification of the UK as a Euro-Continental
corporate governance model, we rerun the analyses by considering the French and UK
settings separately. The results of this test are reported in Table VI. These results do
not show significant differences by comparison to those reported above.
We consider a number of additional tests to further corroborate our results and
address potential alternative explanations. First, following Dechow et al. (2011) who
presented evidence suggesting that conventional approaches of controlling for
industry and performance induce considerable estimation error into the estimation of
discretionary accruals, we repeat the whole analysis using Dechow et al.s (2011) two
non-financial measures, change in employees and change in order backlog, to predict
discretionary accruals manipulation. Our empirical finding remained unchanged.
Second, we used an alternative measure of CEO incentive-based pay. Specifically, we
compute CEOPAY as (value of equity-based compensation/total compensation), where
value of equity-based compensation is the sum of newly granted options value and newly
granted restricted stocks value and total compensation is (base salary bonus value of
equity-based compensation). The empirical finding remained again the same. Third, we
used the natural logarithm of the market value of equity instead of the natural logarithm
of total assets to proxy for company size. This check did not affect our results. The only
difference being that the variable of pay (CEOPAY) gained marginal statistical
significance (t-student 1.83) in the regression performed using income decreasing from
US-Canadian subgroup as dependent variable. Finally, we have ruled separate OLS
regressions by year to control for the effects of the crisis. Obtained results are presumably
the same. They hold unchanged even when we split our sample into pre and post crisis
subsamples. That is, when we considered the 2004-2006 and 2007-2008 panels separately
(see footnote 8).

5. Conclusion
This study examines the association between CEO incentive-based pays propensity to
motivate earnings management and three institutional aspects of two international
contexts: the Anglo-American and Euro-Continental corporate governance
environments. We capture institutional settings by outside investor protection, legal
enforcement, and corporate governance quality and we ran the fixed-effects model, in
presence of interaction terms, over 1,500 firm-year observations from four countries
between 2004 and 2008. Countries under study are USA, UK, Canada, and France
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32
EMJB

UK cases)
Table VI.
Additional robustness
check results (French vs
Variables French sub-sample (n 375) UK sub-sample (n 375)
Dependent variables Predicted sign EM1 EM1 EM1 EM1

Intercept na 0.0371 (2.318)** 0.0283 (2.301)** 0.0437 (1.933)* 0.0407 (2.121)**

CEOPAY (H1) 0.572 (3.107)*** 0.441 (1.451) 0.344 (3.009)*** 0.558 (1.337)
CEOPAY  IPI 7 (H2a) 0.057 (1.505) 0.039 (1.571) 0.027 (1.173) 0.0109 (1.651)*
CEOPAY  LEGAL 7 (H2b) 0.1806 (1.531) 0.117 (1.645) 0.0386 (1.503) 0.1056 (1.581)
CEOPAY  GOV-Score 7 (H2c) 0.033 (2.039)** 0.021 (2.291)** 0.01 (2.207)** 0.0291 (2.313)**
SIZE 7 0.3171 (1.479) 0.177 (3.049)*** 0.57 (1.51) 0.5303 (2.937)***
LEVERAGE 7 0.099 (1.358) 0.013 (2.491)*** 0.011 (1.339) 0.011 (3.303)***
R&D 7 0.011 (2.303)** 0.009 (1.566) 0.007 (2.117)** 0.03 (1.527)
GROWTH 7 0.002 (1.988)** 0.002 (1.802)* 0.007 (1.966)** 0.005 (1.695)*
R2 0.491 0.501 0.424 0.511
F-Fisher ( p-value) 7.048 (0.000) 7.392 (0.000) 8.210 (0.000) 8.303 (0.000)
Notes: For each variable, standard errors are shown in parenthesis. *,**,***Significant at 10, 5, and 1 percent levels
 which we split into two groups. The first group gathers together US and Canadian CEO incentive
firms labeled as representing the Anglo-American corporate governance model. and earnings
The second cluster groups UK and French firms considered as to represent the
Euro-Continental corporate governance model. Our findings suggest that CEOs from
the Anglo-American corporate governance setting express fewer propensities to
engage in earnings management in the intention to gain more salary. We join these
results to the strong investor protection, strict law enforcement, and high corporate 33
governance structure values that prevail within this setting and mitigate the
conflict of interest between firms insiders and outsiders, hence, CEOs power to behave
self-serving. Findings dissert moreover, that institutional constraints on management
discretion cease to exist among the Euro-Continental subgroup of firms. In fact, apart
from corporate governance quality, no up-ward significant interaction is revealed
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between CEO incentive pay and investor protection or legal enforcement terms and
earnings management dimensions. Sensitivity analyses show however, that the
institutional constraining effects are overly asymmetric. That is, they matter only for
restricting income-increasing but not income-decreasing adjustments.
Interpreted collectively, these findings provide prominent evidence that
cross-country differences on institutional values have significantly real impacts on
CEOs performance-based pays potential to motivate deliberate accounting choices.
Otherwise, this potential is not one-size-fits-all, but depends on the countrys
institutional context.
Future studies could extend our findings by focussing on other settings or by
dealing with further cultural, socio-economic, political, religious, etc., country-specific
factors impacts on management compensation to better understanding its efficiency
and/or costs. For policy making, it will be important to consider formal and informal
institutional features.

Notes
1. Earnings management occurs when managers use judgment in financial reporting and in
structuring transactions to alter financial reports to either mislead some stakeholders about
the underlying economic performance of the company or to influence contractual outcomes
that depend on reported accounting numbers (Healy and Wahlen, 1999).
2. UK and USA are included by Leuz et al. (2003) in the cluster of outsider economies with large
stock markets, dispersed ownership, strong investor rights, and strong legal enforcement.
3. Legal systems protect investors by conferring on them rights to discipline insiders, as well as by
enforcing contracts designed to limit insiders private control benefits (Leuz et al., 2003, p. 507).
4. CEO incentive pay is bonus equity-based compensation. Equity-based compensation is
computed as (stock price)  (the member of newly granted shares) (stock price)  (option
delta)  (the number of newly granted stock options). Stock options are valued at the end of
the fiscal year using Black and Scholes (1973) model adjusted for dividends.
5. We screen out all firms that go public during the sample period. Prior works show that those
firms are subject to systematically higher levels of earnings management.
6. The Fama/French 12 industry classification is: Consumer Non-Durables, Consumer
Durables, Manufacturing, Energy, Chemicals, Business Equipment, Telecommunications,
Utilities, Shops, Healthcare, and Other. Authors definitions for these groupings are
accessible from Kenneth R. Frenchs web site: http://mba.tuck.dartmouth.edu/pages/faculty/
ken.french/Data Library/det_12_ind_port.html. The distribution of the sample firms by
industry is available from the authors.
 EMJB 7. Since 2003, listed UK companies are required to establish a transparent disclosure for
developing policies on executives compensation and corporate issues allowing to more
9,1 detailed analyses.
8. For the sake of brevity, the results of these checks are not reported here. Nevertheless, they
are available from us under request.
9. For parsimony, we do not report the dummy industry and year coefficients in any of our tables.
34
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About the authors

Habib Jouber is an Associate Professor in Finance, Higher Institute of Management, University
of Gabes, Tunisia. He is also Member of the LARTIGE Research Laboratory in the Faculty of
Economic Sciences and Management, University of Sfax where he received his PhD in Finance in
2012. He has published many papers in several high-qualified journals and reviews. He has
presented at a number of international academic conferences. His main research interests are related
to Corporate Finance, Financial Theory, and Accounting. Habib Jouber is the corresponding author
and can be contacted at: jouberhabib@yahoo.fr
Hamadi Fakhfakh is a Professor of Finance and the Director of the LARTIGE Research
Laboratory. He received his PhD in Finance from the University of Sfax, Tunisia in 2002.
His research interests include issues related to Corporate Finance and Governance. He has
published many papers in several high-qualified journals and reviews. He has presented,
moreover, many articles in several accounting and finance international conferences.
Hamadi Fakhfakh is actually a Full Professor at the College of Business Administration,
Jazan University, Arabie Saoudite.

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