Managerial Incentive Compensation Research Articles

The Effect of the Compensation System on Earnings Management and Sustainability: Evidence from Korea Banks

Since the global financial crisis, management incentive compensation, which is sensitive to financial firms’ short-term performance, has been noted to threaten financial systems’ sustainability by incentivizing managers to pursue excessive risks. Subsequently, international standards have been established regarding compensation for financial institutions’ senior executives and employees. However, this compensation may impact not only banks’ risk-taking behaviors, but also their earnings management, as the latter affects financial performance while compensation is decided as a reflection of such performance. Therefore, this study analyses executive compensation’s impact on banks’ earnings management using compensation data on South Korean banks. The analysis revealed higher earnings management using a loan loss provision with more variable compensation. On the one hand, if the proportion of equity-linked compensation to incentive compensation increased, then earnings management increased. On the other hand, more deferred compensation led to increased earnings smoothing. This study evaluates regulatory impacts across multiple dimensions by analyzing the effects of incentive compensation standards—intended to increase financial systems’ sustainability—on individual financial institutions and further contributes to studies on managerial decision making.

The Equilibrium Relationships between Performance-Based Pay, Performance, and the Commission and Detection of Fraudulent Misreporting

ABSTRACTWe develop an agency model in which managerial information manipulation creates pooling and entails ex post costs internal and/or external to the firm. We examine the implications of the strategic interactions between shareholders (who set internal governance and managerial incentive compensation), the manager (who exerts effort and reports on its outcome), and an external regulatory authority or RA (who investigates for fraud and levies penalties ex post). When the RA cannot pre-commit to an ex post investigation strategy, a fraudulent equilibrium obtains if the firm's internal governance costs are sufficiently high. Consistent with (so far fairly scant) post-SOX empirical evidence, but the opposite of the implications of signal-jamming models and equilibria with pre-commitment, the model implies an increase in minimum internal governance standards or ex post fraud penalties (as with SOX) results in decreased equilibrium pay-for-performance sensitivity and firm performance.

Collusion, Managerial Incentives and Antitrust Fines

Based on a price setting duopoly model, this paper argues that collusion on managerial incentive compensation may have the equivalent effect to collusion on prices. This paper also provides an analysis of the effect of different antitrust fines regimes in the context of a game between two companies each composed of two-level of decision making (the board of directors and the sales manager). The contribution of this paper is two-fold: it identifies backstage arrangements that may be used by companies in order to achieve monopoly outcome without entering into explicit price-fixing practices. It also highlights the inefficiency of fining regimes based on sales when companies have a multi-layer decision-making structure.

Managerial incentives in the presence of golden handshakes

This paper examines the effect of “golden handshakes” on managerial incentive compensation and risk-taking. Golden handshake, one on hand, increases CEO's pay-for-performance sensitivity by providing a high-powered incentive scheme. On the other hand, it also increases the sensitivity of CEO wealth to stock volatility, and induces CEOs to implement risky investment policy. I show the optimal incentive level increases in the presence of golden handshake. The results help to shed light on the important role of severance contract on the optimal executive compensation.

CORPORATE GOVERNANCE AND CAPITAL STRUCTURE DYNAMICS: AN EMPIRICAL STUDY

AbstractConsistent with theoretical predictions, we find that both a higher level of financial leverage and a faster speed of adjustment of leverage toward the shareholders' desired level are associated with better corporate governance quality as defined by a more independent board featuring CEO–chairman separation and greater presence of outside directors, coupled with larger institutional shareholding. In contrast, managerial incentive compensation on average discourages use of debt or adjustments toward the shareholders' desired level, consistent with its entrenchment effect. The effect of corporate governance on leverage adjustments is most pronounced when initial leverage is between the manager's desired level and the shareholders' desired level where the interests of managers and shareholders conflict.

Information Asymmetry and the Choice of Financial and Non-Financial Performance Targets During an Economic Downturn

Prior studies examining how firms use multiple performance measures when evaluating their managers rarely recognize that managers may be privately informed about how well different measures reflect their effort. We extend the standard multi-tasking model to allow performance measures to be affected by the information asymmetry between the firm and its privately informed manager. We show that reducing the information asymmetry component of one measure reduces the corresponding information rent and consequently increases the relative incentive weight on that measure. This result guides our empirical inquiry of performance target setting using survey data on 2,136 entities collected before, during, and after the 2008-2009 recession. We predict that the recession made it more difficult for managers to understand how their effort translates into financial results and thus reduced the information asymmetry affecting financial performance measures. Consistent with our theoretical result, we find using various regression and matching estimators that financial performance targets are substantially more difficult to achieve (afford managers less slack) and at the same time account for a greater part of managerial incentive compensation during the recession than during our control periods.

Does Corporate Governance Affect Capital Structure Adjustments?

Morellec, Nikolov, and Schurhoff (2012) predict that a self-interested manager prefers a leverage level that is lower than the shareholders’ desired level, and effective corporate governance encourages timely capital structure rebalancing. In a U.S. sample during 1996-2008, we confirm that both a higher level of financial leverage and a faster speed of adjustment of leverage toward the shareholders’ desired level are associated with a better corporate governance quality as defined by a more independent board featuring CEO-Chairman separation and greater presence of outside directors, coupled with larger institutional shareholding. In contrast, managerial incentive compensation on average discourages use of debt or adjustments toward the shareholders’ desired level, consistent with its entrenchment effect. The effect of corporate governance on leverage adjustments is most pronounced when the initial leverage is between the manager’s desired level and the shareholders’ desired level where the interests of managers and shareholders conflict.

Joint Determination of Leverage and Managerial Incentive Compensation: Theory and Evidence

This paper investigates how capital structure and managerial compensation are jointly determined within a contingent claims model where the two interact through manager-stockholder and stockholder-bondholder conflicts. In the presence of frictions, agency conflicts affect investment decisions and, hence, firm value. Rational stockholders set financial policies and managerial compensation simultaneously, to minimize the distortion caused by these conflicts. This joint optimization creates a tradeoff between leverage and managerial incentive compensation: equity holders would avoid setting both high. The model predicts that due to the tradeoff between the two, key firm characteristics should move the two in opposite directions. This article also reports empirical evidence strongly supporting the model by estimating simultaneous equations of market leverage and pay-performance sensitivity. The negative correlation between the two dependent variables is captured in the opposite effects from key firm characteristics. After controlling for the tradeoff, market leverage and pay-performance sensitivity have a positive relation.

Managerial Incentives and the Choice between Public and Bank Debt

I propose a simple model with complete and perfect information on the relation between managerial incentive compensation and choice between public and bank debt. The empirical analysis offers considerable support to the model's predictions. I find that managers whose compensation is tied to firm performance prefer bank to public debt. Further, I find a positive relation between cost of public debt and managerial incentive compensation and no relation between loan spreads and incentive compensation. Finally, I find that banks are more likely to include a collateral provision in the debt contract if the CEO's compensation is tied to firm performance.

The Impact of Risk and Monitoring on CEO Equity Incentives

This paper provides new empirical insights on the association between a firm’s operating structure and the level of CEO equity incentives. We investigate a sample of supplier firms that rely on a few large customers for a significant fraction of their revenues. We predict that suppliers with a higher customer concentration face higher idiosyncratic risk and, as a result, rely less on equity-based managerial incentive compensation contracts. Our empirical results support these predictions.

Managerial compensation and the debt placement decision

Extant research argues that borrowing from financial intermediaries subjects managers to external monitoring. However, given managers' flexibility in choosing the type of debt financing, why would managers submit themselves to external monitoring? Recent theory points to the role of managerial incentive compensation. Specifically, it is argued that managers will borrow from financial intermediaries if their compensation is tied to firm performance. Additionally, it is noted that a more optimal compensation scheme will induce managers to undertake intermediated loans only when the firm is sufficiently profitable. Such a compensation scheme is likely to exist in opaque firm settings where borrowing from financial intermediaries can serve to signal firm profitability. Our study provides corroborative evidence. We find that the choice of syndicated bank loans is positively associated with CEO equity incentives. Second, this syndicated debt-incentive compensation link is influenced by firm profitability, particularly among information problematic firms. Overall, our study points to the role of incentive compensation in the debt placement decision.

Managerial Compensation and the Debt Placement Decision

Extant research argues that borrowing from financial intermediaries subjects managers to external monitoring. However, given managers’ flexibility in choosing the type of debt financing, why would managers submit themselves to external monitoring? Recent theory points to the role of managerial incentive compensation. Specifically, it is argued that managers will borrow from financial intermediaries if their compensation is tied to firm performance. Additionally, it is noted that a more optimal compensation scheme will induce managers to undertake intermediated loans only when the firm is sufficiently profitable. Such a compensation scheme is likely to exist in opaque firm settings where borrowing from financial intermediaries can serve to signal firm profitability. Our study provides corroborative evidence. We find the choice of syndicated bank loans is positively associated with CEO equity incentives. Second, this syndicated debt-incentive compensation link is influenced by firm profitability, particularly among information problematic firms. Overall, our study points to the role of incentive compensation in the debt placement decision.

The Impact of Risk and Monitoring on CEO Compensation

This paper uses a novel empirical setting to explore the association between a firm’s operational risk, managerial monitoring costs, and how managers are compensated. We investigate a sample of supplier firms that rely on a few large customers for the bulk of their revenues. We predict that supplier firms with higher customer concentration face both higher exogenous idiosyncratic risk and lower monitoring costs and, as a result, will rely less on equity-based managerial incentive compensation contracts. Our empirical results support this prediction.

Are Debt and Incentive Compensation Substitutes in Controlling the Free Cash Flow Agency Problem?

This paper investigates the governance implications of a firm's capital structure and managerial incentive compensation in controlling the free cash flow agency problem. The results suggest: debt and executive stock options act as substitutes in attenuating a firm's free cash flow problem; failure to incorporate the substitutability and endogeneity leads to underestimates of the magnitude and economic implication of the disciplinary role of both mechanisms; firm characteristics differ across the prevalence of debt usage versus option usage, suggesting the heterogeneity in the costs and benefits of the monitoring devices; and all the above effects are more pronounced in firms that tend to have more severe agency problem.

Managerial Incentives and the Choice between Public and Bank Debt

I propose a simple model with complete and perfect information that analyzes the relation between managerial incentive compensation and the firm's choice between public and bank debt. My analysis of firm-level data over the period 1992-2005 offers considerable support to the predictions of the model. I find a positive relation between the level of incentive compensation and the preference for bank debt, which is consistent with the prediction that managers whose compensation is tied to firm performance choose bank over public debt as a commitment mechanism to reduce the cost of debt. Further, I find that public lenders price the incentive alignment between manager and shareholders by increasing the cost of debt, while the overall cost of bank loans does not depend on the manager's incentive compensation. Finally, I find that banks are more likely to include a collateral provision in the debt contract if the manager's compensation is tied to firm performance.

Top management incentive compensation and knowledge sharing in multinational corporations

AbstractGrowing interest has emerged in viewing the multinational corporation as a knowledge creating and diffusing entity. The importance of sharing knowledge across organizational and national boundaries has been established in previous research. However, the question of which organizational policies lead to knowledge sharing between multinational units is still not fully understood. In particular, the link between compensation mechanisms and knowledge sharing has not received attention in previous studies. By studying 164 foreign‐owned subsidiaries located in Finland and China, this article attempts to identify the relationship between subsidiary bonus pay based on MNC‐wide performance and knowledge sharing between different units of the MNC. In line with the knowledge‐based perspective of the firm, the results suggest that incentive pay based on the collective performance of the MNC leads to greater knowledge sharing. Copyright © 2008 John Wiley & Sons, Ltd.

Enhancing managerial incentives and value creation: Evidence from corporate spinoffs

We study corporate spinoffs with changes in CEO compensation to examine how spinoffs affect managerial incentive compensation and whether the changes in managerial compensation can explain the value enhancement and operating performance improvements that occur following spinoffs. Analyzing a sample of 124 non-taxable spinoffs during 1990–1997, we find that changes in incentive compensation are a significant motive for spinoffs. Changes in managerial incentives alone are consistent with the post-spinoff changes in operating performance, while changes in business focus are not. Spinoffs that are not accompanied by enhanced pay-performance relationship do not improve operating performance even with increased business focus. (JELG34, J33)

Incentives to Cheat: The Influence of Executive Compensation and Firm Performance on Financial Misrepresentation

Despite the many undesirable outcomes of corporate misconduct, scholars have an inadequate understanding of corporate misconduct’s causes and mechanisms. We extend the behavioral theory of the firm, which traditionally assumes away the possibility of firm impropriety, to develop hypotheses predicting that top management incentive compensation and poor organizational performance relative to aspirations increase the likelihood of financial misrepresentation. Using a sample of financial restatements prompted by accounting irregularities and identified by the U.S. Government Accountability Office, we find empirical support for both incentive and relative performance influences on financial statement misrepresentation.

Are Debt and Incentive Compensation Substitutes in Controlling the Free Cash Flow Agency Problem?

This paper investigates the governance implications of a firm's capital structure and managerial incentive compensation and the substitutability of these two mechanisms in controlling the free cash flow agency problem. The study is designed to explore the different ways that debt and incentives work on the agency problem. Debt directly restricts the investment scale while incentive compensation makes investment less sensitive to free cash flow. The substitutability of debt and incentive compensation and the potential endogeneity of investment, capital structure and compensation are examined by estimating a nonlinear simultaneous equations system. The results suggest: (1) Debt and executive stock options act as substitutes in attenuating a firm's free cash flow problem, which provides a partial answer to the puzzle as to why some firms predominantly grant options but issue little debt despite their excess debt capacity. (2) Failure to incorporate the substitutability and endogeneity of capital structure and incentive compensation leads to underestimates of the magnitude and economic implication of their capital structure and compensation structure to control for overinvestment. (4) Firm characteristics differ across the prevalence of debt usage versus option usage, suggesting the heterogeneity in the costs and benefits of the monitoring devices. (5) All the above effects are more prominent in firms that tend to have more severe free cash flow problems.

Enhancing Managerial Incentives and Value Creation: Evidence from Corporate Spinoffs

I study changes in CEO compensation and pay-performance relations to examine how corporate spinoffs affect managerial incentive compensation and whether the changes in management compensation can explain the value enhancement and operating performance improvements that occur following spinoffs. Analyzing a sample of 124 non-taxable spinoffs during 1990-1997, I find that changes in managerial compensation are a significant motive for spinoffs. Changes in managerial incentives alone are consistent with the post-spinoff changes in operating performance, while changes in business focus are not. Spinoffs that are not accompanied by enhanced pay-performance relations do not improve operating performance even with increased business focus.