The effect of CEO ownership on the information content of reported earnings

This paper examines the relation between capital market perceptions of earnings quality and CEO equity ownership. Using the earnings response coefficients (ERCs) from annual returns–earnings regressions as a proxy for investor perceptions of earnings quality, we find that ERCs first increase and then decline across higher levels of CEO ownership with an inflection point around 25% ownership. Using analyst behavior as another proxy for the perceptions of financial analysts, we find that earnings forecasts are more accurate as ownership increases, but once ownership levels reach about 25%, accuracy declines with further increases in ownership. Forecast dispersion, forecast revision volatility, and analyst following decline and then increase across increasing levels of CEO ownership. Our results suggest that, for low levels of CEO ownership, earnings are perceived as being more informative about future firm performance as ownership increases. However, once ownership levels are high, earnings are perceived as being less informative with further increases in ownership.     

CEO Ownership and Discretionary Investments

Abstract:  This study investigates empirically the relationship between CEO ownership and discretionary investments such as R&D and capital expenditures. We assert that the under-investment problem is high for R&D-intensive projects, while the over-investment problem is high for capital expenditures because of differences in risk between the two types of investments. Building on the linkages between investments and investment-related agency problems, we hypothesize that the relationship between CEO ownership and investments depends on whether increasing ownership mitigates or exacerbates the under- or over-investment problem. We find a non-linear association between CEO stock ownership and R&D investments; R&D investments increase and then decline across increasing levels of ownership. Further, we find that R&D investments and CEO stock options are positively associated at high levels of option holdings. In contrast, capital expenditures do not vary with CEO ownership (stock or options). Finally, consistent with our underlying assumption, we find that the influence of R&D investments on future firm risk is significantly larger than that of capital expenditures. Our findings indicate that managerial risk aversion affects discretionary investments.     

What Drives Investor Response to CSR Performance Reports?

Recent research finds that investors' assessments of a stock's fundamental value are influenced by corporate social responsibility (CSR) performance through the affect-as-information heuristic. We extend prior research by examining two boundary conditions for the use of this heuristic: (i) whether the CSR performance relates to activities that are integrated in a firm's core business practices (material CSR issues) or not (immaterial CSR issues), and (ii) whether the CSR performance is positive or negative. Employing an experimental method, we find that the affect-as-information heuristic applies only to immaterial CSR issues but not to material CSR issues, and only to positive but not negative CSR performance. Our findings suggest that investors likely use a heuristic approach to process immaterial and positive CSR issues, and a more deliberate and systematic approach to process material or negative CSR issues. Our study has both practical and theoretical implications.     

Audit and non-audit fees and capital market perceptions of auditor independence

This study provides evidence on whether auditor independence-in-appearance, proxied by earnings response coefficients, is related to the non-audit fee ratio (non-audit to total fees from a client) or client importance (total fees from a client as a percentage of the total revenues of the audit firm). The results from large samples over the period 2001–2006 show, contrary to popular belief and the findings of some prior studies, that there is no evidence of a relation between perceived auditor independence and the non-audit fee ratio. However, perceived auditor independence is negatively associated with client importance, consistent with the economic theory of auditing. Our paper adds to the literature by examining the relative importance of non-audit fee ratios and client importance as determinants of independence-in-appearance.     

Asymmetric valuation of sustained growth by bond- and equity-holders

Viewing equity as a call option on the firm’s assets with a strike price equal to contractual debt obligations yields an asymmetric prediction on how debt and equity markets view sustained growth. Debt holders are expected to benefit from sustained growth when the default risk is high, while equity holders value such growth when risk is low. Using Altman’s z-score and debt ratings as alternative proxies for the default risk, we document a negative association between bond yield spreads and sustained growth in earnings for firms with high risk only. In sharp contrast, using earnings multiples from returns-earnings regressions as a proxy for equity market rewards, we find that earnings multiples are larger when earnings growth is sustained for the low risk sample only. Decomposing earnings growth into revenue and nonrevenue growth, we find that the debt market rewards for firms with revenue growth are confined to the high risk sample only, while nonrevenue growth firms are not rewarded for either sample. Equity investors value revenue-led earnings growth for low and high risk samples while nonrevenue growth is rewarded for the low risk sample only. Our study adds to our understanding of how changes in firm value from sustained earnings and revenue growth are divided between key providers of capital and how default risk plays an instrumental role in this valuation process.     

The influence of growth opportunities on the relationship between equity ownership and leverage

This study investigates whether the association between ownership structure and leverage varies with the magnitude of growth opportunities. According to the free cash flow hypothesis, managers receive utility from increasing firm size and the over-investment problem is more severe for firms with fewer growth opportunities. Considering the disciplinary role of leverage on the over-investment problem and ownership structure as a control mechanism to affect financing decisions, we hypothesize that the association between ownership structure and leverage is stronger for firms with fewer growth opportunities. We find that the association between equity ownership and leverage is significant for low-growth firms, but not for high-growth firms. The results mostly hold when sample firms are partitioned into large and small firms to directly control for the effect of firm size on the association between ownership structure and leverage.