2012-13: Self-Enforcing Clawback Provisions in Executive Compensation

A clawback provision is the right of a firm to recover from an executive’s compensation as the result of triggering events, such as a financial restatement. We argue that the adoption of clawback provisions may exacerbate a manager’s incentive to avoid financial restatements via earnings management. Only when the accounting verifiability is high, making earnings management very costly, can clawback provisions completely eliminate the manager’s incentive to misreport ex-ante; otherwise, clawback provisions stipulate a reduction of future executive compensation in the event of a financial restatement. We show firms still benefit from implementing clawback provisions, while earnings management is costless. This result may explain why companies voluntarily adopt clawback provisions, in spite of the detrimental effect of earnings management.