CEO equity compensation, external monitoring and earnings quality

Pao Yue-kong Library Electronic Theses Database

CEO equity compensation, external monitoring and earnings quality

 

Author: Yang, Qinqin
Title: CEO equity compensation, external monitoring and earnings quality
Degree: Ph.D.
Year: 2006
Subject: Hong Kong Polytechnic University -- Dissertations.
Chief executive officers -- Salaries, etc.
Department: School of Accounting and Finance
Pages: iv, 177 leaves ; 30 cm.
Language: English
InnoPac Record: http://library.polyu.edu.hk/record=b2059299
URI: http://theses.lib.polyu.edu.hk/handle/200/480
Abstract: CEO equity compensation, mainly in the form of stock options and the restricted stock, is an essential element in the executive compensation package. This study attempts to examine two issues related to CEO equity compensation. The first issue examined in this study is whether CEO equity compensation has an effect on earnings quality. Three factors motivate an investigation of this issue. First, there are some concerns that equity compensation might create incentives for managers to manage earnings to boost stock prices. Second, although agency theory suggests that executive equity compensation aligns the interests of managers with those of shareholders by linking compensation to stock price, the empirical results regarding the actual role played by equity compensation are mixed. While the alignment perspective indicates that equity compensation is associated with high firm value, firm performance and information quality (Core and Guay, 1999; Hanlon et al., 2003; Ittner et al., 2003; Murphy, 2003; Nagar et al., 2003), the entrenchment perspective suggests that equity compensation is not likely to economically or efficiently motivate managers (Bertrand and Mullainathan, 2001; Yermack, 1995; Bebchuk and Fried, 2004) and that it may even lead to some dysfunctional outcomes such as timing the option award dates, timing voluntary disclosures around grant dates and misreporting in the financial statements (Yermack, 1997; Aboody and Kasznik, 2000; Burns and Kedia, 2005). Last but not least, there is limited evidence regarding the relationship between equity compensation and earnings quality. The exceptions are Cheng and Warfield (2005) and Bergstresser and Philippon (2005), which find that equity compensation impairs earnings quality. The second issue examined is the joint effect of CEO equity compensation and external monitoring on earnings quality. Prior literature suggests that corporate governance mechanisms are either substitutable or complementary (Agrawal and Knoeber, 1996; Gul et al, 2002; 2003; Lang et al.; 2004), however, the evidence on the substitutable or complementary nature of various corporate governance variables is limited. This study examines the joint effect of CEO equity compensation and external monitoring by auditors or institutional shareholders on earnings quality. In this way it attempts to shed some light on whether corporate governance variables are substitutes. In this study, CEO equity compensation is measured by the percentage of equity compensation (stock options and the restricted stock) to total compensation. Meanwhile, following Dechow et al. (1998), Earth et al. (2001), and Srinidhi and Gul (2005), earnings quality is measured in terms of the extent to which current period earnings or accruals are realized as future cash flows. This earnings quality measure has an edge over other measures, as it is consistent with the decision usefulness adopted by the FASB. I develop three hypotheses in this study. The first hypothesis tests the effect of CEO equity compensation on earnings quality. The relation between CEO equity compensation and earnings quality is two-folded. On the one hand, based on the alignment explanation, CEO equity compensation might lead to higher earnings quality. CEOs awarded with high equity compensation prefer higher earnings quality, as higher earnings quality is related to lower cost of capital or higher stock price (Francis et al., 2004; 2005). On the other hand, based on the entrenchment argument, CEO equity compensation might be also associated with lower earnings quality, since entrenched CEOs awarded with equity compensation are likely to boost current earnings to drive stock price up so that they can exercise options or sell stocks (Bergstresser and Philippon, 2005; Cheng and Warfield, 2005). By using a sample with 11,151 observations from 1993 to 2002, I find that CEO equity compensation is positively associated with earnings quality, suggesting that CEO equity compensation enhances earnings quality. The results are consistent with the alignment role rather the entrenchment role played by executive equity compensation. The other two hypotheses test the joint effect of CEO equity compensation (institutional ownership) and audit quality on earnings quality. There are two possibilities for the relation between CEO equity compensation and external monitoring: the substitution effect versus the complement effect. The substitution effect is supported by the literature suggesting that equity compensation and audit quality or institutional ownership are substitutes for other governance mechanisms (Feltham et al., 1991; Mehran, 1995; Rediker and Seth, 1995; Agrawal and Knoeber, 1996; Gul et al., 2002). In addition, the substitution effect is supported by the argument that CEOs provide higher quality of earnings to maintain the price level when there is weaker monitoring by auditors or institutional shareholders, and vice versa (Datar et al., 1991; Bikhchandani et al., 1992; Brown and Brooke, 1993; Sias et al., 2001; Mansi et al., 2004; Ghosh and Moon, 2005). However, CEO equity compensation and audit quality (institutional ownership) might be mutually complementary. The reason is that with a lack of monitoring, the entrenchment role of CEO equity compensation may be more pronounced. My results support the substitution effect. The interaction of CEO equity compensation and audit quality (institutional ownership) is significantly negative. In addition, when external monitoring by auditors or institutional shareholders is weak, the association between CEO equity compensation and earnings is positively significant; when external monitoring by auditors or institutional shareholders is strong, the association between CEO equity compensation and earnings is not significant at all. Overall, the findings of this study support the notion that equity compensation is efficient in alleviating the agency conflicts between shareholders and managers. The findings also provide some empirical evidence to support the substitution effect between the incentive mechanism and external monitoring.

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