CEO Shareholdings and Earnings Manipulation: A Behavioral Explanation

• Date: 01 June 2016
• Author: Andreas P. Petrou,Andreas Procopiou
• Published date: 01 June 2016
• DOI: http://doi.org/10.1111/emre.12073

CEO Shareholdings and Earnings

Manipulation: A Behavioral Explanation

ANDREAS P. PETROU and ANDREAS PROCOPIOU

School of Management andEconomics, Cyprus University of Technology, Limassol, Cyprus

Empiricalfindings on the relationshipbetween CEO shareholdingsand earnings manipulationare inconclusive.In

response, this study attempts to shed more light by suggesting that this relationship is influenced by situational

contingencies that affectCEO perceptions ofthe costs and benefits associated withearnings manipulation.To support

this perspective we draw on the prospect theory and the approach/inhibition theory of power to examine the

relationshipbetween CEO shareholdings and earningsmanipulation in light of CEOpower. We test this relationship

on a sample of 16,873observations from 2,257 US public firms. Findings show that increasing CEO shareholdings

has a negative effect on earnings management, and onre-statements due to irregularities, and thatduality positively

moderates these relationships. The findings contribute to the corporate governance practice since they have

implications forthe design of CEO remuneration packages.

Keywords: corporate governance; CEO shareholdings; agency theory; earnings management; irregularities

Introduction

The practice of offering stock incentives to CEOs has

spread during the last two decades as firms try to align

the interests of CEOs and shareholders. As a result, some

CEOs gather a significant shareholding in their own

company. Nevertheless, recent cases of corporate fraud

have raised concerns among the financial press and

regulators that these incentives may increase the extent

to which CEOswould be prepared to deceiveshareholders

about firm performance to serve their own interests.

Studies have shown that a common method for deceiving

shareholders is through earnings management, defined as

the alteration of a firm’s reported economic performance

by insiders to mislead stakeholders (Healy, 1985).

Understandinghow CEO shareholdings relate to earnings

management should be of interest to management

scholarship,given that earnings management couldinflate

firm performance, and subsequently, influence

shareholder expectations and decisions (Datta et al.,

2013; Garcia-Meca and Sanchez-Ballesta, 2009).

In addition, empirical studies have found inconsistent

results regarding the effect of CEO shareholdings on

earnings management (Armst rong et al., 2010). A few

studies have found a positive relationship (Donoher

et al., 2007; Feng et al., 2011), some other studies have

reported a negative relationship (Zhang et al., 2008;

Duellman et al., 2013), and, the majority of the studies

have found insignificant results (Burns and Kedia, 2006;

Erickson et al., 2006; Larcker et al., 2007; Johnson

et al., 2009; Jiang et al., 2010). Armstrong et al. (2013)

have suggested that these ambiguous findings are due to

the interplay of two countervailing incentive effects a

reward effectand a risk effect. Consequently,this research

question merits further examination as we need to

understand the contingencies at play.

One possible expla nation for the inconclusive findings ,

which scholarship has not adequately explored, is

situational contingencies that determine the CEOs’

perception of risks (Alessandri and Seth, 2014). We

expect that such factors could moderate the relationship

of CEO shareholdingsand earnings management(Wowak

and Hambrick, 2010; Chng et al., 2012). One factor is

CEOs’power, defined as the asymmetric control over

valued resources in a social relationship (Westphal and

Zajac, 1995). In the context of this study, we consider

CEOs’power vis-à-vis theboard of directors who monitor

CEO behavior.

Agency theory, which regards CEOs as self-interested,

cannot make predictions about the relationship between

CEO shareholdings a nd earnings management, because,

CEO response to sha reholdings will depend on their

perception of the personal costs and benefits that are

Correspondence: AndreasPetrou, School of Managementand Economics,

Cyprus University of Technology, PO Box 50329, 3063 Limassol,

Cyprus, Tel: 0035725002120, Fax: 0035725002854. E-mail: andreas.

petrou@cut.ac.cy

European Management Review, Vol. 13, 137–148, (2016)

DOI: 10.1111/emre.12073

©2016 European Academy of Management