CEO Employment Contract Horizon and Earnings Management

• In Event: Governance and Financial Reporting

Abstract

We examine the impact of employment contract horizon on managerial discretion in reporting earnings. After hiring a new CEO with a written employment contract, the board learns about CEO talent from realized performance during the contract horizon to determine whether to renew or terminate the contract. When it gets closer to the board’s decision date, firm performance may have a greater impact on the board’s decision making, which motivates the CEO to more aggressively inflate earnings during the later stage of the contract horizon to enhance the likelihood of contract renewal. Conversely, economic theory suggests that the informational value of firm performance to the board declines over time as the board’s estimate of CEO talent becomes more precise. This motivates the CEO to more aggressively inflate earnings during the earlier stage of the contract horizon. Based on the first employment contracts for CEOs of S&P 500 firms, we find more aggressive earnings inflation during the earlier stage of the contract horizon, especially for CEOs having greater concerns about contract termination and for CEOs working in more certain business environment where the board has less learning difficulty. Our evidence shows that the pre-specified employment contract horizon has significant incentive effects on managers’ financial reporting discretion.

Authors

• Guojin Gong, The Pennsylvania State University

• Juan Wang, Central Connecticut State University

• Hyun Jung Lee, The Pennsylvania State University