Relative performance evaluation and executive compensation: Evidence from Chinese listed companies

This paper focuses on the effect of relative performance evaluation (RPE) on top managers’ compensation in Chinese public firms. Overall, we find no evidence of an RPE effect or any asymmetry in firms’ use of RPE. The results obtained using Albuquerque’s (2009) method are similar to those obtained using traditional methods. In addition, we find that RPE is used more in non-SOEs than in SOEs. This may be due to the regulation of compensation, various forms of incentives and the multiple tasks of managers in SOEs.     

Mandatory IFRS Adoption and the Contractual Usefulness of Accounting Information in Executive Compensation

We examine how the mandatory adoption of International Financial Reporting Standards (IFRS) in continental Europe affects the contractual usefulness of accounting information in executive compensation, as reflected in pay‐performance sensitivity (PPS) and relative performance evaluation (RPE). The empirical evidence indicates a weak increase in accounting‐based PPS in the post‐adoption period, primarily driven by countries with large differences between IFRS and their previously adopted local accounting standards. We also document a significant increase in accounting‐based RPE using foreign peers after the adoption. Additional analysis shows that the increase in RPE is greater for firms with more foreign sales, and for those with lower availability of domestic peers of comparable size. The overall results are consistent with the compensation committees in those countries perceiving earnings after IFRS adoption to be of higher quality and comparability. Our paper highlights an important benefit of IFRS largely ignored by the literature, that is, the higher earnings quality and comparability brought by the adoption of IFRS facilitate executive compensation contracting.     

US Managers' Use of 'Pro Forma' Adjustments to Meet Strategic Earnings Targets

Abstract:  The practice of reporting manager-adjusted 'pro forma' earnings numbers in quarterly earnings press releases has attracted considerable attention in recent years in the United States. Prior research suggests that while some managers report these adjusted numbers to better reflect core earnings, others may use these earnings adjustments to meet strategic earnings targets on a pro forma basis when they fall short based on GAAP reporting standards. Assuming the latter motivation could potentially mislead investors, the difficulty lies in distinguishing the 'good guys' from the 'bad guys.' Using hand-collected pro forma earnings data, we investigate the extent to which different types of earnings adjustments affect the spread between pro forma earnings and GAAP earnings from continuing operations. Moreover, we investigate which types of adjustments managers use to meet strategic earnings targets. In addition to the exclusion of one-time items like restructuring charges, the results indicate that managers often exclude recurring expenses such as depreciation, research and development, and stock-based compensation to meet these strategic targets. The exclusion of recurring items is especially indicative of aggressive pro forma reporting. Finally, we find that firms that report adjusted earnings numbers only sporadically are more likely than firms that adjust earnings figures on a regular basis to use pro forma reporting to achieve strategic earnings targets by excluding recurring items.     

Firm life cycle stages and earnings management

We provide evidence that the differences in economic growth and stability of firms during different stages of their life cycle encourage managers to manage the reported earnings differently to achieve their goals. Our findings support the expectation that managers adjust the reported earnings upward using positive discretionary accruals during the introductory and decline stages of firm life cycle. The upward adjustment of reported earnings during the introductory stage enables them to achieve the objective of sending positive signals on firm performance when the firm is in a formative stage, and also provides a better base for prediction of future earnings. The upward adjustment of reported earnings during the decline stage are expected to enhance firm’s life, which would enable managers to take remedial actions to improve firm performance, especially when the firm is in a distress situation. On the other hand, our findings show that managers may consider using negative discretionary accruals during the growth and maturity stages so that they can save some earnings for use during later years when firm performance compared to market expectations is weak. The managers are, however, not likely to adjust the reported earnings downward when the reported earnings fall short of market expectations. Additionally, we find that large institutional shareholdings perform effective monitoring and discourage managers to use discretionary accruals because their use may result in lower reliability of reported earnings.

     

Auditor reporting and earnings management: some additional evidence

This paper investigates the reasons that lead to modification of auditors’ opinions. We revisit the conclusions of prior US‐based research on whether a modification highlights likely earnings management activities. Extending this research, we consider an alternate explanation that managers adjust accruals to report earnings that better predict future firm performance, which has the side‐effect of placing them in conflict with their auditors. Our study sample comprises all firms listed on the Australian Stock Exchange over the period 1999–2003. Consistent with prior research, there is no evidence of earnings management leading to an audit opinion modification. However, we do show that firms receiving inherent uncertainty modifications (other than going concern) have greater persistence of earnings (accruals) relative to other firms. This is consistent with the proposition that managers have made policy choices in reporting current earnings, with which their auditors disagree, that will likely result in a greater ability to forecast the firm's future earnings.     

Detailed management earnings forecasts: do analysts listen?

We provide archival evidence on how a particular type of supplementary information affects the credibility of management earnings forecasts. Managers often provide detailed forecasts of specific income statement line items to shed light on how they plan to achieve their bottom-line earnings targets. We assess the effect of this forecast disaggregation on the credibility of management earnings forecasts. Based on a relatively large hand-collected sample of 900 management earnings forecasts, we find that disaggregation increases analysts’ sensitivity to the news in managers’ earnings guidance, suggesting that analysts find the guidance more credible. More importantly, we identify several factors that influence this relation. First, disaggregation plays a more important role when earnings are otherwise more difficult to forecast. Second, disaggregation is more important after Regulation Fair Disclosure prohibited selective disclosure, especially for firms that were more affected because they had previously provided more private guidance. Finally, in contrast to common assertions in the prior literature, we find that, in more recent years, disaggregation matters more for guidance that conveys bad news. Managers as well as researchers should be interested in evidence suggesting that financial analysts find disaggregation especially helpful in contexts where managers’ credibility is particularly important.     

Accruals Management to Avoid Losses

This study examines whether firms engage in accruals management to beat the zero earnings benchmark from the perspective of earnings per share (EPS). Based on net income scaled by lagged market value of equity (E/MV) to define just‐miss and just‐beat test bins, previous studies provide no or inconclusive evidence of accruals management to beat the zero earnings benchmark. I conjecture that because managers focus on shares scaled earnings performance rather than market value scaled earnings performance, forming test bins based on EPS instead of E/MV is a better approach to detect accruals management. As expected, I find evidence of accruals management to beat the zero EPS benchmark. I also find that firms are more likely to manipulate accruals when managers have stronger incentives to beat the zero EPS benchmark. In addition, accruals of firms just beating the zero EPS benchmark are more likely to reverse the next year, resulting in relatively lower future earnings for firms just beating the benchmark compared with firms just missing the benchmark.     

Disentangling Managers’ and Analysts’ Non‐GAAP Reporting

Researchers frequently proxy for managers’ non‐GAAP disclosures using performance metrics available through analyst forecast data providers (FDPs), such as I/B/E/S. The extent to which FDP‐provided earnings are a valid proxy for managers’ non‐GAAP reporting, however, has been debated extensively. We explore this important question by creating the first large‐sample data set of managers’ non‐GAAP earnings disclosures, which we directly compare to I/B/E/S data. Although we find a substantial overlap between the two data sets, we also find that they differ in systematic ways because I/B/E/S (1) excludes managers’ lower quality non‐GAAP numbers and (2) sometimes provides higher quality non‐GAAP measures that managers do not explicitly disclose. Our results indicate that using I/B/E/S to identify managers’ non‐GAAP disclosures significantly underestimates the aggressiveness of their reporting choices. We encourage researchers interested in managers’ non‐GAAP reporting to use our newly available data set of manager‐disclosed non‐GAAP metrics because it more accurately captures managers’ reporting choices.     

Accounting comparability and relative performance evaluation in CEO compensation

We investigate whether accounting comparability is associated with the likelihood that CEO compensation is tied to relative accounting performance (e.g., return on assets). We predict that higher accounting comparability increases the risk-sharing benefit of accounting-based RPE because peer firm performance better controls for common risk in RPE firm performance. Thus, firms that have higher accounting comparability with potential performance peers will be more likely to include accounting-based RPE as a component of the total CEO compensation contract. We find support for this prediction using (1) an explicit test design that relies on the ex ante terms of CEO compensation contracts obtained from proxy disclosures, and (2) an implicit design that relies on the actual realizations of CEO compensation. To provide further evidence, we examine the association between accounting comparability and the selection of performance peers when the CEO compensation contract includes an accounting-based RPE component. We find that higher comparability between the RPE firm and a potential peer firm increases (decreases) the potential peer firm’s likelihood of being selected into (dropped from) the peer group. Cross-sectional analyses show that this association is less pronounced, or not present, when the relative performance measure is price-based (as opposed to accounting-based), indicating that these results do not merely reflect a more general role of comparability in all RPE contracts.     

On the relation between managerial power and CEO pay

We study how friendly boards design the structure of optimal compensation contracts in favor of powerful CEOs. Our study yields unexpected results. First, powerful managers receive higher pay and a contract with a higher pay-performance sensitivity (PPS) if firm performance is low and vice versa. Moreover, we identify conditions where expected pay and expected PPS are both increasing in the friendliness of the board. Second, we show that friendly boards provide managers with higher salaries, more shares, but less options. Third, friendly boards offering contracts with a higher PPS also make more intensive use of relative performance evaluation (RPE). Overall, our results suggest that frequently used indicators of poor (or sound) compensation practices should be interpreted with care. Extending the scope of our model beyond executive pay, we show that powerful managers underinvest in capital but have less incentives to manage earnings.     

VOLUNTARY DISCLOSURE PRACTICES: THE USE OF PRO FORMA REPORTING

This article looks at how U.S. managers supplement GAAP earnings with pro forma reporting. Pro forma measures, which are not audited, are typically determined through an adjustment to GAAP-based earnings. For example, a manager may choose to present an alternative to GAAP earnings that excludes period write-offs and one-time restructuring charges in order to present a more value-relevant picture of the company's performance.
The authors find that 77% of S&P 500 companies report pro forma results, and that pro forma measures are generally given greater prominence than GAAP earnings in corporate press releases. Based on the evidence, U.S. managers are using pro forma reporting strategically to affect investor perception of corporate performance. The SEC has recently issued rules to ensure that pro forma disclosure is not misleading. The authors present some guidelines on voluntary disclosure that might help forestall further regulation and preserve the ability to pursue this potentially informative practice.     

Relative performance evaluation and peer-performance summarization errors

In tests of the relative performance evaluation (RPE) hypothesis, empiricists rarely aggregate peer performance in the same way as a firm’s board of directors. Framed as a standard errors-in-variables problem, a commonly held view is that such aggregation errors attenuate the regression coefficient on systematic firm performance towards zero, which creates a bias in favor of the strong-form RPE hypothesis. In contrast, we analytically demonstrate that aggregation differences generate more complicated summarization errors, which create a bias against finding support for strong-form RPE (potentially inducing a Type-II error). Using simulation methods, we demonstrate the sensitivity of empirical inferences to the bias by showing how an empiricist can conclude erroneously that boards, on average, do not apply RPE, simply by selecting more, fewer, or different peers than the board does. We also show that when the board does not apply RPE, empiricists will not find support for RPE (that is, precluding a Type-I error).     

Management earnings forecast and financial statement complexity

We investigate the manager’s earnings forecasting strategy when financial statement complexity becomes a significant issue in capital markets. We suppose that complexity in financial statements arises from complexity of firm’s business transactions (business complexity) or complexity of associated reporting standards (reporting complexity) as mentioned in Guay et al. (2016). We find that a manager’s forecasting strategy depends on whether financial statement complexity stems from business or reporting complexity. Specifically, we indicate, among other observations, that managers who initially announced optimistic earnings forecasts will revise and release pessimistic earnings forecasts when financial statement complexity stems from reporting complexity.     

Management of Earnings and Analysts' Forecasts to Achieve Zero and Small Positive Earnings Surprises

Abstract:  This paper corroborates the finding of prior studies that managers avoid reporting earnings lower than analyst forecasts (i.e., negative earnings surprises) and provides new evidence of actions contributing to this phenomenon. Specifically, we provide empirical evidence of both (1) upward management of reported earnings and (2) downward 'management' of analysts' forecasts to achieve zero and small positive earnings surprises. Further analysis of the components of earnings management suggests that both the operating cash flow and discretionary accruals components of earnings are managed.     

Overvalued equity,benchmark beating and unexpected accruals

We investigate the extent to which the overvaluation hypothesis provides incentives for managers to beat earnings benchmarks, and whether this benchmark beating can be reliably interpreted as evidence of earnings management. We carefully identify firms immediately above earnings benchmarks that have a priori, overvaluation‐based incentives to achieve the benchmark. We therefore focus on benchmark‐beating observations where manipulation is most likely, providing a more powerful test of the existence of opportunistic financial reporting. Consistent with overvaluation‐related incentives encouraging earnings management, we find that overvalued firms that just exceed levels‐related earnings benchmarks have higher unexpected accruals than firms with less extreme valuations.     

To What Extent Does the Financial Reporting Process Curb Earnings Surprise Games?

Managers play earnings surprise games to avoid negative earnings surprises by managing earnings upward or by managing analysts' earnings expectations downward. We investigate the effectiveness of the financial reporting process at restraining earnings surprise games. Because the annual reporting process is subject to an independent audit and more rigorous expense recognition rules than interim reporting, it provides managers with fewer opportunities to manage earnings upward. We document that, relative to interim reporting, annual reporting reduces the likelihood of income‐increasing earnings management and, to a lesser extent, of negative surprise avoidance, but increases the magnitude of downward expectations management. Our findings suggest that regulatory attempts to monitor corporations' internal checks and balances are likely to be more effective at curbing upward earnings management than at mitigating negative surprise avoidance.     

Performance peer groups in CEO compensation contracts

How do firms choose performance peer groups used in chief executive officer (CEO) relative performance evaluation contracts? We find that while firms, for the most part, choose performance peers to better identify their CEOs’ impact on firm performance, they also tend to select underperforming peers. Dynamically, we find that peers that are added and retained every year are weaker than ones that were not chosen. These findings suggest managers may have some influence on the choice of performance peers. Finally, using a quasi-natural experiment, we find that enhanced disclosure did not affect the tendency of firms to select underperforming peers.     

An Investigation of Auditors’ Judgments When Companies Release Earnings Before Audit Completion

The majority of U.S. public companies release annual earnings prior to the completion of audit fieldwork. We investigate this phenomenon in a controlled experiment with audit partners and senior managers. We find that releasing earnings before completion of the audit pressures auditors to adopt the goals of management, thereby reducing the likelihood of post‐announcement audit‐adjustment recommendations. We also examine the effect of audit committee (AC) strength in improving auditors’ judgments after annual earnings are released. When ACs are actively involved in accounting issues and proactively communicating with auditors—characteristics currently lacking in most ACs—the negative effects on auditors’ judgments are completely mitigated. Our study provides evidence on potential unintended consequences of early release of earnings and the importance of investing in high‐quality ACs to mitigate adverse effects of client pressures on audit judgment and financial reporting quality.     

THE ASSOCIATION BETWEEN ANALYSTS’ FORECAST REVISIONS AND EARNINGS COMPONENTS: THE EVIDENCE OF FRS 3

This study examines whether the earnings components as required by FRS 3 help UK analysts to predict firms’ earnings changes by investigating the statistical association between analysts’ forecast revisions and firms’ unexpected earnings components. I find that analysts’ forecast revisions made in different time horizons are consistently associated with unexpected earnings components as required by FRS 3. UK analysts are able to incorporate current-year unexpected earnings components into their current and future earnings forecasts even before firms officially release this information. However, empirical results also show that current-year unexpected earnings components are not fully incorporated into analysts’ forecasts of future earnings. Analysts appear to wait for more information releases regarding firms’ future earnings and delay their revisions of future earnings forecasts. This is consistent with the evidence that the cumulative revisions of current earnings forecasts are generally associated with prior-year unexpected earnings components, and the association appears to be stronger as time progresses. Overall, this study provides evidence suggesting that the earnings components as required by FRS 3 help UK analysts to identify firms’ permanent and transitory earnings changes over different forecast horizons. This study also provides strong evidence supporting the informativeness of earnings components for analysts’ forecasts and the information set perspective of FRS 3 that highlights the importance of earnings components in predicting a reporting entity’s future performance.     

Relative performance evaluation in board cash compensation: UK empirical evidence

This paper presents an empirical examination of whether evidence of the implicit use of relative performance evaluation (RPE) can be found in the cash compensation of boards of directors for 169 UK non-financial listed companies that existed for all of the period from 1971 to 1998. We perform two types of analyses. Initially, we estimate individual firm time series regressions of the change in board cash compensation against measures of firm and peer group performance. The measures of firm performance we use are annual cash stock market returns and pre-tax accounting earnings. Peer group measures of performance are industry value-weighted average cash stock market returns and industry value-weighted average pre-tax accounting earnings. Subsequently, we analyse the data as a balanced panel.We provide evidence that board cash compensation is positively related to accounting earnings and negatively associated with peer group pre-tax accounting earnings. Some evidence suggests that board cash compensation is related to firm stock market returns but none suggests it is related to peer group market returns. This result implies the presence of RPE based on accounting earnings in the design of UK board compensation, with the cash compensation of boards of directors implicitly (partially) protected from industry uncertainties.