This study focuses on the strategic behavior of owner-managers in relation to their compensation and its impact on reported earnings. We investigate whether owner-managers of smaller firms manipulate their compensation, specifically by decreasing their salaries and increasing dividends, to meet or beat the zero earnings benchmark.
We emphasize that owner-managers have significant compensation discretion, enabling them to choose between salary (which decreases earnings) and dividends (which does not decrease earnings). We conduct our analysis using data from small Danish owner-managed firms, which enables us to examine compensation shifting in an approximately tax-neutral setting, where compensation shifting has minimal direct costs to owner-managers.
Our study’s first objective is to explore whether reporting incentives, specifically beating the zero earnings benchmark, influence owner-managers’ compensation-shifting behavior. We find that owner-managers who have the potential to shift their compensation to beat the benchmark are almost twice as likely to decrease their salaries as nonpotential beaters are. In addition, when they decrease their salaries to meet or beat the benchmark, they are likely to increase their dividends simultaneously, indicating compensation shifting from salary to dividends.
Our study then investigates whether benchmark beating through compensation shifting is associated with cost of debt benefits, particularly lower interest rates. We document that firms strategically shifting their compensation to beat the benchmark obtain lower interest rates on their debt than firms reporting losses.
Overall, our article contributes to the literature in two main ways. First, it highlights the strategic use of compensation by owner-managers to manage reported earnings, specifically through salary decreases and dividend increases. Second, it expands on previous research by documenting an association between benchmark beating and lower interest rates, even for small privately held firms.
The findings have implications for financial statement users, including banks, suppliers, customers, employees, and potential investors. These users should be aware of owner-managers’ discretion over their compensation and their ability to strategically alter reported earnings. Additionally, we suggest that regulators should consider the suitability of current frameworks and standards that prioritize shareholders as the primary users of financial statements, particularly for owner-managed firms where agency conflicts between managers and owners are minimal.
This paper has been accepted at the European Accounting Review, and the link to the published manuscript is: https://doi.org/10.1080/09638180.2023.2226724