Controllability of Risk and the Design of Incentive-Compensation Contracts

Christopher S. Armstrong, Stephen Glaeser and Sterling Huang

Abstract

We examine how the ability to control firm exposure to risk affects the design of executive compensation contracts. To do so, we use the introduction of exchanged-traded weather derivatives, which significantly increased executives’ ability to control their firms’ exposure to weather risk, as a natural experiment. We find that executives for whom weather derivatives have the greatest impact on the ability to control firm exposure to weather risk experience relative declines in total compensation and equity incentives. The former finding is consistent with a reduction in the risk premium that executives receive for their firms’ exposure to weather risk. The latter finding suggests that risk and incentives are complements when executives can control their firms’ exposure to risk. Collectively, our results show that the executives’ ability to control their firms’ exposure to risk alters the nature of agency conflicts and influences the design of incentive-compensation contracts.

Out-of-equilibrium CEO Incentives, Dynamic Adjustment and Financial Misreporting

Robert Bushman, Zhonglan Dai and Weining Zhang

Abstract

The objective of this paper is to investigate (1) the role of adjustment costs in sustaining divergence between actual and optimal CEO equity incentives; (2) the nature of the dynamic process governing adjustment of non-optimal incentives back towards optimal; and (3) the extent to which deviations from optimal incentives exacerbate financial misreporting. Consistent with adjustment costs driving a wedge between realized and optimal incentives, we document that firm value decreases in deviations from optimal, and that firms only partially close the current gap between target and actual CEO incentives over the subsequent year. Further, speed of adjustment towards optimality varies with differences in monitoring intensity, product market competition and CEO tenure. Examining consequences of out-of-equilibrium incentives, we find that financial misreporting is increasing in the deviation from optimal, where the sensitivity of misreporting to deviation is stronger when CEO incentives are excessive relative to when they are below optimal levels. Finally, the sensitivity of misreporting to deviation is lower for firms with higher monitoring intensity, and magnified for firms with more intense product market competition and early term CEOs.

Styles of regulators: Evidence from the SEC’s comment letters

Abstract

Security regulations are enforced by SEC staff members. Conceptually, the regulations are to be uniformly enforced despite personal differences among SEC enforcers. We offer evidence to the contrary. Using the SEC’s comment letters as our setting, we find that SEC staff members exhibit unique personal “styles.” The effects of their personal styles on firms’ remediation costs, the contents of SEC comment letters, and the quality of firms’ financial reporting are surprisingly large. We manually collect information on SEC staff members. Our results demonstrate that female staff members are generally tougher reviewers and that CPA qualification matters. Overall, our study offers evidence that SEC staff members exhibit individual differences, and their styles shape firms’ financial reporting.

Do Repatriation Tax Holidays Promote Corporate Social Responsibility? Evidence from the American Jobs Creation Act

Abstract

In response to the temporary tax holiday introduced by the American Jobs Creation Act, U.S. multinational corporations repatriated approximately $300 billion from their foreign subsidiaries to the United States. We find that repatriating firms invest at least a portion of the repatriated funds in corporate social responsibility (CSR) initiatives, as evidenced by increasing CSR performance of the repatriating firms relative to non-repatriating firms during the years after the repatriation. The effect of repatriation on CSR performance is more pronounced for financially unconstrained firms, poorly governed firms, and firms located in states with stronger stakeholder preferences for CSR.

Direct Evidence on Earnings Used in Executive Compensation Performance Measurement

Abstract

Motivated by competing theories on the properties of earnings required for compensation performance measurement, we provide direct evidence on the properties of actual accounting earnings that are used in determining compensation payouts (Compensation Earnings). Using a large sample of manually collected Compensation Earnings for U.S. firms, we show that firms make economically significant adjustments to GAAP Earnings in arriving at Compensation Earnings. While GAAP Earnings exhibit conservatism, we fail to detect conservatism (either by statistical significance or by magnitude of coefficient) in Compensation Earnings using the same sample and the same research design. The absence of conservatism in Compensation Earnings is also documented in various subsamples partitioned on market-to-book ratio, leverage, firm size, and corporate governance. Further analyses indicate that the adjustment from GAAP Earnings to Compensation Earnings involves the removal of less persistent components of GAAP Earnings, resulting in Compensation Earnings that are more persistent than GAAP Earnings.

Government Ownership, Non-CEO Top Executives’ Horizontal Pay Dispersion and Firm Performance

Wei Jiang, Bin Ke, Hong Ru, and Yue Xu

Abstract
The objective of this study is to analyze the compensation practices of non-CEO top executives as a group measured by horizontal pay dispersion. We address two specific questions. First, we examine whether government ownership affects non-CEO executives’ horizontal pay dispersion. Second, we examine how such ownership-induced horizontal pay dispersion affects firm performance. We find that non-CEO top executives’ horizontal pay dispersion is lower in government-controlled firms (SOEs) than in privately-controlled firms (non-SOEs). We show that the difference in horizontal pay dispersion between SOEs and non-SOEs is consistent with the institutional differences between the two ownership types. There is evidence that such ownership-induced horizontal pay dispersion is associated with lower firm performance, suggesting that SOEs’ horizontal pay dispersion is suboptimal from the perspective of shareholder value maximization.

Peer Firm Selection and Executive Compensation: The Case of Dual-role Peers

Abstract

The Securities and Exchange Commission’s 2006 Executive Compensation Disclosure Rules require firms to disclose how executive pay is determined by benchmarking total compensation at the competitive labor market level (compensation benchmarking) and by benchmarking performance targets in relative performance evaluation (performance benchmarking). Prior studies examining the selection of peer firms typically focus on one or the other benchmark. Using Incentive Lab’s detailed data on proxy statements from 2006 through 2015, we find that approximately 57% of the peers are used simultaneously for both compensation and performance benchmarking, a pattern largely ignored in prior literature. We label these peers as “dual-role peers” and show that firms can indeed succeed in selecting such peers in order to achieve high pay and yet low expected performance. Moreover, we find that the extent of such discretionary peer selection is positively associated with realized excess CEO pay, and negatively associated with ex-post stock performance in the subsequent year. Additional evidence shows that the power of CEOs to intervene the boards’ compensation decisions exacerbates the opportunistic peer selection. Our study provides new evidence on managerial self-serving behavior in compensation practices and highlights the importance of considering dual-role peers in compensation research.

Sterling HUANG

 

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Biography

Dr. Sterling Huang joined Singapore Management University in 2014. He received his Master of Science and Ph.D. in Management from INSEAD Business School. Prior to his doctoral studies, he was an auditor with PricewaterhouseCoopers (Sydney) and a lecturer at Macquarie University Australia. He has published in the Journal of Accounting Research, The Accounting Review, Review of Financial Studies, Strategic Management Journal, European Accounting Review and Journal of Accounting, Auditing, and Finance. His work has been cited multiple times in major media outlets and practitioner forums, such as Wall Street Journal, Thomson Reuters, Bloomberg, INSEAD Knowledge, Harvard Business Review, Booz & Co Strategy & Business Magazine, Chief Executive Magazine, American Banker Online, Finance & Development (IMF), the Harvard Law School Forum on Corporate Governance and the Columbia Law School’s Blog on Corporations and the Capital Markets. He is a Chartered Financial Analyst Charterholder and a member of Institute of Chartered Accountant Australia.

 

Huai Zhang

 

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Biography

Dr Huai Zhang received his Ph.D in Accounting from Columbia University in 2000. He taught at University of Illinois at Chicago and was promoted to Associate Professor with tenure at University of Hong Kong before joining Nanyang Business School in 2006. He has published in major accounting and finance journals, including Journal of Accounting and Economics, Journal of Finance and Review of Accounting Studies. He received the Best Paper Award at the 2004 International Finance Conference and the 2016 Midwest Finance Association Meeting. He was also the recipient of Nanyang Business School Research Excellence Award in 2011 and 2013. He sits on the editorial board of Review of Accounting and Finance and The International Journal of Accounting, both refereed academic journals, and is an ad hoc reviewer for journals such as Journal of Accounting Research, The Accounting Review, Contemporary Accounting Research and Review of Accounting Studies. He is the keynote speaker at the 5th Annual International Conference on Accounting and Finance, the 1st Boya Management Accounting Research Forum, and the 14th International Symposium on Accounting Research in China. In recognition of his contributions to China-related studies and his efforts in nurturing local researchers, the Fujian Province Government in China conferred him the title of “Ming Jiang Scholar” (闽江学者) in 2015.