The tone from above: Does tunnelling by ultimate owners impinge on the relations between managerial compensation and earnings management?

This study aims to explore the impact of tunnelling by ultimate owners on the relation between managerial compensation and earnings management. Using a sample of the Chinese listed firms from 2009 to 2019, we find that tunnelling by ultimate owners leads to adjustments in pay-performance sensitivity and impinges on the magnitude of earnings management. In private-dominated firms, tunnelling by ultimate owners reduces pay-performance sensitivity, and the decreased pay-performance incentives do not motivate managers to inflate corporate profits by manipulating earnings information. Moreover, owing to managers' resistances, tunnelling does not generate more severe problems in the quality of earnings information. In state-dominated firms, due to government regulation, tunnelling by ultimate owners does not induce significant adjustments in pay-performance sensitivity. However, due to the strong motivation of managers delighting their superiors in the administrative hierarchy by adjusting financial reporting, the quality of earnings information of state-dominated firms may be worse. Our results suggest that in firms with concentrated ownership structures-irrespective of the nature of ownership, both the formulation and implementation of managerial compensation incentive programmes, and the magnitude of earnings management, are equilibrium results of a dynamic game between ultimate owners and managers.