The Effect of the Compensation System on Earnings Management and Sustainability: Evidence from Korea Banks

Abstract

Since the global financial crisis, management incentive compensation, which is sensitive to financial firms’ short-term performance, has been noted to threaten financial systems’ sustainability by incentivizing managers to pursue excessive risks. Subsequently, international standards have been established regarding compensation for financial institutions’ senior executives and employees. However, this compensation may impact not only banks’ risk-taking behaviors, but also their earnings management, as the latter affects financial performance while compensation is decided as a reflection of such performance. Therefore, this study analyses executive compensation’s impact on banks’ earnings management using compensation data on South Korean banks. The analysis revealed higher earnings management using a loan loss provision with more variable compensation. On the one hand, if the proportion of equity-linked compensation to incentive compensation increased, then earnings management increased. On the other hand, more deferred compensation led to increased earnings smoothing. This study evaluates regulatory impacts across multiple dimensions by analyzing the effects of incentive compensation standards—intended to increase financial systems’ sustainability—on individual financial institutions and further contributes to studies on managerial decision making.