When a CEO’s bonus is directly linked to earnings per share (EPS), there is an explicit financial incentive for the CEO to manipulate the EPS through repurchases to increase the bonus payout. Using a large hand-collected sample of CEO bonus structures, the authors empirically investigate whether repurchases are driven by the bonus structure.

Many CEOs’ bonus plans are linked to their firms’ EPS. This bonus structure has become more popular since 2002 and creates an incentive to decrease shares outstanding through repurchases. The authors show that firms are more likely to undertake share repurchases when their CEO’s bonus is linked to EPS. When the EPS is slightly lower than the EPS bonus threshold, 75% of the firm-year observations show a share repurchase, which is a significantly higher frequency than normal.

Furthermore, when the CEO’s bonus is linked to EPS, conducting share repurchases increases the level of the bonus by approximately 34%. It should be noted that when a CEO’s bonus is not linked to EPS, conducting a repurchase does not affect the level of the bonus. The evidence supports the view that the bonus structure can create a personal motivation for CEOs to initiate a share repurchase.

Because these bonus-driven repurchases are motivated differently from other repurchases, the authors argue that the post-announcement abnormal returns will be different as well. They show that repurchasing firms outperform nonrepurchasing firms. But the abnormal returns are not significant in the subset of the firms with CEO bonuses linked to EPS, which hints that personal gain, rather than undervaluation, is the primary motivation for these repurchases.

The authors gather the information on executive compensation of S&P 1500 Index firms from ExecuComp; they obtain the firms’ financial information from Compustat’s Industrial Annual database. After excluding financial and utility firms, firms with negative book value of equity, and firms with a share price of less than $1, there are 17,555 firm-year observations from 1992 to 2007.

To obtain the bonus structures for the CEOs, the authors extract the annual proxy statements (DEF 14A) filed with the US SEC. After matching those statements with the sample from Compustat and ExecuComp, the authors have 12,476 firm-year observations from 1993 to 2007 for 1,423 companies in the final sample.

The authors test their hypotheses on the large dataset using both univariate statistics and multivariate regression models. They show that firms with and without their CEOs’ bonuses linked to EPS differ. In particular, EPS-linking firms with bonuses linked to EPS have weaker corporate governance than those that are not linked to EPS.

The authors address the endogenity bias with various statistical procedures, including the propensity score matching approach and standard two-step analysis. They also measure the CEO bonus and the share repurchase in different ways. The conclusions are similar across methods, and therefore, the results are robust.

Financial analysts can learn a few lessons from the findings. First, although a repurchasing announcement is generally interpreted as an underpricing signal, this signal does not apply for firms that link their CEOs’ bonuses to EPS. Second, firms that link EPS to bonuses are associated with weaker corporate governance, which gives CEOs the chance to manipulate the EPS through repurchasing for personal gain. Institutional investors can prevent this manipulation through active external monitoring.