The Governance Role of Independent Directors' Cash Compensation in Suspect Firms? Evidence From Real Earnings Management

Abstract

This study examines the relationship between independent directors' cash compensation and real earnings management. Using the data of Chinese suspect firms over the period 2009–2023, we show that independent directors' cash compensation helps suspect firms reduce the magnitude of real earnings management, suggesting that cash-based compensation to independent directors enhances board independence and the effectiveness of its monitoring role over real earnings management. Further analysis shows that this relationship is significantly influenced by the ownership structure. Specifically, we find that non-state and foreign ownership strengthen the negative association between independent directors' cash compensation and real earnings management, implying that these investors enhance the governance role of independent directors' cash compensation in monitoring the opportunistic behaviour of managers. Our main findings are robust to alternate proxies of earnings management, sample composition, and endogeneity concerns using several econometric techniques. The study contributes to the related literature by providing empirical evidence on the association between non-equity compensation for independent directors and real earnings management in suspect firms. Our study also offers significant implications for international investors, firms, and regulators, especially after the inclusion of Chinese stocks in the MSCI indices.