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CITY UNIVERSITY OF HONG KONG
香 港 城 市 大 學
Managerial Myopia, CEO Compensation Structure
and Earnings Management by R&D Cuts
經理人員短期行為,薪酬結構
和通過減少研究發展費用進行的盈餘管理
Submitted to Department of Accountancy
會計學系
In Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy
哲學博士學位
by
He Wei Dong
何衛東
February 2004
二零零四年二月
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ABSTRACT
Prior studies show that linking executive compensation to current accounting
performance provides incentive for CEOs to manage earnings by cutting R&D
expenditure (e.g. Baber et al. (1991), Bushee (1998)). However, it has also been
suggested that tying executive compensation with stock price mitigates opportunistic
R&D cuts (e.g. Lambert and Larcker (1987)). This study contributes to this strand of
literature by testing empirically whether CEO compensation structure in terms of the
relative mix of cash-based vs. stock-based compensation affects R&D expenditure in
firms that could reverse earning decreases with a reduction in R&D expenditure.
Analysis of a sample of 7,246 publicly traded U.S. companies shows that CEOs are
more likely to cut R&D expenditure to meet earning targets when the percentage of
cash-based compensation in their total compensation is high or increased, and that a
change from a cash-dominated compensation scheme to a stock-dominated
compensation scheme is negatively related to the likelihood of R&D cuts, suggesting
that stock-based compensation may mitigate opportunistic R&D cuts.
This study also finds that the association between CEO compensation structure and
the likelihood of R&D cuts can be moderated by some governance mechanisms
including CEO dominance, CEO ownership and anti-takeover provisions.
Moreover, this study presents evidence that discretionary accruals are negatively
related to the likelihood of R&D cuts for firms rewarding their managers with
stock-dominated compensation schemes, indicating a substitution effect between
earnings management by R&D cuts and by discretionary accounting choices. Those
results are robust to a variety of sensitivity tests, including those that account for
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endogeneity between CEO compensation structure and firm-level discretionary R&D
expenditures.
Key Word: Managerial Myopia CEO Compensation Structure Earnings
Management R&D Cuts
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ACKNOWLEDGEMENT
I would like to thank my committee members, Bin Srinidhi (Supervisor), Sidney
Leung, Charles Chen for their guidance and support. I thank Professor Ferdinand Gul
and Dr Xijia Su for their helpful comments and suggestions. I also thank Robert
Morris for his invaluable editorial assistance. I am especially grateful to Dr Charles
Chen for providing me with data on CEO compensation.
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TABLE OF CONTENTS
ABSTRACT----------------------------------------------------------------------------------ii
ACKNOWLEDGEMENT-------------------------------------------------------------iii
TABLE OF CONTENTS---------------------------------------------------------------iv
LIST OF TABLES------------------------------------------------------------------------vii
CHAPTER 1 INTRODUCTION-----------------------------------------------------1
1.1 Motivation--------------------------------------------------------------------------------1
1.2 Main Finding -----------------------------------------------------------------------------6
1.3 Contribution------------------------------------------------------------------------------7
1.4 Overview----------------------------------------------------------------------------------9
CHAPTER 2 LITERATURE AND HYPOTHESIS-------------------------11
2.1 Explanation for Earnings Management by R&D Cuts-----------------------------11
2.2 Executive Compensation Components-----------------------------------------------16
2.3 R&D Cuts and CEO Compensation Structure--------------------------------------19
2.4 Change in CEO Compensation Structure--------------------------------------------27
2.5 Influence of CEO Dominance and CEO Ownership-------------------------------31
2.6 Impact of Anti-takeover Mechanisms------------------------------------------------33
2.7 Earnings Management by Discretionary Accounting Choices--------------------35
CHAPTER 3 RESEARCH METHODOLOGY------------------------------39
3.1 Defining Sub-samples-----------------------------------------------------------------39
3.2 Model Specification-------------------------------------------------------------------40
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3.3 Change Regression---------------------------------------------------------------------45
3.4 Measurement of CEO Dominance---------------------------------------------------46
3.5 Corporate Governance Score---------------------------------------------------------48
3.6 Calculation of Discretionary Accruals----------------------------------------------50
CHAPTER 4 SAMPLE DESCRIPTION---------------------------------------52
4.1 Data Source-----------------------------------------------------------------------------52
4.2 Descriptive Statistics------------------------------------------------------------------53
CHAPTER 5 EMPIRICAL RESULTS------------------------------------------60
5.1 Main Result----------------------------------------------------------------------------60
5.2 Result for Change Regression-------------------------------------------------------63
5.3 Moderating Effect of Corporate Governance--------------------------------------64
5.4 Substitution Effect of Earnings Management Methods--------------------------65
CHAPTER 6 SENSITIVITY TEST-----------------------------------------------67
6.1 Test for Simultaneous Determination-----------------------------------------------67
6.2 Institutional Ownership ----------------------------------------------------------------69
6.3 CEO Tenure-----------------------------------------------------------------------------70
6.4 Year-by-Year Result--------------------------------------------------------------------72
6.5 Redefining Change in Compensation Structure------------------------------------72
6.6 Alternative Measure of Discretionary Accruals------------------------------------74
6.7 Re-examining Earnings Target-------------------------------------------------------76
6.8 Result for R&D-Intensive Industry--------------------------------------------------76
6.9 Other Long-Term Investment---------------------------------------------------------76
6.10 R&D Cuts and Earnings Quality----------------------------------------------------79
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CHAPTER 7 SUMMARY AND FUTURE OPPORTUNITY-----------82
7.1 Summary of Findings------------------------------------------------------------------82
7.2 Caveat------------------------------------------------------------------------------------83
7.3 Future Opportunity---------------------------------------------------------------------84
BIBLIOGRAPHY-----------------------------------------------------------------------113
APPENDIX 1 CALCULATION OF STOCK OPTIONS---------------124
APPENDIX 2 GOVERNANCE SCORE--------------------------------------125
ENDNOTES-------------------------------------------------------------------------------128
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LIST OF TABLES
Table 1: Definition of Variables-----------------------------------------------------------85
Table 2: Sample Descriptions--------------------------------------------------------------86
Table 3: Distribution Pattern of Firm-year Observations------------------------------88
Table 4: Mean Difference for All Variables in the SD, LD and IN Samples--------89
Table 5: Descriptive Statistics of Main Explanatory Variables------------------------91
Table 6: Logistic Regression of Indicator for R&D Cuts on CEO Compensation
Structure--------------------------------------------------------------------------94
Table 7: Logistic Regression of Indicator for R&D Cuts on CEO Compensation
Structure Change---------------------------------------------------------------96
Table 8: Logistic Regression of Indicator for R&D Cuts on CEO Cash-based
Compensation (Controlling for CEO Dominance)------------------------98
Table 9: Logistic Regression of Indicator for R&D Cuts on CEO Cash-based
Compensation (Controlling for CEO Ownership)-------------------------99
Table 10: Logistic Regression of Indicator for R&D Cuts on CEO Cash-based
Compensation (Controlling for Anti-takeover Mechanisms)------------100
Table 11: Logistic Regression of Indicator for R&D Cuts on Discretionary
Accruals-------------------------------------------------------------------------101
Table 12: Simultaneous Determination of R&D Cuts and CEO Compensation
Structure-------------------------------------------------------------------------102
Table 13: Logistic Regression of Indicator for R&D Cuts on CEO Compensation
Structure (Controlling for Institutional Shareholding)--------------------103
Table 14: Logistic Regression of Indicator for R&D Cuts on CEO Compensation
Structure (Controlling for CEO Tenure)------------------------------------105
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Table 15: Year-by-year Logistic Regression of Indicator Variable for R&D Cuts on
CEO Compensation Structure in the SD Sample--------------------------106
Table 16: Logistic Regression of Indicator for R&D Cuts on CEO Compensation
Structure Defined by Different Cutoffs of COMSTRU-------------------107
Table 17: Logistic Regression of Indicator for R&D Cuts on Discretionary
Accruals Estimated by Different Methods--------------------------------108
Table18: Logistic Regressions of Indicator for R&D Cuts on CEO Compensation
Structure for R&D Intensive Industries-------------------------------------109
Table 19: Correlation Analysis of Indicator for Other Long-term Investment Cuts
and CEO Compensation Structure-------------------------------------------110
Table 20: Examination of Quality of Earnings for Firms in the SD and Total
Sample---------------------------------------------------------------------------111
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CHAPTER 1 INTRODUCTION
1.1 Motivation
Inter-temporal choice is inherent in business practice, particularly in the issues
faced by top-level managers. Technology investment, workforce training, and entering
new market are basic examples. From a management perspective, the most important
problem involving inter-temporal choice are those decisions in which, with respect to
maximizing profit or achieving some other objectives, the course of action that is
most desirable over the long run is not best course of action in the short term. This is
the dilemma of “managerial myopia”, sparked by the contention that U.S. firms are
losing competitive advantages over overseas competitors because U.S. managers are
unwilling or unable to invest in the long run.
Managerial myopia generally refers to a type of sub-optimal investment behavior
that managers will forgo valuable long-term projects (especially investment in
intangible assets, such as R&D, advertising and employee training) in pursuit of
short-term profits at the expense of long-term interests of shareholders.
Many critics accuse managerial myopia of being responsible for the loss of
technological leadership and growth potential of U.S. companies and attribute it as
one of the main causes of economic malaise that has affected the United States for the
past two decades. For example, Drucker (1986) argues that everyone who has worked
with American management can testify to the need to satisfy the pension fund
manager’s quest for higher earnings next quarter, together with the panicky fear of the
raider, which constantly push top management toward decisions they know to be
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costly, if not suicidal, mistakes. The damage is greatest where we can least afford it: in
the fast-growing middle-sized high-tech or high-engineering firm that needs to put
every available penny into tomorrow1.
Managerial myopia has emerged as modern corporations have come into being. In
the 1980s, prominent CEOs and influential scholars voiced that U.S. corporate
managers were mainly driven by market forces to behave myopically. The Wall Street
Journal made a survey of CEOs of major U.S. corporations in 1986 and found that 82
out of 100 blamed the stock market’s attention to quarterly earnings and over-active
market for corporate control for contributing to a decline in long-term investment and
the loss of the United States’ competitive edge2.
During the 1990s, the U.S. stock market and business practice have experienced
significant structural changes. Two tendencies related to managerial myopia have
come out: One, hostile takeover activities slowed down dramatically and motivations
of managerial myopia from defending hostile takeovers decreased. Two, people
witnessed an extraordinary growth in executive compensation. From 1992 to 1998,
total CEO compensation for all U.S. listed firms has more than doubled, while CEOs
at S&P 500 firms have seen their total compensation rise by over 250%3.
The influence of the rapid growth of executive compensation on managerial myopia
is mixed. It may exacerbate managerial myopia because managers’ motivations for
maximizing compensation increase. Conversely, it may also alleviate managerial
myopia because the enormous growth in top executives’ total compensation is largely
in stock-based compensation that used to be employed as a governance mechanism to
discipline managerial myopia.
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Despite the level of attention paid to the debate and the critical nature of the subject,
the most fundamental issues related to the existence, cause and tendency of
managerial myopia remain unresolved. This study contributes to the progress on this
subject, sheds some light on the association between executive compensation structure
and managerial myopia, and tests competing views on the influence of change in
executive compensation structure on managerial myopia.
This study examines managerial myopia with respect to research and development
(R&D, hereafter) investment. R&D is a major type of long-term investment that
accounts for over 20 percent of gross investment expenditure in manufacturing
companies, and over half of gross investment expenditure in biotechnology and
electronic companies4. The U.S. Generally Accepted Accounting Principles requires
that R&D expenditure be fully expensed and this accounting treatment of R&D
expenditure may significantly affect current accounting earnings upon which cash
components (e.g., salary or bonus) of executive compensation are directly contingent.
R&D expenditure can also be linked with executive compensation through subjective
performance evaluation incorporating R&D activities or non-financial measures
related to R&D inputs or outputs.
Lagging R&D investment has triggered much concern over managerial myopia in
recent years (Jacobs, 1991). On the one hand, this concern reflects recent widespread
technological change, together with the dazzling growth of science and
knowledge-based industries, which generates great needs for R&D investment. On the
other hand, it is also triggered by the current corporate governance debate. Since R&D
projects are usually associated with high information asymmetry between managers
and shareholders, current stock prices may not fully reflect the benefits of R&D
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investment (Lev and Sougiannis, 1996). Managers are likely to take this chance to
engage in managerial myopia because they believe that reductions in R&D investment
are possible without the awareness of investors5.
Shareholders should be very concerned with R&D cuts because R&D investment
plays a key role on establishing core competence and developing competitive
advantages over business opponents, and because R&D cuts caused by managerial
myopia may seriously impair firms’ growth potentials and ruin future profitability. As
appeals for shareholder rights protection rise increasingly, research on managerial
R&D cuts is indispensable and contains great opportunities to attain breakthrough.
One of the basic motivations of this study comes from the contentions that linking
executive compensation with current accounting performance creates incentives for
managerial myopia. This study expects that executive compensation structure is one
of the main explanatory variables to explain and predict managerial myopia. For
example, if accepting lower earnings today might result in a termination or a loss of
bonuses, substantially greater earnings tomorrow may not represent a desirable
trade-off. When earnings are near the unacceptable range, executives’ incentives to
manage them upward will be significant.
However, when bonuses are near maximum, further increase in earnings will be
rewarded little, generating an incentive to rein in current earnings that is, shifting
them forward and making future thresholds easier to meet. Furthermore, executives
may be reluctant to report large gains in earnings because they know their
performance target will be ratcheted up in the future. Earnings so poor as to put
thresholds and bonuses out of reach may be also shifted to the future, so executives
save for a better tomorrow.
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Executive compensation structure here refers to the relative mix of cash-based
compensation vs. stock-based compensation. This study investigates both the static
relative mix and the time-series change in the relative mix of cash-based
compensation vs. stock-based compensation. Due to data availability and the
difference in incentive between Chief Executive Officer and other executives who
care about both promotion and compensation, this study is limited to compensation of
Chief Executive Officer.
From the perspective of accounting academics, myopic R&D cuts are also a type of
earnings management. One of the main results of R&D cuts is that managers
intentionally intervene in the financial reporting process and generate accounting
numbers that either mislead shareholders about the underlying economic performance
of the company or influence contractual outcomes that are contingent upon reported
accounting numbers by opportunistically deferring expenditures on R&D.
It is noteworthy that earnings management could be also efficient because
managers may use accounting judgment to make financial reports more informative
for users. For example, until recently some successful R&D firms created R&D
limited partnerships, which permitted them to effectively capitalize R&D outlays that
otherwise would have been expensed. However, the use of accounting judgment to
make earning numbers more informative for users is not explored in this study.
Earnings management by R&D cuts is more likely to occur when managers face a
trade-off between meeting earning targets and maintaining R&D expenditure. To
capture this context, I select a sample of firms with pre-R&D earnings below the prior
year’s level, but by an amount that could be reversed by cutting R&D expenditure.
For these firms, I examine (1) whether the likelihood of R&D cuts is associated with
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CEOs’ compensation structure, (2) whether a change from cash-dominated to
stock-dominated compensation scheme 6 after controlling growth 7 in total
compensation affects the likelihood of R&D cuts, (3) how the association between the
likelihood of R&D cuts and CEOs’ compensation structure is moderated by corporate
governance variables, including CEO ownership, CEO dominance and the adoption of
anti-takeover mechanisms and (4) whether CEOs use discretionary accounting choice
to manage earnings when the board rewards them with stock-dominated compensation
scheme (the cost of R&D cuts is high).
1.2 Main Finding
Analysis of a sample of US publicly traded companies shows that (1) CEOs are less
likely to cut R&D expenditure to meet earning targets when the percentage of
cash-based compensation (relative to stock-based compensation) in their total
compensation is low or is decreased, (2) when there is a change from cash-dominated
CEO compensation scheme to stock-dominated CEO compensation scheme, (3) the
positive association between the likelihood of R&D cuts and cash-based
compensation become stronger when the CEO also serves as chairman of the board,
(4) the adoption of anti-takeover provisions may increase incentive of CEOs rewarded
with cash-based compensation to cut R&D expenditure, (5) CEO ownership has
mixed influences on the association between the likelihood of R&D cuts and CEO
compensation structure and (6) discretionary accruals are negatively related to the
likelihood of R&D cuts for firms with stock-dominated CEO compensation scheme,
indicating a substitution effect between earnings management by R&D cuts and by
discretionary accounting choices. Overall, these results suggest that linking
managerial compensation with accounting earnings creates incentive for managers to
manage earnings by R&D cuts, rewarding managers with stock-based compensation
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mitigates this incentive, and the association between managerial compensation and
earnings management by R&D cuts is moderated by the effectiveness of corporate
governance mechanisms.
1.3 Contribution
The finding of this study contributes to the existing literature on the association
between executive compensation structure and earnings management by R&D cuts in
several important ways.
First, this study presents evidence which is consistent with Narayanan (1996) who
develops an analytical model to show that a cash-dominated compensation scheme
will induce managers to cut long-term investment, and that a stock-dominated
compensation scheme will motivate managers to increase long-term investment. Prior
research in this area tests for systematic under-investment in R&D by examining the
cross-sectional relation between the level of R&D intensity (e.g., R&D to sales) and
pay for performance sensitivity of different compensation components or the level of
cash-based (stock-based) compensation component. The evidence is mixed, though
largely supporting a positive association between R&D intensity and stock-based
compensation (e.g., Bizjak et al. (1993), Baber et al. (1996) and Eng and Shackell
(2001)). This study extends this line of inquiry by testing for period-specific reduction
in R&D investment in years when managers face a trade-off between maintaining
R&D expenditure and meeting earnings targets. In doing so, this study presents
evidence that the relation between executive compensation structure and change in
R&D expenditure depends on the firm’s current accounting performance.
Second, this study contributes to current research on the association between
executive compensation and earnings management. Since Healy (1985), most of
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studies in this area examine compensation-motivated earnings management by
focusing on discretionary accounting choices (e.g., Holthauslen et al. (1995), Gaver et
al. (1995), and Guidry et al. (1999)). In contrast to those studies, this study focuses on
a more costly means of earnings management, R&D cuts. Such reduction has real
implications for long-term firm value and, therefore, is of great concern to investors.
This study also extends prior studies by documenting a substitution effect between
earnings management by R&D cuts and by discretionary accounting choices.
Third, this study also contributes to recent research on the governance role of
executive compensation contracts in earnings management. It provides direct
empirical evidence that the board adjusts CEO compensation structure to mitigate
R&D cuts as a means of earnings management. Prior studies, such as Dechow et al.
(1994) and Behn et al. (2002), identify the governance role of CEOs’ compensation
contracts but do not examine whether the board adjusts CEOs’ compensation contracts
when the reductions in R&D expenditure are more likely.
In addition, Bushee (1998) demonstrates the governance role of institutional
ownership in earnings management by R&D cuts. This study focuses on the
governance role of executive compensation contracts and extends Bushee (1998)’s
study because compensation contracting and institutional shareholding are
complementary governance mechanisms to monitor managers.
Fourth, this study extends prior literature by providing evidence that the association
between CEO compensation structure and earnings management by R&D cuts can be
moderated by three corporate governance mechanisms, CEO dominance, CEO
ownership, and the adoption of anti-takeover provisions, which suggests that the
interaction between executive compensation contracts and other governance
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mechanisms may affects the effectiveness of executive compensation contracts as a
governance mechanism.
1.4 Overview
This thesis consists of seven chapters.
Chapter 1 presents a brief introduction of this study. Motivation, main finding and
contribution of this study are discussed.
Chapter 2 reviews literature and develops hypotheses by examining extant literature
on managerial myopia, CEO compensation structure, adjustments in CEO
compensation structure, the governance role of CEO dominance, CEO ownership and
anti-takeover mechanisms, and the substitution effect between earnings management
by R&D cuts and by discretionary accounting choices.
Chapter 3 illustrates the methodology used in the empirical tests. A logistic model
is developed to test the association between the likelihood of R&D cuts and CEO
compensation structure.
Chapter 4 describes the sample and presents descriptive statistics. A sample of U.S.
publicly traded companies covering a period from 1992 to 2001 is selected to
construct the sample. The total sample size is 7,246 firm-year observations.
Chapter 5 reports empirical testing results that support or reject main hypotheses on
the association between the likelihood of R&D cuts and CEO compensation structure.
Chapter 6 presents results of the sensitivity test. Some basic econometric problems,
including incomplete sampling, omitted variables, self-selection bias and endogeneity,
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are examined.
Chapter 7 summarizes this study. Main caveats and future research opportunities
are also discussed.
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CHAPTER 2 LITERATURE AND HYPOTHESIS
2.1 Explanation for R&D Cuts
Based on a survey of existing literature on managerial myopia and earnings
management, this study generalizes five explanations for R&D cuts. They are:
shortsighted management practice, managerial opportunism, stock market pressure,
fluid and impatient capital, and information asymmetry.
One of the most frequently cited examples for shortsighted management practice is
the increased use of discounting techniques to evaluate investment projects resulting
in an under-valuation of the future returns from long-term projects. Johnson and
Kaplan (1987) state that R&D cuts results from an attempt to measure performance
over too brief a period, before the long-term adverse consequences from making
short-term decisions become apparent8. Kaplan (1984) argues that the ability of the
firm to increase reported earnings while sacrificing the long-term economic health of
the firm is the fundamental weakness in the accounting model.
Another target is the growth of the multidivisional form because it creates intense
pressures on division managers to perform in the present9. Loescher (1984) contends
that CEOs who rely on quarterly and annual reports for information on divisional
performance cannot motivate divisional managers to make investments that have only
long-term returns10.
Some critics focus on economic incentives for managers to engage in myopic
investment behavior and provide the second explanation for R&D cuts. They employ
an agency framework to explain R&D cuts and attribute it to managers’ opportunistic
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behavior in an attempt to maximize their own compensation. For example, Narayanan
(1985) shows that (1) managers desire to make investments that offer relatively faster
paybacks in order to more rapidly enhance their reputations, (2) such enhancement
has a lasting effect and (3) high reputations link with high compensation. Therefore,
managers who have private information about long-term R&D projects will have
incentives to speed up the projects’ returns to the detriment of long-term performance.
Rumelt (1987) argues that managerial mobility (decision horizon problem) creates
a serious potential for myopia. Managers can display opportunism by choosing
projects that will pay off handsomely in the short term but will not fare well over the
long run. Such opportunistic managers can reap the rewards of associations with a
temporarily successful project as long as the success continues till they exit the firm
before the end of the project’s success11.
In sum, managers’ economic incentives for short-term interests are exacerbated in
some situations where a decision may represent an optimal personal choice for a
manager, but it may be a sub-optimal choice for shareholders.
The third explanation of R&D cuts is related to managers’ beliefs that capital
market participants undervalue investments that will pay off only in the long run. In
current stock markets, stocks are increasingly traded as common goods. Investors
have neither the interest nor the patience to wait for the long run. They are
increasingly responsive to the changes in current market performance (see Jacobs
(1991)). Stock prices (firm value) reflect market participants’ preference of short-term
profits over long-term interests. If managers ignore market participants’ preference for
short-term results, stock price will go down and the firm will be undervalued. Market
raiders will acquire the firm and hire new managers after taking over the firm. By
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inter-temporally shifting earnings from the future to the present, managers may boost
stock prices so that they can succeed in surviving hostile raiders’ takeover bidding.
Besides capital market participants’ shortsightedness, the U.S. capital market
structure characterized by fluid and impatient capital may also result in R&D cuts.
Porter (1992) states that funds supplied by external capital providers move rapidly
from company to company in order to grasp opportunities for near-term appreciation.
External funds are also impatient capital because their owners neither care about the
routine operation of the firm nor hold stocks for a long period12. One of the direct
problems resulting from fluid and impatient capital is that in U.S. firms, there is
over-investment in some activities, such as unrelated diversification, which traps
many fallen industry leaders, and there is under-investment in some complex
capabilities, such as research and development, which are necessary for the
establishment of competitive advantages.
The final explanation is that R&D cuts result from information asymmetry between
investors and managers. Some financial economists try to separate our explanations of
earnings management by R&D cuts from managerial opportunism arguments by
contending that earnings management by R&D cuts may not be a prevalent
phenomenon in an efficient market because the market can discipline opportunistic
managers. Jensen (1986) espouses this point of view by arguing that earnings
management by R&D cuts will only be a problem if managers do not care enough
about stock prices. He argues that R&D cuts occur when managers hold little stock in
their companies and are compensated in ways motivating them to take actions that
increase accounting earnings at the expense of shareholder wealth. They also occur
when managers make mistakes because they do not understand the forces that
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determine stock prices13.
However, Stein (1989) shows that if there is information asymmetry between
managers and investors about the level or return of R&D investment, the preferred
cooperative equilibrium with no R&D cuts on the part of managers and no conjecture
of R&D cuts on the part of shareholders cannot sustain as a Nash-Equilibrium. If
managers have private information over investors, they are able to shift the timing of
earnings between periods without the awareness of investors. For the current period,
investors do not know how much is “true” earnings and how much is “borrowed”
earnings from future periods to make current results look better. Managers may not
want to make shortsighted decisions to increase current earnings, but investors
understand that any manager is able to move earnings around between time periods
without being detected. Because managers have no alternative signals of firm value,
the result is over-investment in projects that enhance short-term performance and
under-investment in projects that lead to long-term profits.
The first three explanations underscore motivation issues for earnings management
by R&D cuts. Both shortsighted management practices and managerial opportunism
originate from managers’ inherent desires to maximize their own interests. Stock
market pressure results from the market participants’ preferences for the short-term
returns. A combination of managerial behavior and stock market participants’
behavior is reinforcing. If the stock market has an apparent preference for the
short-term, firms may need analytical tools focusing on the short-term in order to
survive, and managers may prefer to shift earnings from the future to the present in
order to defend against hostile takeovers or increase compensation. A combination of
managers’ sub-optimal preferences for the short-tem and the stock market’s
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preferences for the short-term may enhance a firm’s survival.
The last two explanations place emphasis on opportunities for earnings
management by R&D cuts. Information asymmetry, fluid and impatient capital
provide opportunities for managers to engage in myopic investment behaviors. If
investors have the same information about the level and return of long-term projects
as that of managers, a fixed-salary contract for managers may serve as the optimal
solution. However, if managers have private information about the level and return of
long-term investments, they may make use of these opportunities to increase or reduce
R&D investments to maximize their own compensation. This argument does not mean
that investors have no choice but to accept the loss from earnings management by
R&D cuts. In contrast, investors can anticipate earnings management by R&D cuts
and develop corresponding governance mechanisms to discipline managers. However,
because the stock market is fluid and impatient, investors favor quick profit and
short-term returns, and few of them hold shares for a long time or care about future
growth and corporate governance. Shortsighted market and weak corporate
governance set the stage for earnings management by R&D cuts.
When managers make discretion on R&D investment, they have to balance the
benefit and cost from earnings management by R&D cuts. Though managers have
strong motivations to maximize their compensation, and the market also provides
opportunities for them to make discretion on R&D investment, they may not cut R&D
expenditure when the cost from R&D cuts is high. Managers probably make a choice
among different ways of earnings management and cut R&D expenditure in a
situation where the marginal cost from doing so is the lowest.
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2.2 Executive Compensation Components
A typical U.S. firm’s executive compensation contract consists of five components:
salary, bonus, restricted stocks, stock options, and other long-term performance plans.
Salary is fixed payment to executives and usually set on an annual basis. Moreover, it
is well documented in prior literature that base salary is related to both the firm’s size
and accounting performance (e.g., Antle and Smith (1992) and Murphy (1999)).
Bonus awards are typically based on short-term performance measures such as
current-year profits or return on equity. Stock option plans award eligible participants
the right to purchase a fixed number of shares of common stock at a predetermined
exercise price over a finite horizon. Restricted stock awards endow managers with a
fixed quantity of shares of the firm’s equity with restrictions on resale or transfer and
a forfeiture clause that invalidates the award if the executive quits or is fired before
the restriction period elapses. Long-term performance plans set performance goals,
typically in terms of accounting measures such as the growth in earnings per share
over a specified horizon (normally ranging from three to five years).
Basically, salary and bonus are classified as cash components in total compensation
because they explicitly tie executive compensation to current accounting performance
and provide short-term incentives. Options and restricted stocks are categorized as
stock components in total compensation since they are based on firm market
performance and provide long-term incentives.
An explanation for offering both restricted stock arrangements and stock options
relates to their complementary nature (Milgrom and Roberts, 1990). If bonding a
manager to the firm through restricted stock reduces his willingness to take desirable
risks (such as risk associated with positive net present value investments), then there
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are incremental gains to the firm from granting options concurrently with restricted
stock. Therefore, restricted stocks and stock options provide different incentives for
managerial R&D investment behavior. Because R&D investment is future-oriented
but risky by nature, stock options may induce managers to increase investment in
R&D, while restricted stocks may reduce managers’ incentives to invest in R&D
because return volatility caused by risky R&D investment may negatively affect firm
value in which managers have a great stake.
The enormous growth in top U.S. executives’ compensation during the last decade
has resulted largely from stock option awards. Partly due to the dramatic increase in
executives’ stock-based compensation, the SEC began in 1992 requiring firms to
disclose detailed information on CEO compensation in proxy statements. Information
on all five components of CEO total compensation is publicly available now.
Figure 1 illustrates average compensation levels for chief executive officers in a
sample of U.S. corporations chosen for this study from 1992 to 2001. Stock option
awards, valued by the Black-Scholes (1973) methodology as of the date of grant,
represented approximately 50% of CEO compensation in 2001, up from one-third in
1992. While other forms of incentive compensation also increased during this period,
the figure indicates that stock options accounted for the large majority of CEOs’
income from contingent instruments.
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18
Figure 1: time-series pattern of compensation structure
00.10.20.30.40.50.60.7
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Year
Com
pens
atio
nSt
ruct
ure
Cash-based compensaation Stock-based compensation
The use of options is pervasive but varies across industries. Core and Guay (2001)
document cross-sectional variation in the magnitude of corporate option plans. They
find that the median large firm has options outstanding that amount to 5.5% of
common shares outstanding. This percentage is relatively larger, 10-14%, for growth
industries with high R&D intensity such as computer, software and pharmaceutical
firms, and relatively smaller, 2-3%, for low growth firms such as utilities and
petroleum firms. The fraction of total outstanding stock options held by CEOs also
varies between industries. Murphy (1999) finds that the importance of options in CEO
annual pay is pervasive across manufacturing firms, but substantially less important
for utility firms.
Previous studies link the award of stock options to several explanatory variables,
including size, monitoring difficulty, managerial decision horizon, firm market
performance, growth opportunities, and managerial ownership, though these studies
do not always agree, and differences in time periods, sample selection, and
methodology make their results difficult to compare (e.g., Murphy (1985), Jensen and
Murphy (1990), Smith and Watts (1992), Kole (1997) and Mehran (1995)).
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19
R&D investment is related to most of those explanatory variables14. For example,
high growth firms probably have high R&D intensity because their growth potentials
largely depend on research and development. R&D projects are more difficult to
monitor because of high information asymmetry between investors and managers.
Managers are more likely to make myopic decisions on R&D projects with high
information asymmetry when they approach retirement or they want to establish their
reputation earlier. Therefore, an effort to link executive compensation structure with
R&D investment has to consider all preceding variables.
2.3 R&D Cuts and CEO Compensation Structure
Much of the prior literature employs an agency framework to illustrate the
association between earnings management by R&D cuts and executive compensation
structure (e.g., Jensen and Meckling (1976) and Holmstrom (1979)). Under the basic
agency model with moral hazard and information asymmetry, managers’ actions are
unobservable. Shareholders offer compensation contracts based on observable
performance measures presumed to be correlated with managers’ actions. In general,
the conditioning of incentive compensation on performance measures increases as the
ability of shareholders to observe or monitor managers’ actions decreases.
Basically, performance measures could be either accounting performance measure
(e.g. earnings) or market performance measure (e.g. stock return). Sloan (1993)
argues that the advantage of including accounting performance measures in executive
compensation contracts is that they help shield executives from fluctuations in firm
value that are beyond their control15. The weakness of using accounting earnings as
performance measures in executive compensation contracts is that accounting
numbers are subject to managers’ manipulation and discretionary accounting choices
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20
can distort accounting earnings as meaningful indicators of economic returns and, in
the extreme, could discourage positive net present value investments.
Linking executive compensation with stock prices can align managers’ interests
with shareholders’ interests. However, stock prices are also noisy measures of
managers’ performance because they are determined by many non-firm-specific
market factors that are not completely contingent upon managers’ efforts.
Based on the dichotomy of performance measures, total executive compensation
can be divided into two components, cash-based compensation, which is contingent
upon accounting performance measures, and stock-based compensation, which
depends on market performance measures. Typical cash components are salary and
bonus16. Stock components in this study refer only to stock options.
Restricted stocks are excluded in this study because they differ from stock options
in many important ways, leading us to have different expectations about their function
in CEO compensation package17. For example, Byran (2001) shows that restricted
stock awards provide relatively inefficient inducements for risk-averse CEOs to
pursue risky but value-enhancing long-term projects. To the extent that CEOs’ utility
functions are concave, the linear payoff mechanism of restricted stock awards cannot
mitigate CEOs’ aversion to risk-taking. Therefore, stock option awards, rather than
restricted stock awards, are likely to provide a more efficient incentive mechanism for
the CEOs to increase investment in long-term projects. Prior studies also show that
restricted stock awards are negatively related to the level of R&D investment (e.g.,
Ryan et al (2001), Byran et al (2001)). In contrast, stock option awards are positively
related to the level of R&D investment (e.g. Yermack (1995)).
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21
Compensation structure in this study is defined as the relative mix of cash-based vs.
stock-based compensation. If the percentage of cash-based compensation is higher
than the percentage of stock-based compensation in total compensation, it is defined
as a cash-dominated compensation scheme. Otherwise, it is defined as a
stock-dominated compensation scheme.
In the standard agency model, managers are portrayed as being risk-averse, which
implies that they will want their compensation structured so that they bear less
personal risk (see Harris and Raviv (1978)). Given a certain level of compensation,
Managers should prefer fixed cash-based compensation to performance-contingent
stock-based compensation. This preference is reinforced because the value of
managers’ human capital will also vary with the firm’s market performance. In order
to reduce their compensation risk, managers may be involved in activities that reduce
the firm’s risk (see Jensen and Meckling (1979)). The benefits from R&D investment
are highly uncertain due to tough market competition and the irregular nature of
technology progress. Risk-averse managers therefore have inherent incentives to cut
R&D investment.
On the other hand, shareholders are considered risk-neutral with respect to any
particular stocks because they can eliminate firm-specific risk by holding a diversified
portfolio. Shareholders can anticipate that managers attempt to avoid risks in ways
that may reduce firm value. While there are several ways to alleviate this conflict over
risk, pervious literature suggests that tying managers’ compensation to firm market
performance motivates managers to make more value-maximizing decisions (see
Holmstrom (1979)), and that one specific way to tie executive pay to firm
performance is to make a greater percentage of a manager’s compensation
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22
equity-based, such as through stock options awards.
Shareholders do not set executive compensation directly. They nominate directors,
who have the right under corporate law to craft executives’ compensation contract.
The board of directors seeks to both reward executives’ contribution to current firm
performance and motivate future profit-maximizing behavior. Both two goals may not
be simultaneously achieved because executive compensation structure is determined
by an array of factors, such as choice of performance measures, weight on different
performance measures, contract length, agency problems with the board, etc. Because
executives have different preference about their compensation structure from that of
shareholders, compensation contracts create incentive for executives to behave
myopically if the board increases the weight on cash-based compensation.
Once compensation structure is determined, executives have several choices to shift
earnings inter-temporally due to compensation-maximizing considerations, among
which deferring expenditure on long-term investment projects is one of prevalent
alternatives.
Narayanan (1996) develops an analytical model to specify the relationship between
executive compensation structure and long-term investment. In his model, while the
executive’s compensation is a function of the executive’s perceived ability alone,
stock price is a function of both the executive’s ability and his investment decision.
When investors do not know the executive’s investment decision, they might
mis-value both the executive’s ability and the future cash flows from the executive’s
investment decision. This combined effect creates incentives for increasing long-term
investment if the executive is rewarded with a stock-dominated compensation scheme.
By reducing short-term investments, the executive depreciates investors’ perception of
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23
his ability and his wage, but is paid in stock that is undervalued largely, resulting in
being overpaid in the long term relative to his true ability. By contrast, if the executive
is remunerated with a cash-dominated compensation scheme, he has incentive to cut
long-term investment to boost his perceived ability on which his compensation
contract is contingent and is overpaid relative to his true ability. Narayanan concludes
that a cash-dominated compensation scheme will induce the executive to cut
long-term investment, and that a stock-dominated compensation scheme will motivate
the executive to increase long-term investment.
As an extension of Narayanan’s analytical model, this study attempts to shed light
on the influence of executive compensation structure on the level of R&D investment.
This study argues that cash-based compensation creates incentives for executives to
cut R&D expenditure to avoid earnings decrease that would trigger negative market
reaction and lead to undervaluing of executives’ perceived ability on which their
compensation is contingent. In contrast, if executives are offered stock-based
compensation, they have incentive to increase R&D investment and shift current
earnings to the future so that they can benefit from the current under-pricing of the
firm’s stocks.
Underlying assumptions for this argument are that (1) executives regard previous
period earnings as targets to meet or beat, (2) the market is sensitive to current
earnings announcement and react to it instantaneously and (3) executive
compensation structure is sensitive to the inter-temporal shift of accounting earnings
caused by R&D cuts.
This study is consistent with several cases to support the first underlying
assumption. In Tenneco’s 1994 annual report, CEO Dana Mead states, “I must
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24
emphasize that all of our strategic actions are guided by and measured against this
goal of delivering consistently high increases in earnings over the long term”.
Similarly, for many years, Eli Lilly emphasized a string of earnings increase that
reached 33 years before it was broken. Similar examples can be found in many other
annual reports (e.g. ConAgra (1995), Bemis (1992) and Anhcuser-Busch (1994)).
Other examples are found in press releases or earnings announcements. In the release
of 1994 earnings, Bank of America’s CEO Richard Rosenberg commented
“Increasing earnings per share was our most important objective for the year.”18
Since Ball and Brown (1968), a lot of accounting literature has provided empirical
evidence to support the second underlying assumption, suggesting that the market will
instantaneously react to earnings announcement though the reaction may not be
complete (e.g., Lev et al.(1982) and Ball and Bartov (1996)).
For the third underlying assumption, Narayanan’s analytical model highlights its
rationality and empirical testing of this study presents evidence.
Existing literature documents incomplete and mixed empirical evidence on the
association between executive compensation structure and R&D investment. Bizjak et
al. (1993) report a significantly negative association between R&D investment and
CEO cash-based compensation, which is consistent with Narayanan’s prediction. In
contrast, Baber et al. (1996) find no significant association between investment
opportunity, of which R&D intensity is an important component, and CEO cash-based
compensation. Eng and Shackell (2001) provide evidence that the adoption of a
stock-based compensation scheme does not affect firms’ R&D investment. Bryan et al.
(2000) find positive relation between R&D investment and stock options, but negative
relation between R&D investment and restricted stocks.
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One possible answer for mixed evidence of the association between executive
compensation structure and R&D investment is that executives have to balance the
benefits and costs from opportunistic behavior when they make a decision on R&D
investment. For example, by cutting R&D expenditure, executives may inflate current
earnings and increase cash-based compensation, while they take the risk of deflating
stock price and sacrificing growth potentials. Rational executives may not engage in
R&D cuts if the loss from cutting R&D investment outweighs the benefits from it.
R&D cuts only occur when the expected benefits from them are high and when the
likelihood to be detected by the market is low. That is why previous studies find
mixed evidence on the association between executive compensation structure and
R&D investment.
This study extends prior studies and examines earnings management by R&D cuts
by focusing on a sample of publicly traded U.S. firms that report a decrease in
pre-R&D earnings relative to prior year’s earnings, but that could reverse earnings
decrease by a reduction in R&D expenditure.
Prior literature suggests that when contracting on executive compensation, the
board usually uses expected earning numbers as one of the basic inputs (performance
measure). Those expected earning numbers are earning targets that executives attempt
to meet. Avoiding earnings decrease (compared to prior year earnings) is one of the
earning targets (e.g., Burgstahler and Dichev (1997). Degeorge et al (1999) argue that
the link between earning targets and executive compensation is straightforward
because investors depend on rules of thumb to reduce transactions costs. The
discreteness of actions, whether by investment analysts recommending sell, hold, or
buy, rating agencies better grades, bankers making or refusing loans, or boards
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26
retaining or dismissing the CEO promotes the use of targets of acceptable accounting
performance. A report to shareholders that earnings have been up 6 years in a row is
cheaply communicated. A statement that they have been up 5 out of 6 years, and only
fell by 1 percent in the off year, is less easily understood, so that struggling across the
threshold of last year’s earnings becomes worthwhile. When a firm falls short of last
year’s earnings, the board may think that the executives do a poor job. Bonuses and
stock option awards may suffer.
R&D cut is one of the typical methods employed by executives to avoid earnings
decrease (Baber et al., 1991). Therefore, for firms that could reverse earnings decrease
by a reduction in R&D expenditure, the executive’s motivation to cut R&D spending
is stronger when he is faced with a trade-off between maintaining R&D investment
and meeting earnings targets, and because the possibility of benefits outweighing
costs is high.
By focusing on this sample of firms, this study may provide apparent and
convincing evidence that managers may be motivated by their compensation structure
to manage earnings by R&D cuts and thus contributes to existing literature on the
association between executive compensation structure and managerial R&D
investment behavior. Preceding arguments lead to the following testable hypotheses.
Hypothesis (H1a): Ceteris paribus, a higher percentage of cash-based compensation
in total compensation increases the likelihood that CEOs reduce R&D expenditure to
meet short-term earnings targets.
Hypothesis (H1b): Ceteris paribus, a cash-dominated compensation scheme
increases the likelihood that CEOs reduce R&D expenditure to meet short-term
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27
earnings targets.
2.4 Change in CEO Compensation Structure
The standard agency model predicts that the ability of the board of directors to
observe the executive’s effort determines the structure of executive compensation.
When the executive’s actions are known and observable, the optimal incentive
contract pays the executive a fixed salary and charges him for sub-optimal behavior.
In contrast, linking compensation to outputs such as the value of the firm is necessary
to induce the executive to behave optimally when his actions are unobservable.
Holmstrom (1979) and Lambert and Larcker (1987) extend the standard agency
model and investigate whether the relative weight placed on a performance measure is
an increasing function of the amount of information it conveys about executives’
actions. They predict greater use of stock-based compensation when accounting
performance measure is noisy relative to market performance measure and when a
firm is in the early stage of investment as characterized by rapid growth in assets and
sales.
R&D investment is a typical long-term investment that may contribute to the firm’s
future profitability. Because there is uncertainty about the impact of R&D investment
on firm value, given the benefits of executives’ decisions on R&D investment are not
immediately observable, motivating executives to make optimal investment decisions
requires long-term contracting.
Bizjak et al. (1993) demonstrate that market participants’ excessive concerns about
current stock price can motivate executives to use observable investment decisions to
manipulate the market’s inferences about the firm, which results in either
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28
over-investment or under-investment. Shareholders can induce optimal investment
choices by structuring executive compensation to balance both future and present
market performance. Therefore, firms with high information asymmetry between
executives and shareholders caused by R&D investment will tend to favor contracts
that focus on long-run stock returns over contracts that focus on near-term stock
returns alone.
All these theoretical works suggest that the board of directors will adjust executive
incentives to mitigate anticipated agency problems. High probability of R&D cuts will
lead to change in the executive compensation scheme from a short to a long-term
basis.
Empirically, Gibbons and Murphy (1992) provide evidence that the sensitivity of
CEO cash-based compensation to stock market performance increases as the CEO
approaches retirement. Similarly, Barber et al. (1998) find that the sensitivity of CEO
cash-based compensation to accounting earnings increases with earnings persistence
and executives’ age. Results from both of the two studies suggest that the board of
directors strengthen explicit incentives when they expect that the CEO’s implicit
incentives from career concerns diminish. Dechow et al. (1992) show that
compensation committees in the board adjust earning-based performance measures
when doing so improves incentive alignments. They present direct evidence that the
board of directors adjust CEO compensation structure in response to anticipated
agency problems.
However, most of those empirical works examine adjustment in CEO compensation
structure by investigating the sensitivity of CEOs’ compensation to different
performance measures. They focus on the cross-sectional difference of CEO
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29
compensation structure, rather than on the time-series change in CEO compensation
structure. This study develops another method that is different from that of previous
studies by exploring how the time-series change in CEO compensation structure
relates to managerial R&D investment behavior. The basic argument is that, though
there is information asymmetry about the level or return of R&D investment between
investors and CEOs, investors (the board) still can anticipate CEOs’ motivations to cut
R&D investment, and hence, they will restructure CEOs’ compensation scheme to
balance short-term and long-term incentives and induce optimal R&D investment by
increasing the percentage of stock-based compensation in CEOs’ total compensation.
Prior literature shows that CEOs are more sensitive to the wealth effects which
result from the substitution of one compensation component (stock) for the other
compensation component (cash) when the total compensation holds constant (e.g.,
Jensen and Murphy (1990)). Therefore, a structural change in CEOs’ total
compensation from a cash-dominated compensation scheme to a stock-dominated
scheme after controlling for growth in total compensation is more likely to be initiated
by the board for firms that CEOs have stronger incentive to meet earning targets by
cutting R&D expenditure. The following testable hypothesis is developed.
Hypothesis (H2): Ceteris paribus, a change in CEOs’ compensation structure from a
cash-dominated scheme to a stock-dominated scheme after controlling for growth in
total compensation is negatively associated with the likelihood that CEOs cut R&D
expenditure to meet short-term earning targets.
It is noteworthy that because the adjustment of CEOs’ compensation structure also
involves costs, the board only adopts a new compensation scheme when earnings
management by R&D cuts is more likely. Most prior studies do not address this issue.
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30
For example, Dechow and Sloan (1991) identify CEO stock and option holdings as a
mechanism to mitigate earnings management by R&D cuts, but they do not examine
whether the board increases CEO stock and ownership holdings as a response to the
problem. Similarly, Bushee (1998) finds that institutional ownership mitigates
earnings management by R&D cuts, but he does not investigate whether institutional
investors increase their shareholding when earnings management by R&D cuts are
more likely.
Cheng (2002) is an exception and attempts to solve this problem by regressing
changes in total compensation (or cash-based compensation) on indicator variables
presenting several situations where R&D cuts are more likely to happen. He
documents that R&D expenditure has a significantly positive effect on CEO
stock-based compensation when (1) the executive approaches retirement, and (2) the
firm face a small earnings decrease or a small loss. He interprets his results as
providing evidence that the board of directors adjusts CEO incentive as a response to
the anticipated opportunistic R&D investment behavior.
However, his focus is on how change in total compensation relates to managerial
incentive to cut R&D expenditure, rather than on how change in compensation
structure associates with managerial myopic investment behavior. Change in total
compensation could be driven by other factors, which is unrelated to mitigating
anticipated earnings management by R&D cuts. For example, the increase in
stock-based compensation could simply result from the change in the exercise price of
stock options.
This study distinguishes from prior studies by examining the influence of change in
CEO compensation structure on the likelihood of R&D cuts after controlling for
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31
growth in total compensation.
This study also examines the simultaneous relationship between CEO
compensation structure and R&D cuts. The association between CEO compensation
structure and R&D expenditure may be subject to endogeneity, which makes the
results from cross-sectional regression analysis difficult to interpret. It could be that a
cash-dominated compensation scheme induces managers to cut investment on R&D.
Alternatively, it could be that R&D expenditure, which is required to be immediately
and fully expensed by the U.S. accounting rules, can significantly affect the
magnitude of accounting earnings and result in changes in CEO compensation
structure because accounting earnings is one of the typical performance measures on
which CEO compensation contracts are based. This study follows a two-stage least
square procedure that is free from endogenous problems to correct for the
endogeneity.
2.5 Influence of CEO Dominance and CEO Ownership
Critics of CEO compensation practice argue that if the board is dominated by the
entrenched CEO who may determine the agenda and the information given to the
board (Jensen, 1993), and can exert significant influence on the nomination and
removal of outside directors (Yermack, 1995), the board members may be unwilling
to take a position adversarial to the CEO, especially concerning the CEO’s
compensation (Crystal, 1991). CEOs, like most individuals, are portrayed as being
risk-averse, which implies that CEOs will want their compensation structured so that
they can bear less personal risk. Given a certain level of compensation, CEOs would
prefer fixed cash-based compensation to stock-based compensation19 (Harris and
Raviv, 1978). If CEOs are rewarded with cash-based compensation, they are more
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32
likely to manage earnings by cutting R&D expenditure in order to maximize their
compensation.
Moreover, if the CEO dominates the board, governance mechanisms developed by
shareholders will become less effective, because the CEO will force the board to offer
a compensation contract with cash-dominated schemes preferred by him. The
entrenched CEO’s motivation to engage in earnings management by R&D cuts
becomes stronger. In this study, CEO duality is used as a proxy for CEO dominance
because prior literature suggests that if the CEO also serves as the Chairman of the
board, he is more likely to be entrenched and may have greater control over the board
(Core et al., 1999). The following testable hypothesis is developed.
Hypothesis (H3a): Ceteris paribus, if the CEO also serves as the chairman of the
board, the positive association between cash-based compensation and the likelihood
of R&D cuts becomes stronger.
However, if the CEO owns many shares of the company, his interests may be
aligned with shareholders’ interests. For example, Lambert et al. (1993) find that CEO
total compensation is lower when the CEO’s ownership is higher. The following case
highlights the role of CEO ownership on designing the CEO compensation contract.
Pfizer Corporation’s 2000 proxy statement asserts that its CEO is expected to own
company common stock equal in value to at least three times his annual compensation.
Similarly, NL industry Inc. encourages chief executive officer to own common stock
amounting to between two and four times his annual compensation. Finally, General
Motors encourages CEO ownership of common stock equal in value to a minimum of
two times his annual compensation20.
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33
If a CEO who holds many shares of the company dominates the board, he is more
likely to encourage the board to come up with a compensation scheme linking his pay
with firm performance, rather than to prefer fixed cash-based compensation to
stock-based compensation given a fixed level of total compensation. When incentives
are aligned, the CEO’s motivation to engage in earnings management by R&D cuts
decreases. The following testable hypothesis is developed.
Hypothesis (H3b): Ceteris Paribus, CEO ownership mitigates the positive influence
of CEO dominance on the association between cash-based compensation and the
likelihood of R&D cuts.
2.6 Impact of Anti-takeover Mechanisms
Regarding the impact of anti-takeover mechanisms on earnings management by
R&D cuts, prior literature refers to two opposite arguments, management
entrenchment and efficient contracting. Some scholars who believe in management
entrenchment contend that anti-takeover provisions can be adopted without
shareholder approval, eliminate the disciplinary effect of the takeover market, and
consequently reduce executives’ incentives to act in shareholder’s interests and
exacerbate earnings management by R&D cuts (e.g., Malatesta and Walkling (1986)
and Ryngaert (1986)).
In contrast, others who espouse efficient contracting contend that anti-takeover
devices may benefit shareholders by increasing takeover premiums and facilitating
contracting through enhancing the efficiency of compensation contracts which bond
executives to the firm. This bonding can motivate executives to increase long-term
investments, suggesting that earnings management by R&D cuts could be mitigated
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34
by anti-takeover mechanisms (e.g., DeAngelo and Rice (1993) and Knoeber (1986)).
Prior empirical works provide mixed evidence on the influence of anti-takeover
mechanisms on earnings management by R&D cuts. Borokhovich et al. (1997) find
that CEOs of firms that adopt anti-takeover provisions have higher levels of
cash-based compensation than CEOs at firms that do not adopt anti-takeover
provisions, which suggests that managers adopt anti-takeover provisions to entrench
themselves and to extract wealth from the firm.
In contrast, Bizjak and Marquette (1998) report that CEOs of firms that adopt
anti-takeover provisions will be more likely rewarded with stock-based compensation
than CEOs at firms that do not adopt anti-takeover provisions, and the adoption of
anti-takeover provisions is positively related to the pay for performance sensitivity,
which is one of the general measures for the degree of management alignment
developed by Jensen and Murphy (1990). They interpret their results as consistent
with the efficient contracting hypothesis.
This study attempts to disentangle these two opposite arguments by examining the
influence of the adoption of anti-takeover provisions on the association between
earnings management by R&D cuts and CEO compensation structure. If anti-takeover
provisions were adopted to entrench incumbent CEOs, we would expect to find
CEOs’ compensation contracts with increased agency problems within the firm
adopting anti-takeover provisions, and find that the percentage of cash-based
compensation in total compensation will increase to reflect risk-averse CEOs’
preference for fixed compensation. Consequently, R&D cuts will be more prevalent.
Alternatively, if anti-takeover provisions were adopted to enhance efficient
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35
contracting, we would expect to find CEOs’ compensation contracts with reduced
agency problems within the firm adopting anti-takeover provisions, and find that the
percentage of cash-based compensation in total compensation will decrease to reflect
the alignment between CEOs and shareholders. The likelihood of R&D cuts reduces.
The following testable hypotheses are developed:
Hypothesis (H4): Ceteris paribus, the positive association between cash-based
compensation and the likelihood of R&D cuts becomes stronger when firms adopt
more anti-takeover provisions.
2.7 Earnings Management by Discretionary Accounting Choices
R&D cuts are a type of “real” earnings management, accomplished by timing
long-term investment to alter reported earnings or some subset of them (Schipper,
1989). From the perspective of investors, relative to other methods to manage
earnings, such as discretionary accounting choices, the loss of R&D cuts is rather
severe because R&D cuts may seriously impair firms’ growth potentials and ruin their
future profitability. However, because of information asymmetry on the level or return
of R&D investment between investors and managers, investors may not distinguish
myopic R&D cuts (driven by maximizing compensation) from strategic R&D cuts
(caused by change in growth opportunity or competition intensity).
From the perspective of a manager, R&D cuts are only one of the many ways
available to manage earnings. R&D cuts only occur when the personal cost of such
cuts to the manager is less than the benefit he expects to receive from the resulting
increase in reported profit. Typically, this situation occurs when the manager has a
direct stake in the reported numbers, and believes that investors lack enough
information to undo the effects of the manipulation. One of the personal advantages of
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36
managing earnings by R&D cuts to the manager is that he may decide on the level of
R&D expenditure without constraints from auditors, board members and other
regulatory bodies. However, the manager has to decide ex-ante the extent of R&D
investment prior to year-end before observing the shortfall between pre-managed
earnings and the earnings target. The manager’s net personal cost of R&D cuts,
however, is likely to be less than the cost to the firm because of reduced cash flows in
future periods.
An alternative earnings management mechanism to cutting R&D that is available to
a manager is to use discretionary accounting choices (including both the change in
accounting procedures and the timing of expense and revenue recognition) or alter
capital expenditures. This earnings management method is not likely to result in a
direct reduction in future economic value of the firm. Indirectly, it could be costly to
the firm because of the resulting loss of investor credibility and the subsequent
increase in the expected cost of capital. As in the case of R&D cuts, the personal costs
and benefits to the manager are different. A manager could change accruals after
year-end after pre-managed earnings have been observed. In the long-term, the
increased expected cost of capital to the firm and the subsequent reduction in the firm
value could also affect the manager’s compensation. The manager also faces a direct
personal reputation cost because of GAAP constraints and possible disciplining by the
auditors and the board. Moreover, there are practical limits on the use of discretionary
accounting choices. At some point, to reach the desired level of earnings, some
adjustments that are not purely cosmetic must be made.
The personal costs to a manager of R&D cut might be higher in some contexts than
a corresponding change of discretionary accruals in some contexts and it might be
lower in some other contexts. In an effort to maximize their compensation, executives
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37
consider the joint effect of discretionary accounting choices and R&D cuts on their
compensation components because different compensation components have different
risk and incentive profiles, which induce different earnings management behavior.
Being rewarded with a cash-dominated compensation scheme, executives would
intentionally postpone expenses or advance revenues to boost current earnings. For
example, Healy (1985) reports a strong association between total accruals and CEOs’
income-reporting incentives under their bonus plan. Holthausen et al. (1995) present
evidence consistent with Healy (1985) that CEOs make income-decreasing
discretionary accruals after they reach their maximum bonus level. However, contrary
to Healy (1985), they find no evidence that CEOs make income-decreasing
discretionary accruals when earnings are below the minimum necessary to earn a
bonus. Guidry et al. (1999) show that business-unit managers in the bonus range have
incentives to make income-increasing discretionary accruals relative to business-unit
managers who are not in the bonus range.
Contrarily, being rewarded with a stock-dominated compensation scheme,
executives would smooth earnings to avoid volatility because prior studies suggest
that, given executives with significant shareholding and stock-based compensation,
income smoothing leads to higher share prices (e.g., Hunt et al. (1995) and Trueman
and Titman (1988)).
Accounting procedure changes are also subject to executives’ discretion. Healy et al.
(1987) find evidence that the relationship between CEO cash-based compensation and
earnings will adjust following changes in accounting procedures that lower earnings
(FIFO to LIFO inventory valuation) and that raise earnings (accelerated to
straight-line depreciation). Hagerman and Zmijewski (1979) find a weak positive
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relation between the probability that a company uses straight-line depreciation and the
probability that its executives have a cash-based compensation plan. Abdel-khalik and
Rashad (1985) estimate a cross-sectional regression of CEO cash-based compensation
on earnings for a treatment sample of firms that change to LIFO, and a control sample
of firms that remain on FIFO. They find that the elasticity of CEO compensation to
reported earnings is higher for the treatment group.
In conclusion, earnings management is pervasive. If rewarding executives with
stock-based compensation may mitigate earnings management by R&D cuts, as
suggested in Hypotheses 1 and 2, executives’ incentives to manage earnings by
discretionary accounting choices become stronger as their compensation schemes
gradually begin to be dominated by stock-based compensation. Therefore, a
substitution effect between earnings management by R&D cuts and by discretionary
accounting choices is predicted. This study employs discretionary accruals as a
general measure for intensity of earnings management by discretionary accounting
choices and develops the following testable hypothesis:
Hypothesis (H5): Ceteris paribus, the likelihood of R&D cuts is negatively related
to discretionary accruals for firms rewarding CEOs with a stock-dominated
compensation scheme.
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CHAPTER 3 RESEARCH METHODOLOGY
3.1 Defining Sub-samples
In the same vein as Burgastahler and Dichev (1997) and Degeorge et al. (1999), this
study assumes that CEOs use prior year’s earnings as their earnings target. If a
reduction in R&D expenditure can lead to positive change in annual earnings, R&D
cuts are more likely to happen. The total sample is divided into three sub-samples
based on the relationship between pre-R&D earnings and prior year’s R&D
expenditure21.
The first sub-sample, “Small Decrease” (SD), includes firms whose earnings before
tax and R&D have declined relative to the prior year, but only by an amount that can
be reversed by a reduction of R&D expenditure. This sample is most likely to exhibit
conditions under which the manager (in this case, CEO) finds using this method of
earnings management more cost-effective than using discretionary accruals or other
methods of earnings management.
This specification assumes that (1) reported earnings follow a “random walk” naïve
model, expected earnings for period t are the actual earnings for period t-1, (2) CEOs
have unbiased expectations of pre-R&D earnings early enough to make discretionary
decision on R&D expenditure and (3) there is information asymmetry between
investors and CEOs about R&D investment so that CEOs can inter-temporally shift
earnings without the awareness of investors. It is more likely that CEOs in the SD
sample to manipulate earnings by cutting R&D expenditure because they have
stronger incentives to do so.
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The second sub-sample, “Increase” (IN), consists of all firms that report positive
earnings growth even they maintain prior year’s R&D expenditure. The third
sub-sample, “Large Decrease” (LD), contains all firms with a decline in pre-R&D
earnings greater than the amount of prior year’s R&D expenditure. For these two
sub-samples of firms, it is less likely for CEOs to manage earnings by cutting R&D
expenditure22, because by doing so, they can neither meet earning targets, nor enjoy
long-term profits by investing in R&D projects.
3.2 Model Specification
The dependent variable that this study employs to test for R&D cuts is an indicator
variable (CUTRD) that is equal to one if the firm cuts R&D expenditure relative to the
prior year, and zero if the firm maintains or increases R&D expenditure. This study
uses an indicator variable rather than a continuous variable as dependent variable
because it is interested in whether the likelihood of change in R&D expenditure is
associated with change in CEO compensation structure, instead of how the magnitude
of change in R&D expenditure relates to CEO compensation structure.
The primary explanatory variable, CEO compensation structure, is defined in the
following two ways. In the first specification, a dummy variable (COMSTRU) is used
as a proxy for the relative mix of cash-based vs. stock-based compensation. If the
percentage of salary and bonus is higher than the percentage of stock options in total
compensation, it is equal to zero. Otherwise, it is equal to one. This specification can
facilitate measuring the relative incentives created by the compensation scheme23.
In the second specification, the proxies for CEO compensation structure are two
continuous variables, which are the percentage cash-based compensation or
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stock-based compensation in total compensation (CASH and STOCK). This
specification is advantageous because we can examine accumulated effects of
explanatory variables on dependent variable by defining explanatory variables as
continuous variables.
To control for motivations to reduce R&D expenditure that are not related to
myopic R&D cuts, this study includes several proxies for the R&D investment
opportunity set that have been identified in previous literature (e.g., Berger (1993) and
Bushee (1998)) as control variables.
This study uses the prior year’s change in R&D (PCRD) to control for changes in
the firm’s R&D opportunity set over time. A decline in R&D expenditure last year
makes a firm less likely to cut R&D expenditure again this year, indicating a negative
association between PCRD and CUTRD24.
The Herfindahl-Hirschman index (HHI) is a composite measure of intensity of
product market competition. For firms in a highly competitive market, the cost of
cutting R&D expenditure is high because it may result in the loss of competitive
advantage and market share. Therefore, a negative asso