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Review of Quantitative Finance and Accounting

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01.11.2010 | Original Research

The effect of CEO ownership on the information content of reported earnings

verfasst von: Aloke Ghosh, Doocheol Moon

Erschienen in: Review of Quantitative Finance and Accounting | Ausgabe 4/2010

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Abstract

This paper examines the relation between capital market perceptions of earnings quality and CEO equity ownership. Using the earnings response coefficients (ERCs) from annual returns–earnings regressions as a proxy for investor perceptions of earnings quality, we find that ERCs first increase and then decline across higher levels of CEO ownership with an inflection point around 25% ownership. Using analyst behavior as another proxy for the perceptions of financial analysts, we find that earnings forecasts are more accurate as ownership increases, but once ownership levels reach about 25%, accuracy declines with further increases in ownership. Forecast dispersion, forecast revision volatility, and analyst following decline and then increase across increasing levels of CEO ownership. Our results suggest that, for low levels of CEO ownership, earnings are perceived as being more informative about future firm performance as ownership increases. However, once ownership levels are high, earnings are perceived as being less informative with further increases in ownership.

Vorheriger Artikel Inter-market competition for NYSE-listed securities under decimals

Nächster Artikel Are good financial advisors really good? The performance of investment banks in the M&A market

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We define the term “high quality” earnings to apply when reported earnings are a good indicator of future economic earnings, as in Penman and Zhang (2002).

See for example, Morck et al. (1988), McConnell and Servaes (1990), Hermalin and Weisbach (1991), Miguel et al. (2005), and Morck et al. (2005).

Accounting numbers are frequently used in debt contracts, management compensation plans, corporate charters, bylaws, or other informal contracts that define the working arrangements of managers (Holthausen and Leftwich 1983). These contracts restrict firms’ actions conditional on certain accounting numbers (Watts and Zimmerman 1990).

For example, risk-averse managers holding a significant fraction of the firm’s equity are over-exposed to risks from holding an under-diversified portfolio because a significant part of their wealth is tied to the stock price of the firm (Lambert et al. 1991). Therefore, managers have incentives to implement business strategies or use accounting choices to reduce firms’ risk rather than optimize the firms’ value (Dechow and Sloan 1991). Managers can reduce the risk of the firm, and thereby reduce the risk of their personal wealth, by (1) reducing R&D expenditure (Kothari et al. 2002; Ghosh et al. 2007), (2) managing accounting choices to smooth earnings (Trueman and Titman 1988), or (3) through conglomerate mergers (Amihud and Lev 1981).

Because CEO ownership is reported annually and since we use annual observations for control variables, we use the average values of various forecast characteristics when more than one observation is available for the reporting year for consistency. As a robustness check, we conduct two additional tests, (1) compute forecast characteristics as of the fiscal year-end, and (2) include the forecast horizon (expressed as the number of months between the forecast and annual earnings report dates) in the regression models. We find that the results are very similar to those reported in Table 5 when we conduct these added tests.

Since the relation between Earnings (E) and Returns (R) conditional on Ownership (O) is curvilinear, the inflection point for the joint effect of Earnings and Ownership on Returns is the level of ownership for which investors’ valuation of earnings (∂R/∂E) is the highest. Thus, based on the regression estimates, ∂ ² R/(∂O∂E) = 6.397−2 × 12.87 × O = 0 indicates that investors’ valuation of earnings is the highest when Ownership is at 24.9%.

Given that firm size is an important factor in determining the level of CEO ownership, we further include the two interaction variables, Size × Ownership and Size × Ownership ², in model (1). We find that none of our results are affected. The coefficient on Earnings × Ownership is 6.482 (t-stat = 7.07), and the coefficient on Earnings × Ownership ² is −11.912 (t-stat = −5.65). In Section 5.2, we also report the results on whether firm size affects the association between CEO ownership and perceived earnings quality.

We also separate the sample into two subsamples based on the median R&D to examine whether growth opportunities affect the valuation of earnings. When we re-estimate model (1) for each subsample, we find that results remain unchanged for firms with both low and high levels of R&D.

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Titel: The effect of CEO ownership on the information content of reported earnings
verfasst von: Aloke Ghosh
Doocheol Moon
Publikationsdatum: 01.11.2010
Verlag: Springer US
Erschienen in: Review of Quantitative Finance and Accounting / Ausgabe 4/2010
Print ISSN: 0924-865X
Elektronische ISSN: 1573-7179
DOI: https://doi.org/10.1007/s11156-009-0140-0

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