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Review of Accounting Studies

Erschienen in:

01.12.2006

Governance structure and the weighting of performance measures in CEO compensation

verfasst von: Antonio Davila, Fernando Penalva

Erschienen in: Review of Accounting Studies | Ausgabe 4/2006

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Abstract

We empirically examine how governance structure affects the design of executive compensation contracts and in particular, the implicit weights of firm performance measures in CEO’s compensation. We find that compensation contracts in firms with higher takeover protection and where the CEO has more influence on governance decisions put more weight on accounting-based measures of performance (return on assets) compared to stock-based performance measures (market returns). In additional tests, we further find that CEO compensation in these firms has lower variance and a higher proportion of cash (versus stock-based) compensation. We further find that CEOs’ incentives (measured as changes in CEO annual wealth which includes expected changes in the value of the CEO’s equity holdings in addition to yearly compensation) do not vary across governance structures. These findings are consistent with CEOs in firms with high takeover protection and where they have more influence on governance negotiating different contracts.

Vorheriger Artikel Do firms understate stock option-based compensation expense disclosed under SFAS 123?

Nächster Artikel Disclosure of fees paid to auditors and the market valuation of earnings surprises

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Core, Guay, & Rusticus (2006) find that firms with higher Gompers’ G have worse accounting performance than the industry average. This result may suggest that CEOs in these firms may not bargain for increasing the weight of accounting measures of performance. However, the use of relative performance evaluation is uncommon at best (Antle & Smith, 1986), while performance against preset targets is more common (Murphy, 2001).

Gompers et al. (2003) examine 24 provisions: anti-greenmail, blank check preferred stock, business combination laws, bylaw and charter amendment limitations, classified board, compensation plans with change in control provisions, director indemnification contracts, control share cash-out laws, cumulative voting requirements, director’s duties, fair price requirements, golden parachutes, director indemnification, limitations on director liability, pension parachutes, poison pills, secret ballot, executive severance agreements, silver parachutes, special meeting requirements, supermajority requirements, unequal voting rights and limitations on action by written consent.

Our data covers the period 1993–2002. The IRRC data is only available for 1990, 1993, 1995, 1998, 2000, and 2002. Gompers et al. (2003) report that for the majority of firms there is little time-series variation in the index. Taking advantage of this fact, like Cremers & Nair (2005), we align the index for 1993 with CEO compensation data for 1993 and 1994, the governance index for 1995 with CEO compensation data for 1995, 1996 and 1997, the governance index for 1998 with CEO compensation data for 1998 and 1999, the governance index for 2000 with CEO compensation data for 2000 and 2001, and the governance index for 2002 with CEO compensation data for 2002.

The number of meetings is reverse coded to obtain TotGov. Like Bertrand & Mullainathan (2001), we use unit weights to construct TotGov following the recommendations of Grice & Harris (1998), who find that unit-weighted composites exhibit better psychometric properties than alternative weighting schemes. Higher values of Totgov are expected to be associated with governance structures with higher takeover protection and CEO influence.

We also included leverage but it was not significant and its exclusion did not change the nature of the inferences.

We compute the number of years in office using the date the individual became chief executive officer.

We measured Earnings quality using the regression of returns on the level and change in earnings: \(\hbox{Ret}=\alpha_{0}+\alpha_{1}*\hbox{EARN}+\alpha_{2}*\Delta \hbox{EARN} + \varepsilon\), where Ret is the firm’s 15-month return ending three months after the end of fiscal year t; EARN is the firm’s income before extraordinary items in year t, scaled by market value at the end of year t − 1; and Δ EARN is the change in firm’s EARN in year t, scaled by market value at the end of year t − 1. We estimate this regression for each firm-year over rolling 10-year windows with a minimum of eight observations. Earnings quality is the annual decile ranking of the adjusted R ² of the above regression to avoid outlier concerns.

We also included the earnings quality terms in Tables 4, 5, 6 and 7 with no changes in the inferences.

This result is consistent with previous research. However, as Core et al. (2003) point out, it should not be interpreted as a confirmation of theory predictions (Holmstrom, 1979; Banker & Datar, 1989). For this to be a test of that theory, the dependent variable should be the change in wealth (total pay plus the change in the CEO’s equity portfolio).

For the change in cash pay the result is robust in a one-tail test with a p-value of p = .054.

All the previous results do not change if our proxy for total governance, TotGov, is defined as the mean of the four standardized proxies defined in Sect. 3.2 before the regression on firm characteristics.

These results are consistent with the findings in Tables 3 and 4.

The variables used in the selection model, in addition to the ones already included in the main regression, are the log of the market value of equity, the log of total sales, and the ratio of research and development expenditures to sales (Core & Guay, 1999).

For completeness we run our main test (Table 3) including the variable Return2. As expected, this variable and its interactions were not significant and the inferences from Table 3 did not change.

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Titel: Governance structure and the weighting of performance measures in CEO compensation
verfasst von: Antonio Davila
Fernando Penalva
Publikationsdatum: 01.12.2006
Verlag: Kluwer Academic Publishers-Plenum Publishers
Erschienen in: Review of Accounting Studies / Ausgabe 4/2006
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-006-9018-8

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