The effect of nonrecurring items on goodwill and CEO market-based compensation

Abstract

PurposeThis paper aims to analyze the association between goodwill defined as difference between market and book value of equity and reports of nonrecurring items, namely, special items, discontinued operations and extraordinary items to suggest information related to restructuring activities measured by these items can link the valuation and incentive roles of accounting. Economic intuition suggests that successful managerial efforts should increase firm value. Yet, the link between the valuation and stewardship roles of earnings has been difficult to verify.Design/methodology/approachThe author first estimates whether nonrecurring items have an incremental ability to explain goodwill, measured as the difference between market and book value of equity, at the industry level and then estimates whether firm-specific accounting bias is associated with the industry-level signals sent by nonrecurring items. The author then analyzes whether these items are associated with the use of chief executive officer (CEO) market-based compensation.FindingsThe author’ results show that information contained in special items increases firm-specific goodwill, indicating that it sends signals to investors about future growth opportunities, while that of discontinued operations reduces goodwill, suggesting that it provides signals about the adjustments of book value. She does not find any significant informational role for extraordinary items. She also finds that the signals sent by special items are negatively associated with the use of CEO market-based compensation, while those relayed by discontinued operations are positively associated with the use of market-based pay.Research limitations/implicationsContrary to prior studies, the results show special items and discontinued operations are both value and incentive relevant. There are two caveats to this analysis. First, owing to the frequent changes in the definition of discontinued operations, the analysis is conducted using data between 1992 and 2003. Second, some might argue that industry-level incremental R2 might not be appropriate for a compensation analysis. However, entities often use industry norms as a benchmark to set CEO compensation. Thus, it is reasonable to think that industry-level signals matter for executive pay.Originality/valueThe author’s findings suggest that compensation committees in firms across industries consider the information contained in special items and discontinued operations, and selectively alter the level of incentives to encourage managerial efforts.