Download Discussion of “The relation between executive

Discussion of
“CEO compensation and fair value
accounting: Evidence from purchase
price allocation”
Daniel A. Cohen
CAPANA Conference
Chengdu, July 2 2010
General Comments
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Primary Contribution:
Provide evidence that CEO bonuses leads to overstatement of
goodwill
Interesting research question, well motivated paper
Timely and relevant topic – fair value accounting debate
Overall, well written and articulated
Main points:
Research design issues and its implications for inferences and
conclusions drawn
Relation to prior research and potential contribution to existing
literature
The Purchase Price Allocation (Shalev, TAR 2009)
Purchase Price
Accounting Treatment
Goodwill,
55.4%
Intangible
Assets
Separate
from
Goodwill
Not Subject to Amortization.
Subject to a Mandatory Annual
Impairment Test
Indefinite-Life, 4% (Trademarks)
Finite-Life, 20%
(Patents, Technology)
In-Process R&D, 4.6%
Net Tangible Assets,
16%
Amortized over Economic
Useful Life
Written-off at Acquisition
Restated to Fair Value
Assumed Relationship between executive
compensation and accounting choices
Executive
Compensation:
BONUS
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Accounting
Choices
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Causality: a complex theoretical setting
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Incentives  Accounting Choices  Private Benefits:
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Goodwill
Allocation
BONUS = F (AC, Performance, X);
AC = G (BONUS, Incentive-based Comp., Performance, X)
COMPENSATION MIX = Y (Incentives, Reporting costs, Performance, X)
“In this study we investigate the effects of the above aspects of compensation on
managerial accounting choices.”
versus
The effect of accounting choices (which are subject to managerial manipulation) on
CEO compensation.
Design of Executive Compensation Packages
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Compensation contracts are quite complex
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Different components will affect accounting choices in different
ways
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Cash salary and bonus, options grants (existing and current), restricted
stocks and long-term incentives plans
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If components of total compensation have different risk and
incentive profiles, empirical analysis of compensation-decision
making relations must consider the interplay between the different
components.
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Can we expect that the recent reforms (e.g., SOX 2002, SFAS
123R) may alter the overall compensation mix in addition to
changes in bonus payments:
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Microsoft, July 2003: discontinue granting stock options and replace such
plans with restricted stock.
Compensation Design, contd’
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Compensation package is a function of numerous
variables (Carter, Lynch and Tuna, 2007):
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Incentive levels
Financial reporting costs
Size
Performance
Risk-aversion
Substitution effect between different components:
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Stock options vs. restricted stocks
Weights on stock price and accounting based components
Industry peers, competitors
Bonus Contracts and Earnings Components
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The bonus contracts are not explicitly observed
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As in Balsam (1998), earnings components are not
distinguished ex ante.
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No guidance provided concerning the expected weights on
earnings components in the compensation mix function (see
Gaver, 1998).
Earnings components are measured with error,
partitioning between cash flows, nondiscretionary and
discretionary accruals is not observed:
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Interpretation of results is difficult:
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Efficient contracting vs. reflection of measurement error
What does the proxy statement reveal?
A few points are in order
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How are the CEO performance targets set?
 Annually vs. other periods? Short term vs. long term plans
 How does the acquisition affect the performance targets in place given the
effect on reported earnings?
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Numerous performance measures
 Emphasis on peer performance
 Are the industry fixed effects included in testing H1 and H2 (2-digit
SIC) capturing the richness and importance of this significant issue?
 INDSAME variable in equation (2)?
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Emphasize more the use of cash-based measures versus earnings.
 Implication for discretion/flexibility in financial reporting
 Relates to recent regulation (e.g., SOX – see Carter et al., 2007)
Compensation, contd’
Compensation Over Time, 1992-2004
0.5
0.45
0.4
Compensation
0.35
0.3
SALARY
0.25
BONUS
OPTION
0.2
0.15
0.1
0.05
0
1992
1993
1994
1995
1996
1997
1998
Year
1999
2000
2001
2002
2003
2004
Research design: measurement issues and
control variables
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Equation 1: what if bonus equals to zero?
 Use the log of (salary and bonus)
BONUS = average over three years (footnote 13)
 Includes the year of acquisition – mechanical relation
 CEOs receive larger bonuses after completing M&A deals:
 Grinstein and Hribar (2004, JFE)
 Changes in bonus over time
Measuring Goodwill – Focus only on abnormal goodwill?
Scaling of variables
Include equity-based incentives variable
 Stock options, restricted stock, etc.
 BONUS is only 19% of total compensation.
Research design: choice variables and sequence of events
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Numerous choices/decisions are made by the firm
 Design of compensation contracts
 Investment strategies: M&A deals. How much to pay for the target?
Is the compensation contract pre-determined before the acquisition? As a
response to the acquisition?
 Heckman model uses three variables: Size, B/M, and long term analyst
forecasts
Control for performance (accounting and stock returns)
 During the period that compensation is measured and goodwill allocated
Is the overall amount paid for the target company a function of the
compensation structure in place?
 Prior research examining investments and compensation will argue - yes.
Future impairments – LACK_SLACK is included as a control variable
 Goodwill impairments have first order effect on compensation through
earnings (Beatty and Weber,2006)
Understanding the determinants of bonuses –
research design implications
Relation to prior research
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Compensation contracts and investments
 Grinstein and Hribar (2004, JFE): investigate CEO compensation
for completing M&A deals. More powerful CEOs get larger
bonuses. Any implication for future impairments?
 Bizjak et al. (1993, JAE): stock-based incentive compensation and
investment behavior
 Kang et al. (2006, JB): estimate jointly the relationship between
investments and CEO incentive compensation structure while
considering the strength of the corporate governance mechanisms
Other related papers:
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Aboody et al. (1999, JAE): pooling versus purchase acquisitions.
 In acquisitions with large step-ups to targets’ net assets, CEO with earningsbased compensation are preferring pooling to avoid the earnings ‘penalty’
Carter et al. (2007, RAST)
Food for Thought…
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Complexity of compensation contracts
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How to differentiate between the incentive vs. measurement
explanations of the relation between accounting choices,
investment opportunities/economic conditions and compensation
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Importance of goodwill allocation as an overall component of
firms’ investment strategies (especially, M&A).
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The ‘Ceteris Paribus’ assumption: holding constant….
Summary
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Overall, an interesting and well written study.
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The paper addresses a relevant, timely and important issue.
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Potential for contribution – emphasis on the importance of
cash flows measures in compensation mix.
Thank you!
谢谢