Master thesis
Corporate governance, CEO compensation
and accounting conservatism
Faculty of Economics and Business, University of Amsterdam MSc: Accountancy and Control, specialization Accountancy
Name: Pakamas Srichoke Student number: 6153593 Date: 22nd of June 2015
First supervisor: Dr. G. Georgakopoulos Second supervisor: Dr. J.J.F. van Raak
Final version Word count: 15404
Statement of Originality
This document is written by student Pakamas Srichoke 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.
Abstract
This study investigates the moderating effect of corporate governance strength on the relation between CEO bonus compensation and accounting conservatism. Both accrual-based and market-based measures are used as proxies for conservatism. Building on existing theories (agency theory and managerial self-interest theory) and literature (Core, Holthausen and Larcker, 1999; Bhojraj and Sengupta, 2003; Rees and Rodionova, 2015) it is predicted that strong corporate governance is able to mitigate the expected negative relation between CEO bonus compensation and accounting conservatism. Using S&P 500 companies for the years 2008-2013, this study provides evidence for a positive relation between CEO bonus compensation and accounting conservatism. This result not in line with the predictions from the aforementioned literature. With respect to the moderating effect of corporate governance strength, this study fails to find strong evidence regarding the direction of the effect. Both measures provide contradicting insignificant relations, therefore a clear conclusion about the moderating effect of corporate governance strength would not be reliable. The conclusion remains after controlling for industry-specific effects. Furthermore, this study has two important limitations. First of all, this study is not able to identify the moderating effect of corporate governance strength. Secondly, the results could not be generalized across settings with smaller (national) companies. This study contributes to the literature on accounting conservatism, corporate governance and CEO compensation. In addition, this research aims to stimulate the future growth and improvement perspective of corporate governance by raising awareness about the effectives and efficiency of the current corporate governance form.
Contents
Chapter 1: Introduction ... 5
Chapter 2: Literature review and hypotheses ... 9
2.1 Accounting conservatism ... 9
2.2 CEO compensation ... 11
2.3 Relation between CEO compensation and accounting conservatism ... 12
2.3.1 Agency theory ... 12
2.3.2 Managerial self-interest theory ... 13
2.3.3 Hypothesis CEO compensation and accounting conservatism ... 14
2.4 Influence of corporate governance ... 17
2.4.1 Corporate governance ... 17
2.4.2 Hypotheses corporate governance and agency problem ... 18
Chapter 3: Research design ... 20
Chapter 4: Evidence ... 25 4.1 Sample ... 25 4.2 Descriptive statistics ... 26 4.3 Results hypothesis 1 ... 30 4.4 Results hypothesis 2 ... 34 4.5 Additional analysis ... 39 Chapter 5: Conclusion ... 42 Reference list ... 45
Tables and figures Figure 1.1: Conceptual framework ... 6Figure 2.1: Hypothesis 1 ... 16
Table 1: Sample ... 26
Table 2: Observations per industry ... 26
Table 3: Descriptive statistics ... 27
Table 4: Correlation matrix between dependent, independent and control variables ... 29
Table 5: Regression hypothesis 1 | CON-ACC ... 30
Table 6: Regression hypothesis 1 | CON-BTM ... 32
Table 7: Regression hypothesis 2 | CON-ACC ... 35
Table 8: Regression hypothesis 2 | CON-BTM ... 37
Table 9: Additional analysis hypothesis 1 ... 40
5
1. Introduction
………
Corporate governance is considered as an important concept in organizations in many cases. It has the duty to monitor management performance and protect shareholder interest (Bhojray and Sengupta, 2003), whereby their ultimate goal is to maximize shareholder value (Luo and Salterio, 2014). However, existing literature indicates that there is a great deal of disagreement on how well existing governance mechanisms are functioning (Shleifer and Vishny, 1997). Joh (2003), for instance, has linked the economic crisis in Asia to firms having poor corporate mechanisms and weak legal environments. In addition, measuring corporate governance quality Luo and Salterio (2014) find a significant difference in corporate governance effectiveness and efficiency between the Canadian “comply or explain” corporate governance disclosure regime.
A phenomenon arising with corporate governance is the classic agency problem. Given information asymmetry, how do shareholders make sure that managers don’t make self-interested decisions by incentivizing managers to make decisions that are considered optimal for the organization as a whole? Watts and Zimmerman (1978) assume that managers are self-interested and it is in their nature to make choices in order to maximize their own wealth. Therefore it is important to know whether corporate governance that is classified as being ‘strong’ by the society is really able to mitigate these agency problems and could be considered as truly effective.
Considering corporate governance while making an investment decision is becoming more common these days. Anticipating the increasing demand for corporate governance data, numerous agencies e.g. Standard & Poor, Moody’s and Fitch have developed a rating system in order to rank individual organizations based on different corporate governance criteria. The valuation of corporate governance based on scores and ranks is considered a valuable source of information for stakeholders.
Prior literature indicates that conservatism in accounting and financial reporting is increasing over time (e.g. Givoly and Hayn, 2000). Basu (1997) explores conservatism in earnings with the focus to provide more information on accruals in accounting. He finds that earnings are two to six times more sensitive to negative returns than to positive returns. Watts (2003) identifies explanations and implications for conservatism in accounting. Besides that, prior research explores the international differences in corporate governance and the link with conservative reporting (e.g. Ball, Kothari and Robin, 2000).
6 Fan and Wong (2002) examine the relation between corporate ownership structure and the informativeness of earnings. A research that is more in line with this study is that of Core et al. (1999). They analyze the impact of corporate governance structure on the level of CEO compensation and firm performance. Overall, their findings suggest that companies with weaker corporate governance mechanisms are related to greater agency problems, higher CEO compensation and poorer firm performance.
This study contributes to the academic literature of accountancy, corporate governance and CEO compensation by analyzing the impact of corporate governance strength on the relation between earnings-based CEO compensation and accounting conservatism.
The research question for this study is as follows:
“How does corporate governance strength influence the relation between earnings-based CEO
compensation and accounting conservatism?”
Figure 1.1: Conceptual framework
Building on existing literature, the agency theory (Jensen and Meckling, 1976; Bris and Cantale; 2004) and the managerial self-interest assumption (Watts and Zimmerman, 1978; Guth and MacMillan; 1986), I expect to find a negative relationship between earnings-based CEO compensation and accounting conservatism. This is due to the assumption that when CEO’s compensation is for a large part earnings-based (e.g. bonus compensation), CEOs have incentives to choose accounting practices that result in overvaluation of the firm’s value (e.g. overvaluation of firms projects, earnings or other assets) in order to receive a higher level of
7 compensation.1 This occurrence could be identified as a classical agency conflict between
shareholders and executive managers (CEOs). Due to the possibility that overvaluation of the firm’s assets could lead to negative consequences that debouch into costly concerns for the organization. For instance, overvaluation implies that CEO’s bonus targets are more ‘quickly’ achieved and lead to higher bonus payments. Moreover, intentional or unintentional disclosure of sensitive information, in this particular case the overvaluation of firm’s net income and net asset, could have a downwards effect on the firm’s stock price.
This is where corporate governance is of great importance. Existing literature (Core et al., 1999; Bhojraj and Sengupta, 2003; Rees and Rodionova, 2015), indicates that a well-functioning corporate governance should be able to prevent and solve agency problems. Resulting in diminished agency costs of an organization. Elaborating on this I predict the following: the stronger the corporate governance strength, the smaller the agency conflict. In this case, corporate governance strength is measured by corporate governance pillar scores from the Thomson Reuters ASSET4 ESG. The agency conflict of this study is the relationship between earnings-based CEO compensation and accounting conservatism, which is expected to be a negative relationship.
During the past decade research on corporate governance increased intensely (Gillan, 2006). Numerous failures, disasters and scandals at international organizations (e.g. WorldCom, Enron, Arthur Anderson and Ahold) combined with the recent financial crisis have led to more attention to corporate governance and CEO compensation. Prior research explored the effect of various corporate governance mechanisms. For instance, Agrawal and Chadha (2005) analyze the relation of several governance characteristics with the likelihood of organizational restatement of earnings. Berry, Fields and Wilkens (2006) investigate the interaction among multiple corporate governance mechanisms. With a specific focus on the interaction between inside ownership, board composition, organizational compensation structure and unaffiliated block ownership.
Gillan (2006) on the other hand provides an overview of recent research by developing a corporate governance framework. Beside the increasing interest in corporate governance, there are noticeable developments in financial reporting as well. Existing literature provides
1 However the opposite relation could hold according to Watts and Zimmerman (1978). Management would only
change accounting standards when the present value of the after tax incentive income per manager is larger than the decrease in the portfolio of each manager. When this is not the case management would not prefer the accounting change, even when it increases the reported earnings of the firm and the subsequent incentive income.
8 evidence suggesting that accounting is becoming more conservative (Givoly and Hayn, 2000). Several studies have been conducted that explore explanations and determinants of conservative reporting in accounting (e.g. Watts, 2003; Ball et al., 2000).
This research has several contributions. First of all from a research perspective, this research extends the existing literature by analyzing the moderating effect of a firm’s corporate governance strength on the relationship between earnings-based CEO compensation and accounting conservatism.
Secondly, this research is relevant from a societal point of view. The knowledge whether and how corporate governance in its current form could impact the relationship between earnings-based CEO compensation and accounting conservatism is important for the future growth and improvement perspective of corporate governance. Is corporate governance in its current condition able to mitigate agency problems, or does society need to change its view of ‘the strong corporate governance’ concept? Thus, is there a hidden need for corporate governance reform? The answer to these questions can have a large contribution and could be considered as valuable knowledge for many actors in society. According to Porta, Lopez-de-Silanes, Shleifer and Vishny (2000), corporate governance reform attracted worldwide attention in the last decade. Interest and discussions regarding reformation has intensified since the Asian financial crisis. The financial crisis is an important attribute to analyze weaknesses and failures of corporate governance mechanisms (Kirkpatrick, 2009). The financial market has experienced a high degree of dynamics due to the financial crisis of 2008, corporate failures and scandals. This has increased the interest in current corporate governance mechanisms and the debate about reform even more. This is in line with the future research suggestion of Matsumura and Shin (2005). They stimulate future research regarding CEO compensation reform and the related corporate governance reform due to the assumption that there is great public interest around these issues that will undoubtedly persists in the future.
Thirdly from an organizational and shareholder perspective, when results suggest that corporate governance in its current form is not functioning well enough, shareholders could choose to invest more in corporate governance reform. This is due to the fact that corporate governance mechanisms are used to protect the interests of shareholders. In addition, shareholders are likely to be interested in corporate governance reform as it is linked by Tuschke and Sanders (2003) to higher levels of market performance.
9 Fourthly, from a debtholders perspective, the awareness that corporate governance in its current form is not effective and/or is considered of relative low quality, could decrease the likelihood of debtholders making ‘bad’ investments decisions. Debtholders would probably be extra alert and scrutinize the organization even more prior to an investment decision.
Overall, this research contributes to the public debate by triggering readers to critically evaluate current corporate governance mechanisms and stimulate them to desire continued improvements in corporate governance quality.
The remainder of the paper is organized as follows, the second chapter consists of the literature review. Existing literature is analyzed and used to build the hypotheses. The third chapter provides the research design; in which the research method and variables are outlined. The research evidence including the results of the additional analysis is captured in chapter four. Information about the sample, descriptive statistics and other results from the data analysis are presented. The fifth chapter, the last chapter, gives an overall conclusion and points out the research implications.
2. Literature review and hypotheses
……….
In this chapter the existing literature regarding the research topic is analyzed. To start, the general concept of accounting conservatism and CEO compensation is explained. This is followed by the discussion of the relationship between these two variables, including the formulation of the first hypothesis. This section ends with literature regarding corporate governance and its influence on the relationship between earnings-based CEO compensation and accounting conservatism. Building on existing literature, the second hypothesis is formulated.
2.1 Accounting Conservatism………
The degree of conservatism in financial statements is often used as one of the quality measurements for financial reporting in prior research. Evidence based on the explored trend of recent years, including numerous FASB announcements, suggests that financial reporting is becoming more and more conservative (Givoly and Hayn, 2000). This is due to the notion that managers, investors and accountants generally prefer that possible measurement errors arise as
10 a result of an understatement, rather than as a result of an overstatement of a firm’s net asset and net income (FASB Statement of Concepts No.2).
Despite of the increasing trend of conservatism in financial reporting, there is no ‘general’ definition of the conservatism concept used in the empirical research. A ‘classic’ definition of the accounting conservatism concept that is referred by many authors is; “anticipating no profit, but anticipate all losses” (Bliss, In Watts, 2003, p. 208). Another definition that could be considered as a more ‘official’ definition is offered by the FASB in the Statement of Concepts No. 2. They express conservatism as ‘a prudent reaction to uncertainty to try to ensure that uncertainty and risk inherent in business situation are adequately considered’. Another definition that is often used in the academic literature is the interpretation by Basu (1997): “the accountant’s tendency to require a higher degree of verification for recognizing good news than bad news in financial statements”(p. 4). Guay and Verrecchia (2006) provide a more combined definition; “more timely recognition of losses than gains as a result of the costs and benefits of reporting verifiable information by managers and/or firms being asymmetric” (p. 149). Elaborating on different definitions, they all recognize that accounting conservatism encompasses asymmetric verification requirements for organizational gains and organizational losses.
Firms’ decisions to apply conservative accounting techniques in financial reporting has been a remarkable research area. An important research is that of Watts (2003), he identifies four explanations for conservatism that are confirmed by Bushman and Piotroski (2006). To start, the contracting explanation assumes that conservative accounting is used to address moral hazard problems in a firm. These problems arise due to the existence of imperfections such as asymmetric pay-offs, asymmetric information, limited ability and limited horizon between several parties in an organizational context. An example by Watts (2003), which is applicable to this study, is the compensation contract. This example points out that conservatism reduces the likelihood of managers overstating net income and net assets in order to distribute the firm’s asset to themselves (Watts, 2003). In this concept, conservatism is used as an efficient
contracting mechanism.
The litigation explanation is specified as the second clarification of conservative decisions of shareholders and/or management. Due to the likelihood of higher litigation cost in the case of overstatement of earnings and assets, managers have incentives to understate net income in order to minimize the possibility of high litigation costs. The third explanation is the
11 taxable income. Reporting higher income, means that taxable income moves along symmetrically. This conjuncture gives an incentive to defer the reported income by providing conservatism in accounting and reporting, with the aim to reduce the present value of taxes. The last reason given by Watts (2003) is built on the regulation explanation. He argues that losses arising from overvaluation are relatively more observable and sensitive to political processes than to forgone gains as a result of undervaluation. This will incentivize regulators and standard setters to act more in line with conservatism.
Consistent with the contracting explanation, Ahmed, Billings, Morton and Stanford-Harris (2002) find evidence suggesting that accounting conservatism not only contributes to firms’ ability to reduce debt costs, but also plays a significant role in mitigating conflicts concerning the dividend policy between bondholder and shareholders. Above that, conservative accounting and reporting reduces firms’ cost of debt as well. This is because conservative reporting provides a disclosure of relevant information for decision making. Firms that disclose more relevant information for decision making are able to signal that they are a low-risk type while firms that disclose limited information are often viewed as a high-risk type.
2.2 CEO Compensation………..
Relative high CEO compensation is not only a source for internal and external criticism, it also contributes to concerns regarding the ethical values and the accountability of an organization. To elaborate, Boyd (1994) states that various CEOs of U.S. firms, who accompanied George Bush on a trade mission to Japan in 1992, received an extensive amount of criticism from the national and international press. In addition, he also notices the attack on several CEOs of non-for-profit organizations. According to the critics ‘opinion those CEOs receive an absurd high compensation. Regulators and corporate governances are under pressure to react to these complaints and concerns in a proper manner. As result, the concept of CEO compensation is scrutinized more by regulators, corporate governances as well as the society in general. An action in response to the concerns is the implementation of Sarbanes Oxley Act of 2002. Cohen, Dey and Lys (2004) analyze the effect of the SOX 2002 implementation on CEO risk-taking behavior and compensation structure. They find a significant decrease in incentive compensation and a reduction in risk-taking behavior after the implementation of SOX.
CEO compensation package for U.S. corporations is often a result from negotiations with the CEO (Bushman, Indjejikian and Smith, 1996). The package usually involves a salary component and an incentive component. The incentive component consists of an annual bonus
12 scheme and a long-term incentive plan, with the aim to incentivize executives to expand their horizon and to act in the firm’s best interest on a short- and long-term base. Payments for the incentive component is subject to performance measures of the CEO and is beheld by executives as of significant importance for their total compensation. Above that, Healy (1985) indicates that earnings-based bonus schemes are a very popular means for organizations to reward their executives. Compensation can be used by companies as a tool to achieve numerous organizational objectives (e.g. investment in non-financial projects to improve quality of provided service, improve organizational performance by increasing net income and earnings). Confirmed by Gillan (2006), compensation policies are an important element in the alignment of interests between shareholders and executive managers. However, according to Denis, Hanouna and Sarin (2006) there is also a ‘dark side’ of using an incentive component in a compensation package. The authors find a significant relation between the increase of stock options (equity-based compensation) and the occurrence of fraudulent activities in organizations. Building on Denis et al.’s perspective (2006), there are other issues resulting from CEO compensation. For instance, executives’ thoughtful decisions to manipulate financial data, commit and the attempt to conceal fraud or overvaluations of net income in order to hit desired bonus targets are important risks of compensation that need to be controlled.
2.3 Relation of CEO earnings-based bonus compensation and accounting conservatism
2.3.1 Agency Theory………..………..
Literature concerning the definition of the concept of ‘the organization’ has shifted from a classical model towards an interpretation which identified the organization as a ‘set of contracts among factors of production’ (e.g. Fama, 1980; Jensen and Meckling, 1976). The organization is considered explicitly as a team of individuals who are able to make rational decisions and act according to their preferences. These decisions and actions are often based on self-interest and result in the attempt to maximize their own wealth. However, these individuals do realize that their future with respect to the security of their profession depends, to some extent, on the survival of the team in its competition with other teams (Fama, 1980). In this case it depends on the CEO’s perception on the survival of their organization.
A phenomenon that often arises in an organization made possible by the occurrence of information asymmetry is the classic agency problem. Shortly stated, it is a conflict of interest between different parties in an organizational context. Jensen and Meckling (1976) provide a ‘traditional’ definition of the agency relationship as: “a contract under which one or more
13 persons (the principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating some decision making authority to the agent”(p. 308). Delegating authority towards executive managers is accompanied by a certain level of risk and a likelihood of paying additional costs. This is due to the assumption that both parties are utility maximizers. The latter assumption provides a good reason to believe that agents will not always make decisions that are in the best interest of the principal, though not unexpectedly. In the meantime, the agent benefits from these actions whilst the principal bears the cost. This problem can’t be solved completely, however, the principal can attempt to minimize the agency problem and cost by steering the interest of the agent. The aforementioned can be achieved by applying certain incentives and by monitoring the agent.
Bris and Cantale (2004) identify two viewpoints on the agency problem in their paper, the external and internal view. The external view point analyzes the conflict of interest between regulators and shareholders. The internal view specifies the agency problem between shareholders and executive management. This is somewhat in line with the stakeholder and shareholder perspective by Larcker and Tayan (2011). With respect to the stakeholder perspective, Larcker and Tayan (2011) emphasize the social obligation of the organization, the management and the employees. In contrast, the shareholder perspective believes that the primary obligation of an organization is to maximize the shareholder’s value. This study will concentrate on the internal/shareholder viewpoint of the agency problem, to be more specific, the conflict of interest between shareholders (owners) and CEOs.
2.3.2 Managerial Self-interest………
CEOs are authorized to make investment, finance and operating decisions. Another responsibility of executive management mentioned by Larcker and Tayan (2011) is deciding on accounting method and applications. Dechow (1994) identifies two possible accounting choices for managers. The first possibility is to make the choice that will maximize their contracting efficiency with the organization by providing unbiased accounting. In this case, the earnings in the financial statements capture the actual performance of the firm. The second option is to make choices that will maximize their own wealth and act in their own interest. This is done by the provision of biased accounting. In this case, the earnings recorded in the financial statement do not captures firms’ actual performance. The interesting question it entails, is which decision will be made by the CEO? What is of more value to them? The welfare of the organization that often is accompanied with job security or their own welfare?
14 An assumption which is adopted by various theories is that individuals are self-interested. They will act and make decisions based on their preferences to maximize their own wealth. Watts and Zimmerman (1978) connect this assumption with the implication that management would lobby for accounting standards based on their self-interest. This is in line with the results from Guth and MacMillan (1986). They provide strong evidence that management is not only willing to redirect a firm’s strategy, delay or reduce the quality of its implementation. However they are even willing to completely sabotage the firms’ strategy if the managers have the conviction that their self-interest is being compromised. Furthermore, the optimal contracting theory recognizes this phenomenon as well. It acknowledges that managers indeed suffer from agency problems and do not automatically seek to maximize shareholders value (Bebchuk and Friend, 2003).
2.3.3 Hypothesis CEO compensation and accounting conservatism……….
Building on the agency theory and the assumption that individuals, in this case CEOs, are self-interested by nature, it should be expected that CEOs are willing to make decisions which are in line with preferences to maximize their own wealth. When the possibility that CEOs could receive a higher compensation arises, in this case an earnings-based compensation in form of a bonus, CEOs are more likely to choose accounting procedures that will lead to overvaluation of net income and net asset in order to receive a higher compensation. This view is supported by Shalev, Zhang and Zhang (2013) as well. Their study provides evidence that CEOs whose compensation package relies more on earnings-based bonuses are more likely to over allocate the purchase price to goodwill in case of an acquisition. Due to the fact that goodwill is not amortized, the over allocation of goodwill is expected to increase post-acquisition earning and eventually increase the CEO’s bonus.
In addition, Healy (1985) investigates the effect of bonus schemes on accounting decisions by managers. The results confirm the assumption that bonus schemes (earnings-based compensation) create a certain incentive for managers to choose specific accounting procedures and accruals in order to increase their bonus rewards. However, Healy (1985) discovered that managers use both income-increasing and income-decreasing accruals. This holds only in particular situations when the upper or lower bound of their bonus plan are binding (Healy, 1985). Evidence that managers are using income-decreasing accruals in some cases (e.g. in case of a big bath) supports the negative relationship between the earnings-based component (bonus) in a CEO’s compensation and the degree of accounting conservatism in financial statements.
15 Using income-decreasing accruals (indication of accounting conservatism) is related to receiving a lower bonus.
Building on existing literature (Shalev et al., 2013), when a CEO’s compensation is for a large part earnings-based (bonus component of the total compensation), it could be expected that CEOs have adopted less conservative accounting practices. As a result, they will achieve their bonus target and receive a higher level of earnings-based compensation.
However there are arguments that suggest the opposite. It is possible that although the earnings-based CEO compensation is relatively high, the level of conservative accounting could be high as well. First of all due to the impact of the recent financial crisis. Regardless of the level of earnings-based CEO compensation, organizations have the incentive to report conservatively to protect investors from making a bad investment decision based on inaccurate information and as a result protect themselves against litigation risk.
The second argument is built on the regulation explanation for conservatism (Watts, 2003). It could be the case that organizations report conservatively fearing that overvaluation would attract scrutiny by government. Said scrutiny could lead to an earnings cap if there is a link made between earnings-based CEO compensation and a low level of conservative accounting by the government. The earnings cap could be an instrument to facilitate the desired outcome of conservative reporting and a social acceptable amount of CEO compensation.
Although the regulation and litigation risk exist, according to Kamalanabhan and Sunder (1999) it is generally believed that managers participate more in risk-taking activities than others. In addition managers rate themselves highly on risk-taking compared to the average people, whereby they believe that risk-taking behavior is important for the managerial function (Kamalanabhan and Sunder, 1999). This could be used by managers to rationalize their risky decisions to participate in overvaluation. Risk- taking behavior (e.g. overvaluation) in order to achieve specific performance targets and receive higher bonus is in alignment with the findings of March and Shapira (1987). They found three conditions whereby managers take risk and exhibit risk preferences. One of them is when managers’ attention is focused on performance targets, this will influence their risk-talking behavior.
Besides this, managers have the tendency to make short-term decisions. This is in line with Rappaport (2005). He argues that corporate executives are obsessed with short-term earnings. CEOs and other senior executives use the behavior of the short-horizon investors to rationalize their own obsession. Short-term decisions are attractive, especially when it is related to serve managements’ own interest by increasing short-term earnings. Linking this to the
16 managerial self-interest theory (Watts and Zimmerman, 1978; Guth and MacMillan; 1986) it could be stated that management would overvalue earnings to receive a higher bonus on the short-term. Whereby an increase in regulation and litigation risk happens over time and could be considered as a problem that could be dealt with in the future.
To summarize, elaborating on the managerial self-interest theory (Watts and Zimmerman, 1978; Guth and MacMillan; 1986), managerial risk-taking behavior (Kamalanabhan and Sunders, 1999; March and Shapira, 1987) and their obsession on short-term earnings (Rappaport, 2005), I expect to find a negative relationship between earnings-based CEO compensation and accounting conservatism. Formulated in the first hypothesis:
H1: Earnings-based component in a CEO compensation is negatively associated with accounting conservatism……….………..
Figure 2.1 Hypothesis 1
This occurrence can be considers an agency problem. Bebchuk and Fried (2003) mention that much research has focused on executive compensation as a method to solve agency problems. In addition, they also argue that the design of compensation arrangements is partly a product of that very agency problem. In this particular case, CEOs are choosing accounting practices which will lead to overvaluation of net income and net asset in order to achieve their bonus
17 targets. This phenomenon is in conflict with the interest of the shareholders. Overvaluation results in higher (unearned) compensation payments to the CEOs. Subsequently, intentional or unintentional disclosure of such information (overvaluation) could result in a drop of share price. In both cases would this lead to negative consequences for the organization and its
shareholders.……….
2.4 Influence of corporate governance………..………
2.4.1 Corporate governance………...
Organizational failures like corporate fraud, accounting scandals, outstanding high executive compensations and inside trading have made corporate governance an extensively discussed topic in the media (Larcker and Tayan, 2011). These shocking events often result in exhausting lawsuits, resignation of managerial functions or even bankruptcy of the organization. Inadequate functioning of corporate governance is often blamed as the roots of these failures. Subsequently, the recent economic crisis and shocking events like the collapse of Enron, WorldCom and Arthur Anderson have made corporate governance more important than ever before. Organizations worldwide express their concerns about corporate governance issues (Khanchel, 2007). These developments including the SOX regulation have made the corporate governance landscape particularly dynamic during the past decade.
Larcker and Tayan (2011) define the concept of corporate governance ‘as the collection of control mechanisms that an organization adopts to prevent dissuade potentially self-interested managers from engaging in activities detrimental to the welfare of shareholders and stakeholders’. This perception allows us to consider corporate governance as a control and monitoring system, which is put in place in the organization system. Corporate governance is equipped with the duty of monitoring management performance, protecting shareholders’ interests and minimizing agency costs. The need for a corporate control mechanism to align the interest of executives with those of the shareholders depends on the size of the agency costs, the ability for the control mechanism and the cost of implementation of those control mechanisms (Larcker and Tayan, 2011).
Corporate governance is especially effective when it is able to reduce agency costs exceeding the implementation costs of the corporate governance mechanism. Klapper and Love (2004) find evidence that a better corporate governance is highly correlated with better market valuation and operating performance. In addition, Shleifer and Vishny (1997) explain that strong corporate governance provides a certain level of assurance to investors in terms of
18 reasonable return to their investment while minimizing the investment risk. Consistent with this, Renders and Gaeremynck (2012) argue that corporate governance has the ability to solve agency conflicts and has a positive effect on firm value. Though the controlling and monitoring role of corporate governance is quite clear, the effectiveness and the quality perception of corporate governance within the society (organizations, shareholders, stakeholders and society in general) diverge. Is the effectiveness of corporate governance in its current condition sufficient to protect shareholders from the agency problem, or is an increase in regulation regarding reshaping and monitoring of corporate governance required?
2.4.2 Hypotheses corporate governance and agency theory………..
Watts (2003) claims that moral hazard problems, a form of an agency problem, will exist in financial reporting as long as the accounting measures inform investors about managerial performance. In turn, the informative role of accounting affect investors' asset allocation decisions and managers' welfare. The point that the managers’ welfare depends on numbers in financial statements, will incentivize managers to introduce bias and noise into accounting measures. Building on Watts (2003), it could be stated that nowadays in the corporate world where management’s welfare depends on the firms’ performance and their financial statements, agency conflicts will occur in every organization. Agency costs are as real as any other costs (Jensen and Meckling, 1976) and ways to minimize them should be considered seriously.
This is where corporate governance is designed and implemented for in an organization, and is thus of great importance to this phenomenon. A strong, working corporate governance is able to mitigate agency problems according to numerous previous researches. Consider Core et al. (1999). They suggest that greater agency problems occur in organizations with weaker corporate governance structures. Besides that they also find evidence that organizations with greater agency problems are positively associated with the level of CEO compensation. In alignment with this, Bhojraj and Sengupta (2003) argue in their paper that corporate governance mechanisms are able to mitigate agency costs, monitoring managerial performance and reducing information asymmetry between the firm and lenders. Which will reduce the firm’s default risk.
Rees and Rodionova (2015) discuss that strong corporate governance systems are giving managers more opportunities to take the interest of stakeholders into consideration. This includes mitigating agency problems and reducing the occurrence of overpaying CEOs by monitoring the remuneration process. In addition, Berry et al. (2006) investigate the interaction
19 among several corporate governance mechanisms (e.g. inside ownership and board composition) and the compensation structure of young newly public firms. They provide evidence that when inside ownership deceases (indication of a stronger, effective corporate governance), this would evolve the alternative corporate governance mechanism to mitigate agency problems. Leventis, Dimitropoulos and Owusu-Ansah (2013) investigate the relation between corporate governance and accounting conservatism in the banking industry. They provide evidence suggesting that well-governed banks engage in significantly higher financial reporting conservatism. Subsequently, Bebchuk and Fried (2003) mention in their research, building on the managerial power theory, that executive compensation is relatively high when the corporate board is weak in comparison with the CEO.
Elaborating on existing literature, the assumption arises that the stronger corporate governance strength is, the more capable it is in mitigating agency problems and costs (in this case the expected negative relationship between earnings-based CEO compensation and accounting conservatism). So, it is predicted that corporate governance strength would weaken the effect of CEO bonus compensation on accounting conservatism. Moreover, there is a positive relation between the moderating effect of corporate governance strength on accounting conservatism. The following hypotheses can be stated:
H2: The relationship between earnings-based CEO compensation and accounting conservatism is positively moderated by corporate governance strength.……….
Thus assuming that firms with stronger corporate governance strength are better able to mitigate agency problems (Bhojraj and Sengupta, 2003; Rees and Rodionova, 2015; Leventis et al., 2013). With respect to this research; the stronger corporate governance strength, the better able they are in mitigating the (negative) effect of earnings-based compensation on accounting conservatism. Which means that the effect of the earnings-based component in a CEO compensation has a smaller impact on conservative accounting, resulting in a higher degree of conservatism.
20
3. Research design
………...
Previous chapters explored the existing literature relating to accounting conservatism, CEO compensation and corporate governance. In addition, the hypotheses related to the research question have been formulated. This chapter describes the research method and empirical model that is used to examine the hypotheses.
Research method……….
The research method used to examine the research question and hypotheses is archival research. Data is collected by using multiple databases. Information concerning earnings-based CEO compensation (bonus) is obtained from ExecuComp. Accounting conservatism data is obtained from Compustat and Datastream. Lastly, data regarding corporate governance is derived from ASSET4 ESG. The decision for database research as the methodology is due the sufficiency of data available regarding this research topic. So there is no necessity to acquire data with other methods. Besides that, using secondary data conserves much time to be used on analyzing and interpreting the data (Saunders, Lewis and Thornhill, 2009).
Dependent variable
Prior research generates several measures for accounting conservatism. Existing literature indicates that the accrual-based measure (Ahmed et al., 2002; Givoly and Hayn, 2000; Ball and Shivakumar , 2005) and market-based measure (Ahmed et al., 2002; Beaver and Ryan, 2000) are widely used. With the intention to increase the credibility of this study I adopt both proxies for conservatism.
The first measure for conservatism is the accrual-based proxy of conservatism and is expressed as CON-ACC. The measure is based on both Givoly and Hayn (2000) and Ahmed et al. (2002). They argue that the sign and magnitude of accumulated accruals over a period of time is a suitable measure for conservatism. Because accruals tend to reverse over time in which periods of positive accruals and negative accruals alternate (Givoly and Hayn, 2000). In the long run, unbiased accounting is likely to result in net accumulative accruals with a value around zero. In case of conservative reporting (biased accounting) gains and losses are acknowledged differently. Over time, the asymmetry recognition results in a persistent predominance of negative accruals (Givoly and Hayn, 2000). Subsequently, the firms’ net income falls below the cash flow from operations (Givoly and Hayn, 2000). So it could be said
21 that the degree of accounting conservatism is related to the magnitude of negative accruals. This is consistent with the view of Bissessur (2008), he explains that the asymmetric recognition of gains and losses produces asymmetric accruals. This is because future losses are fully accrued whilst future profits have a higher recognition threshold. The asymmetric recognition produces negative periodic accruals which could be an important measure for conservative reporting. This is mentioned by Bissessur (2008) as well: “a consistent predominance of negative accruals across firms over a long period is an indication of conservatism” (p. 34). Building on Ahmed et al. (2002), I use the following calculation for CON-ACC: (net income before extraordinary items plus depreciation expense less operating cash flows) deflated by average total assets. For the ease of the presentation, the measure is multiplied by -1 so that conservatism is increasing in the amount of negative accruals. This means that positive
CON-ACC values indicate conservative accounting. The higher the value, the higher degree of
conservatism found.
The second measure is the market-based proxy of conservatism and refer as CON-BTM. Beaver and Ryan (2000) mention in their research that the book-to-market ratio is a function of biased accounting recognition and lagged accounting recognition. Building on Beaver and Ryan (2000), Ahmed et al. (2002) explain that the biased accounting component of the ratio indicates the continually difference between the book and market value resulting from conservative accounting. Beaver and Ryan (2000) demonstrate that conservative reporting is related to a book value that is consistently lower than the market value. The proxy is calculated as book value divided by the market value of the firm multiplied by -1 (Ahmed et al., 2002). Higher measures for CON-BTM reflects a higher level of conservatism.
Independent variable………..
The independent variable for this study is earnings-based CEO compensation. I will measure this based on the bonus intensity of the compensation and refer it as BONUS. The proxy is calculated as the ratio of bonus components divided by the total CEO compensation. Building on the findings of Shalev et al. (2013), the managerial self-interested theory (Watts and Zimmerman, 1978; Guth and MacMillan; 1986), managerial risk-taking behavior (Kamalanabhan and Sunders, 1999; March and Shapira, 1987) and their obsession on short-term earnings (Rappaport, 2005), CEOs have an incentive to report a higher degree of earnings if this would increase their bonus compensation. Therefore it could be said that the higher the
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Moderating variable………...
Prior research provides evidence that rating and ranking companies can significantly influence the investment behavior of investors, sell-inside analysts and consumers (Ioannou and Serafeim, 2010). Independent company corporate governance scores are a valuable source of information for investors with regard to business valuation and investment decision-making. Therefore it could be said that corporate governance scores are of significant importance while different stakeholders groups are determining corporate governance performance and strength. Based on Mackenzie, Rees and Rodionova (2013) the moderating variable corporate governance strength is measured by using corporate governance scores obtained from Thomson Reuters ASSET4 ESG through Datastream and is referred to as CGSTRENGTH. Environmental, social and governance (ESG) data is available for more than 4000 global companies since the fiscal year 2002. Firms are scored by ASSET4 using ESG criteria and are normalized using z-scoring into 0%-100% score, resulting in more than 1000 data items. This includes e.g. the ESG overall scores, 4 pillar scores and 18 category scores. For this research, I focus on the overall score regarding the corporate governance pillar. Higher ASSET4 corporate governance scores, indicate a stronger corporate governance strength within an organizations.
Control variables……….
Factors that could influence the relationship between CEO bonus compensation and accounting conservatism should be explored more broadly than the impact of corporate governance strength. This section gives an overview of the control variables that are included in this research.
The first control variable is firm size (SIZE). Khan and Watts (2009) argue that the information environment of larger firms is relative richer and of higher quality compared to smaller firms. This indicates that larger firms have a lower degree of asymmetric information within their organization, resulting in a lower demand for conservative accounting. On the other hand, Khan and Watts (2009) explain that larger firms have higher litigation risks and costs. This suggest a higher conservatism demand for larger firms. Furthermore, Zmijewski and Hagerman (1981) found that size influences the accounting strategy of the firm. Besides, existing literature suggests that there is a relationship between the level of CEO compensation and firm size (Sanders and Carpenter, 1998). Therefore it is necessary to control for firm size effect.
23 The second control variable is sales growth (SALESGROWTH). Growth options are positively related with agency costs (Smith and Watts, In Khan and Watts, 2009). As a consequence firms with higher sales growth have a higher demand for conservative accounting. Furthermore, Ahmed et al. (2002) note that sales growth is expected to affect firms’ accruals and the market’s expected future growth. This is likely to influence the conservatism measure in which the firm specific market-to-book ratio is incorporated. Next to the significant influence of sales growth on accounting conservatism, Murphy (1985) finds that CEO compensation is positively related to firms’ performance as measured by sales growth. Therefore it could be said that sales growth is expected to influence accounting conservatism as well as CEO compensation.
I include leverage (LEV) as the third control variable. Watts (2003) indicates a positive relationship between leverage and conflicts of interest between shareholders and debtholders. This is due to the asymmetric risk appetite of different stakeholder groups. Furthermore, Brick, Palmon and Wald (2006) suggest a positive relation between leverage and director cash compensation. Therefore it is important to control for leverage effects.
Building on Ahmed et al. (2002), the fourth control variable is return on assets (ROA) and it is included to control for the potential cost of conservatism. Conservatism costs are accompanied by conservative reporting. Highly profitable organizations could afford conservative accounting more easily than organizations that generate lower profits. So it could be expected that organizations with higher ROA tend to use more conservative techniques in the way they report.
The fifth and last control variable is litigation risk (LITIGATIONRISK). Firms with high litigations risk probably have higher litigation cost. According to Watts (2003) organizations use conservatism to decrease their litigation cost. A dummy variable is created for firms with a high litigation risk to control for litigation risk. According to Francis, Hasan, Park and Wu (2009), firms with high litigations risk have the following SIC codes 2833–2836, 3570–3577, 7370–7374, 3600–3674, and 5200–5961. Francis et al. (2009) measure this by identifying whether an industry has a high amount of litigation incidences reported in the past. The industry classification made by Francis et al. (2009) is in line with existing literature (e.g. Lafond and Roychowdhury, 2008; Beatty, Weber and Yu, 2008)
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Empirical model………..
In order the examine the effect of CEO bonus compensation on accounting conservatism (H1)
the following model is used:……….
CONSERVATISMi2 = α0 + α1BONUSi + α2SIZEi + α3SALESGROWTHi + α4LEVi + α5ROAi
+ α6LITIGATIONRISKi + εi
The second hypothesis tests the moderating effect of corporate governance strength on the relation between CEO bonus compensation and accounting conservatism. The following regression model is used to test H2:……….
CONSERVATISMi = α0 + α1BONUSi + α2BONUSi * CGSTRENGTHi + α3CGSTRENGTHi+
α4SIZEi + α5SALESGROWTHi + α6LEVi + α7ROAi + α8LITIGATIONRISKi + εi
Definitions:
CON-ACCi = Net income before extraordinary items plus depreciation
expense less operating cash flows deflated by average total assets; multiplied by -1;
CON-BTMi = Book value divided by the market value of the firm; multiplied
by -1;
BONUSi = Bonus payments divided by total CEO compensation;
CGSTRENGTHi = ASSET4 ESG corporate governance scores;
SIZEi = The natural log of firm’s total assets;
SALESGROWTHi = The annual percentage change in firm sales;
LEVi = Firm’s long-term debt divided by total assets;
ROAi = Firm’s net income before extraordinary items divided by its
total assets;
LITIGATIONRISKi = Dummy variable (1= company with high litigation risk; 0=
otherwise);
25 A negative coefficient on BONUS (α1) suggests that there is a negative relation between the
level of CEO bonus compensation and accounting conservatism. When the result is significant, H1 is supported. Furthermore, a positive coefficient for the BONUS*CGSTRENGTH interaction (α2) suggests that the relation between CEO bonus compensation and accounting
conservatism is relatively small for higher values of corporate governance strength. Such a result would indicate that there is a positive relation between accounting conservatism and the moderating variable CGSTRENGTH. H2 is supported if the results are significant.
4. Evidence
………...4.1 Sample………
The sample consists of U.S. firms (S&P 500) for the years 2008 through 2013. I decide to focus on U.S. firms due to the enormous amount of data available and the limited time frame of this research. The research period of 2008 through 2013 is chosen because this research is motivated to investigate whether and how the current form of corporate governance has an effect on an agency problem. So I am interested in the most recent form of corporate governance. The 2008 financial crisis has intensified the focus on corporate governance mechanisms and executive remuneration systems. According to Kirkpatrick (2009), the financial crisis is an important attribute to identify corporate governance weaknesses and failures. So the 2008 financial crisis is certainly an important determinant for the changes regarding the current form of corporate governance and CEO compensation. For this reason the sample starts at 2008. Unfortunately, inclusion of the year 2014 was impossible due to the fact that corporate governance scores of that year have not yet been published by the ASSET4 ESG.
Table 1 gives an overview of firm years collected for the sample. Initially, the sample started with 3000 company years. After deleting missing values of corporate governance scores derived from ASSET4 ESG (Datastream) 2863 firm years remain in the sample. Merging data with financial data from Datastream and Compustat resulted in 2045 firm years. Subsequently including CEO compensation data from Excecucomp left 1865 firm years remaining in the sample. Above that, I exclude financial service institutions (e.g. banks, insurance companies, securities companies) from the sample, due to the circumstance that these firms’ properties differ from those of other organizations. Specifically, these are companies with SIC codes between 6000 and 6999 (Dechow and Ge, 2006). Finally, all variables have been winsorized
26 (bottom and top 1%) to avoid extreme values. Overall, this results in a total sample of 1717 firm years available for this study.
TABLE 1 Sample
Firm years
Collected firm years 3000
After deleting missing values corporate governance | Datastream 2863 After merging with financial data | Datastream & Compustat 2045 After merging with CEO compensation data | Execucomp 1865 After deleting financial institutions 1717 Total firm years for sample 1717
4.2 Descriptive statistics……….
Table 2 shows the industry distribution of the sample based on 4-digit SIC codes. With 52.2 percent, manufacturing is the largest industry in the sample, followed by transportation and public utilities with 16.1 percent. Mining and construction has the smallest amount of observations with 5.5 percent. There are no observation for the industries agriculture, forestry and fishing and the public administration.
TABLE 2
Observations per industry
Industry SIC Observations %
Agriculture, Forestry and Fishing 0100 – 0999 0 0%
Mining and Construction 1000 – 1999 94 5.5%
Manufacturing 2000 – 3999 896 52.2%
Transportation and Public Utilities 4000 – 4999 277 16.1% Wholesale Trade and Retail Trade 5000 – 5999 211 12.3%
Services 7000 – 8999 239 13.9%
Public Administration 9000 – 9999 0 0%
27 The descriptive statistics of all variables are summarized in table 33. The CON-ACC measure
for accounting conservatism has a positive mean value (.022). This is in line with Ahmed et al. (2002). A positive mean value of CON-ACC gives an indication of conservative accounting. The mean value of CON-BTM is negative (-.399) indicates conservatism. The lower the negative amount, the higher the degree conservatism is found. So both conservatism measures
CON-ACC and CON-BTM find accounting conservatism in the sample.
TABLE 3
Descriptive Statistics
Variable Mean Median Std. Dev. Minimum Maximum
CON-ACC .022 .017 .047 -.096 .246 CON-BTM -.399 -.345 .274 -1.363 .180 BONUS .024 .000 .074 .000 .440 CGSTRENGTH 79.210 82.690 13.888 27.860 96.080 SIZE 23.160 23.039 1.141 20.960 26.250 SALESGROWTH .074 .060 .016 -.357 .675 LEV .226 .212 .154 .000 .750 ROA .076 .070 .068 -.167 .284 LITIGATIONRISK .260 .000 .441 .000 1.000
The average bonus component related to total CEO compensation is 2.4 percent. This is relatively low and could be explained by the large number of years in which the bonus granted to the CEO was 0, decreasing the average rate in the sample. On a scale from 0-100 the average corporate governance strength of the sample is 79.210. This indicates that the sample consists of firms with a relatively strong corporate governance. The average sales growth per year is around 7.4 percent and the average return on assets in 7.6 percent. The sample labels 26 percent of the observations as firms with high litigation risk.………..
The 2-tailed Pearson correlation matrix of the variables is reported in table 4. The correlation matrix is a very useful method to check for multicollinearity in the data during a preliminary stage, where correlations of >.9 indicate multicollinearity (Field, 2000). Given the information
28 in table 4 all correlation values are below the threshold of >.9. This suggest that there is no multicollinearity in the data.
CON-ACC and CON-BTM are negatively correlated, however the relation is not
significant. Continuing with the correlation between the independent variable BONUS and dependent variable CONSERVATISM. BONUS is positively correlated with CON-ACC, however the relation is insignificant. In contrast, BONUS is negatively correlated with
CON-BTM with a significance level of 0.01. This is in line with my first hypothesis that suggests a
negative relationship between the bonus component in the total CEO compensation and conservative reporting. CGSTRENGTH is negatively correlated with CON-ACC (significant at the 0.01 level), CON-BTM (significant at the 0.05 level) and BONUS (significant at the 0.01 level). The negative relation between corporate governance strength and bonus is in line with expectations. A strong corporate governance would limit the possibility of CEOs receiving an extensive bonus size. However, the negative correlation between CGSTRENGTH and both conservatism measures CON-ACC and CON-BTM contradicts my expectations. It was expected that a strong corporate governance would stimulate conservative reporting, as it is often seen as a desired outcome.
The moderating variable BONUS*CGSTRENGTH is negatively correlated with both
CON-ACC (not significant) and CON-BTM (not significant). Concluding, LITIGATIONRISK is
highly positively correlated with both CON-ACC and CON-BTM at a significance level of 0.01. This result agrees with the expectation which is built on Watts (2003) that firms with high litigation risk have an greater incentive to report conservative amounts in their financial reports to reduce litigation cost.
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4.3 Accounting conservatism and CEO bonus compensation………..
The relationship between CEO bonus compensation and accounting conservatism (H1) is analyzed in twofold. First with an accrual-based measure (CON-ACC) for conservatism and secondly with a market-based measure (CON-BTM).
To start, the results of the CON-ACC measure are reported in table 5. Two multiple linear regressions are performed and labeled as model І and model ІІ. The first model contains only control variables, the second model includes the independent variable BONUS.
TABLE 5
Regression of the accounting conservatism measure CON-ACC on CEO bonus compensation
Expectations Model І Model ІІ B Beta Sig. B Beta Sig.
Intercept ? .222 (.000)*** .227 (.000)*** BONUS (-) .002 .046 (.031)** Control variables SIZE (+/-) -.008 -.184 (.000)*** -.008 -.189 (.000)*** SALESGROWTH (+) .000 -.043 (.047)** .000 -.043 (.046)** LEV ? -.010 -.032 (.150) -.010 -.031 (.162) ROA (+) -.344 -.492 (.000)*** -.343 -.491 (.000)*** LITIGATIONRISK (+) .020 .184 (.000)*** .020 .185 (.000)*** R2 .241 .243
Research timeline is 2008 through 2013. Total numbers of firm year observations for accounting conservatism measures are 1.717. */**/*** Significant at 0.10/0.05/0.01 level
CON-ACCi = α0 + α1BONUSi + α2SIZEi + α3SALESGROWTHi + α4LEVi + α5ROAi + α6LITIGATIONRISKi + εi; BONUSi= Bonus payments divided by total CEO compensation; SIZEi = The natural log of firm’s total assets; SALESGROWTHi = The annual percentage change in firm sales; LEVi = Firm’s long-term debt divided by total assets; ROAi = Firm’s net income before extraordinary items divided by its total assets; LITIGATIONRISKi = Dummy variable (1= company with high litigation risk; 0= otherwise).
The R2 of the first model is .241 indicating that around 24 percent of the variance of CON-ACC is explained by the control variables. In the second model, adding the variable BONUS improves the R2 slightly to .243. This means that model ІІ is related to the accrual-based measure for
31 conservative accounting more strongly than model І. However, adding the independent variable to the model only increases the R2 by 0.2 percent (R2-change).
The unstandardized coefficient (B) of the independent variable BONUS is positive and significant at the 0.05 level. This implies that an increase in CEO bonus in relation to the total compensation may lead to a small increase in accounting conservatism (measure with accrual-based measure). This is contrary to the expectations whereby a negative relationship is predicted. For both models the unstandardized coefficient of company size (SIZE) is negative and significant at the level 0.01. So strong evidence is found that an increase in firm size would lead to a decrease in accounting conservatism. This is in line with Khan and Watts (2009), they argue that larger firms have an information environment that is of higher quality in relation to smaller firms. These firms probably have a lower degree of asymmetric information and thus a lower demand for conservatism.
In both model І and model ІІ the unstandardized coefficient of leverage is negative but not significant. In addition, existing literature does not indicate a specific direction regarding the relation between conservatism and leverage. However the empirical model controls for leverage due to earlier findings. First of all, Watts (2003) indicates that there is a positive relation between leverage and conflicts of interest between shareholders and debtholders. Secondly, Brick et al. (2006) provide evidence of a positive relation between leverage and director cash compensation.
Subsequently, both models have negative unstandardized coefficients for the ROA variable and they are significant at the 0.01 level. The result contradicts the argument of Ahmed et al. (2002). They believe that firms with higher profitability are better able to deal with the potential cost of conservative accounting. So firms with higher return on asset could better afford the cost accompanied with conservative reporting. Besides, there is strong evidence that
LITIGATIONRISK is positively related to accounting conservatism. In both models the
unstandardized coefficients are .020 with a significance level of 0.01. This is in accordance with expectations and arguments by Watts (2003), that litigation risk is an incentive for firms to report conservative numbers in their annual report. Furthermore, comparing the standardized coefficient (β) of the independent variables with a significant relation it could be stated the ROA (β=-.491) has the strongest influence and SALESGROWTH (β=-.043) has the weakest influence on CON-ACC.
To highlight the most important results of table 5, including the independent BONUS variable in the model gives an R2 of .243. This means that the movement in CON-ACC could
32 be explained with 24.3 percent by model ІІ. Above that, there is no support found for H1 with the accrual-based measure for conservatism. This is in line with the results of the Pearson correlation matrix that imply a significant positive relationship between BONUS and
CON-ACC, instead of the expected negative relationship outlined in H1.
The second test performed to examine hypothesis 1 includes the market-based measure
CON-BTM for accounting conservatism. The results are outlined in table 6. Corresponding with the
first test, two regressions are conducted. The first regression contains the control variables, the second regression adds the independent variable BONUS to the model.
TABLE 6
Regression of the accounting conservatism measure CON-BTM on CEO bonus compensation
Expectations Model І Model ІІ B Beta Sig. B Beta Sig.
Intercept ? .291 (.015)** .279 (.021)** BONUS (-) -.006 -.022 (.270) Control variables SIZE (+/-) -.041 -.170 (.000)*** -.040 -.168 (.000)*** SALESGROWTH (+) .000 -.022 (.289) .000 -.022 (.289) LEV ? .443 .248 (.000)*** .442 .248 (.000)*** ROA (+) 1.898 .468 (.000)*** 1.895 .467 (.000)*** LITIGATIONRISK (+) .058 .093 (.000)*** .058 .093 (.000)*** R2 .296 .297
Research timeline is 2008 through 2013. Total numbers of firm year observations for accounting conservatism measures are 1.717. */**/*** Significant at 0.10/0.05/0.01 level
CON-BTMi = α0 + α1BONUSi + α2SIZEi + α3SALESGROWTHi + α4LEVi + α5ROAi + α6LITIGATIONRISKi + εi; BONUSi = Bonus payments divided by total CEO compensation; SIZEi = The natural log of firm’s total assets; SALESGROWTHi = The annual percentage change in firm sales; LEVi = Firm’s long-term debt divided by total assets; ROAi = Firm’s net income before extraordinary items divided by its total assets; LITIGATIONRISKi = Dummy variable (1= company with high litigation risk; 0= otherwise).
