The evidence speaks to the debate on how corporate governance regulation interacts with firms' and managers' incentives, and ultimately affects corporate operating and investment strategies. The evidence contributes to the literature on the economic effects of the governance regulations in SOX on CEOs’ compensation contracts and corporate investment strategies. The evidence also contributes to this literature by documenting how the period after SOX is associated with changes in stock- and option-based compensation. The authors find evidence that the changes in investments are related to lower operating performances of firms, suggesting that these changes were costly to investors.

Cohen, D. A., Dey, A., & Lys, T. Z. 2013. Corporate Governance Reform and Executive Incentives: Implications for Investments and Risk Taking. Contemporary Accounting Research 30 (4), 1296-1332.

In response to a series of corporate scandals beginning with Enron, the U.S. Congress enacted the Sarbanes-Oxley Act (SOX) in 2002 aimed at regulating the governance of firms. While this has resulted in a large and growing body of research, the overall consequences of regulating firms’ governance structures is not yet well understood. For instance, one of the questions still under assessment is to what extent corporate governance regulation interacts with firms’ and managers’ incentives and ultimately affects corporate operating and investment strategies. The authors’ objective is to investigate how governance regulations in SOX and the exchanges are associated with chief executive officers’ (CEOs) incentives and risk-taking behavior. While there are no direct mandates in SOX regarding executive compensation, two provisions in SOX motivate the analyses. First, SOX requires that a majority of board members of all publicly traded companies be independent, thus increasing the role of independent directors. Second, SOX increases the liability of corporate officers and directors, including expanding the scope of their legal obligations by requiring CEOs and CFOs to certify financial statement information and increasing the penalties associated with violations of securities acts. The authors discuss how these requirements are likely to affect incentive compensation and risk-taking behaviors of executives.

The sample consists of industrial companies from the COMPUSTAT annual industrial and research files and ExecuComp and covers the period 1992–2006. For the analyses with board independence, the authors merge the above sample with RiskMetrics. This results in a sample of 1,158 firms and 12,486 firm-year observations. The final sample represents only firm-year observations where data for all variables included in the analysis are available.

• The authors find that there were significant shifts in executive compensation to packages that have less incentive-based compensation.
• The sample firms significantly reduced investments in risky projects in the period following SOX.
• While the authors find a decline in incentive-based compensation, they also find that CEOs’ responses to risk-inducing incentives declined significantly in the post-SOX period. Therefore, the reductions in investments are not only the consequence of changes in incentive contracts but also the consequence of increased personal costs perceived by CEOs in the period after SOX.
• Furthermore, the authors find evidence indicating that these changes in investments were, indeed, associated with reduced operating performance of the sample firms and that these changes are correlated with firm-specific stock price changes at the SOX events.
• The authors find evidence that the changes in investments are related to lower operating performances of firms, suggesting that these changes were costly to investors.
• The changes in investments were in part due to changes in executive compensation contracts and in part related to increased executives' personal costs of engaging in risky activities.

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The quality of reported in earnings is influenced by a firm’s fundamentals. To the extent investors differ in their ability to process this information, poor earnings quality can lead to information asymmetry, which can be costly. For these reasons, standard-setters and regulators are concerned about the quality of accounting information and its consequences for capital markets. This study provides empirical support for the concerns articulated by regulators that an important adverse consequence of poor earnings quality is increased information asymmetry and reduced liquidity.

For more information on this study, please contact Nilabhra Bhattacharya.
 

Bhattacharya, N., H. Desai, and K. Venkataraman. 2013. Does Earnings Quality Affect Information Asymmetry? Evidence from Trading Costs. Contemporary Accounting Research 30 (2).

An important attribute of the quality of accounting information is the extent to which earnings (accruals) map into cash flows. Poor mapping of accruals into cash flows reduces the information content of reported earnings and results in lower-quality earnings. If investors differ in their ability to process earnings related information, then poor earnings quality can result in differently informed investors and thereby exacerbate the information asymmetry in financial markets. Regulators and standard-setters view a reduction in information asymmetry to be an important benefit of improved earnings quality. This study examines whether poor earnings quality is associated with higher information asymmetry in capital markets.

The authors examined the association between earnings quality and information asymmetry during non-earnings announcement periods. Additionally, they tested whether earnings quality is associated with the increase in adverse selection risk around earnings release. The initial sample of firms tested included all NSYE and NASDAQ firms with available data on the CRSP, COMPUSTAT, and Trades and Quotes (TAQ) databases. The firm data was measured for the years 1997 through 2006. Information asymmetry was measured as reflected in the adverse selection component of the trading cost.  Descriptive statistics were used to gather empirical results.

• The inverse relation between earnings quality and the increase in information asymmetry around earnings releases is observed for all measures of earnings quality.
• The association between earnings quality and the increase in information asymmetry is more pronounced for smaller firms.
• Managerial choices that cause accruals volatility to be too high or too low relative to industry norms increase information asymmetry.
   

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The analysis shows that (1) equity incentives are more effective in reducing company-level control problems; (2) restricted equity provides greater incentives than unrestricted equity; and (3) CFO incentives have a more significant impact on the quality of internal control than CEO incentives. These insights have important implications for compensation committees who make compensation recommendations and the full board of directors who ratifies those recommendations. They suggest that both the level and type of equity incentives should be considered in compensation design to motivate managers to invest in strong internal controls.

Balsam, S., Jiang, W., Lu, B. 2014. Equity Incentives and Internal Control Weaknesses. Contemporary Accounting Research 31 (1):178-201. 

The authors address the empirical question of whether incentives associated with equity ownership induce managers to maintain strong internal controls. If managers believe adverse internal control opinions negatively affect the value of their equity holdings, equity incentives may provide the motivation for them to strengthen internal controls. The negative wealth consequences associated with the disclosure of internal control weaknesses suggest that equity-based incentives should motivate managers to develop and maintain effective internal controls over financial reporting, though some prior work has shown that equity incentives can lead to opportunistic actions by management. To the extent that lax internal controls provide the opportunity for earnings management, the link between accounting earning and share prices, along with the motivation provided by equity incentive to increase share prices, may provide an incentive for managers to want weaker internal controls. The study adds to the literature on equity incentives by focusing on specific aspect of managerial performance- the effectiveness of internal controls and the literature examining the determinants of internal control deficiencies. The results of the study provide insight into the role equity incentives play in improving the quality of internal control.

The study was conducted using a sample comprised of firms filing SOX Section 404 reports during 2004 and 2005. The authors obtained the data on internal control opinions from Audit Analytics, the financial data from COMPUSTAT, and the compensation and governance variables from Equilar Inc, yielding a sample of 569 firms. The control sample contained 3,798 observations. They used firm size, loss proportion and firm age to capture the level of investment in the internal control systems.

• Equity incentives motivate managers to implement effective controls.
• Evidence suggests that firms where the CEO and CFO have higher levels of equity incentives are less likely to have internal control problems.
• The equity incentives of the CFO play a more significant role in determining internal control quality than those of the CEO.
• The bonus is significantly lower, and salary significantly higher, as a percentage of total compensation, for firms with material internal control weaknesses.
• Firms with material internal control weaknesses are smaller, younger, more likely to have had a loss, have more segments and are more likely to have experienced a restructuring, than firms without weaknesses.
• Material weakness firms had fewer independent directors, smaller audit committees and boards, are less likely to engage a Big 4 auditor, had shorter auditor tenures, and were more likely to have experienced a recent auditor change.
• Lax internal controls provide the opportunity for earnings management, which may allow managers to meet targets to maintain a higher share price than otherwise warranted. When the authors partition based upon type of opinion, they find that equity incentives are more effective in mitigating company-level internal control risk.

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The authors find that the informative disclosure of non-GAAP earnings information enables investors to better understand firms’ future operating performance relative to opaque disclosures. Further, the results suggest that the most pervasive motive behind the disclosure of non-GAAP earnings information is to inform, although an economically significant proportion of firms appear to be opportunistic in that they only disclose non-GAAP earnings information when it increases investors’ perceptions of core operating earnings. The study should be useful to investors, financial analysts, regulators, and researchers for assessing the non-GAAP disclosure motives of management and the effect of these motives on market participants.

Curtis, A. B., McVay, S. E., & Whipple, B. C. 2014. The Disclosure of Non-GAAP Earnings Information in the Presence of Transitory Gains. Accounting Review 89 (3): 933-958.

Managers regularly highlight the transitory components of GAAP earnings in their earnings announcements, and frequently disclose non-GAAP earnings excluding these transitory components. The motivation for managers to disclose non-GAAP earnings, however, is heavily debated. On one hand, managers claim that they disclose non-GAAP earnings to aid investors in assessing the firm’s core operating performance. On the other hand, regulators express concerns that some managers may be motivated to inflate perceptions of core operating performance, which could mislead investors. Essentially, this ongoing debate centers on whether managers disclose non-GAAP earnings to inform or mislead. Non-GAAP earnings are generally more predictive of future operating earnings, but they can also be overstated to meet strategic earnings benchmarks on a non-GAAP basis. Because most transitory items are income-decreasing, both motives predict the same disclosure choice. Because both motives impact managers’ non-GAAP disclosure, it is difficult to determine which motivation is more pervasive or to provide evidence that a particular disclosure is unambiguously informative or opportunistic.

The authors examine the disclosure of non-GAAP earnings information in quarters containing transitory gains to investigate whether the primary motivation for these managers to disclose non-GAAP earnings is to inform or mislead.

The authors examine a sample of 1,920 firm-quarters with transitory gains in the form of net income-increasing special items of at least one penny per share from 2004 to 2009. They require sample firms to have (1) CRSP coverage, (2) a non-missing earnings announcement date on Compustat, (3) a non-missing 10-Q/K filing date on EDGAR, (4) at least two days between the earnings announcement and filing dates, and (5) data available for each of the variables, including one-year-ahead earnings.

Managers motivated to inform stakeholders about sustainable earnings will disclose non-GAAP earnings information excluding the gain, whereas managers motivated to report higher earnings will obscure the transitory nature of the gain by focusing on GAAP earnings.

• The most pervasive motivation for non-GAAP reporting in the presence of transitory gains is to inform.
• Nearly half of the sample discloses non-GAAP earnings information that allows investors to quickly and easily assess operating performance excluding the gain. Investors of these firms appear to efficiently price the transitory nature of these gains.
• The remaining earnings announcements contain more opaque disclosures. Among these firms, investors price the gain positively at the time of the earnings announcement, but this partially reverses at the time of the subsequent 10-Q/K filing. The evidence is consistent with investors not fully incorporating the transitory nature of the gain at the time of the earnings announcement.
• Among opaque disclosers, the authors find that approximately half appear to follow a consistent policy of non-disclosure across both transitory gain and transitory loss quarters. The other half, however, appear opportunistic because they disclose non-GAAP earnings information in transitory loss quarters, but not transitory gain quarters.
• The authors also find some evidence of egregious opportunism. In 101 firm-quarters, which is 5.3 percent of the sample, managers explicitly disclose non-GAAP earnings, excluding expenses but including transitory gains; this is more prevalent when it allows them to meet earnings benchmarks.

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