Written by Daniel Bergstresser and Thomas Philippon
Summarized by William A. Trent, CFA
Edited by Constantinos Papanastasiou, CFAÂ Â Â
President, CFA Society of
The authors provide evidence that increased sensitivity of CEO compensation to company share price encourages greater use of discretionary accruals to manipulate earnings. Furthermore, they demonstrate that years in which accruals are highest are those in which the most shares are sold when options are exercised.
The conflict between dispersed owner–investors and hired management is central to the governance literature. Jensen and Murphy (1990) showed that from 1974 to 1986, CEO pay had little relationship with share price, which resulted in excessive R&D and capital expenditures as CEOs built fiefdoms. To address this issue, companies began tying CEO compensation more closely to the share price. Hall and Liebman (1998) showed that the exposure of CEO wealth to share price tripled between 1980 and 1994, and Mehran (1995) found that firm performance was positively tied to share-based CEO incentives. However, the use of share-based incentives continued to grow, doubling again from 1994 to 2000, and turn of the century scandals led some to question whether the now high exposure resulted in an incentive to manage earnings. The authors provide evidence that that was indeed the case.
The authors use data from firms’ reported income statements to compute the absolute value of accruals (the difference between earnings and cash flows from operations). CEO incentives are described as the sensitivity of CEO wealth to share price, specifically the dollar change in CEO wealth for a 1 percent rise in the company stock price. They call this relationship the “incentive ratio.”
The authors find that a 1 percentage point increase in the incentive ratio is associated with an 11 basis point increase in the absolute value of the firm’s financial accruals. A movement from the 25th percentile of incentive ratio to the 75th percentile would be associated with a 300 bp increase in the absolute value of accruals over assets. These results are robust after controlling for firm size, corporate governance, firm age, lagged leverage, lagged sales volatility, year and industry dummies, 10 deciles of market-to-book values, and dummies for the stock exchange on which the companies trade. These results show a strong link between CEO share-based incentives and earnings management.
The authors then examine CEO option exercises and insider sales in periods of large accruals. They find that periods of high accruals are accompanied by higher levels of insider sales and that such periods are followed by particularly low earnings and stock returns.
Taken together, the results of the study suggest that increased share-based CEO compensation has replaced one governance issue (overinvestment) with another (earnings management).
* The CFA Society of Cyprus is a member society of CFA Institute, an international, nonprofit member organization of more than 88,000 investment practitioners and educators in 129 countries. CFA Institute awards the Chartered Financial Analyst (CFA) professional qualification, the designation of professional excellence within the global investment community. For more information on the CFA designation, please visit CFA Institute web page on www.cfainstitute.org or CFA Society of Cyprus web page on www.cfacyprus.com , e-mail: [email protected] .
