CEO bonus pay, tax policy, and earnings management.

ABSTRACT

In 1993, Congress passed Internal Revenue Code Section 162(m), which eliminated the tax deductibility of nonperformance-based executive compensation over $1 million. Recent research indicates that, as intended, Code Section 162(m) has strengthened the link between executive pay and firm performance.

Although 162(m) apparently has changed executive compensation in a way desired by Congress, we hypothesize that 162(m) has indirectly influenced the financial-reporting process. Specifically, we hypothesize and find evidence to support the following: for numerous reasons associated with "qualifying" a compensation plan per Code Section 162(m), executives in firms that qualify their compensation plans receive relatively low pay when their firm's financial performance is extreme. Because these executives receive relatively low pay for extreme financial performance, an incentive exists to smooth reported earnings overtime in order to maximize longterm compensation. The relatively smooth earnings patterns that we observe in qualified firms are related to the use of discretionary accruals.

Our results appear robust to alternative sampling and modeling techniques. As such, our evidence suggests that a tax policy designed to curb allegedly excessive executive compensation has indirectly affected the quality of reported earnings.

Concern over purportedly excessive executive compensation influenced the Congressional passage of Internal Revenue Code Section 162(m), which eliminates the tax deductibility of nonperformance-based compensation over $1 million. For tax years beginning on or after January 1, 1994, any executive compensation over $1 million is tax deductible only if a firm satisfies the requirements of 162(m). Generally speaking, 162(m) requires that tax-deductible compensation be based on an objective formula with specifically weighted performance measures. Although recent finance research (Perry and Zenner 2001) suggests that 162(m) has increased the pay-for-performance relationship, we find evidence that there is an unintended consequence related to the observed pay-for-performance improvement. Specifically, we find that discretionary accruals are used to smooth earnings to a greater extent when bonus plans are qualified in accordance with 162(m).

We posit that because the typical executive compensation contract places upper and lower bounds on bonus pay, removing discretionary bonus compensation via satisfying the requirements of 162(m) provides executives with an incremental incentive to avoid extreme earnings. In response to this incentive, we investigate whether executives smooth reported earnings in order to maximize bonus compensation over multiple periods (similar to the findings in Gayer et al. [1995], Healy [1985], and Holthausen et al. [1995]). We first identify companies that were likely affected by 162(m), and then we compare firm-years in which the requirements of 162(m) were satisfied (thus allowing the tax deduction) against firm-years in which the requirements of 162(m) were not satisfied (thus preserving discretionary executive bonus compensation). We find that earnings patterns are smoother during firm-years in which the requirements of 162(m) were satisfied. Further, we find that these smoother earnings patterns are related to the u se of discretionary accruals. Our results appear robust to alternative sampling and modeling techniques. As such, our evidence suggests that a tax policy designed to curb allegedly excessive executive compensation has indirectly affected the quality of reported earnings.