Kareen Brown

Ex Ante Severance Agreements and Earnings Management

This research studies whether severance agreements may reduce fraudulent earnings management, and whether severance pay mitigates executives’ career concerns. In a sample of large U.S. firms, those with higher severance pay are less likely to be subject to accounting and auditing enforcement releases (AAERs) by the U.S. Securities and Exchange Commission (SEC). Among S&P 500 firms in the post-SOX period with premanaged earnings below analyst forecasts, firms with higher severance pay are less likely to meet/beat the analyst forecast using abnormal accruals. Overall, these results suggest that fear of losing a lucrative severance package, and/or the insurance offered by such a package curbs earnings management.

Target Ownership Plan and Earnings Management

We examine the determinants of target ownership plans and their association with earnings management. We find that firms adopt target ownership plans not only in response to poor performance as documented by prior research, but also as a means to mitigate moral hazard concerns and in response to peer pressure. Our analyses show that firms engage in less accruals and real earnings management for up to two years following plan adoption. Additionally, we find that the reduction in accruals management is concentrated in adoption firms that have met the target ownership requirements, and in high probability adoption firms whose adoption decisions are driven by performance, moral hazard, governance, capital market, and peer-firm concerns. Our findings support the argument that target ownership plans align CEOs’ incentives with shareholders’ in that these plans result in reduced management short-termism as evidenced by more truthful earnings reporting and less real earnings management through production cost manipulation and discretionary expenditures.

The Firing of CEOS and Severance Pay

Stockholders and regulators question whether severance packages are beneficial to stockholders. We study an agency setting where, in period 2, the shareholder can either retain the manager or fire him if a suitable alternative candidate exists. The manager’s effort in period 1 not only determines his productive output but also the probability that a suitable candidate emerges in the second period. We consider three model variations in which: (1) the shareholder can costlessly commit to a firing strategy, (2) severance pay has a duel role that includes commitment and motivational efficiency, and (3) severance pay influences the manager to choose a high-return, risky project. Generally, severance pay is more efficient than performance-based bonuses when the arrival of a suitable candidate is a better signal of the manager’s effort than the output generated by the manager. We also show that contract settings exist in which the shareholder optimally commits to severance pay for a low productive outcome. Although casual observers may interpret severance pay in such cases as paying the manager for poor performance, committing to severance pay helps motivate the manager to choose high effort and a high-return investment project.