Paul M Healy.

The effect of accounting procedure changes on executive remuneration online

. (page 1 of 2)
Online LibraryPaul M HealyThe effect of accounting procedure changes on executive remuneration → online text (page 1 of 2)
Font size
QR-code for this ebook


HD28
.M414
no. lfe4S-



a



e>vey




WORKING PAPER
ALFRED P. SLOAN SCHOOL OF MANAGEMENT



THE EFFECT OF ACCOUNTING PROCEDURE CHANGES
ON EXECUTIVES' REMUNERATION

Paul Healy,
Sok-Hyon Kang
Sloan School of Management, M.I.T.
and
Krishna Palepu
Harvard Business School



June 1985
MIT Sloan School of Management Working Paper:



#1668-85



MASSACHUSETTS

INSTITUTE OF TECHNOLOGY

50 MEMORIAL DRIVE

CAMBRIDGE, MASSACHUSETTS 02139



THE EFFECT OF ACCOUNTING PROCEDURE CHANGES

ON EXECUTIVES' REMUNERATION

/

Paul Healy,

Sok-Hyon Kang

Sloan School of Management, M.I.T.

and

Krishna Palepu

Harvard Business School

June 1985

MIT Sloan School of Management Working Paper: #1668-85



Second Draft. Not to be quoted.



We wish to thank Andrew Christie, Linda DeAngelo, Bob Kaplan, Rick Ruback,
Ross Watts and Jerry Zimmerman for their helpful comments on earlier drafts
of this paper. We are also grateful to Bob Holthausen and Richard Rikert
for letting us use their data bases of changes in accounting procedures.



1 . INTRODUCTION

Management compensation plans written in terms of accounting numbers are
a popular means of rewarding executives of U.S. corporations. These plans
typically allow managers to receive bonus compensation if their performance
exceeds a target that is stated in terms of accounting earnings. Watts
(1977) and Watts and Zimmerman (1978) hypothesize that if it is costly to
monitor these contracts, changes in accounting rules have economic
consequences for the firm by changing its expected future cash flows and
their distribution among its various claimants .

In this paper we examine whether, subsequent to an accounting policy
change, top management's salary and bonus remuneration is based on earnings
computed under the old or new accounting rules . If the costs of adjusting
compensation for the effect of an accounting policy change are negligible, we
expect awards still to be based on the old accounting rules. However, if
adjustment is costly, compensation awards are likely to be based on the new
rules .

The economic consequences of accounting changes are tested in earlier
studies by Holthausen (1981), Leftwich (1981) and Collins, Rozeff and
Dhaliwal (1981) using stock price data. They investigate the relation
between variables chosen to proxy for monitoring costs and the cross-
sectional variation in firms' abnormal stock price performance around the
time of an accounting change . Their results are mixed and provide only weak
support for the economic consequences hypothesis. However, as Holthausen and
Leftwich (1983) point out, these tests are unlikely to detect the economic
consequences of most accounting technique changes because their wealth
effects are likely to be small relative to the variability in stock prices .



Further, the power of such tests is seriously limited by the difficulty in
identifying the event dates and specifying investors' expectations. This
paper attempts to mitigate these limitations by examining whether accounting
procedure changes are associated with changes in top management remuneration .

Our sample consists of 52 companies that changed from the FIFO to LIFO
inventory method, and 38 companies that changed from accelerated to
straight-line depreciation. For each of these firms, we test whether there
is a change in the time-series relation between executives' salary and bonus
awards and reported accounting earnings following the accounting change. The
results indicate that for our sample of companies, the relation between
compensation and reported earnings does not change following an accounting
policy change, irrespective of whether the change increases or decreases
reported earnings. This implies that top management's salary and bonus
payments are not adjusted for changes in reported earnings due to accounting
policy changes .

The remainder of the paper is organized as follows . Section two
describes the research design, sample selection and data collection. The
results of the statistical tests are presented in section three and our
conclusions are discussed in section four.

2 . RESEARCH DESIGN

2 .1 Management Compensation and Accounting Changes

In most large U.S. corporations managerial remuneration is tied to
reported earnings. Fox (1980), for example, finds that in 1980 more than 90
percent of the 1000 largest U.S. manufacturing companies used some form of
earnings-based compensation . The most popular schemes include bonus and
performance plans. Bonus plans typically award managers cash payments if



-2-



certain annual targets are attained; performance plans award managers the
value of performance units or shares in cash or stock if certain long-term
(three to five-year) performance targets are achieved. The targets in
these plans are usually written in terms of earnings per share, return on
assets or return on equity. Compensation can also be tied to earnings on an
informal basis. For example, executives' salary revisions can be a function
of earnings .

Compensation contracts are usually administered by a committee of
directors who are ineligible to participate in the schemes . Ihis committee
has discretion to set managers' salaries and award bonus and performance plan
payments .

Since compensation plan targets are stated in terms of accounting
numbers, managers' wealth will be affected by voluntary or mandatory changes
in accounting rules unless the compensation committees adjust awards to
offset the effect of the rule changes . If the costs of adjusting
compensation for changes in accounting policies are negligible, compensation
plans can either specify the accounting rules used to compute earnings for
remuneration purposes ex ante , or the plans can be adjusted ex post so that
compensation payments are fully insulated from accounting rule changes . With
costly monitoring, compensation committees weigh the benefits of insulating
compensation payments from accounting rule changes against the associated
costs .

If compensation payments are not fully insulated from the effects of
accounting changes, managers have an incentive to voluntarily switch
accounting policies to increase their compensation. However, two forces
limit their incentives to opportunistically change accounting policies .
First, if managers own shares in the firms that employ them, an accounting



-3-



rule change which reduces the value of the firm reduces their portfolio
wealth. Second, if managers opportunistically take actions that do not
maximize the value of their firms, the value of their human capital is likely
to decline- Hence, in considering accounting changes, managers trade off the
changes in their compensation against changes in their portfolio wealth and
human capital .

To evaluate whether management compensation is fully adjusted by
compensation committees for the effects of accounting changes, we examine two

changes: changes from the FIFO to UFO inventory method, and changes from

2
accelerated to straight-line depreciation. These accounting changes are

chosen for investigation for a number of reasons. First, they have a large
effect on reported earnings. Second, FIFO to LIFO switches typically
decrease reported earnings, whereas changes from accelerated to straight-line
depreciation usually increase reported earnings. Kence , if earnings-based
management compensation is not adjusted for changes in accounting policies,
the inventory policy change would decrease compensation and the depreciation
change would increase it. Third, changes from FIFO to LIFO typically
decrease a firm's tax payments and hence increase the equity value of the
firm. From managers' perspectives, FIFO-LIFO switches are therefore likely
to increase their portfolio wealth provided they own stock in the firms that
employ them. Also, managers' decisions to change from FIFO to LIFO are
likely to increase the value of their human capital since the decision
benefits the shareholders. The increase in portfolio wealth and human
capital may be sufficient to offset the reduction In managers' earnings-based
compensation if no adjustment is made by the compensation committees. In
contrast, the depreciation policy changes are tax neutral and are therefore
less likely to have significant effects on managers' portfolio wealth and
human capital .



-4-



2 .2 Statistical Tests

The statistical tests described below examine whether, subsequent to an
accounting change, the relation between management compensation and reported
earnings of a firm changes to fully offset the effect of the accounting
change on reported earnings . The tests are based on the following
compensation model, which is estimated for each of the firms in our sample.



(1) ln(C0MP lt ) = I 04D it + 13 ln(EARN t ) + e lt

i=l



where, COMf it



EARN.



D t



6,C4



= salary and cash bonus paid to chief executive
officer i during year t ,

= accounting earnings for the firm during year t ,

= 1 if individual i was CEO of the firm during
the year t, and otherwise,

= the number of individuals who held the position
of CEO of the firm during the sample period,

= firm-specific parameters, to be estimated using
time-series data on compensation and earnings,
(i=l,...,n).



The model is estimated in a logarithmic form since there is some evidence
that power transformations perform better than linear regressions in
estimating relations between compensation and measures of performance (see
Bayes and Schlagenhauf (1979)). In addition, prior studies have typically
usea log transformations (eg. Murphy (1985) and Abdel-khalik (1985)). Our
results are therefore comparable to the findings of these studies. If
earnings are negative, we assume their log value is zero. Twenty of the
ninety companies in our sample (29 company-years) are adjusted in this
way. The effect of this assumption is to limit managers to receive



-5-



earnings-dependent compensation only when their company earns profits,
consistent with the option characteristics of most bonus contracts . (see
Healy (1985)).

The intercept term in our model (or the fixed component of compensation)
is allowed to vary across executives, reflecting differences in factors like
age, ability and education among CEOs. The elasticity of compensation to
earnings, 13, is assumed to be firm-specific. Both compensation and earnings
are measured in constant 1967 dollars to control for inflation.

The compensation variable used in our model is salary and bonus payments
to the chief executive officers (CEOs) of our sample firms. This variable
excludes several components of CEOs' compensation, such as performance awards
that are contingent on earnings, and stock option awards, because disclosures
of these awards are frequently incomplete. While this limits the conclusions
of the study, it is worth noting that bonus and salary comprise a nontrivial
proportion of executives' total remuneration. In Murphy's study of 461
executives from 1964 to 1981, salary and bonus is on average 80 percent of
total remuneration.

To evaluate the impact of the accounting change on the compensation-
earnings relation in equation (1), we define two earnings variables: reported
earnings and "original" earnings. Reported earnings (REARN ) are based on
one set of accounting policies before the accounting change, and another
after the change . Original earnings are computed using the original
accounting policies (which are in effect before the change) and are denoted
by OEARN . For periods prior to the accounting policy switch, OEARN
equals REARN ; after the switch, REARN is adjusted for the effect of
the accounting change to obtain OEARN .

If management comensation is fully adjusted for the effects of changes in



-6-



accounting policies, the relevant accounting earnings variable in model (1)

is OEARN , and the compensation model is:

n
(2) ln(COMP it ) = Z OL ± D it + E ln(OEARN t ) + e lt

i=l



If, as the economic consequences theory hypothesizes, management
compensation is not adjusted for accounting changes, the earnings variable In
model (1) is REARN , and the model is:

n

(3) ln(COMP lt ) = Z a ± D ±t + 13 ln(REARN t ) + e lt

i=l

We test the null hypothesis that compensation is based on earnings
computed using the original set of accounting policies (OFARN) . In equation
(4), we include an additional variable ln(RFARN /OEARNj.) to capture the
effect of the accounting change on compensation . The model is thus estimated
in the following form:

n REARN

(4) ln(C0MP.J = L a.D_ + f31n(0EARN ) + Xln( ^..^ ) + e,.

it , . l it t OEARN. It

i=l t

The coefficient of the earnings adjustment variable, X is zero if the
"true" model is equation (2); X is equal to 6 if the "true" model is
equation (3). We use equation (4) to examine the following hypotheses:

(i) There is no significant relation between accounting earnings and top
management bonus and salary compensation (H:I3=0,H:(3>0).

(ii) Top management salary and bonus compensation Is fully adjusted for the
effect of an accounting change on reported earnings (H : X = 0,

H : X > 0) .
a

(iii) lop management salary and bonus compensation is adjusted for the effect
of an accounting change on reported earnings (H:X=I3,H:X^I3).



-7-



Tests of hypothesis (ill) provides stronger evidence on the economic
consequences theory than tests of hypothesis (ii), because hypothesis (ii) is
rejected if the compensation committee partially adjusts compensation by
changing the elasticity of compensation to earnings subsequent to the
accounting change .

Equation (4) is estimated separately for each firm in the sample and the
distribution of the estimated values of 13 and X (and the associated
t-statistics) are used to test the above hypotheses. The sign and
significance of 13 , X and (B-X) are tested by computing the following
statistic for each variable:

, n t .
7 = 1 y 3

7^T , , /(k.-2)/k.

J=l J 3

where, t = t-statistic for firm j associated with the estimates of

13 , X or ((3-X) in equation (4),
k. = degrees of freedom in regression for firm j,
n = number of firms in the sample .



The t statistic for firm j is distributed Student t with variance of
k./(k.-2). Under the Central Limit Theorem, the sum of the standardized t
statistics is normally distributed with variance of n. Each Z-statistic is



therefore a standard normal variate under the three null hypotheses discussed

ram<
7,8



above. In addition to this parametric test, a nonparametric binomial test



is used to test the hypotheses



-8-



2 .3 Sample Selection and Data Collection

The sample of inventory changes is selected from Accounting Trends and
Techniques (1970 to 1976) . We identify 161 companies that changed from FIFO
to LIFO during this period. Our sample of depreciation changes is selected
from Holthausen's database (see Holthausen (1981)) . We exclude companies that
changed to straight-line depreciation prior to 1967 since compensation data
for these companies are incomplete. This restriction limits our sample to 80
of Holthausen's 139 companies.

Eonus and salary data and management changes are collected for the CFOs of
our sample companies for the year of the accounting change and the ten years
before and after that event from two sources: corporate proxy statements and
the annual compensation survey published by Eusiness Week . We require that
(i) at least five years of consecutive compensation data are available before
and after the year of the accounting change, and (ii) a minimum of fourteen
consecutive years of data are available for each company. These data
constraints reduce the samples to 52 companies that changed inventory policies
and 38 companies that changed depreciation methods . The distribution of the
changes over the sample period is reported in Table 1 . The depreciation
changes are clustered in 1968 and 1969, and the inventory changes in 1974 and
1975.

Earnings before extraordinary items are collected from COMPUSTAT for
each company-year that has compensation data available . Compensation and
corporate earnings data are deflated by the CPI to 1967 dollars . A summary of
selected statistics is presented in Table 2 . The median Salary + Ponus in
1967 constant dollars across all executive-years is $186,000 for the inventory
sample and $190,000 for the depreciation sample. The median corporate
earnings in 1967 dollars across all company-years is $50,946,000 for the
inventory sample and $41,806,000 for the depreciation companies.

-9-



The earnings effects of the inventory and depreciation changes are
collected from the financial statement footnotes for years following the
change . Companies that use the LIFO inventory method report the current
replacement value of inventory. This value approximates the FIFO Inventory
value and is used to calculate the difference between reported LIFO income and
income that would have been reported had the company continued to use FIFO
(original FIFO income) . The effect of the depreciation switch from the
accelerated to straight-line method is calculated from the deferred tax
footnote . All the companies in our depreciation sample continue using the
accelerated method for taxes following the reporting change to the
straight-line method . The resulting timing difference between book and tax
incomes gives rise to an adjustment to deferred taxes which is reported in the
tax footnote, we use this value to calculate the difference between reported

income and income that would have been reported had the company continued

9
using the accelerated depreciation method .

Table 3 reports statistics on the earnings effect of the change to LIFO as

a percentage of earnings under FIFO. Lairing the year of change, the median

earnings reduction from the inventory policy change is 19.3?: the median

reduction in earnings for all years after the change is 5 .2% . The effect of

the change in depreciation policy is also reported in Table 3 . The median

increase in earnings from the switch to straight-line depreciation is 6.6%

percent in the year of the change . For years subsequent to this accounting

change, the median earnings increase is 7.3 percent.



-10-



3 .0 RESULTS

3 J. Inventory Sample

Table 4 presents regression results for the sample of 52 firms that

11 ?

changed from FIFO to LIFO . The average R of the regressions is 0.65

indicating that accounting earnings explain a nontrivial proportion of the

variability in CEO bonus and salary compensation .

The estimated coefficients on reported earnings are positive for 92
percent (48 of 52) of the sample firms . A binomial test indicates that there
is a higher proportion of positive coefficients than expected by chance at the
one percent significance level using a one-tailed test . The mean coefficient
on reported earnings is 0.317 implying that a ten percent increase in earnings
is associated with a 3 .17 percent increase In bonus and salary compensation .
The Z-statistic to test the joint significance of the earnings coefficients
for the 52 sample companies is significant at the one percent level, enabling
us to reject the null for hypothesis one, that there is no relation between
accounting earnings and top management bonus and salary compensation .

The estimated coefficients for the earnings effect of the accounting
change (the ratio of reported (LIFO) earnings and FIFO earnings) are positive
for 71 percent (35 of 52) of the sample . A binomial test rejects the null
hypothesis that the proportion of positive coefficients is equal to that
expected by chance at the one percent level using a one-tailed test . The mean
coefficient for the earnings adjustment term is .3613 . The sample
Z-statistic to test the collective significance of the Xs for all the 52
firms in the sample is significant at the one percent level . We therefore
reject the null for hypothesis two, that top management's bonus and salary
compensation is fully adjusted for the effect of the inventory change .

Descriptive statistics for the difference between the estimated



-11-



coefficients on as-if (FIFO) earnings and the earnings effect of the change to
LIFO (13-A) are also reported in Table 4. If the compensation committee uses
reported earnings to reward CEOs and does not adjust earnings for the effect
of the change to LIFO, the difference between these coefficients wil] be
zero. The mean difference is -0.0443 and is not significantly different from
zero at the five percent level using a two-tailed test. The differences In
the estimated coefficients are positive for 48 percent (25 of 52) of the
sample firms . A binomial test fails to reject the hypothesis that the
proportion of positive differences in coefficients is equal to that expected
by chance at the ten percent level. We thus reject the hypothesis that
earnings-dependent compensation is adjusted for the effect of an inventory
change to LIFO .

In summary, the results of the inventory tests support the economic
consequences theory. The estimated coefficient on the earnings effect of the
accounting change Is positive and statistically significant, but is not
statistically different from the as-if earnings coefficient . Compensation
committees therefore appear to use reported earnings to determine executives'
compensation subsequent to a change to LIFO and do not adjust earnings for the
effect of the change in inventory method .

3 .2 Depreciation Sample

The results for the 38 firms that changed from accelerated to
straight-line depreciation are consistent with the results for the inventory

sample presented above . Table 5 reports a summary of the ordinary least

2
squares estimates of model (4). The average R of the regressions is 0.69

and 84.2 percent (32 of 38) of the earnings coefficients are positive. A

binomial test indicates that this number of positive estimates is



-12-



significantly greater than that expected by chance at the one percent level
using a one-tailed test . The mean estimated coefficient is J.745 and is also
statistically significant at the one percent level. Thus, as before, we find
that there is a significant positive relation between reported earnings and
CEOs' bonus and salary compensation.

Ihe estimates of X, the coefficient on the earnings adjustment variable,
are also reported in Table 5. Recall that, if the compensation committee
continues to use earnings based on accelerated depreciation after a charge to
straight -line depreciation, we expect X to be zero. If the committee uses
reported earnings, computed using straight-line depreciation subsequent to the
accounting change, we expect X to be positive. The estimates are positive
for 60.5 percent (23 of 38) of the companies. Using a one-tailed test, the
hypothesis that this percentage is the same as that expected by chance, is
rejected at the five percent level. The mean earnings adjustment coefficient
is 0.2752. The Z-statistic, which tests the hypothesis that the estimated
value of X is positive, is significant at the one percent level. We thus
reject the hypothesis that earnings-dependent compensation is fully adjusted
for the effect of the depreciation change .

The difference between the estimated coefficients on earnings computed
using accelerated depreciation and the earnings effect of the accounting
change is not statistically significant. The mean coeficient of -0.0753 is
not significant at the ten percent level using a two-tailed test . The
differences in the estimated coefficients are positive for 39.5 percent (15 of
38) of the sample firms. Using a two-tailed binomial test, we cannot reject
the hypothesis that this percentage is the same as that expected by chance at
the five percent level. As for the inventory sample, we reject the hypothesis
that earnings-based compensation Is adjusted for the effect of the accounting
change .

-13-



In summary, our results for both inventory and depreciation samples
indicate that there is a significant relationship between top executive
compensation and reported earnings (hypothesis (i)). They are also consistent
with the hypothesis that when the two accounting policies are changed,
compensation committees do not fully adjust reported earnings for their
effect. Finally, our tests support the hypothesis that there is no adjustment
of salary and bonus compensation for the effect of an inventory or use
reported earnings to depreciation change. In other words, compensation
committees appear to compute earnings-based remuneration subsequent to changes
from FIFO to L1F0 and changes from accelerated to straight-line depreciation.


1

Online LibraryPaul M HealyThe effect of accounting procedure changes on executive remuneration → online text (page 1 of 2)