Corporate Governance, Executive Compensation, and Managerial Accounting

1. Corporate Governance, Executive Compensation, and Managerial Accounting David F. Larcker Graduate School of Business Stanford University 5TH CONFERENCE ON NEW DIRECTIONS IN MANAGEMENT ACCOUNTING: INNOVATIONS IN PRACTICE AND RESEARCH

2. HealthSouth … • Accused of overstating earnings by at least $1.4 billion since 1999 in order to meet analyst and bonus targets • CEO paid a salary of $4.0 million, cash bonus of $6.5 million, and given 1.2 million stock options during fiscal 2001 • Former CFO and other executives pleaded guilty to a scheme of artificially inflating financial results • CEO sold 2.5 million shares back to the company, or 94% of his shares just weeks before the firm revealed that the regulatory changes would hurt earnings and battered its stock price

3. HealthSouth … • What was the board of directors doing? • Compensation committee met only once during 2001 • Forbes (April 30, 2002): CEO has "… provided sub-par returns to shareholders while earning huge sums for himself. Still, the board doesn’t toss him out." • What was the external auditor (E&Y) doing? • Audit committee met only once during 2001 • President and CFO were previously auditors for E&Y • Audit fee = $1.2 million versus other fees = $2.5 million • What were the analysts doing? • UBS Warburg analyst had a “strong buy” on HealthSouth • UBS earned $7 million in investment banking fees

4. Some Problem U.S. Companies …

5. Some Problem Non-U.S. Companies … 8.1% of Non-U.S. Companies Listed in the U.S. had an earnings restatement in 2004

6. Corporate Governance … Collection of Mechanisms to Control Managers so that the Interests of Shareholders and Stakeholders are Protected

7. Corporate Governance … Efficiency of Capital Markets

8. Pundits and Consultants … • Many “best practice” frameworks have been proposed by blue ribbon committees and regulators • Ratings are an important product being marketed by many consulting firms (GMI, ISS, TCL, etc.) • The recommendations and scores seem to be largely based on “guesses” • Many assertions, not much science

9. The Corporate Library's ratings are based on a small number of proven dynamic indicators of special interest to shareholders and investors. We want to determine which boards are most likely to enhance and preserve shareholder value, and which boards might actually increase investor risk. The Corporate Library (TCL) … Source: http://www.thecorporatelibrary.com/Products-and-Services/board-effectiveness-ratings.html

10. This approach led to our successfully identifying the Enron, Worldcom, Global Crossing, HealthSouth, Kmart, Warnaco and DPL boards as likely to encounter problems well BEFORE those firms imploded, even while most other ratings systems awarded those boards generally high marks. The Corporate Library (TCL) … Source: http://www.thecorporatelibrary.com/Products-and-Services/board-effectiveness-ratings.html

11. Stock Returns Using TCL Ratings … Source: Larcker, Richardson, and Tuna, Financial Times

12. Less than six takeover defenses Shareholder Focus +3.48% “excess” return per year More than thirteen Takeover defenses Management Focus -5.05% “excess” return per year Academic Research … Board Approved Takeover Defenses (Maximum Score = 24) However, recent research indicates these results are “fragile” Source: Gompers et al., Quarterly Journal of Economics, 2003

13. Academic Research … • Results to date are very mixed and have quite limited explanatory power for explaining: • Accounting manipulations • Restatements • Cost of capital • Organizational performance • Shareholder litigation • Few convergent results exist, with the possible exception of some international (cross-country) research

14. Are These Variables Exogenous? What are the Contextual Variables? Basic Research Question … What is the Precise Structural Model? Determinants of the Corporate Governance Influence of Corporate Governance Self- Interested Executives Make Investment and Financing Decisions Causing Stock Price and Operating Performance

15. Theoretical Concerns … • Extensive economic literature on organizational design and the choice of compensation contracts • However, hypotheses have modest empirical support • Surprisingly few theoretical economic models for the choice of corporate governance • Choice of inside versus outside boards • Endogenous selection of boards • A rich set of “behavioral” models exist: • Managerial power • Social comparison • “Window dressing”

16. Measurement Concerns … • Corporate governance and executive incentives are both ill-defined constructs (theory has not been much help here) • Typically only structural indicators – “on the outside looking in” measures – are used by researchers • Difficult to believe that corporate governance can be adequately measured by a single number (e.g., summing scores on an arbitrary set of indicators) • Almost no evidence about reliability and construct validity of corporate governance or incentive measures

17. Econometric Concerns … • Extremely complex econometric problems exist: • Measurement error (use latent variables ?) • Endogeneity (use instrumental variables ?) • Self-selection (use Heckman approaches ?) • Most of the research simply consists of using a convenient set of individual indicators in a regression – sort of a “regress-a-thon” • Absence of a structural model derived from theory leading to a reduced form model for estimation

18. Structural Modeling … • One potential way to address endogeneity is to use structural econometric modeling (similar to that used in macroeconomics) • Solve an explicit model for the agency problem (environment, technologies, behavioral constraints, objective function, etc.) • Collect relevant data and assume that this model produced the observed data • Estimate the unknown parameters using method of moments or maximum likelihood

19. Structural Modeling … • Using the parameter estimates, assess whether the structural model is adequate • If so, it is possible to make causal statements about how changes in one variable affect various outcomes (addresses the classic Lucas critique) • Endogeneity is not an issue – the “entire system” is modeled • Structural modeling is appealing, but you are asking a lot from the model and data (plus you have to develop the structural model)

20. A Semi-Structural Analysis … What Happens when the Standard Agency Model is Parameterized Using Actual Data and Reasonable Assumptions about the Contracting Environment? • Risk neutral principal and risk and effort averse agent • Agent utility defined over flow compensation and pre-existing wealth less disutility of effort • Agent effort affects both the mean and variance of the stock price distribution • Salary must be greater than or equal to zero (i.e., the contract exhibits limitedliability) Source: Armstrong, Larcker, and Su, working paper, 2006.

21. Mathematical Program …

22. Solution Approach … • Adopt the Grossman and Hart (1983) approach with • Discrete agent actions and discrete stock price • Continuous compensation contract parameters • First-order approach is not used because it is generally invalid for our model • This is an extremely difficult bi-level numerical optimization problem – mathematical program with equilibrium constraints (MPEC) • Numerical methods used for the solution

23. Results for Selected Fortune 500 Firms … • Estimated moralhazard (comparing the first-best to the unconstrained second-best): mean (median) = $28.44 ($9.69) billion; mean (median) = 101% (82%) of current market capitalization • Decrease in expected payoff moving from the unconstrained second-best to a constrained second-best is modest: mean (median) of $1,103 ($55) million – observed contracts are “robust” • For some companies, flow pay has very minor incentive effects (the incentives are almost completely related to CEO wealth)

24. Results for Selected Fortune 500 Firms … R2 (adjusted R2) = 8.41% (6.33%)

25. Role for Managerial Accounting … • What does good governance and compensation contract design look like? • Are there examples where the governance structure stopped self-interested executive behavior? • Do boards actually understand the business model for their firm? • How do boards assess the strategic and operational risk of their firm? • How are compensation decisions really made?

26. Role for Managerial Accounting … • Take advantage of knowledge about internal operations of the organization • Demonstrate the importance of qualitative methods and field research for theory development and hypothesis testing • Support research on construct definition and develop of psychometrically adequate measures • Actively push cross-disciplinary research – it is unlikely that much progress can be made using only an economic or behavioral perspective

27. Thanks to …

28. Academic Research … • Board size (10% increase -- 4% increase in compensation) • Outside directors older than 69 (increase of 1 -- 22% increase in compensation) • Outside directors appointed by the CEO (increase of 1 -- 15% increase in compensation) • Busy outside directors - on at least four boards (increase of 1 -- 6% increase in compensation) “Excess” Executive Compensation is Related to: Source: Core et al., Journal of Financial Economics, 1999

29. One-Year Three-Year Five-Year - 1.36% - 3.56% - 4.88% - 4.97% - 8.47% - 8.88% Academic Research … A 40% Increase in “Excess” Executive Compensation: “Excess” Return on Assets “Excess” Stock Return Source: Core et al., Journal of Financial Economics, 1999