Equity-based Executive Compensation, Managerial Legal Liability Coverage and Earnings Management

This study investigates how managers’ compensation incentives, as measured by equity-based executive compensation and managerial legal liability coverage affect earnings management. The availability of compensation may encourage managers to adopt more aggressive accounting practices; however, the higher the legal liability managers face, the more it will reduce their willingness to engage in such risk-taking behavior. Once managers mitigate their personal legal liability through directors’ and officers’ (D&O) liability insurance, they may be more inclined to manipulate reported earnings. We use excess D&O liability insurance coverage as a proxy for managerial liability coverage and test a sample of listed firms in Taiwan where D&O liability insurance purchases are publicly disclosed. We find that managers whose compensation is equity-based are more likely to adopt an opportunistic accounting strategy when they are covered by relatively high levels of D&O liability insurance; this suggests that the primary determination of earnings management is the joint effect of an increase in managers’ compensation incentives and a decrease in their legal liability.