Earnings smoothing and CEO cash bonus compensation: the role of mandatory derivatives disclosure policy

  • Abiot Tessema
Original Article


Motivated by intense controversy over mandatory derivative instruments disclosure required by the Statement of Financial Accounting Standard No. 133 (SFAS 133), this study is to examine whether the sensitivity of CEOs compensation to earnings smoothing changes following the adoption of SFAS 133. Moreover, the study investigates whether the sensitivity of CEOs compensation to earnings smoothing after the implementation of SFAS 133 varies with the level of market volatility. Using the correlation between the changes in discretionary accruals and the changes in pre-discretionary income as a measure of earnings smoothing and dollar value of a bonus earned by the CEOs during the year as a measure of CEOs compensation, the empirical evidence reveals that while earnings smoothing and CEOs compensation are positively related, the positive relation is stronger after the adoption of SFAS 133. The study also finds that the positive association between earnings smoothing and CEOs compensation after the adoption of SFAS 133 is larger when the market volatility is higher. This study provides direct evidence on the impact of the adoption of SFAS 133 on the sensitivity of CEO compensation to earnings smoothing and sheds light on current literature on the effects of accounting regulations, earnings smoothing, and compensation plan. Moreover, this study helps standard setters to better understand the trade-off between transparency and compensation plans.


Compensation Earnings smoothing SFAS 133 

JEL Classification

G30 G35 G38 



I thank seminar participants at Maastricht University School of Business and Economics, Tilburg University School of Economics and Management, and Zayed University College of Business.


  1. Ahmed, A., E. Kilic, and E. Lobo. 2006. Does recognition versus disclosure matter? Evidence from value-relevance of banks’ recognized and disclosed derivative financial instruments. The Accounting Review 81 (3): 567–588.CrossRefGoogle Scholar
  2. Ahmed, A., E. Kilic, and G. Lobo. 2011. Effect of SFAS 133 on the risk relevance of accounting measures of banks’ derivative exposures. The Accounting Review 86 (3): 769–804.CrossRefGoogle Scholar
  3. Baker, G., M. Jensen, and K. Murphy. 1988a. Compensation and incentives: Practice vs. theory. Journal of Finance 43: 593–616.CrossRefGoogle Scholar
  4. Baker, P., M. Jensen, and K. Murphy. 1988b. Compensation and incentives: Practice vs. theory. The Journal of Finance 43 (3): 593–616.CrossRefGoogle Scholar
  5. Barton, J. 2001. Does the use of financial derivatives affect earnings management decisions? The Accounting Review 76 (4): 1–26.CrossRefGoogle Scholar
  6. Beatty, A., and J. Weber. 2003. The effects of debt contracting on voluntary accounting method changes. The Accounting Review 78 (1): 119–142.CrossRefGoogle Scholar
  7. Bhamornsiri, S., and R. Schroeder. 2004. The disclosure of information on derivatives under SFAS No. 133: Evidence from the Dow 30. Managerial Auditing Journal 19 (5): 669–680.CrossRefGoogle Scholar
  8. Boyd, B. 1994. Board control and CEO compensation. Strategic Management Journal 15: 335–344.CrossRefGoogle Scholar
  9. Choi, J., C. Mao, and A. Upadhyay. 2015. Earnings management and derivative hedging with fair valuation: Evidence from the effects of FAS 133. The Accounting Review 90 (4): 1437–1467.CrossRefGoogle Scholar
  10. Core, J., R. Holthausen, and D. Larcker. 1999. Corporate governance, chief executive officer compensation, and firm performance. Journal of Financial Economics 51: 371–406.CrossRefGoogle Scholar
  11. Das, S., K. Hong, and K. Kim. 2013. Earnings smoothing, cash flow volatility, and CEO cash bonus. Financial Review 48 (1): 123–150.CrossRefGoogle Scholar
  12. Demsetz, H., and K. Lehn. 1985. The structure of corporate ownership: Causes and consequences. Journal of Political Economy 93: 1155–1177.CrossRefGoogle Scholar
  13. Eng, L., and Y. Mak. 2003. Corporate governance and voluntary disclosure. Journal of Accounting and Public Policy 22: 325–345.CrossRefGoogle Scholar
  14. Friend, I., and L. Lang. 1988. An empirical test of the impact of managerial self-interest on corporate capital structure. Journal of Finance 43: 271–81.CrossRefGoogle Scholar
  15. Froot, K., and J. Stein. 1993. Risk management: Coordinating corporate investment and financing policies. Journal of Finance 48 (5): 1629–1658.CrossRefGoogle Scholar
  16. Fudenberg, K., and J. Tirole. 1995. A theory of income and dividend smoothing based on incumbency rents. Journal of Political Economy 103 (1): 75–93.CrossRefGoogle Scholar
  17. Gabaix, X., and L. Augustin. 2008. Why has CEO pay increased so much? Quarterly Journal of Economics 123 (1): 49–100.CrossRefGoogle Scholar
  18. Gaver, J., and K. Gaver. 1995. Compensation policy and the investment opportunity set. Financial Management 24: 19–32.CrossRefGoogle Scholar
  19. Gibbs, M., K. Merchant, M. Vargus, and V. Wim. 2004. Determinants and effects of subjectivity in incentives. The Accounting Review 79 (2): 409–436.CrossRefGoogle Scholar
  20. Graham, J., C. Harvey, and S. Rajgopal. 2005. The economic implications of corporate financial reporting. Journal of Accounting and Economics 40 (1–3): 3–73.CrossRefGoogle Scholar
  21. Grant, J., G. Markarian, and A. Parbonetti. 2009. CEO risk-related incentives and income smoothing. Contemporary Accounting Research 26 (1–3): 1029–1065.CrossRefGoogle Scholar
  22. Guay, W. 1999. The sensitivity of CEO wealth to equity risk: An analysis of the magnitude and determinants. Journal of Financial Economics 53 (4): 43–71.CrossRefGoogle Scholar
  23. Guidry, F., A. Leone, and S. Rock. 1999. Earnings-based bonus plans and earnings management by business-unit managers. Journal of Accounting and Economics 26 (1): 113–142.CrossRefGoogle Scholar
  24. Hallock, K. 1997. Reciprocally interlocking boards of directors and executive compensation. Journal of Financial and Quantitative Analysis 32: 331–344.CrossRefGoogle Scholar
  25. Harry, B., and R. Luis. 1998. Managerial compensation and firm performance: A general research framework. The Academy of Management Journal 41 (1–3): 135–145.Google Scholar
  26. Healy, P. 2001. The effect of bonus schemes on accounting decisions. Journal of Accounting and Economics 7 (2): 85–107.Google Scholar
  27. Hepworth, S. 1953. Smooth periodic income. The Accounting Review 28 (1–3): 32–39.Google Scholar
  28. Hermalin, B. 2005. Trends in corporate governance. Journal of Finance 60: 2351–2384.CrossRefGoogle Scholar
  29. Hutton, A., L. Lee, and S. Shu. 2012. Do managers always know better? The relative accuracy of management and analyst forecasts. Journal of Accounting Research 50 (1): 1217–1244.CrossRefGoogle Scholar
  30. Jensen, M. 1986. Agency costs of free cash flow, corporate finance, and takeovers. The American Economic Review 76: 323–329.Google Scholar
  31. John, T., and K. John. 1993. Top-management compensation and capital structure. Journal of Finance 48: 949–974.CrossRefGoogle Scholar
  32. Kilic, E., G. Lobo, T. Ranasinghe, and K. Sivaramakrishnan. 2013. The impact of SFAS 133 on income smoothing by banks through loan loss provisions. The Accounting Review 88 (1): 233–260.CrossRefGoogle Scholar
  33. Kim, K., S. Pandit, and C. Wasley. 2016. Macroeconomic uncertainty and management earnings forecasts. Accounting Horizons 30 (1): 157–172.CrossRefGoogle Scholar
  34. Lambert, R., D. Larcker, and K. Weigelt. 1993. The structure of organizational incentives. Administrative Science Quarterly 38: 438–461.CrossRefGoogle Scholar
  35. Matsunaga, S., and C. Park. 2001. The effect of missing a quarterly earnings benchmark on the CEO’s annual bonus. The Accounting Review 76 (July): 313–332.CrossRefGoogle Scholar
  36. Minton, B., and C. Schrand. 1999. The impact of cash flow volatility on discretionary investment and the cost of debt and equity financing. Journal of Financial Economics 54 (3): 423–460.CrossRefGoogle Scholar
  37. Palepu, K., and P. Healy. 2007. Business analysis and valuation, 4th ed. South Western: Thomson.Google Scholar
  38. Penman, S. 2007. Financial statement analysis and security valuation. Irwin: McGraw-Hill.Google Scholar
  39. Pi, L., and S. Timme. 1993. Corporate control and bank efficiency. Journal of Banking & Finance 17: 515–530.CrossRefGoogle Scholar
  40. Ronen, J., and S. Sadan. 1981. Smoothing income numbers, objectives, means and implications. Reading: Addison-Wesley Publishing Company.Google Scholar
  41. Ryan, H., and R. Wiggins. 2001. The influence of firm- and manager-specific characteristics on the structure of executive compensation. Journal of Corporate Finance 7: 101–123.CrossRefGoogle Scholar
  42. Sapra, H. 2002. Do mandatory hedge disclosures discourage excessive speculation? Journal of Accounting Research 40 (3): 933–964.CrossRefGoogle Scholar
  43. Sloan, R. 1993. Accounting earnings and top executive compensation. Journal of Accounting and Economics 16 (1–3): 55–100.CrossRefGoogle Scholar
  44. Smith, C., and R. Stulz. 1985. The determinants of firms’ hedging policies. Journal of Financial and Quantitative Analysis 20 (4): 391–405.CrossRefGoogle Scholar
  45. Supanvanij, J., and J. Strauss. 2006. The effects of management compensation on firms hedging: Does SFAS 133 matters? Journal of Multinational Financial Management 16 (5): 475–493.CrossRefGoogle Scholar
  46. Tessema, A., and R. Deumes. 2017. SFAS 33 and income smoothing via discretionary accruals: The role of hedge effectiveness and market volatility. Journal of International Financial Management and Accounting. Scholar
  47. Tessema, A. 2016. Accounting for derivatives and risk management activities: The impact of product market competition. International Journal of Accounting and Information Management 24 (1): 82–96.CrossRefGoogle Scholar
  48. Tessema, A., S. Garas, and K. Tee. 2017. The impact of Islamic accounting standards on information asymmetry: The case of Gulf Cooperation Council (GCC) member countries. International Journal of Islamic and Middle Eastern Finance & Management 10: 170–185.CrossRefGoogle Scholar
  49. Tucker, J., and P. Zarowin. 2006. Does income smoothing improve earnings informativeness? The Accounting Review 81 (1): 251–270.CrossRefGoogle Scholar
  50. Williams, C. 2015. Asymmetric responses to earnings news: A case for ambiguity. Accounting Review 90 (2): 785–817.CrossRefGoogle Scholar
  51. Wooldridge, J. 2002. Econometric analysis of cross section and panel data. Cambridge, MA: The MIT Press.Google Scholar
  52. Xavier, G., and A. Landier. 2008. Why has CEO pay increased so much? Quarterly Journal of Economics 123: 49–100.CrossRefGoogle Scholar
  53. Zhang, H. 2009. Effect of derivative accounting rules on corporate risk-management behavior. Journal of Accounting and Economics 47 (3): 244–268.CrossRefGoogle Scholar

Copyright information

© Macmillan Publishers Ltd., part of Springer Nature 2018

Authors and Affiliations

  1. 1.Zayed University College of BusinessAbu DhabiUnited Arab Emirates

Personalised recommendations