Academic journal article European Research Studies

Management Compensation and Auditor Reputation on Earnings Management and on Share Returns

Academic journal article European Research Studies

Management Compensation and Auditor Reputation on Earnings Management and on Share Returns

Article excerpt

1. Introduction Research Background

Performance evaluation is closely related to compensation that will be given to the management. Some studies regarding to management compensation is often related to agency theory. Agency theory views the existence of relation between owner (principal) and corporate management (agent). Principal trusts agent who gives his/her managerial service. With the service, the agent will receive compensation from the principal. Therefore, compensation is a service value given by corporate owner to the management (Jensen and Murphy, 1990). Most of compensation plans are based on two manager's achievements, which are net income and stock price (Scott, 2009; Vovchenko et al., 2016). The number of bonus, stock, option, and other components of management compensation is evaluated in a certain year depending on the performance of net income and/or performance of stock price.

According to Traichal, et al. (1999), the efforts to minimize or to control conflict occurring between corporate management and owner (shareholders), one of them is by determining a management compensation system properly. The application of proper compensation system is expected to be able to attract and keep competent manager by relating the decision to maximize the corporate value. It is based on the idea that if management compensation is determined properly/well, it will promote the growth of corporate performance, so it can increase the corporate value, as stated by Burchman and Jones (2006).

Lambert (1993) examined the relation between salary and bonus with performance based on accounting and stock return. They found that the performance based on accounting and stock return explains compensation level moderately. Burshman and Indjejikian (1993) also used agency model where a manager has two dimensions of action choice to learn on how the content of earnings information affects the design of compensation construct based on earnings and stock price (Thalassinos and Liapis 2014; Stroeva et al., 2015; Robertie, 2016; Havlicek et al., 2013; Breckova and Havlicek, 2013).

The relation between accounting earnings and top executive compensation was studied by Sloan (1993). The evidence resulted supported the hypothesis stating that incentive based on earnings helps protecting executive from market-wide factors in stock price. Earnings reflect the changing of corporate specification in value, but less sensitive toward market movement. As a result, the performance size based on the earnings in executive compensation contract helps protecting executive from corporate value fluctuation that is in their control. Healy (1985), found the evidence of the relation evidence between bonus given to management and accounting earnings.

Clinch and Magliolo (1993) analyzed the relation between CEO cash compensation of banking firms and accounting earnings from discretionary transaction. The analysis result showed that earnings from discretionary transaction relating to cash flow that is reflected on the function of CEO compensation and does not have an indication that earnings from discretionary transaction that is not related to cash flow affect compensation.

Discretionary transaction is often done by applying earnings management. In certain event, corporate management often determines earnings management policy. The application of earnings management policy is often associated with agency theory. Agency theory views that company as a nexus of contracts (Scott, 2009), both in written or not. A contract between management and shareholders is usually based on the performance achieved by company. If the company has poor performance, the manager can be considered as the party who breaks the contract, that will be receive the consequence from the condition. Therefore, manager might be motivated to conduct earnings management in the process of financial report setting by choosing the proper accounting technique and procedure in order to produce accounting numbers that are often used as the instrument to evaluate management performance. …

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