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Review of Accounting Studies

Erschienen in:

07.10.2022

Is conservatism demanded by performance measurement in compensation contracts? Evidence from earnings measures used in bonus formulas

verfasst von: Ke Na, Ivy Xiying Zhang, Yong Zhang

Erschienen in: Review of Accounting Studies | Ausgabe 1/2024

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Abstract

We explore the informational properties of earnings that compensation contracting requires for performance measurement. While conditional conservatism could be desirable because it can help to alleviate agency conflicts, its downside relates to the trade-off between conservatism and other important properties, such as persistence. We infer boards’ performance measurement preferences from a novel dataset of earnings realizations used to calculate executive bonus payouts (which we label compensation earnings), which can be either GAAP or non-GAAP. On average, compensation earnings do not exhibit any conditional conservatism in the full sample. The lack of conservatism holds even in subsamples with strong corporate governance and subsamples with high ex ante agency costs, suggesting optimal contract design rather than opportunism. Finally, our analyses indicate that compensation earnings are more persistent and informative than GAAP earnings. Overall our results suggest that boards trade off conservatism for other properties in measuring performance for executive compensation.

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Throughout the paper, we use “conditional conservatism” and “conservatism” interchangeably.

This view is important to accounting standard setting because, when combined with the assumption that it is cost-effective for firms to use GAAP earnings for compensation performance measurement, the demand for conservatism from compensation contracting leads to the conclusion that GAAP earnings need to be conservative (Kothari et al. 2010).

For example, in discussing the performance measurement for bonus payouts, Supervalu Inc. states in its 2011 proxy statement: “The Committee may exclude all or a portion of both the positive or negative effect of external events that are outside the control of our executives, such as natural disasters, litigation or changes in accounting or taxation standards.” Source: https://www.sec.gov/Archives/edgar/data/95521/000104746912006444/a2209805zdef14a.htm.

A recent study by Durney et al. (2021) makes a similar argument regarding controllability and performance measures. The authors find that segment earnings exclude items that are beyond the control of segment managers, even when these items could affect segments’ ability to generate revenues.

The Securities and Exchange Commission (SEC) requires firms to disclose compensation earnings under the mandatory disclosure requirement of Rule 33-8732A for all material factors underlying compensation decisions.

We use “exclusions,” “adjustments,” and “differences between GAAP earnings and compensation earnings” interchangeably to refer to GAAP earnings minus compensation earnings, including cases where the difference is zero.

Several other studies, such as by Curtis et al. (2021), Black et al. (2021), Potepa (2020), and Guest et al. (2020), also examine the use of non-GAAP performance measures in bonus contracts. However, while there is evidence that non-GAAP earnings are consistently higher than GAAP earnings, suggesting that compensation earnings are less conservative, direct evidence on the extent of conditional conservatism in compensation earnings is lacking.

Black et al. (2021) find that non-GAAP EPS is of higher quality for investors when disclosed in both the annual earnings announcement and the proxy statement. They conduct a search of non-GAAP keywords to identify a sample of firms that use non-GAAP EPS in compensation contracting. By sample construction, the analysis of Black et al. is conditional on the use of non-GAAP EPS in compensation contracting. In contrast, our sample selection is not conditional on the use of non-GAAP earnings in compensation contracts; using a large comprehensive sample containing all earnings performance measures in compensation contracts, we provide evidence on the average informational properties of all earnings performance measures (both GAAP and non-GAAP, and not limited to EPS) in compensation contracts.

Kwon et al. (2001) show theoretically that, in a limited liability setting, in which penalties that can be imposed on agents are restricted, conservative performance measures arise to efficiently motivate managers.

Consistent with his argument, Lambert observes anecdotally that, in constructing the accounting performance measure for compensation purposes, firms sometimes remove the effects of restructurings or write-downs, which could undo the result of conservatism being applied in GAAP accounting.

Relatedly, Bushman et al. (2006) and Banker et al. (2009) find a positive association between the stewardship and valuation roles of accounting. Bushman et al. propose a theoretical explanation: as managerial actions have multiperiod effects that are not fully captured in current earnings, valuation earnings coefficient is included in the incentive coefficient to motivate the manager to internalize the discounted all-in value effect of current period action. A plausible mechanism for this is for performance measurement to focus on the relatively persistent (recurring) components of earnings.

The SEC rule 33-8732A, which requires expanded disclosure on executive compensation, applies to all proxy statements filed on or after December 15, 2006. However, studies suggest that disclosure is less detailed at the initial years of compliance (Robinson et al. 2011). To minimize potential sample selection issues, we start our sample in 2008.

This requirement eliminates observations where no detailed information regarding performance measures is disclosed and observations where only nonfinancial performance measures or non-earnings financial performance measures (e.g., revenue or cash flow) are used in bonus contracts.

We exclude observations in this step either because there is no disclosure of compensation earnings, or there is disclosure but (1) the performance measure is return on invested capital, where the definition of invested capital is usually not specified and the corresponding earnings figure cannot be determined, or (2) the performance measure is based on growth from the previous year, which cannot be converted to earnings without the value of previous year’s earnings used in the calculation, or (3) the performance measure is defined as performance relative to a peer group.

Excluding these observations does not affect our inferences.

For example, for observations using EBT, EBIT, or EBITDA as compensation earnings, we add back taxes, interests, and depreciation and amortization when applicable and find that the absolute difference between the resulting numbers and GAAP earnings still amounts to 1.4% of total assets at the median.

For performance measures that are on a per share basis (earnings per share and diluted earnings per share) or in ratios (return on assets and return on equity), we convert the realized performance to a dollar amount so that they are comparable to each other and comparable to GAAP earnings.

Using data collected from proxy statements of S&P 1500 firms in 2013, Curtis et al. (2021) also find that earnings per share and operating income are the most commonly used performance metrics in bonus plans.

Ederhof (2010) find 234 of these cases using a keyword search of Forms 8-K and proxy statements in Lexis/Nexis between August 23, 2004, and September 20, 2006.

Previous compensation studies (e.g., Leone et al. 2006) typically use the year-to-year change in ROA in explaining bonus payout, which effectively treats prior year’s earnings (ROA) as the performance expectation, under the assumption of a random walk in annual earnings. In untabulated analyses, we replace the independent variables with their changes from year t-1 to year t and obtain similar results.

Patatoukas and Thomas (2011) suggest that the asymmetric timeliness measure by Basu (1997) contains a bias that is attributable to scale effects. In our setting, this type of scale-induced bias likely applies both to the estimation using GAAP earnings and that using compensation earnings. Since our inference is based on the contrast of the asymmetric timeliness between GAAP earnings and compensation earnings, it is subject less to the concern raised by Patatoukas and Thomas. Ball et al. (2013) characterize the issue identified by Patatoukas and Thomas as a correlated omitted variable problem and suggest that it can be addressed using firm fixed effects. In untabulated analysis, we follow Ball et al. and control for firm fixed effects. Our inferences are unchanged.

In their composite corporate governance measure, García Lara et al. include another variable, the number of board meetings. Execucomp has stopped providing this variable in our sample period. In untabulated analyses, we include in the composite corporate governance index the value of this variable from 2005, which is the last year Execucomp reported this data item, and obtain similar results.

In untabulated analyses, we also construct an alternative aggregate governance measure by summing up the percentile ranking of governance variables and obtain the same inferences. Analyses with subsamples that are partitioned on each of the individual governance measures yield the same inferences.

We report only the coefficient estimates on RETURN × D (i.e., conservatism estimate or Basu coefficient) for brevity.

Specifically, we do not include RET and ROA as control variables because they are already used as main explanatory variables in these tests. In Table 4 compensation regressions, we do not have EXPECT_COMP and EXCESS_COMP as control variables because compensation is the dependent variable. In the Tables 5 and 6 Basu regressions, we do not include STDRET and SPREAD as control variables because they are strongly correlated with the variable of interest RETURN × D (with significant correlation coefficients at −47% and -23%, respectively), impeding interpretation of the Basu coefficient. Including these two variables frequently results in an insignificant Basu coefficient when GAAP earnings are the dependent variable.

In untabulated analyses, we scale all variables by the market value of equity and obtain similar results.

The sample size is reduced by about 23%, compared to that in Panel A of Table 5, due to the requirement of two consecutive years’ compensation earnings and GAAP earnings.

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Titel: Is conservatism demanded by performance measurement in compensation contracts? Evidence from earnings measures used in bonus formulas
verfasst von: Ke Na
Ivy Xiying Zhang
Yong Zhang
Publikationsdatum: 07.10.2022
Verlag: Springer US
Erschienen in: Review of Accounting Studies / Ausgabe 1/2024
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-022-09729-6

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