Earnings benchmarks and future compensation : a study of suspect firms and CFO short-term compensation

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Earnings benchmarks and future compensation

A study of suspect firms and CFO short-term compensation

Name: Mario Mazul Student number: 11080906

Thesis supervisor: Mario Schabus MSc Date: 25-06-2017

Word count: 9,910

MSc Accountancy & Control, specialization Control

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Statement of Originality

This document is written by student Mario Mazul who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.

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Abstract

My study examines the association between the presence of earnings management and future compensation. In particular, I examine the matter of future Chief Financial Officer (CFO) short-term compensation for a subset of firms that are more likely to have managed earnings (I refer to these firms as the SUSPECT firms). Specifically, I examine two indicators of managed earnings, namely, meeting or beating last year's earnings, and avoiding reporting losses, zero earnings benchmark. Additionally, I theorize that corporate governance, and in particular the presence of financial expertise of the Chief Executive Officer (CEO), will have a moderating effect on the relationship between earnings management and future CFO short-term compensation. My results indicate that firms that just meet the zero-earnings benchmark exhibit lower CFO short-term compensation in the upcoming year compared to non-suspect firms. Moreover, in contrast to previous literature, this paper shows no discontinuity around zero regarding beating last year’s earnings benchmark, meaning that my paper shows no evidence of managing earnings upwards to beat last year’s earnings. For this reason, I find no significant evidence in support of change in future CFO short-term compensation when firms just beat last year’s earnings. My results also show no significant change when a CEO has financial expertise on the relationship between suspect firms and future CFO short-term compensation.

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1 Introduction

Throughout literature earnings management is a popular and interesting research topic. Earnings are the main determinant of stock value and thus firm value, because earnings and circumstances relating to them can indicate whether the business will be profitable and successful in the long run. Companies that do not publish positive earnings cannot pay dividends to owners or bonus compensations to managers. Furthermore, when reporting losses auditors are required to issue a going-concern opinion, which often results in intervention from investors (Dierynck, Landsman, & Renders, 2012). According to the prospect theory the effort to maintain earnings in positive conditions, although of a little value, becomes important to get a good market value. Researchers in the accounting literature have often focused on earnings management by executives seeking to hit explicit bonus-linked targets for reported income. Watts and Zimmerman (1978) argue that managers in firms with earnings-based compensation agreements have incentives to report accounting results that maximize the value of their bonus awards.

Healy (1985) hypothesizes that because short-term bonuses based compensation on accounting earnings comprise a large part of managers compensation, they choose to manipulate earnings to maximize their short-term bonuses. This behavior of executive makes sense for managers whose bonus-linked incentives are focused on meeting explicit targets for earnings. Hence, firms frequently design compensation contracts based on earnings to encourage effort by the manager. However, firms deal with a trade-off between encouraging effort and discouraging earnings management

While there is an extensive body of research on earnings management and executive compensation, little is known about the role of the CFO, specifically the effect earnings management has on the future compensation of the CFO. Looking at the compensation structure between the CEO and the CFO, the CEO has more equity based incentives compared to CFO bonus-based compensation ((Xuefeng) Jiang, Petroni, & Yanyan Wang, 2010). Furthermore, CFOs are responsible for a firm’s accounting decisions and disclosure, implementing accounting principles and preparing the financial reports as well as for many of the financial and investment decisions that are the subject of recent financial accounting standards

(Hossain & Monroe, 2015). Hence, CFOs are an important character when examining earnings management. Therefore, my study examines the association between earnings management and the future compensation. In particular, I examine the matter of future CFO short-term bonus compensation for a subset of firms that are more likely to have managed earnings (I refer to these firms as the SUSPECT firms). Specifically, I examine two indicators of managed earnings,

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namely, meeting or beating last year's earnings, and avoiding reporting losses, zero earnings benchmark.

Following prior research (e.g. Carter, Lynch, & Zechman, 2009; Yuliana, Anshori, & Alim, 2015; Yang, 2012) the focus of my study is on firms in a setting in which earnings are just above benchmark. In addition, the CFO has an explicit financial stake in the earnings number and the compensation committees have no obvious incentives to undo the manipulation (Gaver, Gaver, and Austin, Additional evidence on bonus plans and income management, 1995). I expect that following earnings management, the board reduces CFO compensation, as the CFO compensation was likely a cause for higher earnings management in the first place. Financial data on firms and compensation will be gathered from COMPUSTAT and EXECUCOMP from the year 2007-2015 and will be used to test the first hypothesis for a total sample of 8,622 firm-years observations with 835 suspect firms in the category zero earnings benchmark and 1,870 suspect firms in the category beating last year's earnings.

For my second hypothesis, I theorize that corporate governance, and in particular the presence of financial expertise on the Chief Executive Officer (CEO), will have a moderating effect on the relationship between earnings management and future short-term compensation of the CFO. The CFO generally has the authority to make financially complex decisions that require a high degree of specific technical training and knowledge. The level of expertise required to make effective decisions and the complex accounting rules relating to these transactions is likely to create a high degree of information asymmetry between the CFO and the CEO. Corporate governance literature advances the idea that certain aspects of the CEO improve the monitoring of managerial decision. Given that the CEO has the power to replace the CFO who does not follow the CEO’s preferences, I label the CFO as an agent of the CEO. Thus, the information asymmetry is likely to be lowered if financial expertise is present on CEO and therefore improve monitoring of corporate financial accounting processes leading to less earnings management. Information of financial expertise is gathered from the Institutional Shareholder Services (ISS) database from the year 2007-2015 for the full sample of 8,622 firm-years observations.

My results indicate that firms that just meet the zero-earnings benchmark exhibit lower CFO short-term compensation in the upcoming year compared to non-suspect firms. Moreover, in contrast to previous literature, this paper shows no discontinuity around zero regarding beating last year’s earnings benchmark, meaning that my paper shows no evidence of managing earnings upwards to beat last year’s earnings. Hence, the discontinuity in previous literature is

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likely caused by other factors. For this reason, I find no significant evidence in support of change in future CFO short-term compensation when firms just beat last year’s earnings. Overall, my results indicate that in the presence of earnings management, firms will decrease the short-term compensation a CFO will receive in the upcoming year. My results show no significant change when a CEO has financial expertise on the relationship between suspect firms and future CFO short-term compensation.

My study allows me to extend previous research in several ways. First, I conduct tests of short-term compensation-based earnings management in an environment where, relative to prior research, earnings management is likely to occur and thus enhance the power of my test. Second, prior literature has mostly focused on CEO compensation whereas I focus on CFO short-term compensation, furthermore, my study looks at the effect of earnings management on future compensation were prior literature examined the association between forms of compensation and forms of earnings management. Finally, little is known about how financial expertise affects the relationship between earnings management and future compensation. Hence, my study will fill the gap which prior literature, as to best of my knowledge, has not filled up yet. Research on these issues should lead to a more complete understanding of the importance of meeting earnings targets, the extent of financial expertise of the CEO, and the effect these have on CFO short-term compensation.

The paper is organized as follows. Section 2 outlines previous literature regarding earnings management, CFO compensation and financial expertise as part of corporate governance. Section 3 introduces the methodology of my paper, which incorporates the measurement of my variables, as well as, control variables and my model for measuring the effect of the presence of earnings management and future CFO short-term compensation. The empirical results of my model are analyzed in section 4. Section 5 concludes the paper and provides suggestions for improvements and for future earnings management research.

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2 Literature review and hypotheses development

2.1 Importance of earnings and earnings management

Executive compensation plans often include the stated objectives of firm's value maximization and formally tie compensation to a measure of firm value such as earnings (Carter, Lynch, & Zechman, 2009). This is evident in the findings of Deangelo, et al. (1996) where they show that firms breaking a pattern of consistent earnings growth experience an average of 14% negative stock return in the year the pattern is broken. Other studies (Bartov, Givoly, and Hayn, 2002; Kasznik and Mcnichols, 2002) provide evidence of positive market responses to meet or beat analyst forecast. They argue that firms that meet or beat current analysts’ earnings expectations enjoy a higher return over the quarter than firms with similar quarterly earnings forecast errors that fail to meet these expectations. In the study of Burgstahler and Dichev (1997) the authors examined whether, how and why, firms avoid reporting earnings decreases and losses. Their findings show that 8% to 12% of firms with small pre-managed earnings decreases exercise discretion to report earnings increase. Similarly, 30% to 44% of the firms with slightly negative pre-managed earnings exercise discretion to report positive earnings. The author explain their result by presenting two theories. First, is that managers avoid reporting earnings decreases and losses to decrease the costs imposed on the firm in transactions with stakeholders. Second, explanation is based on prospect theory, the effort to maintain earnings in positive conditions, although of a little value, becomes important to get a good market value. A comprehensive survey of Graham, et. al. (2005) shows which benchmarks are perceived to be important when managers care about earnings management. They find that meeting or exceeding benchmarks is very important and that managers describe a trade-off between the short-term need to “deliver earnings” and the long-term objective of making value-maximizing investment decisions. Executives believe that hitting earnings benchmarks builds credibility with the mark and helps to maintain or increase their firm's stock price. The authors also show that 80 percent of surveyed CFOs stated that, in order to deliver earnings, they would decrease R&D, advertising and maintenance expenditures to meet important benchmarks like: same quarter last year, analyst consensus forecast, zero earnings and previous quarter earnings per share (EPS). Roychowdhury (2006) argues that managers avoid reporting annual losses or missing analyst forecast by manipulating sales, reducing discretionary expenditures, and overproducing inventory to decrease the cost of goods sold.

Manipulating earnings by managers can be performed by several types of techniques. Most research focuses on accrual-based earnings management (Bergstresser and Philippon

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2006;(Xuefeng) Jiang, Petroni, and Yanyan Wang 2010; Hossain and Monroe, 2015). Accrual-based earnings management is achieved by changing the accounting methods or estimates used when presenting a given transaction in the financial statements (Yang, 2012, p. 676). With accrual manipulation there are no direct cash flow consequences. However, recent literature has begun to focus more on real activities manipulation, were managers purposeful alter reported earnings in a particular direction, which is achieved by changing the timing or structure of an operation, investment, or financing transaction, and which has suboptimal business consequences. Real activities manipulation is chosen by managers because the manipulation is difficult for average investors to understand, and are normally less subject to monitoring and scrutiny by board, auditors, regulators, and other outside stakeholders. Gunny (2010) finds that firms that just meet earnings benchmarks by engaging in real activities manipulation have better operating performance than firms that do not engage in real activity manipulation. Yang, (2012) shows that the trade-off between the usage of real activities manipulation and accrual-based earnings management is based on their relative costs and that managers adjust the level of accrual-based earnings management according to the level of real activities manipulation realized. Cohen et al. (2008) indicates that after passage of SOX, the level of accrual-based earnings management decline, while the level of real activities manipulation increases, because these techniques, while more, costly, are likely to be harder to detect. The authors also examine accrual-based and real earnings management activities for a subset of firms that are more likely to have managed earnings (suspect firms) and find that the suspect firms had significantly higher real earnings management activities after SOX when compared to firms in similar circumstances prior to SOX. Roychowdhury (2006) provides evidence of real earnings management activities to avoid reporting annual losses throughout price discount to temporarily increase sales, overproduction to report lower cost of goods, and reduction of discretionary expenditure to improve reported margins. The authors also provide evidence, although less robust, of real earnings manipulation to meet annual analyst forecasts.

2.2 Earnings management and CFO compensation

This study focuses on firms where earnings management is like to occur and the trade-off these firms contend with when constructing future CFO compensation. According to the agency theory, organizations use compensation contracts to align the interests of managers with those of the organizations. The firm (principal) frequently designs bonus contracts based on earnings to encourage effort by managers (agent). However, since the manager may control both effort and reporting earnings, such a contract may also encourage earnings management. Hence,

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firms must trade off the incentive for effort against the possibility that managers will not report truthfully (Carter, Lynch, & Zechman, 2009, p. 484). This is evident in the findings of Cheng and Warfield, (2005). Using stock-based compensation and stock ownership data over 1993-2000 time period, the authors find that managers with high equity incentives are more likely to report earnings that meet or just beat analysts’ forecast and that these managers are less likely to report large positive earnings surprises. Bergstresser and Philippon, (2006) find that companies with more “incentivized” CEOs - those whose overall compensation is more sensitive to company share price – have higher levels of earnings management. Baker, et al. (2003) find evidence that firms that compensate their executive with great shares of options relative to other forms of pay appear to use discretionary accruals to decrease current earnings.

However, more recent literature regarding earnings management argue that CFO’s incentives are relatively more important than those of CEOs. Jiang, et al. (2010) argue that because CFOs’ primary responsibility is financial reporting, CFO equity incentives should play a strong role than those of the CEO in earnings management. This statement is enforced by the Securities and Exchange Commission (SEC) which states that the compensation of the principal financial officer is important to shareholders because the financial officer provides the certification required with the company’s periodic reports and has important responsibilities for the fair presentation for the company’s financial statement and financial information. Hence, the SEC amended its disclosure rules on executive compensation by requiring the firms disclose their CFO pay ((Xuefeng) Jiang, Petroni, & Yanyan Wang, 2010, p. 513). However, despite the concern over CFO compensation the authors state that prior literature has focused on the CEO because CEO equity incentives are much larger than those of the CFO and therefore believe to be most influential. The authors nevertheless believe that it is worthwhile to empirically examine the role of CFO equity incentives in financial reporting because this is an area in which CFOs wield significant influence. In their analysis they find that the magnitude of accruals and the likelihood of beating analyst forecast are more sensitive to CFO equity incentives than to those of the CEO. As further evidence of CFOs’ compensation important role in financial reporting and earnings management, Hossain and Monroe (2015) find that earnings management behavior of CFOs is associated with their compensation structure; short-term incentives are positively associated with the absolute value of discretionary current accruals and long-term incentives are positively associated with the absolute value of discretionary non-current accruals. Chava and Purnanandam (2010) find that CFOs with high risk-decreasing incentives are more aggressive in smoothing their firm’s earnings than CFOs with low risk-decreasing incentives. The authors explain that this is due to that CFOs are acting in their best interest based on their ownership of

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stocks and options. Geiger and North (2006) indicate that discretionary accruals decreased significantly following the appointment of a new CFO and that the findings are not driven by concurrent appointment of a new CEO. Their findings show that CFOs exercise independent influence on firms’ financial reporting.

Other studies examine the impact of the Sarbanes-Oxley Act (SOX) on CFO compensation and earnings management. Due to corporate fraud cases such as Enron, WorldCom and Adelphia the Sarbanes-Oxley Act of 2002 formally requires that CFOs, as well as the CEOs, provide personal certification on the accuracy and completeness of the financial information released by the company. Indjejikian and Matĕjka (2009) examine how firms’ reliance on financial performance measures in CFO bonus changed from 2003 to 2007 in response to the post-SOX increase in the costs of misreporting. They find through a survey of 29,857 members of the American Institute of Certified Public Accountants that from 2003 to 2007 public entities reduces the percentage of CFO bonus contingent on financial performance. Their findings show that firms mitigate misreporting practices in part by deemphasizing CFO incentive compensation. They argue that SOX has made firms much more concerned about the integrity of their financial reports and increased the costs of noncompliance, thus firms offer their CFOs muted incentives in order to motivate them to focus more on their fiduciary responsibilities. However, Carter et al. (2009) examines the impact of the Sarbanes-Oxley Act on the relationship between earnings and bonus compensation. The authors argue that the reduced financial reporting flexibility, due to increased penalties for misreporting, increased oversight of financial reporting and increased disclosure requirements, led to a decrease in earnings management and that firms responded by increasing the weight placed on earnings changes in the bonus contract. Cohen et al. (2008) find that accrual based earnings management declined significantly following the passage of SOX, while real earnings management increased. At the same time, option based compensation decreased. Collectively, prior literature that examines post-SOX changes in executive compensation finds mixed results due to the samples and the variety of research methods employed. Moreover, prior literature mostly focuses on the effect of compensation and incentives on the possibility of manipulating earnings, however, they do not provide evidence on the effect earnings management has on the future executive compensation, especially the CFO.

I examine the relationship between earnings management and future CFO compensation in situations where CFOs are more likely to engage in earnings manipulation (suspect firms). Study shows that there is a point discontinuity around zero earnings and last year’s earnings, suggesting that firms whose earnings are expected to fall just below the zero earnings point

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engage in earnings manipulation to help them cross the “red line” for the year (Burgstahler & Dichev, 1997; Degeorge, Patel, & Zeckhauser, 1999). Hence, firms have to deal with a trade-off between encouraging effort and discouraging earnings management, therefore firms operating in an environment where earnings management is likely to occur must design future contract with earnings management in mind. Hence, I examine future CFO compensation in relation to firms just meeting two earnings benchmarks, zero earnings or last year’s earnings This leads to the following hypothesis:

Hypothesis 1:Suspect firms decrease future CFO short-term compensation. 2.3 Corporate Governance: Financial Expertise

In addition to compensation contracts to align the interests of principal and agent, firms also use different mechanics of corporate governance. The main role of corporate governance is to ensure conformance by management and to enhance organizational performance through efficient board supervision (Dimitropoulos, 2011). A good corporate governance structure helps ensure that management properly utilizes the enterprise's resources in the best interest of the absentee owners, and fairly report the financial condition and operating performance of the enterprise (Lin & Hwang, 2010, p. 59). Hence, properly structured corporate governance mechanisms are expected to reduce earnings management because they provide effective monitoring of management in the financial reporting process. Cornett, Marcus, and Tehranian (2008) find in their analysis that earnings management is lower when there is more monitoring of management discretion from sources such as institutional ownership of shares, institutional representation on the board, and independent outside directors on the board. Core et al. (1999)

examine whether there is an association between the level of CEO compensation and the quality of firms’ corporate governance, and whether firms with weaker governance structure have poorer future performance. The authors find that both board-of-directors characteristics and ownership structure have a substantive cross-sectional association with the level of CEO compensation. More specific, the authors find that CEO compensation is higher when the CEO is also the board chair, the board is larger, there is a greater percentage of board composed of outside directors, and the outside directors are appointed by the CEO or are considered ‘gray’ directors. CEO compensation is also higher when outside directors are older and serve on more than three other board. The authors conclude that firms with weaker governance structure have greater agency problems; that CEOs at firms with greater agency problems extract greater compensation and that firms with greater agency problems perform worse. Healy and Palepu (2001) give several solutions to the agency problem, which one of them is optimal contract. They

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argue that optimal contracts between agent and principal, such as compensation agreements and debt contracts, seek to align the interest of the agent with those of external equity and debt claimants. These contracts frequently require agents to disclose relevant information that enables investors to monitor compliance with contractual agreements and evaluate whether agents have managed the firm’s resources in the interest of the principal.

According to Shleifer and Vishny (1997) high powered incentive contracts create enormous opportunities for self-dealing for the managers, especially when managers possess more expertise than shareholder and therefore end up with the residual right of control, giving them enormous latitude for self-interested behavior. This is the essence of the agency theory, the separation of ownership and control. This theory formally models issues of performance measurement in an optimal contracting framework under conditions of asymmetric information

(Bushman & Smith, 2001). Given that the CFO is an expert in the field of accounting and financial reporting, information asymmetry can easily occur. Defond et al. (2005) examine whether the market reacts favorably to the appointment of directors with financial expertise to the audit committee. The authors find a positive market reaction to the appointment of financial experts assigned to audit committees. Additionally, they find that this positive reaction is concentrated among firms with relatively strong corporate governance. Consistent with financial expertise complementing strong governance, possibly because strong governance helps channel the expertise towards enhancing shareholders value. Hence, these findings are consistent with financial expertise on audit committees improving corporate governance. In the study of Xie, Davidson, and Dadalt (2003), they find that board and audit committee members with corporate or financial background are associated with firms that have smaller discretionary current accruals. Board and audit committee meeting frequency is also associated with reduced levels of discretionary current accruals. Hence, the authors conclude that board and audit committee activity and their members’ financial sophistication may be important factors in deterring earnings management. Gore, Matsunaga, and Yeung (2008) focus on information asymmetry between the CFO and the CFO’s superiors, i.e., the CEO and the Board of Directors. They argue that CFOs, in most cases, have much more expertise in finance and accounting compared to their superiors, which creates information asymmetry between agent and principal. They find that in the presence of financial expertise in the board of directors, the information asymmetry between the CFO and the CFO’s superiors is reduced. Prior literature (Cohen, Dey, and Lys, 2008; Gunny, 2010; Yang, 2012) has shown that suspect firms use more real earnings management, because this type of earnings management is difficult to detect, however, in the presence of financial expertise on the board or audit committee, the CFO’s supervisors can

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detect real earnings management and therefore can intervene throughout adjustments in the CFO compensation structure. In this study, I characterize the CFO as an agent who performance a productive task much like other executive, but reports to the CEO, which I characterize as the principal. Hence, this line of thought leads to the following hypothesis: Hypothesis 2: The relation between suspect firms and decreases in CFO short-term compensation is moderated by the presence of financial expertise of the CEO.

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3 Methodology

3.1 Sample selection

My sample consists on all firms with available financial data on CFO compensation from COMPUSTAT and EXECUCOMP. Firms in the financial industry (SIC 6000-6500) and utility industry (SIC 4400-5000) are excluded because they operate in highly regulated industries with accounting rules that differ from other industries. To test my hypotheses, I require that data on CFO compensation, i.e. bonus, non-equity incentives and total compensation, is available as well as financial data on earnings, i.e. total assets and net income. I label an executive as a CFO if the EXECUCOMP CFOANN field is labeled “CFO”. Because of the limited time-frame of the Institutional Shareholder Services (ISS) database, my analysis will be performed in the years 2007-2015 with available data on corporate governance, i.e. the presence of financial expertise of the CEO. Hence, my sample yields 8,626 firm-year observations.

3.2 Measurement of suspect firms

Prior research has argued that it is likely that firm-year in the interval just right of zero manage their earnings to report earnings marginally above zero. This is supported by Burgstahler and Dichev (1997), they find unusually low frequencies of small decreases in earnings and small losses and unusually high frequencies of small increases in earnings and small positive income, suggesting that firms manage reported earnings to avoid earnings decreases and losses.

Roychowdhury (2006) argue that the zero target is probably more important at the annual level, since a number of firms are likely to report losses at the quarterly level due to seasonality in business. Annual losses, on the other hand, are likely to be viewed more seriously by the numerous stakeholders of firms, such as lenders and suppliers, particularly because they are audited and considered more reliable. Thus, managers are likely to have greater incentives to avoid reporting annual losses (Roychowdhury, 2006, p. 344).

Following prior research, I identify suspect firms that meet or beat the zero earnings benchmark as consisting of firm-year observation for which the net income as a percentage of the beginning of year total assets is larger than or equal to zero but smaller than 1.5 percent

(Dierynck, Landsman, & Renders, 2012, p. 1225; Gunny, 2010, p. 866). Drawing from previous studies I categories earnings in a scale of 0.015 width for the range -0.15 to +0.15, firms to the immediate right of zero have net income scaled by total assets that is greater than or equal to zero, but less than 0.015 (Roychowdhury, 2006).

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Fig. 1 shows the number of firm years by earnings interval for the range -0.15 to +0.15: for example, the first interval to the right of zero contains all scaled earnings in the interval [0.00, 0.015], the second interval contains [0.015, 0.03], and so on. The vertical axis labeled frequency represents the number of observations in each earnings interval. The interval contains 7,536 firm-years over the period 2007-2015. The histogram is a single –peaked, bell-shaped distribution with an irregularity near zero which is consistent with previous literature (Burgstahler and Dichev, 1997; Roychowdhury,(2006) suggesting that earnings management is performed to avoid earnings decreases. I concentrate on firms-years in the interval to the immediate right of zero, the suspect firms. Suspect firms with zero earnings benchmark have net income scaled by total assets that is greater than or equal to zero but less than 0.015. There are 836 suspect firm-year observations with the zero earnings benchmark.

Fig. 1. Empirical distribution of scaled earnings by total assets at the beginning of the year, where earnings is defined as Net Income/𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠𝑡−1. The distribution interval widths are 0.015 and are

distributed over the range -0.15 to +0.15.

To identify firms that meet last year’s earnings, I follow the study of Gunny (2010),

grouping firm-years into intervals based on the change in net income divided by total assets at the beginning of the year. I construct categories of scaled changes in earnings for width of 0.015

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Fig. 2. Histogram of change in earnings scaled by beginning of the year total assets: (𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒𝑡 -

𝑁𝑒𝑡 𝐼𝑛𝑐𝑜𝑚𝑒𝑡−1)/𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠𝑡−2

in the interval -0.15 to +0.15. The firms to the immediate right of zero have net income scaled by total assets that are greater than or equal to zero, but less than 0.015. Fig. 2 shows also an irregularity near zero, however, not that evident as the zero earnings benchmark. Evidence from previous papers suggest that incentives to avoid earnings decreases become stronger with the length of previous run of earnings increase. These strong incentives should lead to a more pronounced effect of earnings management in the interval to zero (Burgstahler & Dichev, 1997, p. 105). The interval immediate right of zero has in total 1,872 firm-year observations.

The irregularity near zero is more pronounced in the zero-earning benchmark, then in the beat the last year’s earning benchmark. This can be explained by that firms whose ‘unmanipulated’ earnings are substantially above zero possibly have an incentive to manage earnings downwards to report profit that are only slightly above or below zero, in order to create reserves for the future. In that case, the interval just right of zero possibly includes firms-years with downward earnings management. This lowers the power of my test. However, I do not include other intervals in the suspect category, as the interval are likely to contain a higher proportion of firm-years that did manipulate earnings (Roychowdhury, 2006, p. 346).

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3.3 Measurement of CFO short-term compensation

Firms set compensation philosophies to attract, retain, and motivate top-quality senior management. Toward this end, CFO compensation typically includes both short-term and long-term incentive mechanisms. The fixed component of short-long-term compensation (salary) provides a secure base of cash. The variable component of short-term compensation includes cash bonuses, which are assessed at the end of each year and are designed to reward achievement of firm annual objectives. Long-term compensation (stock options and restricted stock) is used to incentivize executives to promote sustainable firm growth and to align the interests of management with those of shareholders (Hoitash, Hoitash, & Johnstone, 2012, p. 771).

Bonuses have been hypothesized to be one rationale for earnings management, since most firms tie the bonus to some variant of accounting earnings. This is shown in the study of

Indjejikian and Matĕjka (2009) where their model suggests that a bonus-based compensation on financial performance is necessary to motivate a CFO to be productive. They further show that annual bonuses are by far the most common incentive compensation of CFO compensation plans and that, on average, about 50% of CFO bonus is based on accounting-based financial performance. The authors also find some evidence that such bonuses are more prevalent in settings where CFOs’ productive decisions are more important. Although literature regarding earnings management and executive compensation take equity incentives as a variable for compensation, most literature focus on CEO compensation because CEO compensation are mainly composed of equity based rewards compared to the CFO compensation. Gaver and Gaver (1998) argue that bonus plans typically specify annual earnings as relevant performance measures, whereas other forms of compensation do not. Baber et al. (1998) indicates that earnings persistence significantly influences CEO cash compensation, but not significantly related to level of stock-based compensation components.

Hence, because the focus of this study is on suspect firms’ trade-off between encouraging CFO effort and discouraging earnings management through compensations, I focus on bonus-based compensation contracts as a fraction of the total assets. Because some CFOs do not receive a bonus every year, I use the sum of bonus and non-equity incentives from EXECUCOMP to address the missing values, and then scale this by total assets at the beginning of the year to incorporate the scale effect of firm's size, moreover, I winsorize the outcome variable at the 1st_{and 99}th_{percentile to address any outliers that may affect my results. With this}

measure, I aim to capture the short-term compensation (ST_COMP) of the CFO, hence the incentives to manage earnings.

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3.4 Measurement of Financial expertise

In most corporate organizations, the CFO reports to the CEO. Hence, the CEO can be considered as CFO’s superior and thus play an important role in CFO compensation decisions. Data on financial expertise are obtained from the Institutional Shareholder Services (ISS) database, in particular the ISS directors database. This database covers more than 115,000 global directors across 90+ countries, with up to 115 data attributes of which includes if a CEO possesses financial expertise.

3.5 Control variables

Following prior literature (Roychowdhury, 2006; Gunny, 2010), I use SIZE as a control variable for the size of firms, large firms can benefit from economies of scale, or on the opposite side they can suffer from problems of coordination. Hence SIZE is the logarithm of market value of equity at the beginning of the year. Furthermore, to control for systematic variation in abnormal change in short-term compensation with growth opportunities, I include MTB, the market-to-book ratio, as a control variable. Also, my regression includes a control variable for risk, which is the leverage ratio between long-term debt and total assets. Furthermore, I drop firms with CFOs that work in more than 1 firm in a given year and firms with more than one CFO in a given year.

Literature regarding earnings management use other control variables, which I do not include in this paper. I do not discriminate between earnings management through accounting manipulation or through operating decisions, hence, I do not include control variables that are related to the calculation or determination of forms of earnings management.

3.6 Descriptive statistics

I begin with an overview of the variables which I will use in my analysis. Table 1, provides variable description of these variables and describes the characteristics. Second, table 2 provides descriptive statistics on the mean, median, standard deviation, 25th_{percentile and the}

75th_{percentile of the full sample of 8,622 observations. Lastly, table 3 presents an overview of}

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Table 1

Variable description

AT Total Assets, Compustat #6

NI Net Income (Loss), Compustat #172

BONUS The Bonus earned by the named executive

officer during the fiscal year (thousands)

NONEQ_INCENT Value of amounts earned during the year

pursuant to non-equity incentive plans. The amount is disclosed in the year that the performance criteria was satisfied and the compensation was earned.

TDC1 Total Compensation (Salary + Bonus + Other

Annual + Restricted Stock Grants + LTIP Payouts + All Other + Value of Option Grants)

ST_COMP Measured short-term compensation,

(BONUS+NONEQ_INCENT)/ 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠_𝑡−1

ROA Return on Assets, net income (NI) scaled by

total assets (AT) at the beginning of the year.

CHANGE_EARNINGS Measured change in earnings, (𝑁𝐼𝑡 −

𝑁𝐼_𝑡−1)/ 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠_𝑡−2

MVE The market value of equity, Compustat

#199*Compustat #25

BVE The book value of equity, Compustat #18

SUSPECT_ZERO An indicator variable that is equal to one if

firms have net income scaled by total assets (ROA) that is greater than or equal to zero but less than 0.015.

SUSPECT_LAST An indicator variable that is equal to one if

firms have earnings scaled by total assets (CHANGE_EARNINGS) that are greater than or equal to zero, but less than 0.015.

EXPERT_CEO An indicator variable that is equal to one if

firms have a CEO with financial expertise. Control variables

SIZE Logarithm of MVE, expressed as deviation

from the corresponding industry-year mean

MTB The ratio of MVE to the BVE, expressed as

deviation from the corresponding industry-year mean.

LEVER Leverage ratio [total liabilities (Compustat

Item #9 +#34)/total assets (Compustat Item #6)

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Table 2

Descriptive statistics

Mean Median Deviation Standard Precentile 25th Precentile 75th Full Sample, 2007-2015 (n=8,622) AT 8435.62 2003.33 31374.33 752.37 5741 NI 532.17 93.21 2155.66 25.52 320.9 BONUS 65.19 0.00 235.82 0.00 0.00 NONEQ_INCENT 920.10 431.27 1555.93 0.00 1190.7 TDC1 2057.45 1514.81 2203 884.65 2564.92 ST_COMP 0.43 0.19 0.63 0.05 0.54 ROA 0.07 0.06 0.1 0.02 0.1 CHANGE_EARNINGS 0.01 0.00 0.12 -0.02 0.03 MVE 9841.17 2157.59 30.37 8457.45 6524.78 BVE 3318.46 879.69 11147.38 374.07 2199.6 SIZE 7.83 7.68 1.52 6.74 8.78 MTB 3.46 2.3 28.37 1.5 3.61 LEVER 0.22 0.2 0.19 0.05 0.33

In table 2, the mean and the median values of ROA are close to zero yet slightly positive indicating, as expected, that there is systematic evidence of earnings management in the zero earnings benchmark. However, the 25th and 75th percentile of CHANGE_EARNINGS are normal distributed around zero indicating that these is no systematic evidence of earnings management in the randomly selected variables. Hence, the prediction based on prior literature that there is a discontinuity around zero for beating last year’s earnings, is not evident in my model. Explanation is given in the paper of Durtschi and Easton, (2009). They argue that the so-called “discontinuities” of the Burgstahler and Dichev (1997) paper is likely caused by by other factors. The authors provide sets of evidence that these discontinuities are likely caused by factors other than earnings management. The authors show that the shapes of earnings distributions are driven by sample selection bias and scaling. Furthermore, the authors explain the relation between net income and market capitalization. They show that deflation will distort the distribution because the relation between the numerator (net income) and the denominator (market capitalization) differs in predictable ways with the magnitude and the sign of the net income (Durtschi and Easton, 2009). However, as mentioned before, the interval immediate right of zero has the most observations, and is likely to contain a higher proportion of firm-years that managed their earnings to beat the last year’s earnings.

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Table 3

Difference in mean and median

Suspect firms Non Suspect firms Difference in Mean Median Mean Median

Mean (t-stat)

Median (z-stat) Panel A: Zero benchmark suspect firms

AT 5250.64 1124.96 8777.14 2131.47 3526.50*** (3.09) 1006.51*** (11.00) NI 101.03 26.72 578.40 110.24 477.37*** (6.09) 83.52*** (18.29) BONUS 72.19 0.00 64.44 0.00 -7.75 (-0.90) 0.00*** (-3.35) NONEQ_INCENT 504.90 220.59 964.62 470.40 459.71*** (8.144) 249.81*** (12.83) TDC1 1473.28 1063.91 2120.09 1572.63 646.81*** (8.09) 508.72*** (13.01) ST_COMP 0.17 0.04 0.47 0.21 0.30*** (13.03) 0.07*** (17.74) ROA 0.01 0.01 0.07 0.06 0.07*** (18.36) 0.05*** (33.83) CHANGE_ EARNINGS -0.02 -0.01 0.02 0.01 0.04*** (9.19) 0.02*** (16.42) MVE 3631.00 1052.77 10506.46 2361.20 6875.47*** (6.23) 1308.43*** (15.22) BVE 1550.78 540.27 3508.01 928.91 1957.23*** (4.83) 350.45*** (5.63) SIZE 7.96 7.84 7.81 7.66 -0.15*** (-2.66) -0.18*** (-2.70) MTB 0.97 1.87 3.73 2.34 2.76*** (2.67) 0.47*** (9.51) LEVER 0.24 0.22 0.22 0.20 -0.02** (-2.48) -0.02* (-2.06)

Suspect firms Non-Suspect firms Difference in Mean Median Mean Median (t-stat) Mean Median (z-stat) Panel B: Beating last year's earnings benchmark suspect firms

AT 10995.45 2420.33 7726.66 1884.25 -3268.79*** (-3.99) -536.08*** (-6.55) NI 704.44 132.18 484.45 81.67 -219.99*** (-3.91) -50.51*** (-11.59) BONUS 69.15 0.00 64.09 0.00 -5.06 (-0.82) (-0.18) 0 NONEQ_INCENT 1081.64 580.31 875.36 399.96 -206.28*** (-5.08) -180.35*** (-6.90) TDC1 2170.41 1669.88 2026.17 1470.27 -144.24 (-2.51) -199.61*** (-5.21)

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***Significant at the 1% level. **Significant at the 5% level. * Significant at the 10% level.

The sample period spans 2007-2015. Panel A gives results related to suspect firms that are firm-years with reported net income (NI) of total asset between 0% and 1.5% s. Panel B gives results that are related suspect firms that are firm-years with reported change in net income (NI₀ - NI₁) of total assets between 0% and 1.5% . The numbers in the parentheses are t-statistics from t-test for the difference in means, and z-statistics are reported from Wilcoxon tests for the difference in medians. Data in panel A consists of 835 suspect firms-years and 7,787 non-suspect firms-yeas. Panel B consists of 1,870 suspect firm-years and 6,752 non-suspect firm-years.

Table 3 panel A shows that the mean market capitalization (MVE) of the suspect firms with zero earnings benchmark, at around $3.6 billion, is almost 40% of the mean for the non-suspect firms sample, $10.5 billion. Interestingly, The ST_COMP shows a significantly lower mean for the suspect firms with zero earnings benchmark of 835 observations against the non-suspect firms of 7,787 observations. Panel B shows that the mean MVE of the non-suspect firms with beating last year’s earnings benchmark ($11.9 billion) is not smaller than the non-suspect firms sample mean, same can be observed with the mean total assets ($10.9 billion) and the non-suspect firms sample ($7.7 billion). Scaling net income by total assets (ROA) gives the measure for earnings, as expected the ROA for the suspect firms with zero earnings benchmark is near zero, hence manipulation of earnings. Interesting, the mean bonus of the suspect firms with zero earnings benchmark ($721.000) is greater than mean of the non-suspect firms sample ($644.400), however, not significantly different for both the zero and last earnings benchmark suspect firms. ST_COMP 0.45 0.22 0.43 0.18 -0.02 (-1.02) -0.04*** (-5.04) ROA 0.07 0.06 0.07 0.05 -0.00 (-2.02) -0.01*** (-8.90) CHANGE_ EARNINGS 0.01 0.01 0.02 0.00 0.01*** (3.08) (-6.28) -0.01 MVE 11876.41 2673.50 9277.64 2046.31 -2598.78*** (-3.28) -627.19*** (-7.58) BVE 4080.34 1043.57 3107.45 827.72 -972.89*** (-3.34) -215.85*** (-6.16) SIZE 7.98 7.82 7.78 7.64 -0.20*** (-4.98) -0.18*** (-4.97) MTB 3.61 2.48 3.42 2.25 -0.18 (-0.25) -0.23*** (-5.58) LEVER 0.24 0.22 0.22 0.20 -0.02*** (-4.44) -0.02*** (-4.66)

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3.7 Empirical Model

To examine the effect of suspect firms on future CFO short-term compensation, I use the following model:

∆ST_COMP

_𝑡

= α₀ + α₁*Suspect firms

𝑡−1

+ α₂*𝑆𝐼𝑍𝐸

𝑡−1

+α₃*𝑀𝑇𝐵

𝑡−1

+

α₄*𝐿𝐸𝑉𝐸𝑅

𝑡−1

+ ɛ

where ∆ST_COMPt is the change of the CFO short-term compensation from t-1 to t0, measured

as (BONUS + NONEQ_INCENT)/ 𝑇𝑜𝑡𝑎𝑙 𝐴𝑠𝑠𝑒𝑡𝑠𝑡−1.

Suspect firms_𝑡−1 is an indicator variable that is set equal to one if firms-years belong to the earnings category just right of zero, and zero otherwise. Suspect firms𝑡−1 will be measured

in the case of SUSPECT_ZERO if firms-years belong to the zero earnings benchmark and SUSPECT_LAST if firms-years belong to the meeting last year’s earning benchmark. The coefficient, alpha 1, is the percentage increase/decrease in CFO short-term compensation when Suspect firms_𝑡−1 equals one (as opposed to the non-suspect firm group).

To determent the effect of financial expertise of the CEO on the relationship between CFO short-term compensation and suspect firms, I use the following model:

∆ST_COMP

_𝑡

= α₀ + α₁*Suspect firms

𝑡−1

+ α₂*𝐸𝑋𝑃𝐸𝑅𝑇_𝐶𝐸𝑂

𝑡−1

+

α₃*Suspect firms

𝑡−1

*𝐸𝑋𝑃𝐸𝑅𝑇_𝐶𝐸𝑂

𝑡−1

+ α₄*𝑆𝐼𝑍𝐸

𝑡−1

+ α₅*𝑀𝑇𝐵

𝑡−1

+

α₆*𝐿𝐸𝑉𝐸𝑅

_𝑡−1

+ ɛ

where EXPERT_CEO is an indicator variable that is set equal to one if firm-years have a CEO with financial expertise, and zero otherwise.

The moderating effect of financial expertise is measured by the following interaction α

₃

*Suspect firms*EXPERT_CEO Hence, alpha 3 indicates how much financial expertise effect the change in short-term compensation for the suspect firms. Alpha 2 indicates the percentage increase/decrease in CFO short-term compensation when firms have an CEO with financial expertise.

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4 Multivariate results

4.1 Suspect firms and changes in future CFO short-term compensation

If firm-years that report earnings just above zero or beat last year’s earnings undertake activities that adversely affect the future short-term cash compensation of the CFO, then, according to my first hypothesis, the first calculated model described in Section 3.7 should show a negative alpha 1, which would mean that suspect firms decrease short-term compensation for CFO’s.

Table 4

Regression analysis comparison between suspect firms and non-suspect firms

Change in CFO short-term Cash Compensation

Coef. t-statistic

Panel A: Zero benchmark suspect firms

SUSPECT_ZERO -0.17*** -4.80

SIZE -0.11*** -22.57

MTB 0.00 0.84

LEVER -0.53*** -12.36

Adjusted 𝑹𝟐 _0.12

Panel B: Beating last year's earnings benchmark suspect firms

SUSPECT_LAST -0.02 -0.88

SIZE -0.12*** -22.16

MTB 0.00 0.85

LEVER -0.55*** -12.75

Adjusted 𝑹𝟐 _0.12

***Significant at the 1% level. **Significant at the 5% level. *Significant at the 10% level.

Results regarding regression of SUSPECT_ZERO panel A and of SUSPECT_LAST panel B on future short-term compensation. The total sample includes 5,755 observations.

Table 4 reports the results from the first model described in Section 3.7. Panel A shows that the CFO short-term compensation is negatively associated with firms that just meet the zero earnings benchmark (-0.17) and is significant at the 1 percent level (t = -4.80). Hence, suspect firms have short-term compensation that is lower on average at t+1 by 17 percent compared to the non-suspect firms. This is in line with table 3 panel A, which shows that the mean of ST_COMP of suspect firms which just beat the zero earnings benchmark is 60 percent (0.30) lower than the mean of the non-suspect firms. Thus, the results from table 4 panel A provide evidence on hypothesis 1, suspect firms that just beat the zero earnings benchmark decrease future CFO short-term compensation.

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Panel B represents the results for the difference between the suspect firms that beat the last year’s earnings benchmark and the non-suspect firms. The results show a negative coefficient (-0.02) for suspect firms that just beat the last year’s earnings, however, this effect is not significant (t = -0.88) indicating that there is no significant relationship between the suspect firms that just beat the last year’s earnings benchmark and the non-suspect firms regarding the CFO short-term compensation.

4.2 The presence of financial expertise and future short-term compensation

My second hypothesis predicts that the presence of a CEO with financial expertise should change the relationship mentioned in my first hypothesis. Thus, depending on the coefficient of SUSPECT_ZERO in panel A, the coefficient of SUSPECT_ZERO*EXPERT_CEO could increase the relationship between suspect firms and future compensation or decrease this effect depending on the direction of the coefficient.

Table 5

Analysis of financial expertise on future cash compensation

Change in CFO short-term Cash Compensation

Coef. t-statistic

Panel A: Zero benchmark suspect firms

SUSPECT_ZERO -0.17*** -4.71 EXPERT_CEO -0.09* -1.94 SUSPECT_ZERO*EXPERT_CEO -0.03 -0.14 SIZE -0.12*** -22.62 MTB 0.00 0.83 LEVER -0.53*** -12.35 Adjusted 𝑹𝟐 _0.12

Panel B: Beating last year's earnings benchmark suspect firms

SUSPECT_LAST -0.02 -0.98 EXPERT_CEO -0.11* -2.08 SUSPECT_LAST*EXPERT_CEO 0.07 0.68 SIZE -0.12*** -22.21 MTB 0.00 0.84 LEVER -0.55*** -12.75 Adjusted 𝑹𝟐 _0.12

***Significant at the 1% level. **Significant at the 5% level. * Significant at the 10% level.

This table report the results a regression analysis over a period of 2007-2015 with 5,755 observations. Panel A represents the results of firms-year with zero earnings benchmark. Panel B represents the results for the firm-year with the beat the last year’s earnings benchmark.

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Table 5 panel A includes the effect of financial expertise of the CEO in the equation between the suspect firms that just beat the zero earnings benchmark and future CFO short-term compensation. When looking at the coefficient on SUSPECT_ZERO I find once more evidence in support of my first hypothesis, indeed, the effect seen in table 5 panel A is unchanged compared to the results in table 4. The results also show that EXPERT_CEO is negatively associated (-0.09) with CFO short-term compensation and is significant the 10 percent level (t = -2.08). This means that firms that have a CEO with financial expertise decrease CFO short-term compensation in the upcoming year by 9 percent on average. SUSPECT_ZERO*EXPERT_CEO shows no significant results, which means that I find no evidence that a CEO with financial expertise moderates the effect of suspect firms that just beat the zero earnings benchmark and future short-term compensation of the CFO.

Panel B of table 5 shows the results for suspect firms that just beat the last year’s earnings benchmark with the effect of financial expertise of the CEO. Similarly, as in table 4 panel B, the results indicate no significant relationship between the suspect firms that just beat the last year’s earnings benchmark and the non-suspect firms regarding the CFO short-term compensation. Furthermore, the results also indicate no significant effect of alpha 3 of my second model in section 3.7, however the results show a significant and negative coefficient of the EXPERT_CEO variable which means that firms that have a CEO with financial expertise decrease CFO short-term compensation in the upcoming year by 11 percent on average.

The results of the models in section 3.7 generated a R-squared value of 0.12, which means that 12 percent of the variations is explained by the dependent variables in the models. A plausible explanation could be the amount of observations. Suspect firms with the zero earnings benchmark consist of 835 observations of which 18 firms have a CEO with financial expertise. Furthermore, not all CFOs receive a bonus or non-equity incentives every year, which also could have an impact on the explanatory power of the regression. Although the R-squared is small, the models show a significant relationship between the independent variable and the dependent variables.

Overall, it appears that firms that operate in an environment where earnings are expected to fall just below the zero earnings point, engage in earnings manipulation to help them cross the “red line” for the year. The evidence presented in this section suggest that these firms decrease future CFO short-term compensation to discourage the manipulation of earnings. Thus, the presence of earnings management has a negative influence on the short-term compensation a CFO will receive in the future.

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5 Conclusion and recommendations

This paper examines the association between earnings management and future short-term compensation. In particular, I examine the matter of future CFO short-term compensation for a subset of firms that are more likely to have managed earnings Specifically, I examine two indicators of managed earnings, namely, meeting or beating last year's earnings, and avoiding reporting losses (zero earnings benchmark). Additionally, I theorize that corporate governance, and in particular the presence of financial expertise of the Chief Executive Officer (CEO), will have a moderating effect on the relationship between earnings management and future CFO short-term compensation.

I contribute to the earnings management literature by showing that firms decisions for future CFO short-term compensation are influenced by the presence of earnings management. My findings show that, firms with earnings slightly above zero, decrease future CFO short-term compensation to discourage the manipulation of earnings. Additionally, in contrast to previous literature, this paper shows no discontinuity around zero regarding beating last year’s earnings benchmark, meaning that my paper shows no evidence of managing earnings upwards to beat last year’s earnings. Hence, consistent with the paper of Durtschi and Easton, (2009), the discontinuity in previous literature is likely caused by other factors. For this reason, I find no significant evidence in support of change in future CFO short-term compensation when firms just beat last year’s earnings, nor do my results show any significant change when a CEO has financial expertise on the relationship between suspect firms and future CFO short-term compensation. Thus, my results indicate that in the presence of earnings management, firms will decrease the short-term compensation a CFO will receive in the upcoming year.

The findings in this paper show a significant relationship between the presence of earnings management and future CFO short-term compensation, however, the models in section 3.7 generated a R-squared value of 0.12, which means that 12 percent of the variations is explained by the dependent variables. Future research can expand my paper by looking at the age of the CFO or the difference in industries to explain the variations. Furthermore, my paper used bonus + non-equity incentives as a measure for overall bonus-based short-term compensation. Future research can explore different kinds of measures for short-term compensation. For instants, adding stock options and restricted stock grants to the CFO’s bonus provide a broader measure of compensation. However, taking bonus as a single measure will generate the same results but the regression will have an approximated R-squared of 1 percent, as opposed to the 12 percent when I use bonus + non-equity incentives. Lastly, the effect of earnings management can be

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deepened by looking at the different kind of earnings management and which kind of earnings management has more effect on future CFO short-term compensation.

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Earnings benchmarks and future compensation : a study of suspect firms and CFO short-term compensation