CEO Pay Contracts and IFRS Reconciliations

Abstract

We examine whether UK managers exploit the discretion provided in the UK GAAP to IFRS reconciliation process to manage earnings and whether this earnings management is associated with the structure of the managers' compensation contracts. We use a comprehensive data set of mainly hand-collected information from the firms' annual reports to provide evidence that, given the existence of an accounting-related vesting target in their pay schemes, CEOs use UK GAAP to IFRS reconciliations as an earnings management tool. We test our hypotheses under a number of different specifications, including a propensity score matching analysis. Our study contributes to the literature on the relation between earnings management and contractual incentives by focusing on a major structural change in accounting policies.     

Earnings Management in Domestic and Foreign IPOs in the United States: Do Home Country Institutions Matter?

Using a large sample of domestic and foreign IPOs in the US, we investigate how threats of enforcement by the Securities and Exchange Commission (SEC) and private litigation influence earnings management in IPO prospectuses. We propose that perceptions of foreign institutions may influence SEC enforcement action and private litigation. We provide evidence that enforcement and litigation threats are negatively related to the strength of legal institutions in the foreign IPO’s country of origin. We find earnings management is more pronounced in foreign IPOs from countries with strong legal institutions. We further explore whether earnings management is priced in the IPO market and find no relation between IPO proceeds and earnings management. Our results are consistent with upward earnings management as in Stein (1989), the magnitude of which is reduced when the anticipated cost of enforcement and litigation is higher. Collectively, our results cast doubt on the validity of the bonding hypothesis.     

CEO Retirement,Corporate Governance and Conditional Accounting Conservatism

Based on 16,604 observations between 1994 and 2006, this study revisits the ‘horizon problem’ by examining how CEO retirement affects conditional accounting conservatism. We hypothesize and find that firms become less conservative in their financial reporting before the retirement of their CEOs, and that strong corporate governance mitigates the effect of CEO retirement. The literature concerning the horizon problem has suggested that CEOs manipulate earnings to boost short-term performance before they leave their companies (Dechow, P. M., & Sloan, R. G. (1991). Executive incentives and the horizon problem: An empirical investigation. Journal of Accounting and Economics, 14(1), 51–89; Smith, C. W., & Watts, R. L. (1982). Incentive and tax effects of executive compensation plans. Australian Journal of Management, 7(2), 139–157), but the evidence is mixed. By examining conditional conservatism, we avoid some of the methodological difficulties that confront researchers when examining either real or accrual earnings management. Ours is the first study to provide evidence on how the horizon problem shapes conditional accounting conservatism.     

The Role of Institutional and Economic Factors in the Strategic Use of Non-GAAP Disclosures to Beat Earnings Benchmarks

Abstract

We use hand-collected data for a sample of large European firms to investigate the influence of countries’ institutional and economic factors on managers’ non-generally accepted accounting principles (GAAP) disclosures. We find that managers are more likely to use non-GAAP measures to meet or beat earnings benchmarks that GAAP earnings would miss in countries with efficient law and enforcement, strong investor protection, developed financial markets, and good communication and dissemination of information. We also find that managers in countries with developed institutional and economic conditions are more likely to adjust non-GAAP earnings for recurring expenses such as R&D, depreciation, and stock-based compensation expenses. Our findings suggest that in environments in which there is more pressure to achieve earnings benchmarks and less opportunity to manipulate GAAP earnings, managers use more non-GAAP earnings disclosures to meet the benchmarks.     

Whistle‐Blowing and Incentives in Firms

Whistle‐blowing is an important mechanism of corporate governance. We show that whistle‐blowing has negative effects on productive efficiency by undermining the incentives within a corporate hierarchy. In our model, a top manager intends to overreport earnings; a division manager may have evidence about the intended overreporting. We show that the division manager is more likely to have such evidence when the performance of his own division is low. Top management may offer a bribe to prevent the manager from blowing the whistle. This provides the division manager with an additional payoff when his division’s output is low. Therefore, potential whistle‐blowing undermines the division manager’s incentives to exert effort, which results in a less efficient outcome.     

CEO and Outside Director Equity Compensation: Substitutes or Complements for Management Earnings Forecasts?

Abstract

This study examines how the equity compensation of chief executive officers (CEO) and that of outside directors affect management earnings forecasts (MFs) and the relationship between these two positions in terms of compensation. Our evidence reveals that CEO (director) equity compensation is positively associated with MF likelihood, frequency, and accuracy when director (CEO) equity compensation is not high. However, an increase in director (CEO) equity compensation is not effective in improving disclosure quality when the level of CEO (director) equity compensation is already high. These results suggest that the two incentive mechanisms act as substitutes when both are intensively used in the context of MF disclosure.     

An Improved Test for Earnings Management Using Kernel Density Estimation

Abstract

This paper describes improvements on methods developed by Burgstahler and Dichev (1997, Earnings management to avoid earnings decreases and losses, Journal of Accounting and Economics, 24(1), pp. 99–126) and Bollen and Pool (2009, Do hedge fund managers misreport returns? Evidence from the pooled distribution, Journal of Finance, 64(5), pp. 2257–2288) to test for earnings management by identifying discontinuities in distributions of scaled earnings or earnings forecast errors. While existing methods use preselected bandwidths for kernel density estimation and histogram construction, the proposed test procedure addresses the key problem of bandwidth selection by using a bootstrap test to endogenise the selection step. The main advantage offered by the bootstrap procedure over prior methods is that it provides a reference distribution that cannot be globally distinguished from the empirical distribution rather than assuming a correct reference distribution. This procedure limits the researcher's degrees of freedom and offers a simple procedure to find and test a local discontinuity. I apply the bootstrap density estimation to earnings, earnings changes, and earnings forecast errors in US firms over the period 1976–2010. Significance levels found in earlier studies are greatly reduced, often to insignificant values. Discontinuities cannot be detected in analysts’ forecast errors, while such findings of discontinuities in earlier research can be explained by a simple rounding mechanism. Earnings data show a large drop in loss aversion after 2003 that cannot be detected in changes of earnings.     

Camouflaged Indicators of Earnings Management†

Abstract

We argue that, in response to increased scrutiny and greater attention to accruals versus sales, firms become more likely to engage in accrual conversion (AC) cash management aimed at aligning cash and accruals with earnings and sales (e.g. by factoring of receivables). In doing so, they reduce the statistical power of standard indicators of accrual-based earnings management – in effect, camouflaging their earnings management activity. This proposition is of interest because many influential papers on earnings management have utilized accrual-based indicators to reach their conclusions. Our results indicate that firms indeed became more likely to engage in AC cash management after the passage of the Sarbanes-Oxley Act (SOX), and that this tendency was particularly pronounced among firms with strong incentives (or enhanced ability) to perform and hide earnings management. In particular, our findings suggest that the post-SOX decrease in standard measurements of accrual-based earnings management, identified in prior research, is partially attributable to firms’ increased engagement in AC cash management activity.     

Arab Consumers' Behavior Towards Credit Card Usage

Abstract

Credit card usage by consumers across the oil-rich Arab countries (such as Qatar, Bahrain, and Kuwait) is changing the landscape of consumer behavior, motivating Arab consumers to buy more often, and promoting impulse buying. Our study examines Arab consumers' behavior towards credit card usage from multi-cultural perspective by replicating a western model propounded by Kaynak et al. (1986) and Kaynak et al. (2001)     

The Impact of Accounting Conservatism on the Compensation Relevance of UK Earnings

Abstract

It has long been established that because of accounting conservatism, the contemporaneous correlation between returns and earnings is lower (higher) for good (bad) news firm-years. Meanwhile, prior analytical agency work suggests that the compensation role of accounting earnings is potentially greater (for tasks such as noise filtering and incentive balancing) when the contemporaneous correlation between earnings and returns is lower. Hence, since accounting conservatism implies that earnings have a lower correlation with returns in good news firm-years, the present paper hypothesises that UK CEO cash compensation exhibits a stronger (weaker) sensitivity to accounting earnings in good (bad) news firm-years. The empirical findings offer substantial support for this hypothesis and are robust to alternative estimation methodologies. In addition, the results appear not to be attributable to the well-established impact of earnings persistence on the compensation–earnings association. Overall, the findings are consistent with the notion that UK compensation committees appear to take cognisance of the impact of accounting conservatism when awarding earnings-based compensation. In addition, the present work offers additional insights into the nature of the interaction between the contracting and valuation roles of accounting numbers.     

How CEO narcissism affects earnings management behaviors

This study examined whether chief executive officers’ (CEOs) with narcissistic tendencies are more likely to execute earnings management behavior because of pressure to fulfill earnings thresholds. The results revealed that a CEO who exhibits high narcissism is more likely to be involved in earnings management to compensate for her/his performance. Our findings suggest that CEO narcissism directly influences financial decisions. Considering the earnings thresholds, firms with a more narcissistic CEO experience a regulatory effect on real earnings management behavior. Studies have indicated that CEOs manipulate earnings to satisfy three primary earnings thresholds: prior year’s reported earnings, zero earnings, and analysts’ forecasts. Our empirical results provide further evidence that CEOs engage in earnings management to fulfill positive earnings thresholds and analysts’ forecasts. We infer that CEOs use the abnormal production cost method as an underlying mechanism to increase reported earnings. Our findings help clarify the relationship between CEO personality traits and earnings manipulation to assist investors with decision-making.     

The Effect of CEO Stock-Based Compensation on the Pricing of Future Earnings

This paper examines whether CEO stock-based compensation has an effect on the market’s ability to predict future earnings. When stock-based compensation motivates managers to share their private information with shareholders, it will expedite the pricing of future earnings in current stock prices. In contrast, when equity-compensated managers attempt to temporarily manipulate the stock price to maximize their own benefit rather than that of shareholders, the market may not fully anticipate future performance. We find that a CEO’s stock-based compensation strengthens the association between current returns and future earnings, indicating that more information about future earnings is reflected in current stock prices. In addition, we find that the positive effect is weaker for firms that have a high level of signed discretionary accruals or a low management forecast frequency. Overall, our study suggests that on average, equity-based compensation improves the informativeness of stock prices about future earnings, while opportunistic discretionary accruals or lowered earnings guidance hamper this improvement.     

Accounting and the Truth of Earnings Reports: Philosophical Considerations

This paper investigates the philosophical nature of accounting reports of earnings. Standard setters' authoritative pronouncements (conceptual frameworks, GAAP, EITFs, etc.) hold to the realist philosophical view that true earnings reports are ex post representations of some ex ante out-there, preexisting, extra-linguistic real economic increase in the enterprise's wealth. Contra this view, in practice financial accounting executives, in league with investment analysts, routinely engage in earnings management and manipulation in order to satisfy the capital market's insatiable demands for earnings levels which will support and enhance the enterprise's stock market price. The paper considers this state of affairs from Harold Frankfurt's truth, lies and ‘bullshit’ treatise (2005, 2006). It sees earnings reports as ‘short of lies’, and so the accountants can only be faulted for their indifference to the truth and for giving the impression that they are trying to present the truth. A poststructuralist philosophical perspective, however, problematizes this conclusion on the basis that accounting language is not a transparent medium but rather is the material used to manufacture accounting ‘truths’. It sees accounting ‘truths’ as contingent upon linguistic doctrinal accounting discourses currently ceded place of privilege by standard setters and upon the subjective considerations of accountants when they produce reports of earnings. The paper concludes that both Frankfurt's perspective and that of poststructuralist philosophers can provide valuable insights into this ironic state of affairs.     

Real Earnings Management Uncertainty and Corporate Credit Risk

Abstract

This study examines the accounting information uncertainty effects on corporate credit risk from the perspective of real earnings management (RM) activities by investigating 9565 American bond observations from year 2001 to 2008. The main results show that the volatilities of RM activities significantly and positively affect corporate bond yield spreads when well-known bond spread determinant variables are controlled. In addition, the results are robust to alternative model specifications, including the suspect firm analyses, another less ambiguous measure of abnormal cash flows from operations, and abnormal production cost analyses in manufacturing industry or with control of the input price variation. This research also finds that the positive effects of RM volatilities become weaker if a firm has a lower credit rating. Finally, our results remain hold with considering endogeneity issues and analyst characteristic variables and for another estimation period of RM volatilities.     

Contracting on the Stock Price and Forward-Looking Performance Measures

Abstract

We examine the use of earnings, forward-looking performance measures and stock prices in managerial compensation. When the firm's owner and its manager have identical time preferences, the stock price is not useful for motivating the manager, as it is a noisy aggregation of a forward-looking measure and future earnings. In contrast, when the owner and the manager have conflicting time preferences, the noisy stock price is useful for contracting. If the manager has no access to banking and cannot trade the firm's shares, the timeliness of the stock price dominates the extra risk imposed by its noise. At the same time, forward-looking performance measures (such as customer satisfaction) can induce a desirable allocation of management effort between the short term and long term more efficiently than the stock price can. Forward-looking performance measures and the stock price are thus not direct substitutes in rewarding farsighted effort.     

Strategy,Valuation, and Forecast Accuracy: Evidence from Italian Strategic Plan Disclosures

Using a sample of 264 strategic plan presentations by Milan Stock Exchange firms during 2001–2012, we present evidence of both a security price reaction and an increase in the accuracy of analysts’ earnings forecasts pursuant to plan disclosure. In the cross-section, the information content of the plan disclosures and the accuracy increase are incrementally associated with the extent of forward-looking narrative disclosures in the plan, after controlling for other disclosures within and outside the plan presentation and the fact that the firm has self-selected into the sample. Both quantitative and qualitative narrative disclosures are informative to investors and analysts. The results are driven by narrative disclosures about company strategy and action plans rather than about the business environment in which the company operates. Our study informs the current debate on the use of voluntary comprehensive, integrated, long-run-oriented strategic plan disclosure as a potential complement for disclosures such as quarterly earnings forecasts that have been described as an example of ‘short-termism’.     

Performance Measurement and Compensation Practices in Hospitals: An Empirical Analysis in Consideration of Ownership Types

Against the background of regulatory initiatives that put hospitals under increasing financial pressure, we explore performance measurement and compensation practices in hospitals through a multiple case study. We extend previous research by comparing practices among different ownership types (i.e. public, non-profit, and private) and by providing initial evidence on compensation schemes for the clinical staff. Our empirical investigation is embedded in the ‘stewardship–agency axis’ that allows the development of theoretical arguments about the interdependencies between ownership and performance measurement systems (PMS). We distinguish two primary levels of analysis – the types of measures implemented and their linkage with compensation and decision-making. Our findings suggest that the types of measures are primarily affected by regulatory pressures, while powerful internal actors considerably influence the linkage between these measures and compensation. Consistent with our theorised patterns, cross-case analyses indicate differences between ownership types concerning the performance dimensions that are prioritised and the linkage of performance measures with compensation of the clinical staff. Together, these findings provide evidence on the interdependent effects of the regulatory environment, the type of ownership and internal actors on a hospital's PMS. We also provide some tentative explanations for these findings based on insights from institutional and behavioural theory.     

The Corrosive Effect of Offshore Financial Centers on Multinational Firms’ Disclosure Strategy

Abstract

This study investigates whether U.S. multinational firms with subsidiaries located in offshore financial centers (OFCs) (i.e. offshore firms) are more likely to be opaque in their voluntary disclosure relative to U.S. multinationals without such subsidiaries (non-offshore firms). We use management earnings forecasts to capture corporate voluntary disclosure. Consistent with the opportunism view, but inconsistent with the efficiency argument, our results (including robustness checks) show that offshore firms are less likely to issue earnings forecasts, disclose forecasts less frequently, exhibit a stronger tendency to withhold bad news forecasts, and release less precise forecasts than non-offshore firms. Moreover, of the three distinct dimensions of OFCs’ institutional environment, namely, low taxation, lax regulation, and secrecy policy, each plays a role in negatively shaping firms’ disclosure strategy. Thus, OFCs’ institutional features exacerbate the opacity that plagues firms seeking to avoid taxes via their OFC subsidiaries. Our results are consistent with the notion that, beyond the scope of taxes, multinational firms’ use of OFCs has a corrosive effect on market information dynamics. Hence, OFCs have a much wider impact on the U.S. economy as well as other major economies than just tax avoidance or evasion.     

Management Changes,Reputation, and “Big Bath”—Earnings Management

We study the effects of managerial turnover on earnings management activities in a model in which managers care about their external reputation. We develop an overlapping generations model showing that both outgoing and incoming managers bias reported earnings such that typically very low returns are reported in the first period after a manager has been replaced. Outgoing managers shift earnings forward to their last period in office as they will not benefit from earnings realized after that. Incoming managers can have an incentive to shift earnings to the second period in office as reported earnings will, immediately after a management change, only be partly attributed to their own ability. Deferred compensation can reduce incentives for earnings management.     

The Effect of Internal Control Certification Regulatory Changes on Real and Accrual-based Earnings Management

ABSTRACT

This study examines the effect of changes in internal control certification requirements (ICCR) on the earnings management choices of Australian firms in the period 2007–2015. The Australian setting is unique as the certification requirements change from voluntary in 2004–2007 to mandatory in 2008–2014, before being abolished in 2015. Consistent with the notion that real earnings management (REM) is less susceptible to detection, the results suggest that firms place greater reliance on REM than on accrual-based earnings management (ABEM) when having to comply with certification requirements. In particular, I find voluntary certifiers have lower REM and ABEM relative to first-time certifiers in the mandatory period between 2008 and 2014, and there is an increase in REM activities among first-time mandatory period certifiers. Moreover, firms that discontinue certification, after the abolition of the requirement in 2015, switch from REM to ABEM. This suggests that regulatory ICCR changes affect firms’ earnings management choices.