January 21, 2015
Study: CEO Pay Cuts Lead to Earnings Manipulation
– Broc Romanek, CompensationStandards.com
This article from “Accounting Today” illustrates the need for the compensation risk assessment required by the SEC since December 2009:
Slashing a CEO’s compensation after a company produces disappointing financial results may help improve earnings for a time, but it can also encourage earnings manipulation, according to a new study. The study, which was presented at last month’s annual meeting of the American Accounting Association, acknowledged that some prior academic research has found company performance to improve when boards of directors cut CEO remuneration, but found the improvement could stem from financial and managerial manipulations as opposed to solid gains. “In the year following a pay cut, CEOs are more likely to engage in earnings management because it will lead to a faster improvement in the reported performance and a speedier restoration of CEO pay to earlier levels,” said the study, co-authored by accounting professors Gerald J. Lobo of the University of Houston, Hariom Manchiraju of the Indian School of Business in Hyderabad and Sri S. Sridharan of Northwestern University.
For the most part, the tactic works, the researchers found, noting that “the board does not punish manipulative activities sufficiently,” despite the fact that CEO earnings management “impos[es] significant agency costs on the firm in terms of both lower market returns and diminished operating performance…in the longer term.” Researchers attributed the board failure to the CEO’s dominant influence on the pay-setting process. “The CEO accepts a cut in the wake of poor performance to placate stakeholders and subsequently, when the firm’s performance improves (though via earnings management), the CEO’s pay is restored to earlier levels, thereby avoiding negative publicity and scrutiny,” said the study.
The CEO’s pay is frequently restored the following year to nearly the same level as it was prior to the cut. The median pay cut in the study was 42.2 percent, while the median compensation rise the following year was 40 percent. “Certainly the issue of CEO pay cuts is a tricky one for investors,” Lobo said in a statement. “On the one hand, they welcome slashing CEO pay in response to inferior company performance and hope this will light a fire under the CEO. On the other hand, they need to be on the alert for the kind of manipulation our study uncovers.”
A good rule of thumb recommended by the researchers is to be particularly wary of CEO pay cuts at companies where institutional investment is low, especially where there are CEO-friendly governance mechanisms such as poison pills, golden parachutes, and rules that diminish board power over the CEO. “We find that a high level of institutional investment tends to constrain earnings management following pay cuts, while a high degree of CEO entrenchment tends to foster it,” said Lobo.
To produce the study, the researchers drew on a database of executive compensation and examined an 18-year period up through 2011. They analyzed data on 1,330 single-year cuts of 25 percent or more in CEO pay (including salary, bonuses, long-term incentive plans, and stock and option awards) and compared the performance of companies where there were CEO pay cuts with companies constituting the study’s control group. In analyzing the corporate financial reports, the researchers focused on two types of earnings manipulation. The first category consisted of what “discretionary accruals”—that is, non-cash accounting items that typically entail some element of guesswork, such as predictions of future write-offs for bad debts or estimates of inventory valuations. Companies that cut CEO pay reported discretionary accruals that were 2.33 times greater than those of companies in the control group, a level suggestive of earnings manipulation.
The second category consisted of company operations designed to produce a short-term boost in corporate income. The authors specifically looked for three factors: 1) acceleration of sales through price discounts, 2) overproduction of goods to lower the manufacturing cost per unit, and 3) reduction of outlays for research and development, advertising and other discretionary expenses.
Companies that slashed CEO compensation experienced an increase in reported financial performance the following year, both in terms of stock gains and bottom-line returns on assets.
Median share prices rose at a market-adjusted rate of 1.1 percent, a marked improvement over negative returns totaling about 18 percent in the two previous years. Meanwhile, the return on assets rose to about 5.7 percent, which represented about a 50 percent increase over the average for the previous two years and matched the profit margin of companies in the control group.
Yet when the researchers took into account abnormal accruals and real-activities manipulation, the profit picture changed markedly. Without these earnings boosts, the median return on assets fell to 0.3 percent among the companies that slashed CEO pay, compared to approximately 5.3 percent among those that did not. The fact that the profit ratio shrunk nearly 100 percent in the first group, and only 10 percent in the second group, suggested the considerable amount of earnings manipulation occurring in the companies where there were CEO pay cuts. Professor Manchiraju estimated that over one-third of the companies where there were CEO pay cuts would have needed to report their bottom-line losses, were it not for the lifts they received from earnings manipulation.
In terms of whether the stock market is aware of what is happening, the study found that investors do seem to respond negatively to the high level of accruals in the pay-cut companies, but not to their operational manipulations. In any event, investors who shun these companies proved wise in doing so, as the earnings management occasioned by the CEO’s pay cut led on average to a decline in the industry-adjusted return on assets beyond the first year after the pay cut.