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E-MailPing Wang is Assistant Professor of Accounting at Pace University Lubin School of Business. This post is based on a recent article by Professor Wang; Masako N. Darrough, Professor of Accountancy at Baruch College/CUNY Zicklin School of Business; and Linna Shi, Assistant Professor of Accounting at SUNY Binghamton. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).
When faced with an impending negative earnings surprise, CEOs have to decide whether or not to voluntarily issue earnings warnings. A warning (defined as negative earnings guidance) might be issued when a firm expects that its actual earnings will fall short of existing market expectations. Such a warning is typically issued near or after the end of a fiscal quarter, but before quarterly or annual earnings are announced. The extant literature on U.S. firms documents a number of reactions to the issuance of an earnings warning, including: an adjustment by the market of its expectations, typically through a reduction in share prices; a decrease in litigation costs; less information asymmetry among investors; increased analyst following; and increased chances of meeting or beating analysts’ forecasts. Given that these firms tend to be performing poorly (or at least below market expectations), the issuance of warnings appears to be an integral part of the timely disclosure of bad news.
Timely disclosure of news is important to investors, especially when firms expect to fall short of market expectations. Issuing warnings ahead of actual earnings announcements brings some benefits to firms in this position, such as reducing the potential class period in the case of litigation, while incremental costs appear to be small since negative market reactions are likely to occur anyway, at the time either of warnings or of actual earnings announcements. One would expect that most firms facing a negative earnings surprise would issue warnings so that investors would not be caught off guard. Thus, it is surprising to find that a relatively small number of companies issue these warnings when they face negative earnings surprises; prior literature reports that less than 25% of firms preempt negative earnings surprises by issuing warnings. This finding suggests that the decision on whether to issue warnings is not as straightforward as one might think. Since this decision is likely made by CEOs (and CFOs) rather than firms as a whole, an agency problem might exist.
In our recent article, Earnings Warning and CEO Welfare, forthcoming in the Journal of Business Finance & Accounting, we examine the consequences of warnings that might directly accrue to CEOs who have to decide whether to issue these warnings. Our overall research question is whether and how boards of directors make use of voluntary disclosures in the form of warnings in determining CEOs’ compensation and retention/turnover.
Using 1,320 firm-year observations of warnings and 8,969 firm-years of non-warnings from 1996-2010, we examine the following issues: (1) how warnings affect bonus and stock-based compensation of CEOs; (2) how warnings affect pay-performance sensitivity; (3) how warnings affect CEOs’ total compensation; and (4) how warnings affect CEO turnover. Both warning and non-warning CEOs may expect negative earnings surprises, but the former decide to warn, and the latter decide not to warn.
The first issue we study is whether warnings directly affect the level of CEO compensation, as reflected both in bonus and in stock options. Prior evidence suggests that the very act of issuing warnings could provide incremental information about firm prospects over and above the actual earnings shortly to be released. If warnings provide information about CEOs’ performance that is incremental to that gleaned from actual accounting and stock-based returns, then compensation committees might use this information to adjust CEO compensation. On the other hand, compensation committees may not pay attention to warnings since actual earnings would be available at the time they determine CEO compensation. It is also possible that in trying to encourage CEOs to be more forthcoming about impending bad news, compensation committees shield CEOs from bad news. If so, a CEO’s compensation would not be affected by warnings. Taken together, it is an empirical question as to whether and how warnings affect CEO compensation.
While performance-based CEO compensation has several components, we focus on bonus and stock options in this study. The bonus of CEOs is typically awarded, ex post, based on past performance, while option grants are awarded, ex ante, to incentivize CEOs to take future value-maximizing actions. The poor performance signaled by warnings may indicate that the interests of managers are not well-aligned with those of shareholders. To optimally incentivize CEOs for future performance, compensation committees may reduce bonuses but grant additional options to provide stronger incentives to CEOs. After controlling for CEOs’ self-selection in the issuance of warnings, we find that warnings are significantly negatively associated with CEO bonuses, but positively associated with option grants. This association indicates that determining compensation.
The second issue we examine is the effect of warnings on bonus-to-performance and option-to-performance sensitivity. Prior literature argues that stock returns should become more useful in evaluating CEO performance when the consequences of the agent’s current-period actions are realized in the future but are not fully reflected in current-period accounting numbers. We would then expect to see an increase in compensation sensitivity to stock returns for warning CEOs. We find the sensitivity of bonus to stock returns is increased.
Third, we investigate the effect of warnings on total compensation. We find that total compensation is not affected by warnings, suggesting that compensation committees adjust CEO compensation towards a more option-based structure to ensure that CEOs’ interests are better aligned with those of shareholders. Issuance of warnings appears to be interpreted as a signal that re-alignment of incentive structures is warranted.
Lastly, we explore the effect of warnings on CEO turnover. On the one hand, if management guidance accuracy (about future prospects) is an indicator of ability, then we would expect warnings to reduce CEO turnover by increasing perceived management ability and reputation. On the other hand, if warnings signal a disappointing future performance, then CEO turnover rate may increase. Our empirical results, however, paint a nuanced picture. We find weak evidence that warnings directly increase the rate of forced turnover, however, we also find that warnings increase the sensitivity of turnover to stock returns, indicating that such an increase benefits CEOs who were able to generate positive stock returns during the year but penalize CEOs who were unable to do so.
This article contributes to literature by documenting the welfare impact of the issuance of warnings on CEOs. We report evidence that suggests that compensation committees view the information conveyed in warnings as an important performance measure. While CEOs are not penalized in terms of total compensation, their compensation packages are restructured and become more equity-based when they issue warnings. In addition, we show that CEO turnover is affected by the issuance of warnings. Our findings may explain why a relatively small proportion of CEOs warn when they face a negative earnings surprise, even though their firms as a whole benefit from warnings.
The complete article is available for download here.
