Managing EPS Through Accelerated Share Repurchases: Compensation Versus Capital Market Incentives

Transcription

1 Managng EPS Through Accelerated Share Repurchases: Compensaton Versus Captal Market Incentves Carol Marquardt Assocate Professor Baruch College CUNY Chrstne Tan Assstant Professor Baruch College CUNY and Susan Young Assocate Professor Baruch College CUNY Prelmnary Draft March 2007 Abstract: Ths paper emprcally examnes the determnants of frms decsons to undertake accelerated share repurchases (ASRs). In an ASR, the frm repurchases ts own shares of stock through an nvestment bank rather than on the open market, allowng the company to acqure a targeted number of shares and record ts effects on earnngs per share (EPS) mmedately. Consstent wth our predctons, we fnd that ASR frms are more lkely to compensate ther managers explctly on reported EPS fgures and are less lkely to beat earnngs benchmarks than are OMR frms. These results are robust to controllng for sgnalng effects, as well as other known determnants of stock repurchase decsons. Addtonal evdence on ASR settlement costs suggests that frms are wllng to ncur costs to secure perceved fnancal accountng and compensaton benefts. Our results have mplcatons for standard settng, publc polcy, and corporate governance. 1

2 Managng EPS Through Accelerated Share Repurchases: Compensaton Versus Captal Market Incentves 1. Introducton Ths paper emprcally examnes the recent phenomenon of accelerated share repurchases (ASRs). ASRs dffer from typcal open market repurchases (OMRs) of stock n two mportant respects. Frst, n an ASR, the frm does not repurchase shares on the open market but rather borrows ts own shares of stock from an nvestment bank. Ths allows the company to both acqure a targeted number of shares mmedately and to recognze the full effects of the transacton on reported earnngs per share (EPS) n the current accountng perod. Second, the frm enters nto a forward contract wth the nvestment bank and s thus oblgated to repurchase a pre-specfed number of shares at a purchase prce determned by an average market prce over the contract perod; there s no smlar oblgaton n OMRs. Recent artcles n the fnancal press have crtczed the ncreasng use of ASRs (Maremont and Ng 2006). The man concern s that frms are usng ASR arrangements to obtan short-term EPS ncreases but damage shareholder value n the long run due to the guaranteed nature of the repurchase agreement. Pror research on stock repurchases shows that frms do use OMRs to manage earnngs per share (EPS). For example, Bens et al. (2003) fnd that frms ncrease the level of ther frms stock repurchases when earnngs are below the level requred to acheve the desred rate of EPS growth, and Hrbar, Jenkns, and Johnson (2006) fnd that frms use stock repurchases to meet or beat analysts forecasts of EPS. We extend the pror lterature on the use of stock repurchases to manage EPS by examnng whether 2

3 there are systematc dfferences n frms motvatons n undertakng ASRs rather than OMRs. We explot the underlyng dfferences between ASRs and OMRs to derve dfferental predctons regardng frms decsons to engage n ASRs versus OMRs. In partcular, we expect the dfferent fnancal reportng treatment of ASRs versus OMRs to be an mportant determnant n the decson to undertake one or the other of these transactons. Because the full amount of shares targeted for repurchase are acqured mmedately through an nvestment bank n an ASR, shares outstandng mmedately decrease, wth the correspondng effect reflected n reported EPS on a weghted average bass. In contrast, there s no mmedate fnancal reportng effect that occurs upon announcement of an OMR; shares outstandng decrease only as actual open market repurchases occur over tme. 1 Because the fnancal reportng effect of ASRs occurs all at once, we argue that t s less lkely that frms undertakng ASRs are dong so n order to mantan fnancal reportng flexblty to meet earnngs benchmarks, as has been shown wth OMRs. We therefore expect captal market ncentves to be relatvely less mportant n the decson to undertake an ASR versus an OMR. The mmedate recognton of a decrease n shares outstandng wth ASRs does suggest an alternatve motvaton, however that the managers of ASR frms are more lkely to be compensated on reported EPS fgures than are the managers of OMR frms. Pror research shows that the use of earnng-based bonuses affects frm s fnancal reportng choces. For example, Beatty and Weber (2006) fnd that the lkelhood of managers recevng earnngs-based bonuses affects goodwll 1 In fact, n many OMR plans, the full amount of the shares repurchase s never reached. In a sample of 450 repurchase programs over , Stephens and Wesbach (1998) fnd that frms on average acqured 74-82% of the shares announced as repurchase targets wthn three years of the repurchase announcement. 3

4 mparment decsons, and Marquardt and Wedman (2005) fnd that frms are more lkely to structure convertble bond transactons to ncrease EPS when manager bonuses are based on reported EPS fgures. Gven the relatvely large magntude of ASRs on reported EPS and the lack of fnancal reportng flexblty that ASRs offer, we beleve that compensaton ncentves are a lkely determnant n the decson to undertake an ASR versus an OMR. Usng multvarate probt analyss, we emprcally test our predctons usng a sample of 156 repurchase announcements from January 2004 through March We proxy for captal market ncentves by creatng a varable, STRING, that equals the number of consecutve quarters pror to the announcement date of the repurchase that the frm has met or exceeded the benchmark of the pror year s EPS for the same fscal quarter. We proxy for compensaton ncentves by creatng an ndcator varable, BONUS, that equals one f EPS s explctly mentoned as a determnant of annual bonuses n the frms proxy statement and zero otherwse. After controllng for the possblty that sgnalng arguments mght affect the decson to undertake an ASR versus an OMR, as well as for other varables known to be assocated wth stock repurchases, ncludng growth, pror stock prce performance, free cash flows, and frm sze, we fnd that frms are more lkely to choose an ASR over an OMR when managers are explctly compensated on EPS. We also fnd that ASR frms have shorter strngs of quarterly earnngs ncreases than do OMRs, consstent wth captal market ncentves playng a stronger role n the case of OMRs. ASR frms also tend to be sgnfcantly larger, wth hgher free cash flows and lower stock prce volatlty, than 4

5 OMR frms. Contrary to assertons n the fnancal press, we do not fnd strong evdence that sgnalng s a sgnfcant determnant n the decson to undertake an ASR. In addton, we provde descrptve evdence on the settlement costs of ASRs and fnd that, on average, the settlement cost of the forward contract exceeds the ntal repurchase prce by an average of 7.1%. We further fnd that n cases where the settlement prce exceeds the ntal repurchase prce (20 out of 22 cases), the contract s settled n cash, whle n nstances where the settlement prce s less than the ntal repurchase prce (7 out of 9 cases), the contract s settled n shares. Ths pattern s consstent wth frms choosng the form of settlement n order to mnmze the contract s dlutve effect on EPS. The paper contrbutes to the accountng lterature n several ways. Frst and most obvously, we extend the lterature on stock repurchases by examnng the determnants of the decson to undertake ASRs versus OMRs. Whle ether repurchase type may be used to ncrease reported EPS, our results suggest that compensaton ncentves are the prmary drver n the ASR decson whle, consstent wth pror work by Bens et al. (2003) and Hrbar et al. (2006), captal market ncentves appear to be more mportant for OMRs. Ths fndng should be of partcular nterest to equty nvestors, as t bears on the relatve qualty of earnngs of frms engagng n these transactons. Second, we add to the small but growng lterature that demonstrates that frms are wllng to ncur costs to secure fnancal reportng benefts. Whle ASRs delver a perceved fnancal reportng beneft n mmedately mprovng reported EPS, the guaranteed nature of the repurchase also makes ASRs more costly to mplement than 5

6 OMRs. 2 Our evdence on ASR settlement costs that exceed ntal repurchase prces by 7.1%, on average, s consstent wth ths vew. As such, the paper complements fndngs by Erckson, Hanlon, and Maydew (2004), Ayers, Lefanowcz, and Robnson (2002), Lys and Vncent (1995), and Matsunaga, Shevln and Shores (1992), who all emprcally document that frms ncur costs to report hgher net ncome. 3 Our evdence on ASR settlement costs further shows that whle ASR frms structure the forward contract transacton such that t allows them to avod mark-tomarket accountng (.e., they retan the opton to settle the forward contract n cash or shares), they typcally settle the contracts n cash to avod ssung new shares that would dlute reported EPS. Ths fndng has mplcatons for standard settng, as the Fnancal Accountng Standards Board (FASB) n ts re-delberaton of SFAS 128 has recently ssued a tentatve decson n October 2006, statng that contracts that may be settled n ether cash or shares at the entty s opton should presume that the contract wll be settled n shares f the effectve s dlutve. 4 Our results suggest that such a provson may be necessary to prevent managers from structurng forward contract transactons n a manner that enrches themselves at the expense of shareholders. Fnally, we contrbute to the lterature lnkng executve compensaton and earnngs management. Prevous research (Healy 1985; Holthausen, Larcker, and Sloan 1995; Gudry, Leone, and Rock 1999) shows that managers wll manpulate net ncome n response to bonus contracts. We contrbute to ths lterature by provdng evdence that 2 McConnell, Pegg, Senyek, Mott, and Calngasan (2006) provde an example nvolvng TXU llustratng ths pont. In the frst quarter of 2005, TXU Corp. mssed earnngs estmates due to an outstandng ASR and a rsng share prce. The company entered nto a $3.4 bllon ASR n November 2004 at an approxmate share prce of $65. The settlement share prce n May 2005 was $74, requrng the company to pay approxmately $423 n cash to settle the ASR contract, ncreasng the cost of ts share repurchase program. 3 Graham, Harvey, and Rajgopal (2005) comment on the dffculty of convncngly documentng the tradeoff between fnancal reportng costs and benefts usng archval data. 4 See 6

7 managers are more lkely to undertake potentally value-decreasng ASRs when ther bonuses depend on EPS, consstent wth arguments by Watts and Zmmerman (1990). The remander of the paper s organzed as follows. Secton 2 presents the accountng treatment for ASRs n more detal. We develop our hypotheses n Secton 3 and descrbe our research desgn n Secton 4. We outlne our sample selecton crtera n Secton 5 and provde descrptve statstcs. Our results are presented n Secton 6. Secton 7 provdes some detals on the assocated costs of settlng the forward contract and Secton 8 concludes. 2. Accountng Treatment of ASRs The volume and magntude of share repurchases has reached record levels n the past few years wth lttle evdence that ths trend wll soon subsde. A report by Standard and Poor s ssued n June 2006 showed that companes had spent a record $367 bllon on stock buybacks n the year ended March 31. Companes n the S&P 500 alone were expected to repurchase more than $435 bllon n shares durng 2006, a consderable ncrease from the approxmately $349 bllon repurchased by the 500-ndex frms n 2005 One method of share repurchases that has shown a correspondng ncrease s an ASR. An ASR s an arrangement n whch a company borrows a block of frm shares from an nvestment bank and mmedately recognzes a reducton n EPS (on a weghted average bass). At the tme of the arrangement, the company also enters nto a forward agreement wth the nvestment bank. The nvestment bank mmedately sells the shares to the company by borrowng the shares from other nvestors. The nvestment bank buys the 7

8 company shares back n the open market over tme, generally less than one year, and replaces the borrowed shares (see Fgure 1). Two accountng transactons occur when a frm enters nto the ASR agreement. Frst, equty s mmedately decreased by the number of shares to be repurchased tmes the current share prce, and cash s decreased or a lablty s ncreased by an equal amount. Second, the frm enters nto a forward contract wth the fnancal nsttuton, whch allows the nvestment bank to hedge ts short sale of shares. For most ASR agreements, the frm can choose to settle the contract n ether cash or shares for the volume-weghted-average-value of the dfference n share prce as of the begnnng of the ASR agreement to the settlement date. Under an ASR agreement wth a cash or share settlement opton, companes are not requred to mark the forward contract to market on ther books. The assumpton behnd the accountng treatment of the forward contract (not requrng t to be marked to market as the underlyng value of the frm s stock changes) s that the company ntends to settle the forward contract n shares and therefore need not consder the change n the far value of the forward contract n the calculaton of net ncome. In realty, the large majorty of ASR forward contracts are settled n cash. At settlement, the accountng treatment s to decrease cash (or ncrease labltes) and to decrease equty, assumng the prce of the companes stock has ncreased. The repurchased shares may be kept n treasury or retred. The key dfference n accountng treatments between ASR agreements and OMRs s the tmng of the recognton of the decrease n shares outstandng. Therefore, the man advantage to a frm n choosng an ASR s the mmedate mpact on outstandng shares and perhaps a stronger sgnal to the market about frm value. The dsadvantage s that 8

9 cash must be provded up front, and the frm must pay the average share value over the lfe of the contract regardless of the ncrease n share prce. Frms do not have an opton to dscontnue repurchasng shares once the ASR has been entered nto as they would wth an OMR program. In fact, pror research has shown that almost 25% of frms that announce an OMR do not repurchase shares n the announcement quarter (Le 2005). We beleve the noted ncrease n the occurrence of ASR agreements s prmarly due to the ssuance of Statement of Fnancal Accountng Standard (SFAS) No. 150, Accountng for Certan Fnancal Instruments wth Characterstcs of both Labltes and Equty. FAS 150 became effectve for nterm perods after June 15, Pror to SFAS 150, frms commonly wrote put optons on ther own shares to hedge aganst prce ncreases. SFAS 150 requres that frm use mark-to-market accountng on puts and forward optons, reducng the beneft to the frm by requrng changes n value to be recorded as ncreases or decreases to net ncome. However, as noted above, the forward contracts assocated wth ASRs are not requred to be marked to market when the frm has the opton of settlng the contract n cash or shares. 5 We provde a numercal example of the accountng treatment for ASRs n the Appendx. 3. Hypothess Development We consder the above dfferences n the accountng treatment of ASRs versus OMRs n developng our hypotheses about manageral ncentves behnd each repurchase type. Specfcally, because the decrease n equty s recognzed mmedately for the full 5 An addtonal dscusson of accountng for ASRs can be found n EITF 99-7, Accountng for an Accelerated Share Repurchase Program. 9

10 amount of shares announced as repurchase targets n an ASR, ths repurchase type does not provde the fnancal reportng flexblty that OMRs offer. For example, Hrbar et al. (2006) emprcally show that n response to captal market pressures to meet analysts EPS forecasts, frms explot the flexblty that OMRs offer n terms of choosng when or whether to buy back stock when they fall short of meetng analyst expectatons;.e., they do an OMR when they need a penny to make the forecast. Because there s no such flexblty avalable wth ASRs, we expect captal market ncentves to be relatvely less mportant n the decson to undertake an ASR versus an OMR. Our frst hypothess s therefore as follows: H1: Captal market ncentves play a more mportant role n open market repurchase decsons than they do for accelerated share repurchases. In addton, the all at once nature of the EPS effect of ASRs suggests to us to a qute dfferent motvaton: we predct that the managers of ASR frms are more lkely to be compensated on reported EPS fgures than are the managers of OMR frms. Pror research by Marquardt and Wedman (2005) shows that frms are more lkely to structure convertble bond transactons to ncrease EPS when manager bonuses are based on reported EPS fgures, and Bens et al. (2003) argue that compensaton ncentves may apply to stock repurchases as well. Gven the relatvely large magntude of ASRs on reported EPS and the lack of fnancal reportng flexblty that ASRs offer, we beleve that compensaton ncentves are a lkely determnant n the decson to undertake an ASR versus an OMR. Stated formally: H2: Compensaton ncentves play a more mportant role n decsons to undertake accelerated share repurchases than n open market repurchases. 10

11 4. Research Desgn We use a multvarate probt regresson model to test Hypotheses 1 and 2, where the dependent varable, ASR, equals one f the frm chooses to undertake an ASR and zero f the frm chooses an OMR. As such, our analyss s condtonal on the decson to repurchase stock; that s, we assume that frms frst decde to repurchase stock and subsequently determne the type of repurchase to undertake. To proxy for captal market ncentves (H1), we create a varable based on the fndngs of Barth, Ellott, and Fnn (1999), who fnd that the market rewards patterns of ncreasng earnngs, and Graham, Harvey, and Rajgopal (2005, p. 22), who report that chef fnancal offcers regard the same quarter last year s EPS as the most mportant benchmark. Ths varable, STRING, equals the number of consecutve quarters pror to the announcement date of the repurchase that the frm has met or exceeded the benchmark of the pror year s EPS for the same fscal quarter, up to a maxmum of 20 quarters. If captal market ncentves to mantan ths strng are stronger for OMR frms, we expect a negatve coeffcent on STRING n our probt analyss. To proxy for compensaton ncentves (H2), we follow Marquardt and Wedman (2005), and create an ndcator varable, BONUS, that equals one f EPS s explctly mentoned as a determnant of annual bonuses n the frms proxy statement and zero otherwse. We beleve that ths s the most drect measure of whether a manager s compensated based on reported EPS. If managers of ASR frms are motvated by compensaton concerns, we expect a postve coeffcent on BONUS. We also control for a possble alternatve motvaton for undertakng an ASR nstead of an OMR: frms want to send a stronger sgnal of good future prospects by 11

12 lockng themselves nto the repurchase. Research n corporate fnance shows that a stock repurchase announcement typcally leads to an ncrease n the value of the frm s stock, whch s prmarly attrbuted to nformaton sgnalng (see, e.g., Peyer and Vermaelen 2005). Ths theory suggests that the wllngness of managers to ncrease ther holdngs of a company s stock conveys new, postve nformaton to the market regardng the future cash flow of the company, drvng the prce ncrease. It may be argued that the guaranteed nature of the repurchase n an ASR sends a stronger sgnal to nvestors than does an OMR, snce there s no oblgaton on the part of the ssuer to actually repurchase any shares n an OMR. We attempt to control for sgnalng effects by ncludng frms debt-to-equty ratos (DE) and dvdend yelds (DIVYIELD) as ndependent varables n our analyss, both measured for the fscal year pror to the repurchase announcement. When managers possess nsde nformaton, fnancal structure sgnals nformaton to the market, wth the value of the frm rsng wth ncreasng leverage; smlarly, when outsde nvestors have mperfect nformaton about frms proftablty, dvdends functon as a postve sgnal of expected cash flows (Barclay, Smth, and Watts 1995). If ASRs serve n a sgnalng role, t may be more lkely that frms undertakng ASRs have already exhausted ther sgnalng capactes by havng hgh debt levels and hgh dvdend yelds. We therefore expect DE and DIVYIELD to be postvely assocated wth the ASR decson. Our predcton that accelerated stock repurchasers have hgher dvdend yelds also suggests that these frms have lower growth relatve to open market repurchasers. In ther examnaton of the choce between payng dvdends or repurchasng stock, Jagannathan, Stephens, and Wesbach (2000) fnd that growth, stock returns, free cash 12

13 flows, and frm sze all affect repurchase decsons. Repurchasers are lkely to be hgh growth frms because the alternatve form of corporate cash payout,.e., dvdends, tends to be pad out of long-run, sustanable earnngs, and a growth frm would be less lkely to commt to regular dvdend payments. In addton, the captal market ncentves to meet or exceed earnngs benchmarks are more pronounced for growth frms. Sknner and Sloan (2002) fnd that the dramatc losses n frm value that often occur after mssng an earnngs benchmark are more severe for growth stocks. We thus expect open market repurchasers to have hgher growth than accelerated share repurchasers. We use three measures to capture dfferent aspects of growth: the market-to-book rato (MB), whch s commonly used n the accountng lterature as a growth proxy; the annualzed daly stock prce volatlty, STKVOL, n the year pror to the repurchase announcement; and earnngs volatlty, STDROA, defned as the standard devaton of quarterly return-on-assets over the fve-year perod pror to the repurchase announcement. We expect a negatve assocaton between each of these varables and the decson to undertake an ASR rather than an OMR. Because Jagannathan et al. (2000) and others have found that poor stock prce performance typcally precedes a stock repurchase, we add buy-and-hold abnormal returns (BHAR), measured over the 12-month perod pror to the repurchase announcement date, as a control varable. Jagannathan et al. (2000) also fnd that stock repurchasers tend to have hgh free cash flows. Ths s lkely to be even more characterstc of accelerated stock repurchasers, snce they must reacqure the targeted number of shares mmedately through an 13

14 underwrter, whch would requre a large cash outlay. We therefore nclude free cash flows, FCF, as an ndependent varable n our analyss and predct that t wll be postvely assocated wth the ASR decson. Lastly, we nclude frm sze, SIZE, defned as the log of total assets at the end of the fscal year pror to the repurchase announcement, as a control varable, as Jagannathan et al. (2000) fnd that repurchasers tend to be smaller frms. Gven our prevous predctons that accelerated stock repurchasers wll have hgher dvdend yeld and lower growth than open market repurchasers, we expect SIZE to be postvely assocated wth the ASR decson. Our fnal model s as follows: ASR = α + β STRING + β BONUS + β DE + β DIVYIELD + β STKVOL + β STDROA + β MB + β BHAR + β FCF + β SIZE + ε where denotes frm. We predct postve coeffcent on BONUS, DE, DIVYIELD, FCF, and SIZE, negatve coeffcents on STRING, STKVOL, STDROA, and MB, and make no predcton on BHAR. 5. Sample Selecton and Descrptve Statstcs 5.1 Sample Selecton Crtera We dentfy our sample of ASR frms by conductng key word searches on Lexs- Nexs and the SEC s EDGAR database for the term accelerated share repurchase. Our ntal search over yelded 72 frms that had engaged n an ASR durng ths tme perod. Consstent wth reports n the fnancal press that state that the prevalence of 14

15 ASRs has only recently ncreased dramatcally, we note that we could dentfy only sx ASRs pror to 2004; we therefore lmt our focus to the perod. To obtan our control sample of frst-tme open market repurchasers, we conducted a search on the SDC Platnum database over and ntally dentfed 531 OMRs. We then elmnated observatons f they dd not have the necessary Execucomp, Compustat, or CRSP data or f we could not dentfy announcement dates. We also elmnated frms that had multple repurchasers (we retaned the earlest one), duplcate observatons, and frms wth negatve book value of equty. The fnal sample conssts of 40 ASRs and 116 OMRs. We provde more detal on the sample selecton n Table 1. We present descrptve statstcs for the ASR and OMR subsamples n Table 2. Panel A provdes the dstrbuton of ASR and OMR frms by year. We observe a dramatc ncrease n the number of ASRs from 2004 to 2005, and whle there s an apparent decrease n 2006, recall that our sample perod ends n March 2006, leavng us wth only three months of data. Panel B provdes nformaton on ndustry membershp, and Panel C shows the ASR and OMR announcement dates by fscal quarter. Most notable s the fact that 47.5% of our sample ASRs fall nto the frst quarter, whle only 26.72% of our sample OMRs do; a ch-squared test reveals that ths dfference s hghly sgnfcant (χ2 = 5.895, p=0.015). Ths fndng provdes ndrect support for our compensaton (H2). Managers would beneft most from share repurchases made at the begnnng of the fscal year n computng ther year-end bonus based on EPS. 15

16 6. Results 6.1 Unvarate tests Table 3 presents the results from unvarate comparsons of frm characterstcs across the ASR and OMR subsamples. We report lmted evdence for H1, whch predcts that captal market ncentves play a more mportant role for OMR frms. OMR frms do have a longer seres of havng met or exceeded last year s quarterly reported EPS; mean (medan) STRING s 5.85 (5) quarters for OMR frms versus 4.33 (3) for ASRs, and the dfference for medans s margnally sgnfcant. There s stronger evdence n favor of H2, whch predcts that compensaton ncentves play a more mportant role for ASRs than OMRs. Mean BONUS s for ASRs versus for OMRs, and ths dfference s hghly sgnfcant. The unvarate results also reveal that ASR frms have sgnfcantly hgher debtto-equty ratos. Mean (medan) DE s (0.659) for ASR frms versus (0.385) for OMR frms; dfferences n means and medans are sgnfcant at the 0.05 and 0.01 levels, respectvely. We also fnd that medan dvdend yelds are sgnfcant hgher for ASR frms, wth a medan of versus for OMR frms. These results provde some evdence for sgnalng arguments ASR frms already have hgher debt ratos and dvdend yelds are therefore may have exhausted these choces as potental sgnals of good future performance. We fnd mxed results for our growth proxes. Whle there s no sgnfcant dfferences between ASR and OMR sample frms for market-to-book ratos (MB), we do fnd that ASR frms have sgnfcantly lower stock prce volatlty (STKVOL) over the year pror to the repurchase announcement (p<0.01) and lmted evdence of lower 16

17 earnngs volatlty (STDROA) (p<0.05, medans). These results support our expectaton that OMR frms would have hgher growth than ASR frms. Contrary to our expectatons, however, we fnd no sgnfcant dfferences n ether free cash flows (FCF) or pror stock prce performance (BHAR) between ASR and OMR sample frms. Fnally, we fnd that ASR frms are sgnfcantly larger than OMR frms; dfferences n both mean and medan SIZE are sgnfcant at the p=0.01 level. Ths may reflect the fact larger frms are more lkely to already have establshed relatonshps wth nvestment banks, whch would enable them to negotate the ASR contracts more quckly and easly than smaller frms. Larger frms may also be more lkely to have the avalable assets to repurchase a large block of stock n a sngle transacton. 6.2 Multvarate tests Table 5 presents the results of a multvarate probt analyss n whch we examne the role of compensaton and captal market ncentves n determnng the decson to undertake ASRs versus OMRs. Consstent wth H1, where we predct that captal market ncentves play a less mportant role n ASRs than n OMRs, we fnd that STRING s sgnfcantly negatve at the p=0.05 level (χ 2 = 4.93). Ths ndcates that the ncentve to contnually meet the benchmark of last year s EPS for the same fscal quarter s less pronounced for ASR frms than for OMR frms. We also fnd emprcal support for H2, where we predct that compensaton ncentves play a more mportant role n the decson to undertake an ASR versus an OMR. As expected, BONUS s sgnfcantly postve (χ 2 = 3.06), ndcatng that frms that explctly lnk managers annual bonuses to reported EPS are more lkely to accelerate ther share repurchases to mprove ths fgure than are frms that repurchase stock on the open market. 17

18 We control for sgnalng effects n our probt model by ncludng DE and DIVYIELD as ndependent varables. As stated earler, we expect these varables to be postvely assocated wth the ASR decson f ASRs are meant to serve as a sgnal of good future performance. Our results ndcate that the estmated coeffcents on both DE and DIVYIELD are nsgnfcantly dfferent from zero, ndcatng that they do not play a promnent role n the share repurchase choce. Our analyss also ncludes the ndependent varables MB, STKVOL, and STDROA, whch proxy for dfferent aspects of frm growth. Only STKVOL s sgnfcant n the expected drecton (χ 2 = 12.08). In untabulated fndngs, our man results for H1 and H2 are qualtatvely smlar we nclude/exclude varous combnatons of these growth proxes n the probt analyss. We also control for the pror stock performance of our sample frms by ncludng BHAR, the 12-month buy-and-hold abnormal returns pror to the share repurchase announcement, whch does not appear to be a sgnfcant determnant n the choce between an ASR and OMR. Our prors suggest that ASR frms are more lkely to be larger n sze and have hgher free cash flows. As predcted, both SIZE and FCF are sgnfcantly postve (χ 2 = 3.18 and χ 2 = 5.53, respectvely). In addton, the pseudo-r 2 for the model s approxmately 28%, suggestng that the model has reasonable explanatory power, and the average varance nflaton factor (VIF) s approxmately 1.4, whch s far below 10, ndcatng that multcollnearty s not a concern. Overall, our results support both our hypotheses that 1) captal market ncentves play a strong role n open market repurchase decsons than they do for accelerated share 18

19 repurchases; and 2) compensaton ncentves play a more mportant role for accelerated share repurchases than they do for open market repurchases. These fndngs are robust to controllng for sgnalng arguments, as well as for other known determnants of the decson to repurchase stock. 7. Addtonal Analyss Settlement Costs for ASR Frms To gan further nsght nto the costs of engagng n an ASR, we examned the 10- Ks and 10-Qs for the 40 ASR frms to determne the costs of settlng the forward sale contract. We were able to collect ths nformaton for 29 frms. Of these 29 frms, 22 frms settled the forward sale contract n cash, and 7 frms settled n stock. The overwhelmng majorty of frms choosng cash settlement had to pay addtonal amounts to the nvestment bank, resultng n addtonal costs to the frm. The average payout made by the 22 ASR frms s approxmately $20M (approxmately 6% of the ntal ASR deal sze). Only two frms choosng cash settlement receved cash from the nvestment bank. All seven frms selectng stock settlement receved addtonal stock from the nvestment bank at the tme of settlement. Overall, the descrptve evdence on settlement costs suggests that companes structure ther transactons to avod the mark-tomarket treatment (by retanng the opton to settle the forward contract n cash or shares). Nevertheless, the overwhelmng majorty of companes typcally avod ssung new shares to settle the forward contract n order to prevent further EPS dluton. 19

20 8. Conclusons Ths paper emprcally examnes the determnants of frms decsons to undertake accelerated share repurchases (ASRs). In an ASR, the frm repurchases a large block of shares through an underwrter, whch allows for mmedate recognton of a decrease n shareholders equty and a correspondng ncrease n reported EPS. We argue that the fnancal reportng effects assocated wth ASRs suggest that the ncentves behnd these transactons are fundamentally dfferent from those assocated wth open market repurchases (OMRs). Consstent wth our predctons, we fnd that ASRs frms are more lkely to compensate ther managers explctly on reported EPS fgures and are less lkely to beat earnngs benchmarks than are OMR frms. These results are robust to controllng for sgnalng effects, as well as other known determnants of stock repurchase decsons. Fnally, we provde descrptve evdence on the settlement costs ncurred by ASR frms. One lmtaton of the paper s that we rely on sngle measures to proxy for captal market ncentves (STRING) and for compensaton ncentves (BONUS). In a future draft of the paper, we wll nclude alternatve measures of manageral ncentves to provde addtonal evdence on our hypotheses. A second lmtaton s that n the current specfcaton of our probt model, we do not control for the need to offset dluton from employee stock optons, nor do we nclude the fnancal reportng effect on EPS n our model. These ssues wll also be addressed n the next draft of the paper. Our results suggest addtonal questons that are worth explorng. For example, how do nvestors vew ASRs? The fnance lterature has documented that stock repurchase announcements typcally result n a stock prce ncrease. Do nvestors react 20

21 less (or more) postvely to ASR versus OMR announcements? An analyss of ths queston wll be ncluded n a future draft of the paper. 21

22 APPENDIX The followng s an example of the accountng treatment for an ASR. Suppose Company X wants to buy back 1 mllon shares of stock. Currently, the company has 10 mllon shares outstandng and the stock prce s $10 per share. After the decson, the company has net earnngs of $2 mllon for the quarter ended March 31. Scenaro 1: The stock prce stays the same over the quarter. Company X enters nto an ASR agreement on January 1 and agrees to repurchase 1 mllon shares of stock. The ASR has an end contract date of March 31. The current stock prce s $10 per share. Jan. 1: Treasury Stock $10,000,000 Cash or Lablty $10,000,000 Forward agreement: no entry made as the forward contract has no sgnfcant value at the contract s ntaton date. Aprl 30: No entres requred Effect on EPS at 4/30: Wth ASR: Wthout ASR: $2,000,000/9,000,000 = $.22 $2,000,000/10,000,000 = $.20 Scenaro 2: The stock prce ncreases to $15/share on January 31 and remans there for the rest of the quarter. Jan. 1: Treasury Stock $10,000,000 Cash or Lablty $10,000,000 Aprl 30: If settled n cash: Treasury Stock $5,000,000 Cash or Lablty $5,000,000 If settled n stock: An adjustment would be made to the shares outstandng. The company would now show that approxmately 666,667 shares have been repurchased, versus 1,000,000. There s no mpact on the balance sheet. 22

23 REFERENCES Ayers, B., C. Lefanowcz, and J. Robnson Do frms purchase the poolng method? Revew of Accountng Studes 7, Barclay, M., C. Smth, and R. Watts The determnants of corporate leverage and dvdend polces. Journal of Appled Corporate Fnance 7: Barth, M., J. Ellott, and M. Fnn Market rewards assocated wth patterns of ncreasng earnngs. Journal of Accountng Research 37: Beatty, A. and J. Weber Accountng dscreton n far value estmates: An examnaton of SFAS 142 goodwll mparments. Journal of Accountng Research 44: Bens, D., V. Nagar, D. Sknner, and M.H.F. Wong Employee stock optons, EPS dluton, and stock repurchases. Journal of Accountng and Economcs 36: Erckson, M., M. Hanlon, and E. Maydew How much wll frms pay for earnngs that do not exst? Evdence of taxes pad on allegedly fraudulent earnngs. The Accountng Revew 79: Graham, J., C. Harvey, and S. Rajgopal The economc mplcatons of corporate fnancal reportng. Journal of Accountng and Economcs 40: Gudry, F., A. Leone, and S. Rock Earnngs-based bonus plans and earnngs management by busness-unt managers. Journal of Accountng and Economcs 26: Healy, P The effect of bonus schemes on accountng decsons. Journal of Accountng and Economcs 7: Holthausen, R., D. Larcker, and R. Sloan Annual bonus schemes and the manpulaton of earnngs. Journal of Accountng and Economcs 19: Hrbar, P., N. Jenkns, and W.B. Johnson Stock repurchases as an earnngs management devce. Journal of Accountng and Economcs 41: Jagannathan, M., C. Stephens, and M. Wesbach Fnancal flexblty and the choce between dvdends and stock repurchases. Journal of Fnancal Economcs 57: Lys, T. and L. Vncent An analyss of the value destructon of AT&T s acquston of NCR. Journal of Fnancal Economcs 39:

24 Maremont, M. and S. Ng Movng the market Trackng the numbers outsde audt: Buybacks va loophole can have hdden cost. The Wall Street Journal, January 31, p. C1. Matsunaga, S., T. Shevln, and D. Shores Dsqualfyng dspostons of ncentve stock optons: Tax benefts versus fnancal reportng costs. Journal of Accountng Research 30 (Supplement): McConnell, P., J. Pegg, C. Senyek, D. Mott, and A. Calngasan Accountng Issues: Accelerated Share Repurchase Share Repurchase Usng Dervatves. Bear Stearns Equty Research, January 10. McDonald, Ian Bg companes put record sums nto buybacks. The Wall Street Journal, June 12, p. A1. Marquardt, C. and C. Wedman Earnngs management through transacton structurng: Contngent convertble debt and dluted EPS. Journal of Accountng Research. Peyer, U. and T. Vermaelen The many facets of prvately negotated stock repurchases. Journal of Fnancal Economcs 75. Ross, S The determnaton of fnancal structure: The ncentve-sgnallng approach. Bell Journal of Economcs 8: Sknner, D. and R. Sloan Earnngs surprses, growth expectatons and stock returns, or, don t let an earnngs torpedo snk your portfolo. Revew of Accountng Studes 7: Stephens, C. and M. Wesbach Actual share reacqustons n open-market repurchase programs. Journal of Fnance 53: Watts, R. and J. Zmmerman Postve Accountng Theory. Prentce Hall, New York, NY. 24

25 Fgure 1 Overvew of ASR transacton ASR Frm Pays cash and enters E nto forward contract Loan shares to bank Borrows shares and enters nto forward contract Investment Bank Purchases shares and returns to nvestors Investors Open Market 25

26 Table 1 Sample Selecton Accelerated Share Repurchases (ASR) Lexs-Nexs word search for accelerated share repurchase durng Drop: No announcement date 2 Duplcate frm observaton 1 ASR pror to Multple ASRs n the one year 4 Incomplete/Unavalable ExecuComp data n the year 11 pror to the ASR Incomplete/Unavalable Compustat data n the year 1 pror to the ASR Fnal ASR sample 47 Open Market Repurchases (OMR) Securtes Data Platnum search for frst-tme OMRs durng Drop: Incomplete/Unavalable ExecuComp data n the year 396 pror to the OMR Fnal OMR sample 135 Total Fnal sample of ASRs and OMRs 182 Drop: Outlers, negatve book value of equty, ncomplete 26 CRSP data Total Fnal sample of ASRs and OMRs used for tests

27 Table 2 Descrptve Statstcs Panel A: ASRs and OMRs by Year Year ASR OMR Total Number % of Total Number % of Total Total Panel B: ASRs and OMRs by Industry Industry ASR (% of Total) Busness Servces 3 (30.00%) Chemcals and Alled 3 Products (23.08%) Electronc and Other 0 Electrcal Equpment and (0%) Components Fnancal Insttutons 9 Industral and Commercal Machnery and Computer Equpment (60.00%) 2 (12.50%) Insurance 2 (20.00%) Other 21 (25.93%) Panel C: ASRs and OMRs by Quarter Quarter ASR (% of Total ASR) 1 19 (47.50%) 2 3 (7.50%) 3 11 (27.50%) 4 7 (17.50%) Total 40 (100.00%) OMR (% of Total) 7 (70.00%) 10 (76.92%) 11 (100%) 6 (40.00%) 14 (87.50%) 8 (80.00%) 60 (74.07%) OMR (% of Total OMR) 31 (26.72%) 28 (24.14%) 33 (28.45%) 24 (20.69%) 116 (100.00%) Total Total (% of Total) 50 (32.05) 31 (19.87%) 44 (28.21%) 31 (19.87%) 156 (100.00%) 27

28 Table 3 Unvarate Results Varable STRING (3.000) BONUS (1.000) DE (0.659) DIVYIELD (0.015) STKVOL (0.200) STDROA (0.006) MB (2.575) BHAR (0.012) FCF (0.072) SIZE (9.555) ASR Mean (Medan) n = 40 OMR Mean (Medan) n = (5.000) (0.000) (0.385) (0.000) (0.293) (0.007) (2.530) (-0.031) (0.084) (7.898) t-statstc (Wlcoxon z- statstc) (-1.810) * *** (3.460) *** ** (3.049) *** (3.526) *** *** (-5.203) *** (-2.210) ** (0.093) (0.860) (-0.262) *** (3.941) *** ***, **, * denote sgnfcance at the 1%, 5% and 10% levels, respectvely. BONUS s equal to 1 f the annual bonus compensaton of employees, as determned from a search of the frm s 10-K, s ted to the earnngs-per-share fgure. STRING s the number of consecutve quarters pror to the announcement date of the share repurchase that the frm has met or exceeded the benchmark of the pror year s EPS for the same fscal quarter, up to a maxmum of 20 quarters. DE s debt/equty. DIVYIELD s the frm s dvdend yeld. STKVOL s the stock returns volatlty n the 12-month perod pror to the share repurchase announcement. STDROA s the standard devaton of the return on assets of the frm over the 20 quarters pror to the share repurchase announcement. MB s the begnnng-perod market value of equty/book value of equty. BHAR s the buy-and-hold-returns of the frm n the 12-month perod pror to the share repurchase announcement. FCF s (operatng ncome captal expendture)/begnnng of year total assets. Both operatng ncome and captal expendture are determned from the pror fscal perod. SIZE s the log of total assets of the frm. 28

29 Table 4 Spearman and Pearson Correlatons Varables ASR STRING BONUS DE DIVY STKVOL STDROA MB BHAR FCF SIZE ASR STRING * BONUS *** ** *** (-0.158) ** DE ** ** *** (-0.119) (0.182) ** DIVYIELD *** *** (-0.026) (0.158) ** (0.500) *** STKVOL *** *** ** *** *** (-0.025) (-0.257) *** (-0.403) *** (-0.599) *** STDROA ** * * * *** ** (-0.214) *** (-0.183) ** (-0.296) *** (-0.296) *** (0.424) *** MB *** (0.233) *** (-0.094) (-0.070) (-0.145) * (0.058) (0.030) BHAR ** (0.023) (0.018) (0.258) *** (0.172) ** (-0.142) * (-0.044) (-0.067) FCF *** * *** (0.280) *** (-0.159) ** (-0.230) *** (-0.141) * (0.032) (0.114) (0.534) *** (-0.127) SIZE *** *** *** *** *** ** * ** *** (0.048) (0.266) *** (0.508) *** (0.524) *** (-0.633) *** (-0.357) *** (-0.170) ** (0.199) ** (-0.246) *** ***, **, * denote sgnfcance at the 1%, 5% and 10% levels, respectvely. BONUS s equal to 1 f the annual bonus compensaton of employees, as determned from a search of the frm s 10-K, s ted to the earnngs-per-share fgure. STRING s the number of consecutve quarters pror to the announcement date of the share repurchase that the frm has met or exceeded the benchmark of the pror year s EPS for the same fscal quarter, up to a maxmum of 20 quarters. DE s debt/equty. DIVYIELD s the frm s dvdend yeld. STKVOL s the stock returns volatlty n the 12-month perod pror to the share repurchase announcement. STDROA s the standard devaton of the return on assets of the frm over the 20 quarters pror to the share repurchase announcement. MB s the begnnng-perod market value of equty/book value of equty. BHAR s the buy-and-hold-returns of the frm n the 12-month perod pror to the share repurchase announcement. FCF s (operatng ncome captal expendture)/begnnng of year total assets. Both operatng ncome and captal expendture are determned from the pror fscal perod. SIZE s the log of average total asset of the frm. 29

30 Table 5 Multvarate Probt Regresson ASR = α + β STRING + β BONUS + β DE + β MB + β BHAR + β FCF + β SIZE + ε β DIVYIELD + β STKVOL + β STDROA Varable Expected Coeff. estmate 2 Wald χ Sgn Interecept STRING ** BONUS * DE DIVYIELD MB STKVOL *** STDROA BHAR? FCF ** SIZE * Log- Lkelhood ***, **, * denote sgnfcance at the 1%, 5% and 10% levels, respectvely. BONUS s equal to 1 f the annual bonus compensaton of employees, as determned from a search of the frm s 10-K, s ted to the earnngs-per-share fgure. STRING s the number of consecutve quarters pror to the announcement date of the share repurchase that the frm has met or exceeded the benchmark of the pror year s EPS for the same fscal quarter, up to a maxmum of 20 quarters. DE s debt/equty. DIVYIELD s the frm s dvdend yeld. STKVOL s the stock returns volatlty n the 12-month perod pror to the share repurchase announcement. STDROA s the standard devaton of the return on assets of the frm over the 20 quarters pror to the share repurchase announcement. MB s the begnnng-perod market value of equty/book value of equty. BHAR s the buy-and-hold-returns of the frm n the 12-month perod pror to the share repurchase announcement. FCF s (operatng ncome captal expendture)/begnnng of year total assets. Both operatng ncome and captal expendture are determned from the pror fscal perod. SIZE s the log of average total asset of the frm. 6 30