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1 May 2018 CFA Institute Journal Review

What Does CEOs’ Pay-for-Performance Reveal about Shareholders’ Attitude toward Earnings Overstatements? (Digest Summary)

  1. Servaas Houben, CFA
In the classic principal–agent dilemma, there is a conflict of interest between the shareholders financing a company and the board managing the company. The board is keen to overstate earnings to obtain bonuses, whereas the shareholders care about long-term fundamental firm value. CEO pay-for-performance sensitivity is higher for companies for which shareholders benefit from overstatements. The introduction of new regulations can change CEO behavior.

How Is This Research Useful to Practitioners?

A conflict of interest on earnings overstatement is not only between shareholders and boards but also between current and future shareholders: Current shareholders can behave myopically and try to maximize firm value in the short term at the expense of future shareholders. One reason is that overstatements can result in lower borrowing costs.

There is no empirical evidence that earnings overstatements are caused by incentive pay or by shareholders’ benefits from overstatements. The authors use the introduction of the Sarbanes–Oxley Act (SOX), which mandated reforms to improve financial disclosures from corporations and prevent accounting fraud, to observe changes in pay-for-performance sensitivities (PPS). They find that the introduction of SOX decreased PPS, with the decrease being the highest for companies with high pre-SOX shareholder benefits from overstatements. High PPS may be caused not by poor governance but by the conflict of interest between current and future shareholders.

Previous literature shows a positive relationship between overstatements and incentive pay. There are different views of the PPS effects of SOX: Some say that it has resulted in PPS increases, reflecting more incentives for managerial effort; others believe that the penalties of misreporting have resulted in lower PPS.

There are also different views in the previous literature on the effects of corporate governance. Monitoring and incentives can be substitutes because more monitoring implies the agent’s interest is more likely to be aligned with the principal’s interest. Monitoring and incentives can also be complements: More monitoring will result in more-precise incentives.

The novelty of the authors’ model is that it includes not only the traditional principal–agent problem but also the possibility that the principal benefits from overstatements.

This research can serve as an eye-opener for a wide range of investment professionals. Good governance is usually considered to be a tool to limit board pay, but when incentives for overstatements also benefit short-term investors, good governance by itself might not be sufficient.

How Did the Authors Conduct This Research?

The authors use a model in which the agent can overstate the fundamental firm value at the risk of discounting by the market. They assume the principal is risk neutral, the agent is risk taking, and the shareholders want to maximize either market value or fundamental value. The theoretical framework is solved by backward induction from which several propositions follow. The authors then apply empirical analysis to test the propositions. They use a 1999–2005 dataset of 850 large, publicly traded firms and annual CEO compensation data and firm characteristics data.

Based on empirical analyses, the authors conclude that PPS decreased significantly after the introduction of SOX and continues to be lower since the introduction of SOX. SOX has increased CEOs’ personal exposure to liability when overstatements take place, which explains the change in CEO behavior after SOX implementation. Because earnings overstatements continue to be lower after the introduction of SOX, SOX has resulted in a permanent shift in earnings overstatements. The authors conclude that CEO compensation before SOX is the result of shareholder myopia.

They also assess some alternative explanations—for example, the decline of the stock market value around the introduction of SOX, speculative mispricing, or a decreasing added value of overstatements—but none of these explanations seem plausible. Finally, the authors dismiss the possibility that the introduction of recognizing stock option compensation would challenge their findings.

Abstractor’s Viewpoint

This research is quite novel because the classic principal–agent problem is made more likely by adding a short- and long-term choice that shareholders face. Because of market pressure and expectations, CEO payments have become more and more short term, which seems to align with shareholders’ interests. The introduction of new legislation that increases penalties for misstatement apparently has more impact on CEO behavior than normal market forces. The research thus seems to indicate that when society believes stock markets behave in a shortsighted and opportunistic manner, regulations provide opportunities to change market participants’ behavior.

The authors provide a good historical overview of different streams of thought on the matter, but they also add other elements and thus provide a good mix of traditional views and innovation. Because many investment professionals will face the trade-off between short- and long-term objectives, this article will appeal to many investment professionals.

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