The Relation between Equity Incentives and Earnings Management through Permanently Reinvested Foreign Earnings for US Multinational Corporations

Abstract

Krull (2004) finds that US multinational corporations (MNCs) increase amounts designated as permanently reinvested earnings (PRE) to maximize reported after-tax earnings and meet earnings targets. We extend this research by examining the relationship between executive equity compensation and the opportunistic use of PRE by US MNCs, and the market reaction to earnings management using PRE designations. Firms use equity compensation to incentivize executives to strive for maximum shareholder wealth. One unintended consequence is that executives may engage in earnings management activities to increase their equity compensation. In this study, we examine whether the equity incentives of management are associated with an increased use of PRE. We predict and find strong evidence that the changes in PRE are positively associated with the portion of top managers' compensation that is tied to stock performance. In addition, we find this relationship to be strongest for firms that meet or beat forecasts, but only with the use of PRE to inflate income, suggesting that equity compensation incentivizes managers to opportunistically use PRE, especially to meet analyst forecasts.

Further, we provide evidence that investors react negatively to beating analysts' forecasts with the use of PRE, suggesting that investors find this behavior opportunistic and not fully convincing. This chapter makes an important contribution to what we know about the joint effects of tax policy, generally accepted accounting principles, and incentive compensation on the earnings reporting process.

Citation

Furner, Z., Walker, K. and Durrant, J. (2020), "The Relation between Equity Incentives and Earnings Management through Permanently Reinvested Foreign Earnings for US Multinational Corporations", Hasseldine, J. (Ed.) Advances in Taxation (Advances in Taxation, Vol. 28), Emerald Publishing Limited, Leeds, pp. 127-168. https://doi.org/10.1108/S1058-749720200000028005