The Impact of Real Earnings Management on Innovation: The Role of Top Executive Compensation

Abstract

Innovation is the key factor to improve the competitiveness of company, with large amount of investment and high risk. Therefore, when facing the pressure of profitability, reducing research and development expenditure is a real earnings management method commonly used by top executives. R&D cuts related to real earnings management belongs to the suboptimal decision-making. Various frictions and high adjustment costs in reduction process may lead to the decline of follow-up innovation. Compensation contract is a governance mechanism for the board of directors to motivate and supervise top executives. Based on the study of the impact of real earnings management on innovation, this paper also analyzes how to design a compensation contract to better mobilize the innovation initiative of executives. This paper chooses the data of Chinese A-share listed companies from 2007 to 2019 to test the economic consequences of real earnings management from innovation perspective by using tobit model. The empirical results show that R&D cuts related to real earnings management can obstruct companies’ innovation, top executive performance pay of non-state-owned enterprises has a negative impact on innovation, and equity incentive can encourage state-owned enterprise executives to improve innovation output. The conclusions highlight the potential costs of managerial manipulation of R&D expenditures to alter reported earnings, and can help to formulate economic policies and top executive compensation contracts to promote innovation.