Financial Leverage,CEO Compensation,and Corporate Hedging: Evidence from Real Estate Investment Trusts

This paper studies the determinants of corporate hedging practices in the REIT industry between 1999 and 2001. We find a positive significant relation between hedging and financial leverage, indicating the financial distress costs motive for using derivatives in the REIT industry. Using estimates of the Black–Scholes sensitivity of CEO’s stock option portfolios to stock return volatility and the sensitivity of CEO’s stock and stock option portfolios to stock price, we find evidence to support managerial risk aversion motive for corporate hedging in the REIT industry. Our results indicate that CEO’s cash compensation and the CEO’s wealth sensitivity to stock return volatility are significant determinants of derivative use in REITs. We also document a significant positive relation between institutional ownership and hedging activity. Further, we find that probability of hedging is related to economies of scale in hedging costs.

Regulator Scrutiny and Bank CEO Incentives

This study analyzes the effects of monitoring intensity on compensation and turnover for CEOs of publicly-traded banks. Using a sample of banks from 1992 to 2004, I find that monitoring intensity plays a significant role in compensation levels, pay-for-performance sensitivity, and CEO turnover. The results show that CEOs from highly-rated institutions receive smaller pay than CEOs from competing institutions, and that monitoring intensity, as proxied by CEO age, influences the relationship between market performance and executive incentives. These findings suggest that regulatory ratings and CEO age impact optimal bank governance structure by varying incentive sensitivity to market performance.

CEO Involvement in Director Selection: Implications for REIT Dividend Policy

This paper examines the relationship between CEO entrenchment and dividend policy of real estate investment trusts (REITs). We develop an index for CEO entrenchment using CEO tenure and duality and find that this index has significant impact on dividend policy. We further separate our sample into two sub-groups: REITs with and without nomination committees. Our analyses show a strong positive relationship between CEO entrenchment level and dividend payout for REITs without a nomination committee. In REITs with nomination committees, CEO entrenchment has less influence on dividend policy. We conclude that dividend policy serves as a substitution for other governance mechanisms. Further, our results are consistent with the evidence for other US firms—CEO that are more entrenched pay higher dividends to avoid shareholder sanctions and the threat of takeover.

Do firms understate stock option-based compensation expense disclosed under SFAS 123?

Focusing on the four key option pricing model inputs—expected option life, expected stock price volatility, expected dividend yield, and the risk-free interest rate for the expected life of the option—this study finds that firms understate option value estimates and, thus, stock-based compensation expense disclosed under SFAS 123. As predicted based on incentives and opportunities for management to understate SFAS 123 expense, the understatement of option value estimates is increasing in proxies for the magnitude of the expense, is greater for firms with weaker corporate governance, and, to a lesser extent, is increasing in the excessiveness of executive pay. The findings are strongest for the expected option life and expected stock price volatility input assumptions, consistent with firms’ greater latitude in determining these inputs. We find weaker evidence of understatement associated with the expected dividend yield assumption, and none for the interest rate assumption, consistent with these inputs being less amenable to discretion. Taken together, our findings raise some concern that the exercise of management discretion adversely affects the overall reliability of SFAS 123 expense.

Director Compensation and CEO Bargaining Power in REITs

We analyze director compensation for Real Estate Investment Trusts (REITs) and investigate the relations between director compensation and other measures of the board independence and board monitoring. Using 136 REITs in 2001, we find that REITs that pay higher equity-based compensation to their board members are associated with higher financial performance. Our data indicate that board equity-based compensation is positively related to the existence of an independent nomination committee, however, it has no significant relationship with board size, proportion of outside directors, CEO duality and CEO tenure and ownership.

An empirical assessment of the premium associated with meeting or beating both time-series earnings expectations and analysts’ forecasts

Recent research provides evidence of a market premium accruing to firms that meet or beat analysts’ forecasts. We find similar results for our sample of firms. However, we also find a market premium for firms that meet or beat time-series forecasts, and that the highest market premium accrued to firms that meet or beat both analysts’ and time-series forecasts. These findings are supported by assessments of future financial performance over the next two subsequent years. Our findings are consistent with the notion that when time-series benchmark is used in conjunction with analysts’ forecasts, investors obtain a more reliable (i.e., less noisy) signal regarding whether firms have actually met or beaten market expectations.

Executive pay dispersion,corporate governance,and firm performance

Much of the research on management compensation focuses on the level and structure of executives’ pay. In this study, we examine a compensation element that has not received so far considerable research attention—the dispersion of compensation across managers—and its impact on firm performance. We examine the implications of two theoretical models dealing with pay dispersion—tournament versus equity fairness. Tournament theory stipulates that a large pay dispersion provides strong incentives to highly qualified managers, leading to higher efforts and improved enterprise performance, while arguments for equity fairness suggest that greater pay dispersion increases envy and dysfunctional behavior among team members, adversely affecting performance. Consistent with tournament theory, we find that firm performance, measured by either Tobin’s Q or stock performance, is positively associated with the dispersion of management compensation. We also document that the positive association between firm performance and pay dispersion is stronger in firms with high agency costs related to managerial discretion. Furthermore, effective corporate governance, especially high board independence, strengthens the positive association between firm performance and pay dispersion. Our findings thus add to the compensation literature a potentially important dimension: managerial pay dispersion.

The effect of controlling shareholders’ excess board seats control on financial restatements: evidence from Taiwan

This study examines the relation between controlling shareholders’ excess board seats control and financial restatements. An analysis of a sample comprising 106 Taiwanese listed firms (53 restating firms vs. 53 non-restating control firms) shows that financial restatements are more likely to occur when there is a greater divergence between controlling shareholders’ board seats control rights and ownership rights. We also find that the excess board seats control of controlling shareholders is positively associated with the materiality and pervasiveness of financial restatements. Overall, these results suggest that the entrenchment incentive from controlling shareholders’ excess control motivates firms to adopt aggressive accounting policies.

Can corporate governance save distressed firms from bankruptcy? An empirical analysis

We examine financially distressed firms and document how governance characteristics affect (1) a firm’s ability to avoid bankruptcy and (2) the power of financial/accounting information to predict bankruptcy. Overall, our findings indicate that a distressed firm’s governance characteristics significantly affect its probability of bankruptcy. We find that smaller and more independent boards with a higher ratio of non-inside directors and with larger ownership stakes of inside directors are more effective at avoiding bankruptcy once distress is indicated. These results are consistent with the belief that these types of governance structures induce more effective monitoring. The results are also consistent with the view that the inclusion of governance characteristics enhances the power of financial accounting models in predicting bankruptcy.

Underwriter warrants,underwriter reputation,and growth signaling

We present an alternative explanation of warrant use for underwriter compensation. We consider underwriter warrants as a signaling device to convey an issuing firm’s future growth potential and test this signaling role of warrant use by taking a direct approach in a seasoned equity offering (SEO) environment. Employing a matched-sample approach, we find that the use of warrants mitigates the negative price effects of SEOs. Specifically, the issuance of SEOs with warrant-based compensation has a significantly less negative impact on abnormal return performance than the issuance of SEOs with cash-based compensation. The results of logit regressions confirm this linkage. We further find that this less negative impact on firm value is attributable to the signaling value representing the issuing firm’s future growth prospects through warrant compensation even in the presence of underwriter reputation variables. These results suggest that firms with greater growth prospects benefit more by issuing SEOs with warrant compensation than with cash compensation. Overall, our results support the growth signaling effect of warrant compensation as an additional role of underwriter warrants in the SEO market.

Underwriter choice and earnings management: evidence from seasoned equity offerings

Using a sample of seasoned equity offerings (SEOs), this paper examines the association between the choice of financial intermediary and earnings management. We contend that with more stringent standards for certification and intense monitoring, highly prestigious underwriters restrict firms’ incentives for earnings management to protect their reputation and to avoid potential litigation risks, while firms with greater incentives for earnings management avoid strict monitoring by choosing low-quality underwriters. Consistent with our predictions, we find an inverse association between underwriter quality and issuers’ earnings management. In addition, we find that underwriter quality is positively related to SEOs’ post-issue performance, even after controlling for the effect of earnings management. We also find that firms with low-underwriter prestige and high levels of earnings management under-perform the most. However, the effect of underwriter choice on post-issue performance does not last long.

Make or buy new technology: The role of CEO compensation contract in a firm’s route to innovation

A firm’s board of directors, based on its risk tolerance or “appetite,” sets the corporate objectives. It is then the management’s job to meet the objectives by adopting appropriate strategies. However, the board can design compensation policies to encourage desired management strategy choices. This paper explores the extent to which management compensation policies are aligned with strategy choices for obtaining new technology. Firms obtain new technology either through internal R&D or through acquisitions, often labeled “make” and “buy” strategies, respectively. The “make” strategy is inherently more risky, with much of the high risk idiosyncratic. Furthermore, U.S. GAAP requires that R&D expenditures be expensed but allows capitalization of acquisition costs, thus a firm using the “make” as opposed to the “buy” strategy will experience a greater negative effect on accounting earnings. I hypothesize that these differences will lead risk-averse and utility-maximizing managers to implement the “buy” strategy if their compensation is heavily weighted on accounting-based performance measures. Conversely, managers with more stock-based compensation, especially stock options, are more likely to choose to develop new technology internally. Using data from U.S. high-tech industries and a simultaneous equations regression framework, I find evidence consistent with the above hypotheses.

Changes in CEO compensation structure and the impact on firm performance following CEO turnover

We document changes in compensation structure following CEO turnover and relate them to future performance. Compared to outgoing CEOs, incoming CEOs derive a significantly greater percentage of their compensation from option grants and new stock grants. The voluntary turnover sample shows similar changes in compensation structure while the forced turnover sample results suggest that new stock grants drive the significant increase in incentive compensation following turnover. Post-turnover performance is positively associated with new stock grants as a percentage of total compensation in the full sample and when analyzing forced and voluntary turnovers separately. We find limited evidence that future operating income is positively associated with option grants following forced turnover. Post-turnover improvement in operating income is positively associated with an increase in new stock grants for the incoming relative to the outgoing CEO.

Economic consequences of financial reporting changes: diluted EPS and contingent convertible securities

This paper examines the economic consequences of changes in the financial reporting requirements for contingent convertible securities (COCOs). Using a sample of 199 COCO issuers from 2000 to 2004, we find that issuers are more likely to restructure or redeem existing COCOs to obtain more favorable accounting treatment when the financial reporting impact on diluted earnings per share (EPS) is greater and when EPS is used as a performance metric in CEO bonus contracts. These results provide new evidence that managers are willing to incur costs to retain perceived financial reporting and compensation benefits. We also present evidence of significantly negative stock returns around event dates associated with the financial reporting changes, consistent with investor anticipation of the agency costs associated with the rule change.

Voluntary disclosure of accruals in earnings press releases and the pricing of accruals

This study investigates firms’ decisions to disclose accruals information in earnings press releases versus to provide it only in 10-Q filings and the impact of this disclosure on the pricing of accruals. I find that firms disclose accruals in their press releases when earnings alone are a weak indication of cash flow performance and that following these disclosures the accruals information is fully impounded into stock prices. The evidence suggests that when investor demand for accruals is likely to exist and firms disclose the information in earnings press releases, the mispricing typically associated with accruals is mitigated.

Accounting conservatism and corporate governance

We predict that firms with stronger corporate governance will exhibit a higher degree of accounting conservatism. Governance level is assessed using a composite measure that incorporates several internal and external characteristics. Consistent with our prediction, strong governance firms show significantly higher levels of conditional accounting conservatism. Our tests take into account the endogenous nature of corporate governance, and the results are robust to the use of several measures of conservatism (market-based and nonmarket-based). Our evidence is consistent with the direction of causality flowing from governance to conservatism, and not vice versa, indicating that governance and conservatism are not substitutes. Finally, we study the impact of earnings discretion on the sensitivity of earnings to bad news across governance structures. We find that, on average, strong-governance firms appear to use discretionary accruals to inform investors about bad news in a timelier manner.

The relation between R&;D intensity and future market returns: does expensing versus capitalization matter?

The Australian accounting environment provides an ideal setting for examining the impact of different accounting treatments of firms’ R&D activities on their subsequent returns. Unlike US firms, which can only expense R&D, Australian GAAP permits firms to either expense or capitalize their R&D expenditure. We examine separately the market impact of the R&D intensity of all R&D active firms, ‘capitalizers’ and ‘expensers’. Our results suggest that firms with higher R&D intensity perform better, regardless of the accounting method used, consistent with the resource-based view of the firm. We also find some evidence that firms which expense R&D outperform those which capitalize R&D after controlling for R&D intensity.

Board size and firm performance: the moderating effects of the market for corporate control

We examine whether takeover threats affect the importance of board size using the passage of state antitakeover laws enacted in mid-to-late 1980s as our empirical setting. While the Complement Hypothesis predicts that board size matters more before the passage of the laws, the Substitute Hypothesis predicts the opposite. For a sample of 350 Forbes 500 firms over the period 1984–1991, we find a significant association between smaller boards and better firm performance before passage of antitakeover laws, but a much weaker relation (reduced by more than one-third) after the takeover restrictions were in place. Consistent with the Complement Hypothesis, this finding suggests that decreasing board size is more valuable when the market for corporate control is more active.

Disclosure of fees paid to auditors and the market valuation of earnings surprises

We investigate if the SEC’s recently mandated disclosure of fees for audit and nonaudit services paid by firms to their incumbent auditors affected the market’s perception of auditor independence and earnings quality. Following the initial fee disclosures in 2001, we find that the market valuation of quarterly earnings surprises (earnings response coefficient) was significantly lower for firms with high levels of nonaudit fees than for firms with low levels of such fees. In contrast, in the year prior to the new fee disclosures, there was no reduction in earnings response coefficients for firms that subsequently reported high nonaudit fees. Our evidence suggests that mandated fee disclosures provided new information that was viewed by the market as relevant to appraising auditor independence and earnings quality.

Trading House Price Risk with Existing Futures Contracts

This paper examines the use of futures contracts to hedge residential real estate price risk. We examine whether existing futures contacts can effectively be used to offset volatility in national house prices. Little evidence of any simple systematic relation between national prices and futures prices is found. Since house prices are not easily replicated with a portfolio of existing futures contracts, a further implication is that the Chicago Mercantile’s introduction of a financial asset whose value reflects house prices will help complete the market. Nevertheless, the success of the CME’s new derivative contracts may be limited in light of state and regional house price correlations.