CEO Cash Compensation and Earnings Quality

CEO Cash Compensation and Earnings Quality Item Type text; Electronic Thesis Authors Chen, Zhimin Publisher The University of Arizona. Rights Copyright is held by the author. Digital access to this material is made possible by the University Libraries, University of Arizona. Further transmission, reproduction or presentation (such as public display or performance) of protected items is prohibited except with permission of the author. Download date 27/06/2018 13:58:42 Link to Item http://hdl.handle.net/10150/146591

CEO Cash Compensation and Earnings Quality Abstract I examine the uses of accounting performance measures by testing the association between CEO cash pay sensitivity and earnings quality. I assume that the valuation and evaluation uses of accounting information are linked through the information risk. I expect to find that the sensitivities of CEO cash compensation to accruals and cash flows are associated with accrual quality and cash flow persistence. I find that there is a significant positive relation between accrual quality and CEO cash pay sensitivity to earnings. I find no association between the asymmetric pay-sensitivity to stock returns and earnings quality, and no relation between persistence to pay sensitivity to earnings. This research extends the accounting literature on earnings quality. This research also leads to the discussion of one of the problems of CEO compensation contracting since there appears to be no evidence showing that CEO receives incentives for reporting high quality earnings information and penalties for reporting low quality earnings information.

I Introduction A number of prior studies have examined how certain attributes of earnings and stock returns are used in CEO compensation contracts. For instance, Leone, Wu and Zimmerman [2006] test how the information of unrealized gains and losses reflected in stock returns affect CEO cash compensation. Stock returns, therefore, serve both the performance measuring and incentive contracting purposes for firms. Nonetheless, limited literature focuses on the association between CEO compensation and the quality of accounting information. The compensation committee uses earnings and stock returns for incentive contracting; their consideration of the quality of accounting information is unclear. On the one hand, the compensation committee should concern about the quality when they use the information for decision-making; on the other hand, it is uncertain whether the compensation committee gives CEO the incentive for reporting information with good quality. If CEOs are paid based on unreliable and irrelevant accounting information, both CEOs and firms would experience the miscalculation of payment. In an effective compensation contract, CEO pay would be related to the quality of accounting information used. Banker, Huang and Natarajan [2009] provide evidence that value relevance of earnings plays a significant role in its use for incentive contracting. In the study, value relevance is the ability of earnings to explain variation in returns; it presents to what extent shareholders can perceive the uncertainty in earnings. They examine the association between value relevance of earnings and cash flows and pay-sensitivity. Along with relevance, reliability is considered to be one of the two primary qualities 3

(Richardson et al [2005]). To expand Banker s result, I examine the association between CEO cash pay-sensitivity and earnings quality focusing on reliability. This paper builds on the work of Banker et al [2009]. I test whether earnings quality (accrual quality and persistence of cash flow) are associated with CEO cash compensation sensitivity of earnings, earnings components, and stock returns. Accrual quality and persistence reflect earnings reliance. The valuation role of earnings is that earnings are used for valuing firms together with other performance measures. Therefore, earnings quality can proxy to which extent the earnings information is useful for valuing firm performance. This study is aimed at further exploring whether the valuation role of earnings is associated with the contracting role of earnings. I consider earnings and earnings components (accruals and cash flows) as accounting performance measures with contracting purpose, for the purpose of this study. A possible reason why the contracting purpose and the valuation role should be associated with each other is that earnings quality is a signal of information risk that has impact on CEO compensation contracts. I conjecture that information risk links the valuation and contracting uses of earnings. Information risk derives from imprecision (i.e., dispersion) in estimates of the pay-off structure to investors based on available information (Easley and O Hara [2004]). High uncertainty in earnings gives rise to high information risk while low uncertainty in earnings reduces information risk. To guarantee investor s interest, one can assume the compensation committee is interested in long-term value. CEOs receive the incentives for keeping information risk low and for keeping information useful for decision-making, if the compensation sensitivity is 4

related to the earnings quality. I follow Francis et al [2004] s measures of earnings quality. They use earnings attributes to proxy for information risk in the examination of seven earnings attributes and the cost of equity capital. The seven earnings attributes captures earnings characteristics and reflects the quality of earnings. They provide evidence that earnings quality reflects the uncertainty in earnings; for this reason, earnings quality can be a signal for information risk. For example, high earnings quality provides the board of directors with low information risk. Among the seven attributes, accrual quality and persistence of cash flow are more sensitive signals for information risk. As a result, I examine the impact of information risk on effective CEO compensation contracts. My measures of earnings quality follow Francis et al [2004]. They measure accrual quality using the mapping of current accruals into cash flows 1 : Accruals = φ 0 + φ 1 CFO t 1 + φ 2 CFO t + φ 3 CFO t+1 + τ (1) AccrualQuality t equals to the standard deviation of firm s estimated residuals. Large (small) values of AccrualQuality correspond to poor (good) accrual quality. The measure of persistence is the slope coefficient of current cash flow and future cash flow. I distinguish accruals and cash flows as two separate accounting performance measures as they have different implications for the assessment of future earnings (Sloan [1996]). Sloan finds that some accruals are less likely to persist in future 1 CFO= the difference between Earnings and Accruals Accruals= the change in non-cash current assets, less the change in current liabilities,less depreciation expense, all divided by average total assets 5

periods earnings; however, cash flow persistence into earnings is greater than accruals. Consequently, persistence is used as signal of cash flows information and accrual quality as signal of accruals information when testing CEO cash compensation sensitivity to accounting performance measures. In summary, this research contributes in three ways to accounting literature. First, it confirms the use of accounting information s quality in CEO compensation. Second, it contributes to the impact of information risk on CEO cash compensation to stock returns and earnings. Third, it adds evidence to the asymmetric level of the sensitivity of CEO cash compensation to stock returns. Section II discusses the background of CEO compensation and earnings quality. Section III develops the predictions. Section IV presents research design. Section V and VI are results and conclusions. II Background In United States, the CEO pay packages are set by the compensation committee with board members. Cash compensation components are salary, bonus and deferred compensation; stock-based compensation components are option and restricted stock grants. The results of Leone s article show that 62% of the performance measures used in bonus contracts are accounting based, while the other measures include individual performance measures, stock price, and non-financial measures (Leone et al [2006]). III Hypothesis Development This paper builds on the empirical research investigating the relationship 6

between CEO cash compensation and earnings equity. From previous studies, CEO cash compensation (salary, bonus and deferred compensation) is determined by both earnings and stock returns (e.g. Bushman and Smith [2001]). This suggests that accounting information plays a role in contracting. Banker, Huang and Natarajan [2009] find that value relevance of performance measure plays an important role in the choice of accounting performance measures for incentive contracting purposes, following that the incentive contracts are written with consideration of the quality of accounting information. How accounting information is reliable impacts to which degree it is used in contracting as performance measurements. I use earnings quality as a signal for information risk measuring how accounting information s used for valuing firm performance. Earnings quality has an effect on how accounting information is processed. For example, high earnings quality leads to low information risk and low cost of equity (Francis, LaFond, Olsson, and Schipper [2004]). I test whether earnings quality influences the sensitivity of stock returns and earnings on CEO cash compensation. Earnings quality is defined by earnings attributes that capture the characteristics of earnings (Francis et al. [2004]). Accounting-based attributes, including accruals quality, persistence, predictability and smoothness, are measured using accounting information only. Market-based attributes, value relevance, timeliness, and conservatism, take stock returns as a reference construct. First, I test the relation between CEO compensation sensitivity to earnings and earnings quality. Second, I test the relation between the asymmetric level of CEO compensation sensitivity to stock returns and earnings quality. Prior researches find 7

that accrual quality and persistence have the largest cost of equity effects among accounting-based attributes (e.g. Francis, LaFond, Olsson, and Schipper [2004]). Therefore, I use these two earnings attributes for earnings quality. 3.1. Pay sensitivity to earnings and earnings quality Sloan [1996] provides evidence that accrual and cash flow of current earnings contain information about future earnings for investors. He argues that the extent to which current earnings performance persists into the future is dependent on the relative magnitudes of the cash flows and accruals components of earnings. It follows that both components of earnings have valuation purposes. For this reason, I decompose earnings into accruals and cash flows to test the separate sensitivity of each to CEO compensation. Accrual quality and persistence are associated with the valuation use of earnings (Francis [2006]). They determine how useful earnings are for decision-making. Accrual quality tells the board of directors about the mapping of current accruals into last-period, current-period, and next-period cash flows; good accrual quality decreases information risk and the cost of equity. Persistent earnings are linked to low information risk (Francis et al. [2005]). In other words, high accrual quality and persistence send a signal indicating low information risk to the board of directors. The compensation committee interprets this signal, and thus can increase their reliance on the earnings when contracting CEO incentives or awarding pay. I address whether firms with high accrual quality and persistence have a higher sensitivity between earnings components and cash compensation, than firms with low 8

earnings quality. When earnings quality is high, does the compensation committee rely on earnings more and feel more certain rewarding the CEO with greater pay? Therefore, accrual quality and persistence may be associated with the pay sensitivity of earnings components. Using accrual quality together with persistence as a signal for information risk, H1 in null form follows: H1: Accrual quality and persistence are not associated with the sensitivity of CEO cash compensation to earnings and earnings components. 3.2. Asymmetric pay sensitivity to stock returns and earnings quality Leone, Wu and Zimmerman [2006] document that CEO cash compensation is twice as sensitive to negative stock returns as it is to positive stock returns, to reduce costly ex post settling up in cash compensation paid to CEOs. This suggests that the compensation committee immediately penalizes CEOs for unrealized losses and fails to reward CEOs for unrealized gains due to conservatism 2. I conjecture that earnings quality influences the asymmetric level of pay sensitivity to stock returns. For instance, the board of directors may be more likely to reward CEOs for good news reflecting unrealized gains with high earnings quality than good news with low earnings quality. It follows that high earnings quality tells board of directors that the gains have a higher probability to be realized, considering the low information risk. The relatively low information risk allows board of directors to increase the sensitivity of unrealized gains to CEO cash compensation. H2 follows: H2: When the earnings quality is high, the sensitivity of CEO cash 2 Conservatism is the differential verifiability required for the recognition of accounting gains versus losses that generates an understatement of net assets (Basu [1997]). (S.Basu, 1997) 9

compensation to positive stock returns is greater than when the earnings quality is low. H2 assumes that the quality of accounting information provides a signal about the extent of accounting information weighting in contracting. Conversely, I make no specific predictions on earnings quality and pay-sensitivity to negative stock returns. There are two possible situations. First, conservatism suggests that the compensation committee will penalize CEOs for the unrealized losses reflected by bad news immediately regardless of the earnings quality signal. They would not allow any avoidable unrealized losses. CEOs would endeavor to eliminate high uncertain unrealized losses as well as low uncertain unrealized losses to evade penalization. Therefore, the contract protects shareholders from unrealized losses effectively. Second, instead of ignoring information risk, the compensation committee may penalize CEO more for bad news with high earnings quality, but CEOs will not be penalized less for low earnings quality. High earnings quality and low information risk tell the compensation committee that the losses have a great probability to be realized. CEOs would avoid the lowest uncertain unrealized losses first to mitigate penalization. Suppose that there are two investment decisions leading to unrealized losses and only one of them can be avoided. In the first situation, CEOs would remain either one; in the second situation, CEOs would remain the one with high information risk. As a result, the second method of compensation contract controls the unrealized losses with good possibility to be realized more that the first one. 10

IV Research Design All the equations are based on the equations used by Leone et al [2006]. Linear regression models are used. I test H1 with the following models: In(COMP) = β 0 + β1 Earnings + β2accrualquality + β3earnings * AccrualQuality + δcontrol*size + α (2) In COMP = β 0 + β 1 Eanings + β 2 Persistance + β 3 Earnings Persistance + δcontrol Size + α (3) In COMP = β 0 + β 1 CFO + β 2 Accruals + β 3 Accrualss AccrualQuality + δcontrol Size + α (4) In COMP = β 0 + β 1 CFO + β 2 Accruals + β 3 CFO Persistance + δcontrol Size + α (5) Where: COMP= CEO cash compensation (salary+bonus) Eanings= income from continuing operations/average total assets Persistence= CFO t+1 /CFO t The β 3 coefficient measures the sensitivity of CEO cash compensation to earnings, accruals or cash flows when considering accrual quality or persistence. A significant positive value for β 3 is expected to provide support for the argument that the association between pay-sensitivity and earnings quality is positive. Following Leone et al [2006], sales and sales 2 are included to control for potential (non-linear) size effects. 11

I test H2 with the following models: In COMP = β 0 + β 1 R + β 2 CFO + β 3 Accruals + β 4 AccrualQuality + β 5 R AccrualQuality + δcontrol Size + α (6) In COMP = β 0 + β 1 R + β 2 CFO + β 3 Accruals + β 4 Persistance + β 5 R Persistance + δcontrol Size + α (7) Where: R= compounded monthly returns for fiscal year Years of firms when the market-adjusted stock returns is negative are in negative sample set and years of firms when the market-adjusted stock returns is positive are in positive sample set. The β 5 coefficient measures the sensitivity of CEO cash compensation to negative or positive stock returns when considering accrual quality or persistence. For positive sample set, a significant positive value for β 5 is expected to provide support for H2. I make no prediction for β 5 for negative sample set. Following Leone et al [2006], sales and sales 2 are included to control for potential (non-linear) size effects. V Sample and data CEO compensation data are obtained from Execucomp, earnings from Compustat, and stock returns from CRSP. CEO-year observations from 1998-2008 are selected. The restrictions on the sample are the followings: (1) CEO did not change during the year, (2) positive total assets, (3) sufficient data to calculate changes in can compensation and earnings components. The number of firms observed is 651, 7 out of which are with missing values. Therefore, the useable observations are from 644 12

firms. VI Results 6.1. Descriptive Statistics Table 1 presents the descriptive statistics of samples, including the entire sample, the sample of good news firms and the sample of bad news firms. 306 firms report bad news and 338 firms report good news. The mean of stock returns is -26% for bad news firms, 39% for good news firms and 8% for the entire sample. The average of CEO salary is $688.48 in thousands and the average bonus is $647.61 in thousands. Both salary and bonus for CEOs of good news firms are higher than those for CEOs of bad news firms. For the full sample as well as the other two samples, the accruals are negative whereas the cash flows are positive. The mean of accruals for all firms is -278.8 while the mean of cash flow is 565.32, resulting in the positive average earnings. Good news firms have the smallest AccrualQuality and the largest Persistence among the three samples. The accrual quality and persistence is higher in good news firms than bad news firms. Table 2 demonstrates Pearson and Spearman correlations among the variables and CEO cash compensation. The coefficients correspond to 1% significance levels. Accrual quality, persistence, stock returns, accruals and cash flows are all significantly correlated to ln(cash comp). The coefficients are 0.08, 0.13, 0.26, 0.63, and 0.29 respectively. The correlation between accruals and ln(cash comp) is larger in magnitude than that between cash flows and ln(cash comp). The correlation between persistence and ln(cash comp) is larger in magnitude than that 13

between accrual quality and ln(cash comp). Table1- descriptive statistics All firms Bad news firms Good news firms Mean STD Median Mean STD Median Mean STD Median R 0.08 0.48 0.02-0.26 0.18-0.23 0.39 0.45 0.24 Accruals -278.86 803.89-74.97-216.79 848.84-52.28-335.06 757.80-97.90 CFO 565.23 1327.20 178.58 468.03 1449.46 139.96 653.22 1201.31 229.92 Earnings 0.05 0.08 0.04 0.04 0.09 0.04 0.06 0.05 0.05 Accruals -24.035 99.71-4.70-20.53 712.11-5.40-27.20 476.71-3.61 CFO 61.93 787.34 9.16 46.79 934.97 3.22 75.64 625.48 18.36 AccrualQuality 122.37 162.38 62.83 112.25 156.92 56.42 131.54 166.87 67.75 yyyy Persistence -0.50 32.12 1.00-1.35 40.60 0.94 0.26 21.82 1.03 Sales 5446.14 8670.48 1902.92 5224.64 8934.43 1835.40 5647.21 8432.05 1959.18 Salary 688.48 298.77 657.67 685.84 297.83 651.94 690.87 300.05 659.38 Bonus 647.61 739.93 414.61 486.03 612.42 300.00 793.90 812.40 566.97 Table2- correlations ln(cash comp) accrual quality 0.08 persistence 0.13 R 0.26 Accruals 0.63 CFO 0.29 6.2. Empirical tests results Table 3 presents the primary test results of equation 2,3,4 and 5 for H1. Adjusted R 2 are 0.09, 0.03, 0.08 and 0.05 respectively for equation 2,3,4 and 5. Focusing first on the earnings and accrual quality regression, the coefficient of Equation2 on Earnings is 1.1096, positive as predicted and statistically significant. The coefficient on Earnings interacted with AccrualQuality is positive and statistically insignificant. This result shows that the accrual quality is not related to the pay-sensitivity to earnings. With high accrual quality, the sensitivity of CEO cash 14

Table3-equation 2,3,4,5 Equation 2 Variables ln(cash comp) Predict.sign Coef. (t statistic) Earnings + 1.0196(2.19) AccrualQuality 0.0016(4.85) Earnings*AccrualQuality + 0.0046(1.27) Sales 0.0000(1.09) Equation 3 Earnings + 1.3406(3.13) Persistence -0.0012(-0.88) Earnings*Persistence + -0.0001(0.00) Sales 0.0000(3.75) Equation4 CFO 0.0003(4.48) Accruals + -0.000003(-0.02) Accruals*AccrualQuality + 0.0000006(2.13) Sales 0.0000(-0.01) Equation5 CFO + 0.0001(2.36) Accruals -0.0012(-0.09) CFO*Persistence + 0.0001(1.20) Sales 0.0000(-0.27) compensation to earnings bumps up. Also, the coefficient on AccrualQuality is statistically significant, meaning that CEO cash compensation is related to the accrual quality. The regression result of Equation 3 shows persistence of cash flow is not associated with pay-sensitivity to earnings. The coefficient on Earnings is positive and statistically significant. Against the prediction, the coefficient on Earnings interacted with Persistence is negative and statistically insignificant. This follows that the persistence of cash flow has limited influence on the pay sensitivity to earnings. The coefficient on Sales is statistically significant. In Equation 4 and 5, Earnings are decomposed into CFO and Accruals. 15

Equation 4 tests the effect of AccrualQuality while Equation5 tests the effect of Persistence. Focusing on Equation 4, I find that the coefficient on CFO is 0.0003 and statistically significant while the coefficient on Accruals is not the same as my prediction. The result illustrates that the coefficient on Accruals is negative; in addition, it is not statistically significant. This shows that Accruals are not the major component of Earnings to be considered by the board of directors when deciding CEO cash compensation. Meanwhile, when interacted with AccrualQuality, the coefficient becomes statistically significant and positive as predicted, showing that when accrual quality is high, the pay sensitivity to accrual slightly changes. Only with high accrual quality will accrual be considered by the board of directors. It shows that CEOs receive incentives for keeping a high accrual quality; otherwise, their cash compensation is barely related to accruals. The coefficient on the control variable is statistically significant. The results of Equation 5 report that the coefficient on CFO is 0.0001, positive and statistically significant as predicted. The coefficient on Accruals supports the previous result that Accruals are not related to CEO cash compensation sensitivity. Interacted with Persistence, the coefficient is positive but statistically insignificant. Consistent with the results of Equation 3, persistence has no relation with the pay sensitivity to cash flow. Table 4 reports the test results of equation 6 and 7 for H2. Adjusted R 2 are -0.0034, 0.0015, 0.0012 and -0.0145 respectively for Equation 6 for bad news firms, Equations 6 for good news firms, Equation 7 for bad news firms and Equation 7 for Table4-equation 6,7 16

Bad news Good news Variable ln(cash comp) ln(cash comp) Predict.sign Coef. (t statistic) Predict.sign Coef. (t statistic) Equation 6 R + 0.5345(1.12) + 0.0823(0.54) CFO -0.0001(-0.62) 0.0001(0.38) Accruals 0.00001(0.06) 0.0001(0.37) AccrualQuality 0.0004(0.50) 0.0012(2.38) R*AccrualQuality 0.0015(0.56) + -0.0010(-1.28) Sales 0.0000(0.79) 0.0000(-0.27) Equation 7 R + 0.6965(1.79) + -0.0047(-0.04) CFO -0.0001(-0.40) -0.0001(-0.32) Accruals 0.0001(0.33) -0.0001(-0.30) Persistence 0.0047(0.20) 0.0269(0.72) R*Persistence 0.0158(0.30) + -0.0277(-0.73) Sales 0.0000(0.74) 0.0000(0.80) good news firms. For good news firms sample, the coefficients on R interacted with AccrualQuality and CFO are not positive or statistically significant as I predicted in H2. Earnings quality is not realated to pay sensitivity to stock returns for good news firms. This follows that the information risk of unrealized gains is not considered as an incentive when the board of directors contract CEO cash compensation. For bad news sample, the results of Equation 6 and 7 prove that the coefficients on R are positive and statistically significant, adding evidence that CEOs receive immediate penalty for unrealized losses. The coefficients on R interacted with AccrualQuality and CFO are positive and statistically insignificant. Earnings quality is not related to the pay sensitivity to stock returns for bad news firms. This follows that the information risk of unrealized losses does not relate to cash compensation penalty for unrealized losses. In summary, earnings quality is not related to the asymmetric level of pay sensitivity to stock returns. 17

H1 suggests that earnings quality is not associated with pay sensitivity to earnings and earnings components. The regression analysis confirms H1 to the extent that accrual quality is not associated with pay sensitivity to accruals and cash flows, and persistence is not associated with pay sensitivity to earnings, accruals and cash flows. Inconsistent with H1, accrual quality is associated with the sensitivity of CEO cash compensation to earnings. When earnings have higher accrual quality, the sensitivity of CEO cash compensation to earnings is higher; when earnings have lower accrual quality, the sensitivity of CEO cash compensation to earnings is lower. H2 suggests that earnings quality is associated with the asymmetric level of pay sensitivity to stock returns. The regression analysis disproves H2. Neither accrual quality nor persistence is associated with the sensitivity of CEO cash compensation to stock returns for good news and bad news companies. CEOs are receiving no penalty for low earnings quality and high accounting information risk, and no incentives for high earnings quality and low accounting information risk. VII Conclusion This paper tests the relation between earnings quality and CEO cash compensation. They represent the valuation and evaluation uses of earnings information. First, I analyzed that earnings quality can signal information risk while information risk links the uses of accounting information. Second, I examine the impact of earnings quality on pay sensitivity. I use accrual quality and persistence to present earnings quality and I decompose earnings into accruals and cash flows. Based on this research, it is clear that accrual quality is associated with CEO cash 18

compensation and impacts pay sensitivity to earnings. Earnings with high accrual quality would be considered more useful than earnings with low accrual quality when CEO incentives are contracted. One of the reasons could be that earnings with high accrual quality signals low information risk and the board of directors face little uncertainty in earnings information. I find no relation between accrual quality and pay sensitivity to accruals, cash flows and stock returns and no relation between persistence of cash flows and pay sensitivity to earnings, accruals, cash flows and stock returns. With the research, I failed to see the compensation contracts that include adequate consideration of earnings quality. Since CEOs are responsible to report earnings information and unrealized gains and losses, the incentives for high earnings quality may mitigate information risk and uncertainty in the reported information. To upgrade the effectiveness of compensation contracts, the board of directors and the compensation committee may consider the quality of received accounting information rather than the mere information. Future research may examine the role of earnings quality in determining CEO cash compensation with Say-on-Pay policy starting at the financial crisis period and whether the policy brings effective compensation method with respect of earnings quality and information risk. 19

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