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E-MailThis post comes to us from Qiang Cheng at the University of Wisconsin-Madison and David B. Farber at the Trulaske College of Business at the University of Missouri-Columbia.
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.
