In our paper, Managerial Incentives and Management Forecast Precision, forthcoming in The Accounting Review, we focus on one important characteristic of management forecasts—forecast precision—and examine how managerial incentives affect the choice of forecast precision. We choose to focus on forecast precision (or specificity, as it is sometimes referred to in the literature) for two reasons. First, precision is one of the most important forecast characteristics over which managers have a great deal of discretion. Managers can issue qualitative or quantitative forecasts, and the latter may take the form of point forecasts, range forecasts, or open-ended forecasts. More than 80% of the quantitative forecasts compiled by Thomas Financial are in the range format (i.e., estimates with explicit upper and lower bounds), and there is a large degree of variation in forecast width (i.e., the difference between the upper and lower bounds). One might even argue that managers have greater discretion over the precision of their earnings forecasts than over whether to provide forecasts in the first place (Hirst et al. 2008). Managers cannot always withhold information because it is part of their fiduciary duty to update and correct previous disclosures. Furthermore, withholding information can lead to considerable litigation risks and can cause great damage to a manager’s reputation (Skinner 1994). Second, forecast precision has a significant effect on market reactions to management forecasts. A number of theoretical papers, such as Kim and Verrecchia (1991) and Subramanyam (1996), argue that the magnitude of the market reaction to a disclosure is positively related to its precision, and empirical studies examining the impact of management forecast precision on stock returns and analyst forecast revisions provide support for this argument (e.g., Baginski et al. 1993; Baginski et al. 2007).
Posts Tagged ‘Qiang Cheng’
In the paper, Internal Governance and Real Earnings Management, which was recently made publicly available on SSRN, we examine whether key subordinate executives can restrain the extent of real earnings management. We focus on key subordinate executives, i.e., the top five executives with the highest compensation other than the CEO, because we hypothesize that they are the most likely group of employees that have both the incentives and the ability to influence the CEO in corporate decisions. As argued in Acharya et al. (2011), key subordinate executives have strong incentives not to increase short-term performance at the expense of long-term firm value. This tradeoff between current and future firm value is particularly salient in the case of real earnings management (as compared to accruals earnings management) because over production and cutting of R&D expenditures are costly and can reduce the long term value of the firm.
The motivation for the research question is twofold. First, the majority of the papers in the literature explicitly or implicitly assume that the CEO is the sole decision maker for financial reporting quality and the impact of other executives has been generally overlooked. Recent studies argue that subordinate executives usually have longer horizons and they can influence corporate decisions through various means. We hypothesize that differential preferences arising from differential horizons can affect the extent of real earnings management. Second, while there are studies focusing on the impact of external corporate governance (e.g., board independence and institutional ownership), little is known about whether there are checks and balances within the management team. This lack of knowledge is an important omission because control is not just imposed from the top-down or from the outside, but also from bottom-up (Fama 1980).
In our forthcoming Accounting Review paper entitled Earnings Restatements, Changes in CEO Compensation, and Firm Performance, we provide insights into the design and efficacy of chief executive officer (CEO) compensation contracts following an earnings restatement.
Using a sample of 289 restatements and the year prior to restatement announcement as the benchmark year, we find that while total CEO compensation does not significantly change by the second year after the restatement announcement, there is a significant shift from option-based compensation to salary over this period. In univariate tests, we find that the proportion of the value of option grants to total compensation declined by 5.6 percentage points for the restatement firms, while control firms experienced an increase of 2.6 percentage points in this proportion over the same period. The analyses indicate that the number of option grants also declines for restatement firms compared to control firms. The reduction in the use of option grants for restatement firms holds after we control for the level of stock and option holdings as well as other determinants of option-based compensation, such as firm size, growth opportunities, leverage, idiosyncratic risk, R&D intensity, stock returns, cash compensation, and industry and year fixed effects. Because about half of the restatement firms experienced CEO turnover after restatements, we also investigate the change in option grants separately for extant and new CEOs. We find that our results hold for both extant and new CEOs.
If the reduction in option-based compensation is a result of unwarranted negative public perception of option usage, we would expect a decrease in firm performance as firms deviate from optimal contracting. However, if restatements result from too high a level of incentive compensation and the reduction in option compensation after the restatement better aligns managerial incentives with those of shareholders, we would expect to observe improved firm performance. Overall, our results imply that economic benefits accrue to restatement firms that reduce their CEOs’ option-based compensation, indicating that the reduction in option grants helps adjust managers’ equity incentives toward optimal levels. A natural question that follows is if reducing option usage is associated with improved firm performance, why is it that all restatement firms do not do so? To help answer this question, we conduct a within-sample analysis. We find that the likelihood of a reduction in options usage is positively related to the level of option grants prior to the restatement and in some specifications, this likelihood is higher for income-decreasing restatements.
The full paper is available for download here.