Bond Covenants and Delegated Monitoring

This paper examines alternative contracting arrangements available to a firm seeking to finance an investment project. The authors consider the choice between loan contracts with covenants based on noisy indicators of the firm's financial health and loan contracts enforced by a monitoring specialist. In one interpretation, the specialist is a financial intermediary. The firm's choice is shown to depend upon the firm's credit rating, the accuracy of financial indicators of the firm's condition, the loss from premature liquidation of the firm's project, and the cost of monitoring.     

Are Employee Selection and Incentive Contracts Complements or Substitutes?

There is a debate in the literature as to whether employee selection is a substitute or complement to incentive contracting. We argue that incentive contracts and selection can be both complements and substitutes conditional on the contracting difficulty faced by the firm. We examine these control choices in a setting where contracting difficulties arise due to the firm's choice of strategy and from the volatility created by the firm's external environment. We select a firm's commitment to organizational learning (OL) as our strategic choice variable as this provides a useful proxy for identifying settings where explicit incentive contracting is difficult. The results show that, as firms become increasingly committed to OL, incentive contracts and employee selection operate as complements. However, with a high commitment to OL and an increasing level of external volatility, contracting on performance measures will become less effective. In this context, our results indicate that there is a substitution effect toward employee selection.     

Corporate suppliers and customers and accounting conservatism

We argue that a firm's suppliers and customers prefer it to account more conservatively due to information asymmetry and these stakeholders' asymmetric payoffs with respect to the firm's performance. We predict that a firm meets this demand for accounting conservatism when suppliers or customers have bargaining advantages over it that enable them to dictate terms of trade or whether trade occurs at all. We show that when a firm's suppliers or customers have greater bargaining power, the firm recognizes losses more quickly. Our findings provide insights into how a firm's powerful suppliers and customers are associated with its accounting practices and also support the contracting explanation for accounting conservatism.     

Executive Compensation Tied to ESG Performance: International Evidence

Using a wide sample of international publicly traded firms, this paper studies the rapidly increasing practice of incorporating Environmental, Social, and Governance (ESG) metrics in executive compensation contracts. Our evidence suggests that this compensation practice varies at the country, industry, and firm levels in ways that are consistent with efficient incentive contracting. We also observe that reliance on ESG metrics in executive compensation arrangements is associated with engagement, voting, and trading by institutional investors, which suggests that firms could be adopting this practice to align their management's objectives with the preferences of certain shareholder groups. Finally, we find that the adoption of ESG Pay is accompanied by improvements in key ESG outcomes, but not by improvements in financial performance.     

Corporate governance,external market discipline and firm productivity

Using a sample of Australian companies over the 2000–2005 period, we examine the impact of internal corporate governance on firm's total factor productivity, taking into account the interaction between internal governance and external market discipline. Our empirical findings point to a substitution effect between product market competitiveness and firm-level corporate governance. Overall, internal corporate governance mechanisms – more efficient boards and greater CEO stock-based compensation – are effective instruments for improving firm productivity. However, internal governance is less effective when a firm faces a highly competitive product market. We find only weak empirical support for an association between firm's ownership structure and productivity, and no support for an association between industry takeover intensity and firm productivity.     

The timing of changes in CEO compensation from cash bonus to equity-based compensation: Determinants and performance consequences

This study examines the determinants and performance consequences of changes in CEO compensation structure. The study uses the unique setting when Australian companies have changed from cash bonus to equity-based compensation. While most US CEOs receive some form of equity-based compensation, Australian CEOs have not always been paid equity-based compensation. According to efficient contracting theories, we argue that the change to equity-based compensation is driven by changes in firm characteristics and by the occurrence of CEO turnover, the latter of which provides a less costly opportunity for such change. Our results are consistent with the above arguments. We also document a significant negative association between changes in compensation structure and subsequent firm performance in the following year, even after controlling for CEO turnover and poor governance environments. Overall, our results suggest that the initial change to equity-based compensation is part of an error learning process made by firms that leads them towards efficient CEO compensation contracts.     

Executive ownership,corporate value,and executive compensation: A unifying framework

This study presents an integrated investigation into the factors affecting executive ownership, the market value of the firm, and executive compensation by explicitly incorporating the simultaneity of the process determining these variables into the empirical estimation. Overall, the results of the study support the notion that a firm's market value, executive stock ownership, and executive compensation are jointly determined. Further, the findings suggest that executive stock ownership and executive compensation may serve as a type of bond by which top executives are induced to act in the best interests of shareholders. The study also finds that a firm's q ratio and an executive's job-specific experience (as well as firm size) are important determinants of executive compensation. This result is generally consistent with the view that the firm optimally establishes its managerial compensation plan in response to both its operating environment and the specific personal characteristics of its chief executive(s).     

CEO and CFO equity compensation and dividend payout over the firm lifecycle

We examine the separate and joint effects of CEO and CFO equity compensation on the dividend payout decision, taking into account changes in the relationship over the firm's lifecycle. Compensation contracts and dividend payout both are used to reduce agency costs, which change over a firm's lifecycle. Studies report a negative association between CEO equity compensation and dividend payout, suggesting a substitutionary relationship. Our results show that when the two are considered jointly, CFO equity compensation dominates CEO compensation, indicating the need for sophisticated financial expertise in the dividend decision. The relationship appears only in mature firms, signifying that agency problems are of most concern during the mature stage of the firm lifecycle.     

Optimal CEO Compensation with Search: Theory and Empirical Evidence

We integrate an agency problem into search theory to study executive compensation in a market equilibrium. A CEO can choose to stay or quit and search after privately observing an idiosyncratic shock to the firm. The market equilibrium endogenizes CEOs’ and firms’ outside options and captures contracting externalities. We show that the optimal pay‐to‐performance ratio is less than one even when the CEO is risk neutral. Moreover, the equilibrium pay‐to‐performance sensitivity depends positively on a firm's idiosyncratic risk and negatively on the systematic risk. Our empirical tests using executive compensation data confirm these results.     

Stock-based managerial compensation,price informativeness,and the incentive to overinvest

This paper investigates the relationship among a firm's managerial incentive scheme, the informativeness of its stock price, and its investment policy. It shows that the shareholders' concerns about the effectiveness of stock-based compensation can lead to overinvestment. However, unlike other explanations in the literature, our results are neither caused by suboptimal incentive contracts nor do they rely on the assumption that managers are “empire builders.” Rather, overinvestment serves to induce information production by outside investors. By accepting positive and negative NPV projects, a firm effectively increases the market's uncertainty about its cash flow, thereby giving traders more incentives to become informed.     

Earnings‐based Delisting Regulations and Government Subsidies

This paper examines who receives government subsidies when a firm faces delisting risk and how subsidies affect such a firm's performance in China. It focuses on the accounting‐based delisting rule issued in 1998 that relies heavily on the profitability of firms. Using the probit model, this study finds that subsidies are less likely to be granted to a firm that has a higher risk of being delisted than a healthy firm, but are more likely to be granted to such a firm if it is state‐owned. It is also found that having a political connection increases a firm's chance of receiving subsidies, but such an effect disappears when a firm faces a delisting risk. In assessing the impact of a subsidy on firm performance, this study shows that a subsidy increases a firm's valuation and profitability for firms at delisting risk.     

An Analysis of the Relation between the Stewardship and Valuation Roles of Earnings

In this paper, we seek a deeper understanding of how accounting information is used for valuation and incentive contracting purposes. We explore linkages between weights on earnings in compensation contracts and in stock price formation. A distinction between the valuation and incentive contracting roles of earnings in Paul [1992] produces the null hypothesis that valuation earnings coefficients (VECs) and compensation earnings coefficients (CECs) are unrelated. Our empirical analyses of the relations between earnings and both stock prices and executive compensation data at the firm and industry levels over the period 1971–2000 rejects Paul's [1992] hypothesis of no relation. We also document an increasing weight over time on other public performance information captured by stock returns in the determination of cash compensation. Specifically, we find that the incentive coefficient on returns is significantly higher in the second of two equal sample subperiods relative to the incentive coefficient on earnings.     

The economic determinants of the market reaction to proposed mandatory accounting changes in the oil and gas industry: A cross-sectional analysis

This paper examines the economic reasons for the observed negative abnormal common stock performance of firms whose reported earnings and stockholders' equity were negatively affected by the proposed elimination of full cost accounting in the oil and gas industry. Four explanations of the market effects of this mandatory accounting change are examined: (1) naive investor theory, (2) modified naive investor theory, (3) contracting cost theory, and (4) estimation risk theory. These hypotheses are developed in detail and used to generate variables for a cross-sectional model which explains observed return behavior. The effect of the accounting change on total stockholder's equity, the existence of financial contracts denominated in terms of accounting numbers and, to a lesser extent, firm size are shown to be important explanatory variables. The importance of these variables is consistent with both the contracting cost and estimation risk theories.     

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 Effects of Compensation and Board Quality on Non-GAAP Disclosures in Europe

This study reports international evidence on the impact of compensation and board quality on the voluntary disclosure of non-GAAP earnings numbers. We find that compensation contracts of board directors that are linked to firm's market performance are associated with a higher probability of disclosure of non-GAAP figures in the earnings announcements' press release. Furthermore, when this type of compensation is used, firms tend to report non-GAAP figures in the title of the press release, make more adjustments for recurring items, and avoid reporting reconciliations. These reporting practices have been associated with opportunistic disclosure. We also show that an efficient governance structure of the board of directors can help restrain most of these discretionary disclosure decisions regarding non-GAAP reporting.     

Reliability-Relevance Trade-Offs and the Efficiency of Aggregation

This paper studies how an accountant's method of aggregating information in a financial report is affected by differences in the reliability and relevance of components of the report. We study a firm that hires an accountant to produce a report that reveals information to investors regarding the returns to the firm's past investments. In constructing the report, the accountant must combine information elicited from the firm's manager with other information directly observable to the accountant. The manager's information is assumed to be directly observable only by the manager and to be of superior quality to the other information available to the accountant. Reliability‐relevance trade‐offs arise because as the accountant places more weight on the manager's report, potentially more useful information gets included in the report, at the cost of encouraging the manager to distort his or her information to a greater extent. Capital market participants anticipate this behavior and price the firm accordingly. We show how the market's price response to the release of the firm's aggregate report, the efficiency of the firm's investment decisions, and the manager's incentives to manipulate the soft information under his or her control are all affected by—and affect—the aggregation procedure the accountant adopts. In addition, we identify a broad range of circumstances under which aggregated reports are strictly more efficient than disaggregated reports because aggregation tempers the manager's misreporting incentives. We also demonstrate that, as any given component of the aggregated accounting report becomes softer, the equilibrium level of the firm's investment diminishes and the market places greater weight on the remaining components of the report.     

Do firms follow GAAP when they record share repurchases?

This paper examines U.S. firms' accounting for share repurchases and the accounting choice provided to Delaware-incorporated firms between the treasury and retirement methods. This accounting choice does not affect income, cash flows, or net assets, but it nevertheless affects financial reporting transparency and the allocation of equity between retained earnings and contributed capital. According to Generally Accepted Accounting Principles (GAAP), the accounting choice to record share repurchases should reflect management's intended disposition of the repurchased shares. We compare characteristics of Delaware-incorporated treasury and retirement firms and find that the choice between the two accounting methods is not always consistent with GAAP, but neither is it random; rather, this choice is related to a number of firm characteristics including firm growth, industry membership, trading exchange, and price–earnings ratio. We also find that a firm's accounting method for share repurchases is associated with a firm's propensity to make future share repurchases.     

The Impact of Capital Structure on Efficient Sourcing and Strategic Behavior

We model the capital structure choice of a firm that operates under imperfect competition. Extant literature demonstrates that debt commits a firm to an aggressive output stance, which is an advantage to the firm under Cournot competition. However, empirical evidence, indicates that debt is a disadvantage under imperfect competition. We reconcile the theory with the evidence by incorporating firms' relations with their suppliers, in a model of strategic firmrival interactions. Under imperfect competition and incomplete contracting, we show that although debt financing improves a firm's input sourcing efficiency it could also benefit the firm's rivals by lowering their input costs. This effect offsets the benefits due to aggressive product market strategies that result from increased debt. Under certain conditions this subsidy effect is sufficiently strong that debt is suboptimal in equilibrium and leads to an increase in rival's shareholder value.     

Redacted Disclosure

In this paper we investigate a firm's decision to redact proprietary information from its material contract filings. Information redaction results when the Security and Exchange Commission (SEC) grants a firm's request to withhold information from investors in its material contract filings, presumably because the information is proprietary. We hypothesize that when firms redact information, measures of adverse selection deteriorate. That is, the redaction of proprietary information from material contracts should be associated with: a larger adverse selection component of the bid‐ask spread, reductions in market depth, and lower market turnover. In addition, we conjecture that the decision to redact depends on whether the firm plans on raising capital, the competitiveness of the firm's industry, and the performance of the firm. Overall the results of our analysis generally support our predictions. We find that when firms redact information, contemporaneous measures of the adverse selection component of the bid‐ask spread rise, and market depth and share turnover deteriorate; this suggests an increase in adverse selection. We also find firms are less likely to redact when they issue long‐term debt and are more likely to redact when they are in a competitive industry or experience losses.     

Firm Characteristics,Unanticipated Inflation,and Stock Returns

This paper re-examines the effects of nominal contracts on the relationship between unanticipated inflation and an individual stock's rate of return. This study differs in three main ways from previous research. First, announced inflation data are used to examine the effects of unanticipated inflation. Second, a different specification is used to obtain more efficient estimates. Third, additional nominal contracts are considered. The empirical results indicate that time-varying firm characteristics related to inflation predominately determine the effect of unanticipated inflation on a stock's rate of return. A firm's debt-equity ratio appears to be particularly important in determining the response.