Print
E-MailThis post comes from Mary Ellen Carter of Boston College, Luann J. Lynch of the University of Virginia, and Sarah L. C. Zechman of the University of Chicago.
Complain all you want about Sarbanes-Oxley, but the 2002 act and related reforms have created a tighter link between executive pay and company performance. Our study, Changes in bonus contracts in the post-Sarbanes-Oxley era, forthcoming in the Review of Accounting Studies, examines the relation between CEO and CFO bonuses and their firms’ earnings from 1996 to 2005—in other words, before and after these reforms. We find that firms place greater weight on earnings in determining executive bonuses after 2002. Put differently, boards appear to trust earnings more and therefore are willing to use them as a bigger factor in setting pay.
Our results are strongest in firms most affected by Sarbanes-Oxley—that is, those that show the largest decrease in earnings management after the law took effect. We find that these firms change their bonus contracts the most, putting even more weight than average on earnings in bonus contracts in the post-period.
Sarbanes-Oxley, prompted by financial scandals like Enron and WorldCom, was intended to reduce the ability of executives to manage earnings. Economic theory predicts that, when managers have less discretion over earnings, firms will place greater weight on them in writing executive compensation contracts—the earnings should reflect executive effort rather than accounting shenanigans.
Of course, real-world factors might prevent the theoretical predictions from playing out. Sarbanes-Oxley and related reforms exposed executives to greater risks—post-reform, they have to personally certify their companies’ financial statements, and they face serious penalties, including imprisonment, for misstatements. To counter-balance those risks, boards might have left bonus contracts unchanged since bonuses themselves are inherently risky—if an executive doesn’t perform, she doesn’t receive the bonus.
But when we compare the bonus contracts of CEOs and CFOs—that is, the executives who face the new regulatory risks—with those of other top executives at the same firms, we find that the CEO/CFO contracts give even more weight to earnings in the post-period than do the contracts of the other executives.
This suggests that boards seized the opportunity that Sarbanes-Oxley offered. The law enabled them to hold CEOs and CFOs more accountable for financial results, which, after the law, reflected executive effort more than earnings manipulation.
The full paper is available for download here.
