Performance goals and real earnings management: evidence from compensation contracts

We examine whether and how multiple performance metrics and goals specified in CEO bonus contracts are associated with firms’ real earnings management. We find that, for firms using earnings per share (EPS) as the main accounting metric, managers are more likely to cut research and development (R&D) expenditures but not selling, general, and administrative (SG&A) expenses when realised EPS just meets the bonus target. When sales is the primary accounting metric, managers are more likely to increase SG&A expenses to boost sales. However, when EPS- and sales-based metrics are used jointly, managers’ incentives to adjust R&D and SG&A expenditures are attenuated. Similarly, when non-financial metrics are incorporated alongside EPS-based bonus contracts, the incentive to cut R&D expenditures is weakened. In contrast, when non-financial metrics emphasise customer satisfaction, their co-occurrence with sales-based bonus contracts increases managers’ incentive to raise SG&A expenditures. Overall, our findings highlight the importance of employing multiple metrics in bonus contracts and carefully designing their relative weights, as the dominance of specific metrics critically shapes firms’ real earnings management.