The executive compensation implications of the tax component of earnings

We extend prior research by examining the weight applied to earnings generated by changes in ETRs (i.e., the tax component of earnings) in determining CEO and CFO compensation. We examine both bonus and total compensation and find that the predicted relationships between compensation and the tax component of earnings are largely limited to bonus compensation. This is not surprising since bonus compensation represents an unambiguous link between contemporaneous performance and compensation, while equity compensation is in part determined by agency considerations. Our evidence suggests that both CEOs and CFOs are compensated for the tax component of earnings. We find that CEOs are rewarded equally for the tax component of earnings relative to other components of earnings, while CFOs are rewarded more for the tax component of earnings relative to other components of earnings. Additionally, the weight applied to the tax component of earnings when determining CFO bonus compensation is greater when; (1) the tax component of earnings does not appear to be related to earnings management; (2) ETRs decrease rather than increase, (3) the firm pays bonus based on after-tax earnings rather than pre-tax earnings, and (4) the firm is tax aggressive rather than non-tax aggressive. The variations in the weighting of the tax component of earnings for CFO bonus compensation noted above in combination with evidence that CEO bonus compensation is indifferent to ETR-related earnings versus other components of earnings, suggests that the tax component of earnings is a contractual component of CFO bonus compensation.     

Accounting fundamentals and CEO bonus compensation

Research indicates that there is a positive association between accounting earnings and chief executive officer (CEO) cash compensation; however, evidence also suggests that this positive association ceases to exist when earnings performance is poor or declining. This latter result has led some critics of corporate compensation policies to conclude that CEOs are not penalized for poor or declining firm performance. The purpose of this study is to further illuminate the pay-performance debate by expanding the traditional executive bonus compensation model to include a set of accounting fundamentals that prior research indicates are related to both current and future firm performance. Our results indicate that there is a highly significant relationship between accounting fundamentals and the level of and change in CEO bonus compensation. Moreover, we find a highly significant relationship between accounting fundamentals and both bonus omissions and bonus reductions. When earnings are negative or declining, we find that the above relationships remain intact. In contrast, when earnings are negative or declining, we find that the relationship between aggregate earnings and bonus compensation is weak or insignificant in most of our analyses. Taken together, our results suggest that the apparently weak relationship between accounting earnings and CEO bonus compensation (particularly when earnings are negative or declining) is partly due to the fact that the bonus compensation model excludes accounting fundamentals which are strongly associated with bonus compensation. Thus, we conclude that (i) bonus compensation is more closely tied to firm performance than critics sometimes claim and (ii) bonus compensation awarded to CEOs when earnings performance is poor is at least partially explained by the presence of favorable accounting fundamentals.     

Cost behavior and executive bonus compensation

Prior literature provides compelling evidence of an asymmetric relation between executive bonus compensation and earnings performance. In particular, this literature reports that compensation committees assign greater weight to good (positive) earnings performance than poor (negative) earnings performance. Taken together, the prior literature provides strong support for critics who claim that compensation committees blindly protect executives from earnings underperformance. We further examine this issue by investigating whether a firm's cost behavior (i.e., the relation between expenses and sales) provides an explanation for the apparent inefficiency in executive compensation contracts. Our evidence suggests that executives are rewarded more for increases in ROA that arise from normal cost behavior than other increases in ROA consistent with these increases being perceived as more persistent. In contrast, we do not find such a relationship for decreases in ROA which suggests that executives are largely shielded from decreases in ROA that follow normal cost behavior. We examine two factors suggested by the prior literature, expected future sales and the extent of capacity utilization, which may provide an explanation for why executives are shielded from normal cost behavior decreases in ROA. When these additional factors are included in our empirical models, our evidence suggests that the asymmetric relation between changes in CEO bonus compensation and increases and decreases in earnings performance documented in prior literature goes away. That is, our results suggest that compensation committees do not blindly protect executives for earnings underperformance. On the contrary, our evidence suggests that these committees take into account other non-earnings information when deciding how much weight to give to a decrease in earnings and that executive compensation may not be as inefficient as suggested by prior research.     

The impact of accounting restatements on CFO turnover and bonus compensation: Does securities litigation matter?

This paper examines the association between accounting restatements, class-action securities litigation and chief financial officer (CFO) turnover and bonus compensation. We identify income-decreasing earnings restatements that were the result of aggressive accounting policies, and hypothesize that these restatements will result in higher CFO turnover rates, and lower bonus compensation, especially when the firm is the target of a restatement-related class-action securities lawsuit. Our results indicate that CFO turnover and bonus compensation are affected by restatements, but only when the restatement firm is the target of a class-action suit. When we expand the analyses to consider other types of executives (e.g., CEOs and COOs), we continue to find that turnover only occurs in the presence of a class-action suit. However, bonus compensation penalties to other types of executives are not limited to litigation-related restatements.     

Executive compensation and earnings management: Empirical evidence from Japan

This study investigates the relation between discretionary accounting choices and executive compensation in Japanese firms. The results show that the use of discretionary accruals increases executive compensation. The analyses also show that firm managers receiving no bonus adopt income-decreasing accruals and extraordinary items. In particular, evidence shows that negative extraordinary items are strongly associated with no bonus payment. Finally, the research indicates that the association between discretionary accruals and executive bonus varies depending upon the circumstances of the firm. This study contributes to the literature on earnings management from an international comparative perspective since most previous studies on earnings management and executive compensation have focused on U.S. firms.     

Why do managers avoid EPS dilution? Evidence from debt–equity choice

Survey evidence reveals that managers prefer to avoid dilution of earnings per share (EPS), though financial theory suggests it is irrelevant in firm valuation. We explore contracting and behavioral explanations for this apparent paradox using a large sample of debt–equity issuers. We first provide evidence that firms with greater agency conflicts between managers and shareholders are more likely to use EPS as a performance measure in bonus contracts. After controlling for possible endogeneity related to compensation contract design, we find that managers are more likely to avoid earnings dilution when their bonus compensation explicitly depends upon EPS performance. This effect is increasing in the magnitude of bonus compensation for this subset of firms; we document no such associations for the firms that do not use EPS in setting bonus pay. Additional tests of firms’ speed of adjustment to target leverage ratios and firms’ debt conservatism levels indicate that explicitly rewarding executives on EPS performance helps to resolve underleveraging problems. We also find that clientele effects are associated with managers’ aversion to earnings dilution. Our findings provide a deeper understanding of the factors that underlie the use of accounting performance in compensation contracts and new evidence on the implications of the contracting role of accounting in firm decision-making.     

The economics of earnings manipulation and managerial compensation

This article examines managerial compensation in an environment where managers may take a hidden action that affects the actual earnings of the firm. When realized, these earnings constitute hidden information that is privately observed by the manager, who may expend resources to generate an inflated earnings report. We characterize the optimal managerial compensation contract in this setting, and demonstrate that contracts contingent on reported earnings cannot provide managers with the incentive both to maximize profits and to report those profits honestly. As a result, some degree of earnings management must be tolerated as a necessary part of an efficient agreement.     

Discussion of earnings-based bonus plans and earnings management by business unit managers

Guidry, Leone, and Rock use business unit data from a multinational conglomerate to reexamine whether earnings-based bonus plans are associated with earnings management. By focusing on business unit compensation, the authors increase the power of the tests and control for earnings management incentives provided by stock-based compensation. Questions raised by the study include the generalizability of the findings beyond the sample firm, the economic significance of earnings management, the effect of earnings management on bonus awards, and how group-level incentives to manage earnings interact with incentives at the business unit level.     

Effect of mandatory pro forma earnings disclosure on the relation between CEO share bonuses and firm performance

This paper examines the effect of mandatory pro forma earnings disclosure on the alignment of CEO share bonuses and firm performance (i.e., annual stock returns). Using 6,583 executive-level observations from 986 non-financial firms in Taiwan over the period 1999–2004, we find a significant shift in the CEO share bonus pay-earnings relation caused by a marked reduction in bonus shares after the new disclosure rule becomes effective. The change in CEO compensation structure in turn leads to a closer link between CEO stock bonuses and annual stock returns. The result suggests that a more transparent earnings disclosure could positively affect board choices regarding compensation arrangements, thus inducing a better convergence of manager and shareholder interests.     

Equilibrium earnings management and managerial compensation in a multiperiod agency setting

To investigate how the possibility of earnings manipulation affects managerial compensation contracts, we study a two-period agency setting in which a firm’s manager can engage in window-dressing activities to manipulate reported accounting earnings. Earnings manipulation boosts the reported earnings in one period at the expense of the reported earnings in the other period. We find that the optimal pay-performance sensitivity may increase and expected managerial compensation may decrease as the manager’s cost of earnings management decreases. When the manager is privately informed about the payoff of an investment project to the firm, we identify plausible conditions under which prohibiting earnings management can result in a less efficient investment decision for the firm and more rents for the manager.     

The association between non-financial performance measures in executive compensation contracts and earnings management

Executive compensation, especially cash bonus compensation, has come under fire by the Securities and Exchange Commission (SEC), the US Federal government, and the media for its role in the current economic crisis. Specifically, the SEC has argued that some compensation packages provide incentives for risk-taking that may undermine shareholder value over the long-term. Short-term incentive payments to executives in the form of cash bonuses are mostly contingent on reaching targets of accounting-related measures or financial performance measures (FPMs). However, the incentives from these payments may lead to accrual manipulation and earnings management (EM). Alternative measures are non-financial performance measures (NFPMs). We expect that firms that employ NFPMs in bonus contracts will have a lower prevalence of EM, since these measures tend to focus executives on the long-term. In this paper, we examine the type of performance measures used by firms in the S&;P 500 index in their cash bonus compensation. We find that firms that use both FPMs and NFPMs have lower discretionary accruals compared to firms that use only FPMs, consistent with lower income-increasing EM. However, we do not find evidence of a reduction in EM behavior using the incidence of meeting or just beating analyst earnings benchmarks, another common EM proxy. In additional tests on a subset of firms with equity offerings, in which incentives for income-increasing manipulation are likely high, we find that firms with NFPMs have lower discretionary accruals. The implication is that NFPMs can be used in compensation contracts to reduce EM behavior and mitigate erroneous executive compensation. This is important to investors as well as regulators, especially in light of the recent debate on compensation reform.     

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.     

CEO Compensation and Fair Value Accounting: Evidence from Purchase Price Allocation

This study investigates the impact of CEO compensation structure on post‐acquisition purchase price allocation, an accounting procedure that involves fair value estimation of various assets and liabilities. We find that CEOs whose compensation packages rely more on earnings‐based bonuses are more likely to overallocate the purchase price to goodwill, the largest asset recorded post‐acquisition. Because goodwill is not amortized, the overallocation likely increases post‐acquisition earnings and bonuses. We also find that, when the acquirer's CEO bonus plan includes performance measures that are not affected, or are less affected, by the overstatement of goodwill, such as cash flows, sales, or earnings growth, the overallocation to goodwill motivated by bonus plans diminishes.     

Predictive versus opportunistic earnings management,executive compensation,and firm performance

We examine the association between earnings management and an important component of corporate governance, the incentives provided through compensation. We argue that firms with predictive (opportunistic) earnings management, in which discretionary accruals do (do not) relate to future cash flows, provide a more (less) ideal setting for the use of compensation as incentives. Our empirical tests show that CEO compensation levels (measured by salary, bonus, and other forms of compensation) are positively related to predictive earnings management and negatively related to opportunistic earnings management. We also find that predictive earnings management is positively associated with future returns, whereas opportunistic earnings management is negatively associated with future returns. Overall, our results suggest that firms provide more incentives if their earnings are also more informative because of discretionary accruals.     

Seasonal affective disorder and investors’ response to earnings news

We examined the relationship between seasonal affective disorder (SAD) and investor response to a firm’s quarterly earnings announcements. Our results show that the market’s cumulative abnormal returns are associated with unexpected earnings and with SAD. Investors respond more negatively when earnings are announced in the fall than in other seasons. We also found an asymmetric SAD effect that is more significant for positive earnings announcements, on average. Moreover, the SAD affect is most evident in stocks that are more salient to investors.     

Managerial flexibility and the wealth effect of new product introductions

This paper examines whether investors recognize the value of managerial flexibilities, as proxied by real options, in their valuation of new product introductions. We define a firm’s real options portfolio as the difference between the firm’s market value and its assets in place. A firm’s strategic flexibilities are modeled as the ratio of its real option portfolio to its book value. Using a sample of new product introductions from 1998–2007, we find our real options measure is positively related to announcement period abnormal returns. This result holds after we control for other variables known to be correlated with the announcement effect in previous studies. Our result is robust to alternative measures of real options based on analysts’ earnings expectations and whether a firm has one or multiple segments. In summary, our results suggest that a firm’s perceived strategic and operating flexibilities are an important factor in the valuation of new products.     

Firms' use of accounting discretion to influence their credit ratings

This paper examines whether firms that deviate from an empirically modeled (“expected”) credit rating engage in earnings management activities, as measured by abnormal accruals and real activities earnings management. We find evidence that firms use income-increasing (-decreasing) earnings management activities when they are below (above) their expected ratings. We then test whether such actions are successful in helping these firms move toward their expected credit ratings. The results suggest that firms below or above their expected credit ratings may be able to move toward expected ratings through the use of directional earnings management.     

Earnings Warnings and CEO Welfare

Some CEOs decide voluntarily to issue a warning when they expect a negative earnings surprise. Prior research suggests that warnings contain incremental information beyond actual earnings; warning firms tend to experience permanent earnings decreases. This paper investigates whether compensation committees take warnings into account in setting CEO compensation. We find that warnings are significantly negatively (positively) associated with CEO bonus (option grants), suggesting that compensation committees adjust CEO compensation towards a more high‐powered structure after warnings. However, the sensitivity of bonus or option grants to earnings and stock returns is not affected except for bonus sensitivity to stock returns. We also find weak evidence of an increase in forced CEO turnover after warnings, accompanied by a significant increase in its sensitivity to stock returns. This benefits CEOs with higher ability but imposes more risk on other CEOs. These findings provide a partial explanation of why not every CEO facing a negative surprise decides to issue a warning. Our results are robust to various specifications. In particular, the impact of warnings on compensation appears invariant to the timing or the number of warnings. Overall, these findings suggest that the signal from warnings is used in determining CEO compensation and retention.     

Optimal Contracts with Performance Manipulation

We study optimal compensation contracts that (1) are designed to address a joint moral hazard and adverse selection problem and that (2) are based on performance measures, which may be manipulated by the agent at a cost. In the model, a manager is privately informed about his productivity prior to being hired by a firm. In order to incentivize the manager to exert productive effort, the firm designs a compensation contract that is based on reported earnings, which can be manipulated by the manager. Our model predicts that (1) the optimal compensation contract is convex in reported earnings; (2) the optimal contract is less sensitive to reported earnings than it would be absent the manager's ability to manipulate earnings; and (3) higher costs of manipulating reported earnings (e.g., due to higher governance quality) are associated with higher firm value, lower expected level of earnings management, and higher output.     

Real earnings management and cost of capital

This study investigates whether a firm’s cost of equity capital is influenced by the extent of a firm’s real activities management. Using a large sample of U.S. firms, we find that our proxy for the cost of capital is positively associated with the extent of earnings management through the real activities manipulation after controlling for the effect of the accrual-based earnings management. We also provide evidence suggesting that this positive association stems from managerial opportunism rather than from the measurement errors in our real earnings management proxies. The main findings are robust to a battery of sensitivity tests. Collectively, our results suggest that real earnings management activities exacerbate the information quality of earnings used by outside investors, and thus the market demands a higher risk premium for these activities, which is incremental to the risk premium for the accrual-based earnings management.