Discussion of Corporate Governance Reform and Executive Incentives: Implications for Investments and Risk Taking

We discuss the strengths and weaknesses of the article by Cohen, Dey and Lys (CDL). Strengths include persuasive theoretical arguments for impacts of the Sarbanes Oxley Act (SOX) on corporate investment strategies and for several mechanisms through which firms influence changes in risky investments. CDL also provides intriguing opportunities for learning about impacts of external regulatory events and for enriching management accounting research and classroom discussions of management control. Weaknesses include (1) narrow scope, perhaps driven by archival data availability; (2) difficulties in implementing the research design and method; (3) possible bias of incentive and investment measures; (4) incomplete estimates of the effect of SOX on compensation, incentives, and investments; and (5) questionable control of endogeneity. We offer recommendations from extant literature to mitigate these weaknesses in future research.     

CEO Hedging Opportunities and the Weighting of Performance Measures in Compensation Contracts

This study examines the rather controversial practice of managerial hedging, which allows CEOs to delink their compensation from stock price performance. We presume that boards are aware of these practices and adjust the weights placed on accounting‐based and stock‐based performance measures in executive compensation contracts to mitigate the problem. Empirically, we find that, in the presence of managerial hedging opportunities, accounting‐based performance measures receive more weight, whereas stock‐based performance measures receive less weight in determining executive compensation. Moreover, these results are more pronounced when managerial hedging needs are high. Regarding the effects of earnings management resulting from accounting‐based incentives, we find that good auditing and strong governance mechanisms strengthen the benefit of placing more weight on accounting‐based performance measures. Taken together, our findings suggest that corporate boards shift the relative weights of performance measures in compensation contracts in response to managerial hedging opportunities, which is consistent with optimal contracting.     

The Effects of Governance on Classification Shifting and Compensation Shielding

Prior research (e.g., Dechow, Huson, and Sloan 1994 ) documents that, on average, compensation practices appear to shield CEO pay from income‐decreasing special items. In some circumstances, compensation shielding can be efficient. For example, it may encourage CEOs with earnings‐sensitive pay to take an action that reduces current earnings but nevertheless enhances value. Compensation shielding can be inefficient in other circumstances, such as when a board of directors is captured by an overly powerful CEO or the magnitude of negative special items has been overstated (e.g., by shifting core expenses into special items). This paper explores whether strong governance can explain cross‐sectional variation in compensation shielding, and whether stronger governance and auditing are associated with less shifting of expenses. We find that strong corporate governance mechanisms, as captured by board (and committee) independence, the Sarbanes‐Oxley (2002) Act (SOX) and its related governance reforms, and switches to Big 4 auditors, are all associated with less compensation shielding. While our evidence suggests that strong overall governance is associated with a reduction in manipulation of core earnings through classification shifting in the cross‐section, we find inconclusive evidence to suggest that board independence or SOX influence classification shifting.     

Deferred Executive Compensation Policies in Chinese State-owned Enterprises

Since the commencement of industrial reform in China, most Chinese state‐owned enterprises have adopted a deferred executive compensation policy to provide incentives for their management teams. However, the effectiveness of such a policy needs to be evaluated. In this paper, we specify a model of deferred executive compensation policy, in which the compensation for executives is contingent on firms' future revenue. The model suggests that under deferred executive compensation policies, managers exhibit an increasing level of effort in every period. Furthermore, the deferred compensation policy encourages managers to make long‐term investments, which might generate revenue even after the termination of managerial contracts.     

Equity‐Based Compensation of Outside Directors and Corporate Disclosure Quality

We examine the relationship between a firm's disclosure quality and equity‐based compensation of independent members of the board of directors. The dimensions of disclosure quality we focus on are management's earnings guidance and information flowthrough financial analysts. Using both levels and changes specifications, we find the average ratio of equity‐based pay to total pay of independent board members to be positively related to a firm's disclosure quality. Our findings are robust to the inclusion of management's equity‐based compensation, other governance measures, and financial controls, and robust to instrumental variable tests of endogeneity. Furthermore, we find directors’ equity‐based compensation to be negatively associated with the firm's cost of equity capital. Our results are consistent with equity‐based compensation providing incentives to independent directors to push for better disclosure quality.     

Corporate Investment Incentives and Accounting‐Based Debt Covenants*

This paper studies the conditions under which accounting‐based debt covenants increase firm value in a setting that incorporates the conflicting incentives of shareholders, bondholders, and managers. We construct a model in which debt is needed to discipline managerial investment decisions despite endogenous compensation contracts. We show that accounting covenants increase value when (1) debt serves as a credible commitment to penalize poor investment decisions; (2) the firm faces other (exogenous) sources of uncertainty that can make debt risky despite good investment decisions; and (3) accounting information serves as a contractible proxy for firm's economic performance. In these circumstances, accounting covenants ensure that shareholders do not offer compensation schemes that would encourage bondholder wealth expropriation when the debt becomes risky. A covenant specifying a required level of accounting performance provides additional bondholder power when performance is low. An accounting‐based dividend covenant allows a disbursement to maintain investment incentives when performance is high without allowing dividend‐based expropriation. The optimal covenants depend on the reliability of accounting information, and the interaction between accounting performance and the different incentive conflicts provides new insight into the empirical literature on accounting‐based covenants.     

Outside Blockholders' Monitoring of Management and Debt Financing

Corporate governance mechanisms designed to alleviate manager‐shareholder agency conflicts can worsen shareholder‐bondholder conflicts. This study examines how one such corporate governance mechanism, monitoring by large outside shareholders, influences the choice between public and private debt. I conjecture and find that firms with higher outside blockholdings are inclined to choose bank loans over public debt when they borrow, consistent with the notion that banks are better monitors than public debt markets. I also find that bank loans carry less price protection than corporate bonds against increased agency risk associated with outside blocks. Corroborating the monitoring story, I document that bank loans contain more accounting‐based covenants and dividend restriction provisions for firms with higher outside blockholdings than for those with lower blockholdings. I find no such relation for public debt covenants. This supports that banks' monitoring of their loans counters the agency risk caused by blockholders. This study extends prior research that associates governance mechanisms with agency costs of debt, by incorporating lenders' differential monitoring mechanisms in the overall corporate governance system.     

Tax Avoidance and the Implications of Weak Internal Controls

I examine whether corporate tax avoidance is associated with internal control weaknesses (ICWs) disclosed under the Sarbanes‐Oxley Act (SOX). ICWs disclosed under SOX are frequently related to a firm's tax function. When pervasive ICWs exist, the likelihood increases that these frequent tax‐related ICWs spill over from financial reporting issues to tax avoidance objectives. Thus, my research helps corporate stakeholders understand the implications of internal controls beyond simply financial reporting objectives. Results indicate that, on average, firms with a tax‐related ICW have a 4 percent higher three‐year cash effective tax rate relative to firms without any such weaknesses. Further estimates reveal that this negative relation stems from pervasive, company‐level tax ICWs. Analysis of remediation suggests a causal link. I find that after remediating tax‐related ICWs, firms report higher levels of tax avoidance in the future. Broadly, these findings support that internal control quality represents a proxy for internal governance, and thus the strength of alignment between managers and shareholders. Furthermore, tax‐related internal controls represent an important underlying determinant of tax avoidance with significant cash flow effects, and implications beyond financial reporting.     

Can Employee Stock Options Contribute to Less Risk-Taking?

The executive compensation literature presumes that shareholders offer risk-averse managers stock options to entice them to take on more risk, resulting in riskier investment decisions and thus a greater return on investment. However, recent empirical work challenges this assumption, and theoretical research even argues that high levels of option-based compensation for generally under-diversified managers may actually lead to greater risk aversion. We evaluate the incentive structure of employee stock options by examining the level of R&D investment and the return on that investment conditional on the portfolio “vega,” which captures the sensitivity of option value to stock price volatility. Our results suggest that both investment in R&D and the return on R&D, as measured by future earnings and patent awards, varies concavely with vega. That is, low to moderate levels of vega correspond to increasing investment in and returns on R&D, consistent with vega inducing more profitable investments, but marginal returns decline as vega increases. Collectively, these results, bolstered by several supplemental analyses, suggest that this surprising relation between vega and risky investment is driven by greater risk aversion at higher levels of vega. Overall, our results imply that employee stock options may not always align the incentives of managers and shareholders.     

A comparison of shareholder identity and governance mechanisms in the monitoring of CEOs of listed companies in China

This paper compares the relative effectiveness of two measures by which the Chinese government attempted to improve the monitoring of listed companies: shifting the ownership of state shares from government agencies (GAs) to the corporate form of state-owned enterprises (SOEs), and strengthening corporate governance through statutory regulations and guidelines. The results show that SOEs are better able than GAs to monitor top executives, as indicated by a higher sensitivity of top executive turnover to firm performance. However, corporate governance mechanisms have no significant impact on the sensitivity of top executive turnover to firm performance. This study suggests that incentives for controlling shareholders are more important than governance mechanisms in replacing executives due to poor performance in a transitional economy such as China's, where institutions that support governance mechanisms are still being developed.     

Credit Ratings and CEO Risk‐Taking Incentives

This study examines the sophistication of rating agencies in incorporating managerial risk‐taking incentives into their credit risk evaluation. We measure risk‐taking incentives using two proxies: the sensitivity of managerial wealth to stock return volatility (vega) and the sensitivity of managerial wealth to stock price (delta). We find that rating agencies impound managerial risk‐taking incentives in their credit risk assessments. Assuming other things equal, a one standard deviation increase in vega (delta) will lead to an approximately one‐notch (two‐notch) rating downgrade. In addition, we evaluate the significance of credit ratings in the design of CEO compensation. Our findings suggest that rating‐troubled firms will gear down managerial incentives of risk seeking. In particular, other things equal, a rating downgrade to the lower edge of the investment category (i.e., BBB?) in the immediate prior year will bring about an approximately 51 percent reduction of vega incentive from options newly granted to the CEO in the current year. However, we find no evidence that firms' rating concerns significantly affect delta. Given the significance of credit ratings in the marketplace and their close connection to accounting, the findings of the current study advance our understanding, not only of how sophisticated rating agencies are in incorporating forward‐looking information (i.e., vega and delta) into risk assessments, but of how influential the raters are in changing firms' compensation policies. The findings also have implications on the role of accounting in constraining excessive managerial risk taking with improved disclosures on managerial compensation.     

Can Shareholders Be at Rest after Adopting Clawback Provisions? Evidence from Stock Price Crash Risk

Using a propensity score matched sample and a difference‐in‐differences research design, we find that stock price crash risk increases after a firm voluntarily incorporates clawback provisions in executive officers' compensation contracts. This heightened crash risk is concentrated in adopters that increase upward real activities‐based earnings management and those that reduce the readability of 10‐K reports. Based on cross‐sectional analyses, we also find that the increased crash risk is more pronounced for adopters with high ex ante fraud risk, low‐ability managers, high CEO equity incentives, and low dedicated institutional ownership. Collectively, our results suggest that the clawback adoption per se does not curb managerial opportunism but rather induces managers to use alternative channels for concealing bad news, which may contribute to a greater stock price crash risk; and the increase in crash risk is more likely in cases where incentives are strong or monitoring is weak. Our results should be of interest to regulators and policymakers considering the effects of clawback adoption on the investing public.     

Corporate In‐house Tax Departments*

In‐house human capital tax investment is a significant input to a firm's tax decisions. Yet, due to the lack of data on corporate in‐house tax departments, there is little empirical evidence on how tax departments are associated with tax planning and compliance outcomes. We expect the size of tax departments to be positively associated with the effectiveness of tax planning and compliance. Using hand‐collected data on the number of corporate tax employees in S&P 1500 firms over the 2009–2014 period, we find that firms with larger tax departments are associated with lower and less volatile cash effective tax rates. Furthermore, using tax employees' specialization, we identify tax departments' relative focus on planning or compliance and document a trade‐off between tax avoidance and tax risk. Specifically, tax departments with more of a tax planning focus have incrementally greater tax avoidance but higher tax risk, whereas tax departments with more of a tax compliance focus have incrementally lower tax risk but higher tax rates. Overall, this paper contributes to the literature by looking inside the “black box” of corporate tax departments and shedding light on the importance of human capital tax investment for tax outcomes.     

营销投入、高管激励和企业绩效关系的实证研究——基于159家农业类A股上市公司的数据

选取159家A股农业类上市公司数据，考察营销投入、高管激励对企业绩效的影响，并运用阿尔蒙（Almon）法测定营销投入对企业绩效影响的滞后期。研究发现：营销投入与企业财务绩效和市场绩效均呈显著倒“U”形关系；营销投入对企业财务绩效和市场绩效的影响分别滞后2期和3期；高管股权激励正向调节营销投入对企业绩效的影响；高管薪酬激励仅正向调节营销投入对财务绩效的影响。研究成果可为农业企业市场营销策略和政策制定提供决策参考。     

Effect of promotion pressure and financial burden on investment in public–private partnership infrastructure projects in China

By identifying the political motives of officials and local governments, this study aims to provide a new political economic analysis framework for understanding China's incentives for investing in public–private partnership (PPP) infrastructure projects. Chinese urban panel data for the period 2013–17 were used to examine the mechanisms of promotion pressure and financial burden in relation to investments in PPP infrastructure projects. Based on our findings, the following policy recommendations are proposed: standardise the behaviour of local government officials in promoting PPP projects, establish a lifelong accountability mechanism for PPP project performance, establish a mechanism for local government debt risk assessment and prevention, and avoid the risk of local debt arising from over‐investment in PPP infrastructure projects. Moreover, a match should be formed between local economic infrastructure planning and investment plans to avoid over‐ or under‐investment.     

The Association between the Legal and Financial Reporting Environments and Forecast Performance of Individual Analysts*

We test the ability of analyst characteristics to explain relative forecast accuracy across legal origins (common law versus civil law). Common‐law countries generally have more effective corporate governance mechanisms, including stronger investor protection laws and inputs provided through higher‐quality financial reporting systems. In this type of environment, we predict that analysts with superior ability and resources in common‐law countries will more consistently outperform their peers because appropriate market‐based incentives exist. In civil‐law countries, where the demand for earnings information is reduced because of weaker corporate governance mechanisms and lower‐quality financial reporting, we predict that analysts with superior ability will less consistently provide superior forecasts. Results are consistent with our expectations and suggest an association between legal and financial reporting environments and analysts' forecast behavior.     

Operations of a Pension Fund after the Asian Crisis: The Thai Experience*

During and after the Asian crisis, institutional investors and pension funds in Asian financial markets have been confronted with a number of difficulties effecting their performance and the way they carry out their role within the national pension system. We analyze these problems by comparing the actual investment policy of an institutional investor with an optimal investment strategy derived from the insights of modern portfolio theory. We also analyze whether the organizational set‐up of a pension fund allows it to adequately perform its role within the pension system. As an example, we examine the operations of the Thai Government Pension Fund (GPF). We find that allowing international investments and reducing restrictions on equity investments while lowering the implicit requirements for investments in government debt would allow the GPF to further diversify its investment risk and to increase its risk‐adjusted return. We also show that some changes in the governance structure of the GPF would lower the occurrence of conflicts of interest for the management and increase the efficiency of the GPF operations.     

EBITDA and Managers' Investment and Leverage Choices

EBITDA is a commonly used performance measure for (i) valuation, (ii) debt contracting, and (iii) executive compensation. The widespread use of EBITDA by stakeholders may induce managers to focus their attention on EBITDA. Since EBITDA excludes various expenses, managers who fixate on EBITDA may underweight the excluded expenses when determining their firms' investments in capital and leverage levels. I find that managers who fixate on EBITDA overinvest in capital and overlever their firm relative to their industry peers. These results are robust to alternative proxies for managers' focus on EBITDA and alternative specifications. I also find that firms whose managers focus on EBITDA have weaker operating performance, which is attributed to higher depreciation expense. My primary proxy for managers' focus on EBITDA is whether they choose to disclose EBITDA in annual earnings announcements. I find that the use of EBITDA in setting executive compensation, the prevalence of EBITDA estimates by analysts, and the use of EBITDA‐based covenants in firms' debt contracts are all positively associated with the propensity to disclose EBITDA in earnings announcements. I find weaker evidence of opportunistic motives explaining EBITDA disclosure. These results are consistent with managers disclosing EBITDA to portray to investors that it is a metric they seek to maximize. Overall, this study suggests that while EBITDA is a widely used metric, there is a systematic cost to using this measure—it provides managers with incentives to overinvest in capital and to acquire excessive debt.     

Accounting-Based Compensation and Debt Contracts*

We examine how accounting-based compensation plans influence a firm's contracts with its creditors. After granting long-term accounting-based compensation plans (LTAPs) to CEOs, firms pay lower spreads and have fewer restrictive covenants in new bank loans. Mechanisms leading to lower borrowing cost include improvements in debt repayment ability, reduced shareholder-debtholder conflicts, and reduced risk-taking incentives. Creditors view LTAPs as a substitute for monitoring, adjust covenant design based on LTAP features, and value plans with concave performance-payout functions and reasonable performance targets. A firm's credit rating improves and CDS spread declines after LTAP grants, suggesting that LTAPs help reduce firms' credit risk.     

Tax Incentives and Maturity Mismatch between Investment and Financing: Evidence from China

This paper examines the effects of China's accelerated depreciation policy (ADP) on the maturity mismatch between investment and financing. Using panel data for China's A-share nonfinancial listed companies from 2010 to 2019 and a staggered difference-in-differences approach, we found the following. First, ADP significantly aggravated the degree of corporate maturity mismatch, and this result was robust across multiple checks. Second, due to an insufficient long-term loan supply, firms had to finance the fixed investments induced by ADP with short-term debts, leading to maturity mismatches. Third, the positive policy effects were mainly significant for firms with high policy exposure, high-risk preferences, a high degree of information asymmetry, and firms with weak long-term financing capacity. Finally, maturity mismatch exacerbated corporate financial risks. Our research findings indicate that passive maturity mismatch is prevalent among Chinese companies and emphasize the need to address financial repression in order to mitigate the potential financial risks that may arise from tax incentives.