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  • Jennifer M Mueller-Phillips
    Board Monitoring and Endogenous Information Asymmetry.
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 13.0 Governance, 13.05 Board/Audit Committee Oversight, 14.0 Corporate Matters, 14.09 CEO Tenure and Experience, 14.10 CEO Compensation 
    Title:
    Board Monitoring and Endogenous Information Asymmetry.
    Practical Implications:

    The author claims that motivating the CEO to reveal information may or may not be beneficial. The disconnection between compensation and outcomes results from active monitoring. Compensation contracts rely on board evaluation, not on the final outcomes, to provide incentives. The proactive board activity can result in poor firm performance. This proactive activity requires extra care to reign in an expert: the CEO.

    Citation:

    Tian, J. J. 2014. Board Monitoring and Endogenous Information Asymmetry. Contemporary Accounting Research 31 (1): 136-151.

    Keywords:
    boarding monitoring, information acquisition, information asymmetry, project decision, executive compensation, CEO compensation
    Purpose of the Study:

    Boards of directors are frequently questioned pertaining to their monitoring role in executive decision making and compensation. The sequence of financial fraud in the early 2000s called public attention that boards have not done enough to align executive incentives with shareholders’ interests. Since shareholders do not normally observe executives’ actions and may not even know what actions executives should have taken to maximize shareholder value, increasing board effort to reduce such information asymmetry is commonly viewed as desirable.

    The present study challenges this common view that increasing board effort in monitoring is always desirable. This view neglects a key fact in corporate decision making: the information asymmetry between the CEO and shareholders is a result of the CEOs expertise. This study highlights the fact that CEOs are hired for their superior ability to make strategic decisions, particularly for their unique skills to acquire, process and interpret information relevant to these decisions.

    Design/Method/ Approach:

    The authors uses analytical modeling to conclude on the questions of interest.

    Findings:

    If board monitoring eliminates all information asymmetry, the board can easily ensure that decisions are made in the best interest of shareholders. It resolves all uncertainty in the remaining decision problems. However, preserving uncertainty is crucial ex ante in order to motivate a risk-averse CEO to acquire information, as effort need not be expended if there is no concern for uncertainty. Thus, board monitoring creates a time consistency problem for the CEO to acquire information.

    The board should actively engage in monitoring activities only when the board is able to evaluate the information provided by the CEO with high accuracy. That is, when board monitoring is able to produce enough information about the CEO’s effort directly, preserving uncertainty to incentivize the CEO to acquire information is a second-order concern. However, if a project requires special skills for implementation and board evaluation may not be accurate enough, it is better for the board to remain passive and not interfere with the CEO’s decisions.

    Category:
    Corporate Matters, Governance
    Sub-category:
    Board/Audit Committee Oversight, CEO Compensation, CEO Tenure & Experience
  • Jennifer M Mueller-Phillips
    CEO Equity Incentives and Financial Misreporting: The Role...
    research summary posted July 23, 2015 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.01 Earnings Management, 14.10 CEO Compensation 
    Title:
    CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise.
    Practical Implications:

    The evidence documents an important role for financial statement verification in the way managers are incentivized. While the economic consequences of auditing have focused on improvements to the information environment and a lower cost of capital, this study broadens the role of auditing in the efficient functioning of firms. The link between auditor expertise and managerial incentives is an important one because CEO incentives have wide implications for managerial risk-taking.

    This study contributes to the CEO contracting-financial misreporting literature by providing an economic rationale for the inconsistent evidence in prior studies. The authors show that detection mechanisms such as auditor expertise mitigate the effect of equity incentives on misreporting by limiting the ability of managers to misreport financial statements.

    Citation:

    Jayaraman, S., & Milbourn, T. 2015. CEO Equity Incentives and Financial Misreporting: The Role of Auditor Expertise. Accounting Review 90 (1): 321-350. 

    Keywords:
    auditor expertise, equity incentives, misreporting, earning management, CEO compensation
    Purpose of the Study:

    In the aftermath of accounting scandals at the turn of the century, many academics, regulators, and the media have questioned whether managerial compensation contracts are the culprits behind these acts of reporting transgressions. Greater equity incentives allegedly encourage managers to indulge in myopic acts aimed at maintaining stock prices and earnings at artificially high levels in the near term. A large literature in accounting and finance tests whether CEOs with equity-based incentives manipulate their financial statements. While the other studies differ in their research designs, empirical measures, and sample periods, none of them consider the role of detection mechanisms that would limit the ability of managers to successfully carry out any misreporting, assuming that equity incentives do indeed encourage misreporting. The authors posit effective auditing as one such mechanism, and argue that incorporating it in a CEO contracting-financial misreporting framework is likely to shed light on the preceding inconsistent findings. Following the auditing literature, the authors use auditor industry expertise to capture the effectiveness of auditing and examine how it affects the association between CEO equity incentives and financial misreporting.

    Design/Method/ Approach:

    The authors merged four databases: (1) data on lawsuits from1994 to 2004, (2) data on CEO equity incentives from ExecuComp, (3) data on auditor expertise from 2003 to 2007 from Audit Analytics, and (4) data on control variables from Compustat and IRRC. The final sample comprises 7,427 firm-year observations over the period 1994 to 2004, of which 201 firm-years of the sample involve a lawsuit concerning an accounting or other misreporting. These observations involve 87 unique firms.

    Findings:

    Controlling for previously identified determinants of CEO incentives, firms audited by an industry expert grant their CEOs an average of 14 percent more equity incentives than those audited by a non-expert. To further validate the inferences, the authors exploit variation across industries in the extent to which earnings matter for determining the stock price, and find that auditor expertise is positively associated with CEO incentives only in industries where earnings matter for stock price informativeness. Overall, these results are consistent with optimal contracting theories where equity-based incentives are, at least in part, granted by trading off the benefits of effort with the costs of financial misreporting.

    The authors find that AA firms audited by an expert auditor in the post-period experience an average of 17 percent larger increase in CEO incentives as compared to AA firms audited by a non-expert in the post-period. Overall, these time-series tests performed complement the cross-sectional inferences on the important effect of auditor expertise on CEO equity incentives.

    Category:
    Corporate Matters
    Sub-category:
    CEO Compensation, Earnings Management
  • Jennifer M Mueller-Phillips
    Corporate Governance Reform and Executive Incentives:...
    research summary posted July 29, 2015 by Jennifer M Mueller-Phillips, tagged 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior, 14.10 CEO Compensation 
    Title:
    Corporate Governance Reform and Executive Incentives: Implications for Investments and Risk Taking.
    Practical Implications:

    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.

    Citation:

    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.

    Keywords:
    corporate governance, executive compensation, investments, risk-taking, executives
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    The sample consists of industrial companies from the COMPUSTAT annual industrial and research files and ExecuComp and covers the period 19922006. 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.

    Findings:
    • 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.
    Category:
    Corporate Matters
    Sub-category:
    CEO Compensation, Earnings Targets & Management Behavior
  • Jennifer M Mueller-Phillips
    Equity Incentives and Internal Control Weaknesses.
    research summary posted July 28, 2015 by Jennifer M Mueller-Phillips, tagged 07.0 Internal Control, 07.03 Reporting Material Weaknesses, 14.0 Corporate Matters, 14.05 Earnings Targets and Management Behavior, 14.07 Executive Compensation, 14.10 CEO Compensation 
    Title:
    Equity Incentives and Internal Control Weaknesses.
    Practical Implications:

    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.

    Citation:

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

    Keywords:
    Internal auditing, equity incentives, stock options, internal controls, material weakness (auditing), CEO compensation, CFO compensation, executive compensation
    Purpose of the Study:

    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.

    Design/Method/ Approach:

    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.

    Findings:
    • 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.
    Category:
    Corporate Matters, Internal Control
    Sub-category:
    CEO Compensation, Earnings Targets & Management Behavior, Executive Compensation, Reporting Material Weaknesses
  • Jennifer M Mueller-Phillips
    Executive Equity Risk-Taking Incentives and Audit Pricing.
    research summary posted January 19, 2016 by Jennifer M Mueller-Phillips, tagged 02.0 Client Acceptance and Continuance, 02.01 Audit Fee Decisions, 02.02 Client Risk Assessment, 14.0 Corporate Matters, 14.10 CEO Compensation 
    Title:
    Executive Equity Risk-Taking Incentives and Audit Pricing.
    Practical Implications:

    The study results are important to regulators and audit practitioners as they show an association between executive compensation and auditor compensation. The study results show that high executive risk-taking incentives, as measured by vega, contributes to higher audit fees. These results provide important insights into how incentives designed to compensate and motivate executives can alter the audit fee structure.

    Citation:

    Chen, Y., F. A. Gul, M. Veeraraghavan, and L. Zolotoy. 2015. Executive Equity Risk-Taking Incentives and Audit Pricing. The Accounting Review 90 (6): 22052234.

    Keywords:
    executive compensation, audit fees, vega, misreporting, SOX
    Purpose of the Study:

    This study assesses whether there is an association between executive stock compensation and audit fees. The authors specifically investigate whether the sensitivity of CEO compensation to stock return volatility (vega) and stock prices (delta) are associated with audit fees. Prior literature shows that higher vega leads managers to engage in more financial misreporting. This increase in financial misreporting could in turn influence audit risk assessment and audit fees.  

    The main motivation for this study comes from the PCAOB’s recent related-party standard proposal. The proposed standard requires auditors to perform procedures to evaluate compensation practices when gaining an understanding of relationships between the company and its executive officers. In addition, current audit fee models do not consider executive compensation incentives in the pricing of audit services. Finally, there are extensive literatures on executive compensation and auditor compensation but no evaluation at the intersection of executive compensation practices and their effect on audit fees. This study attempts to address these gaps in the literature.

    Design/Method/ Approach:

    The authors employ an archival research methodology in this study. They obtain audit fee data from the Audit Analytics database and executive compensation from ExecuComp. The sample period is from 2000-2010. Company financial data is from Compustat Fundamentals Annual File.  

    Findings:
    • The authors show that for clients with a high executive vega, audit firms charge higher audit fees. This follows the logic that clients with higher vega have a higher likelihood to misreport and that auditors consider that likelihood when pricing audit services. The authors also found that the increase in fees is not related to the effort needed to audit expenses related to stock-based compensation.
    • The introduction of the Sarbanes-Oxley Act weakens the association between vega and audit fees.
    • CEO characteristics affect the relationship between vega and audit fees. Specifically, the positive association between vega and audit fees is stronger when the CEO is older and when the CEO is the board chair.
    Category:
    Client Acceptance and Continuance, Corporate Matters
    Sub-category:
    Audit Fee Decisions, CEO Compensation, Client Risk Assessment

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