The Effects of Governance on Classification Shifting and Compensation Shielding

Abstract

Prior research (e.g., Dechow, Huson, and Sloan 1994) documents that, on average, compensation practices appear to shield CEO pay from income‐decreasing special items. In some circumstances, compensation shielding can be efficient. For example, it may encourage CEOs with earnings‐sensitive pay to take an action that reduces current earnings but nevertheless enhances value. Compensation shielding can be inefficient in other circumstances, such as when a board of directors is captured by an overly powerful CEO or the magnitude of negative special items has been overstated (e.g., by shifting core expenses into special items). This paper explores whether strong governance can explain cross‐sectional variation in compensation shielding, and whether stronger governance and auditing are associated with less shifting of expenses. We find that strong corporate governance mechanisms, as captured by board (and committee) independence, the Sarbanes‐Oxley (2002) Act (SOX) and its related governance reforms, and switches to Big 4 auditors, are all associated with less compensation shielding. While our evidence suggests that strong overall governance is associated with a reduction in manipulation of core earnings through classification shifting in the cross‐section, we find inconclusive evidence to suggest that board independence or SOX influence classification shifting.