Asset Write Downs and Executive Compensation Liu-Ching Tsai Professor, National Chia-Yi University Chaur-Shiuh Young Professor, National Cheng Kung University Hui-Wen Hsu Ph. D. Student, National Cheng Kung University
Outline Background and Motivation Research Questions Contribution Hypothesis Development Research Method Empirical Results Conclusion
The influential factors : • reflecting economic essence (Rees et al., 1996). • a tool of earnings management (Zucca and Campbell 1992). • Economic effects from stock return: • negative market reactions (Bens et al. 2011) • positive market reactions (Strong and Meyer 1987) There have been a lot of literature examine the incentives and effects of asset write-down decisions. Background and Motivation-literature on asset write-down decisions From external perspectives, investors may have to take more information into account in accessing the nature of a write-down.
Background and Motivation-the role of the compensation committee • From internal management perspectives, the role of the assets write down in CEO compensation is unknown. • Given the debate that the earnings based incentive leads to managerial myopic investments or opportunistic earnings manipulating • The compensation committee look beyond the reported earnings and shield compensation from specific earnings components • Loss (Gaver and Gaver 1998) • restructuring charges (Adut et al. 2003; Dechow et al. 1994) • R&D and advertising expenditures (Duru et al. 2002)
Background and Motivation • A write-down decision • endowed with managerial discretion • when and how much to write down an asset (Hilton and O'Brien, 2009). • has a substantial negative impact on current earnings and in turn on earnings-based executive compensation. How a firm’s asset write-down is treated in earnings-based compensation design
reduces managers’ incentives to overstate earnings ( Watts, 2003). Research Questions 1 A firm’s long-lived asset is required to be written down to the fair value when it is less than the carrying value. Timely loss recognition: mitigating deadweight losses (Ahmed et al., 2002). monitoring firms’ investment policies (Ball, 2001). Whether the board of directors shields executive compensation from write-down loss.
Although the optimal contracting view posits that the board, working in shareholders’ interest, provides the optimal, cost-effective incentives Bebchuk and Fried (2003) suggest that directors’ behavior is also subject to an agency problem, which may undermine the effectiveness of incentive design. Evidences find that CEOs earn greater compensation when governance structures are less effective (Core et al. 1999; Hawkins 2006; Strier 2010). Research Questions 2
The managers may use their power over the board to shield their own pay from the effects of asset write-downs. Bebchuk and Fried (2003) argue that managerial power have an important influence on CEO compensation arrangements. Gaver and Gaver (1998) find that CEO cash compensation is shielded from the effects of above the line losses which may reflect managerial entrenchment. Research Questions 2 Whether the shielding effect varies with managerial power.
Hypothesis 1 From optimal contracting view • helps firms enhance efficient risk-sharing • motivate timely recognition of write-downs (Dechow et al. 1994). However, it can driven by managerial entrenchment the optimal contracting view may not be the most relevant explanation (Main 2005). managers may use their power over the board Hypothesis 1: Compensation committees adjust earnings specified in incentive contracts to shield CEOs from the income-decreasing effects of asset write-downs.
Hypothesis 2 the managerial power is related to several attributes of compensation designs • higher executive compensation (Choe et al. 2009; Chen et al. 2010) pay for luck (Bertrand & Mullainathan, 2001) higher compensation weights on accounting performance measures relative to on market based measures (e.g., Davila and Penalva 2006). H2: The less sensitivity of CEO compensation to asset write downs is more pronounced in firms with higher managerial power.
Research Design Sample period : firms that reported asset write-downs in 2004 and 2005. The following restrictions on the sample are imposed: (1) if the CEO was not in office for the entire current and previous year; (2) firms with substantial events; (3) firms with incomplete compensation data; (4) firms with missing CEO tenure data; (5) firms with insufficient financial and market value data. The final sample was composed of 302 firms.
positive value of income before write-downs loss in year t, zero otherwise. Hypothesis 1: Compensation committees adjust earnings specified in incentive contracts to shield CEOs from the income-decreasing effects of asset write-downs. firm i's reported asset write-downs in year t, divided by total assets at the end of t-l. negative value of income before asset write-downs loss in year t, zero otherwise; the natural log of CEO base salary plus cash reward, special allowances and bonus
Hypothesis 2: More powerful CEOs experience a larger degree of compensation shielding from the income-decreasing effect of asset write-downs. . CEO_HOLD β5: captures the differential impact for most powerful CEOs. CEO_FAM, DUALITY β5<0
Results for hypothesis one Hypothesis one is supported α1 α3 compensation committees fully shield CEO compensation from the effect of asset write-downs.
Results for hypothesis two Hypothesis two is supported β 1 β 3 0.0055-0.126=-0.121 β 5 shielding executive annual pay from losses reflects managerial entrenchment.
Hypothesis two is supported again Compensation committees fully shield compensation from asset write-downs for CEOs who have higher shareholding, are also one of family members and are also in the position of chairman. Results for hypothesis two γ 1 γ 3 0.106-0.172=-0.066 0.106-0.127=-0.021 0.106-0.143=-0.037 γ 7 γ 8 γ 9
Sensitivity Analysis- The Effect of Write-down quality on the Shielding of CEO Compensation • The recognition of assets write-downs has an ambiguous economic nature. • Therefore, we conduct additional analyses to test the shielding effect conditioned on write-down quality. • Following Balsam et al. (2009), we employ the cumulated abnormal return (CAR) upon the asset write-downs announcement (Table 10) • Following Riedl (2004), we use “big bath” reporting and “earnings smoothing” reporting as proxies for earnings management incentives (Table 11)
Table 10 The Relation between Asset Write-downs Quality and CEO Compensation-Using Cumulated Abnormal Returns (CAR) to Partition the Sample the boards shield compensation of high-power CEO from low-quality asset write-downs, while do not shield that of low-power CEO, implying the shielding being related to the exert of managerial power. τ 1 CEO compensation is shielded from high quality write-downs regardless of CEO power. τ 3 0.088-0.234=-0.146 τ 5 -0.041-0.136=-0.177
Table 11 The Relation between Asset Write-downs Quality and CEO Compensation-Using Earnings Management Incentives to Partition the Sample the shielding is primarily attributed to the managerial power, with a weak support for optimal compensating purpose. τ’1 τ ’1 0.020-0.138=-0.118 τ’1 -0.077-0.071=-0.148
Sensitivity Analysis- Simultaneity Considerations The results we discussed above suggest that managerial power is significantly and positively associated with the degree of shielding. However, managerial power and CEO compensation shielding in our models are likely determined simultaneously (Berger et al. 1997; Cheng, 2003), making it difficult to determine cause-and-effect relations from estimated regression coefficients. First, we follow Klein (1998) and Weir et al. (2002) to introduce a lagged dependent variable into the model (Table 12). Second, we follow Berger et al. (1997) and Cheng (2003) to replace dependent variable (LN(COMP)) and main independent variables (POS_INC, NEG_INC, WOTA and POWER) in our models by their corresponding changes (Table 13).
Table 12 Results for Including Lagged Dependent Variable η1 η3 -0.008-0.086=-0.094 η5
Table 13 Results for Using Changes Model λ 1 the results reported in table 12 and table 13 are robust to the simultaneity considerations. λ 3 0.19-0.214=-0.024 0.277-0.271=0.006 λ 5
The Relationship between the Degree of CEO Compensation Shielded from Write-downs and Subsequent Firm Performance First, we perform OLS regressions on equation (1) andcalculate the coefficient difference between WOTA and POS_INC to measure the compensation weight adjustment for shielding. Next, we calculate the shielded amount of CEO compensation (SHIELD_COMP) using the following equation: Third, to examine the relationship between the shielded amount of CEO compensation and subsequent firm performance, we develop the following equation:
Table 14 The Relation between the Shielding Amount of CEO Compensation and Subsequent Firm Performance
Conclusion The existence of shielding executive compensation from asset write-downs and the shielding behavior of asset write-downs increases with managerial power. We find a significantly negative relationship between the shielding and subsequent market performance. Our evidence shows that the shielding driven by managerial power is favorable to executives and causes harm to firm performance, manifesting a suboptimal contract for shareholders.
Contribution Based on the internal management perspective adds to the related literature by stressing the role of a write down in contracting and performance evaluation. Adds to a growing line of work documenting managerial power as an important factor of CEO pay
Suggestion • Consider the role of audit committee in the compensation arrangements.