Richard G. Sloan

Executive incentives and the horizon problem: An empirical investigation

Abstract This paper investigates the hypothesis that CEOs in their final years of office manage discretionary investment expenditures to improve short-term earnings performance. We examine the behavior of R & D expenditures for a sample of firms in industries that have significant ongoing R & D activities. The results suggest that CEOs spend less on R & D during their final years in office. However, we find the reductions in R & D expenditures are mitigated through CEO stock ownership. There is no evidence that the reduced R & D expenditures are associated with either poor firm performance or reductions in investment expenditures that are capitalized for accounting purposes.

Annual bonus schemes and the manipulation of earnings

Abstract Using confidential data of executive-specific short-term bonus plans, we investigate the extent to which executives manipulate earnings to maximize the present value of bonus plan payments. As such, this paper extends the work of Healy (1985). Like Healy, we find evidence consistent with the hypothesis that managers manipulate earnings downwards when their bonuses are at their maximum. Unlike Healy, we find no evidence that managers manipulate earnings downwards when earnings are below the minimum necessary to receive any bonus. We demonstrate that Healys results at the lower bound are likely to be induced by his methodology.

Accounting earnings and top executive compensation

Abstract This paper investigates the role of accounting earnings in top executive compensation contracts. It provides evidence in support of the hypothesis that earnings-based incentives help shield executives from market-wide factors in stock prices. The paper demonstrates that earnings reflect firm-specific changes in value, but are less sensitive to market-wide movements in equity values. As a result, the inclusion of earnings-based performance measures in executive compensation contracts helps shield executives from fluctuations in firm value that are beyond their control. The hypothesis is shown to explain cross-sectional variation in the use of earnings-based incentives.

Short-sellers, fundamental analysis and stock returns *

Abstract Firms with low ratios of fundamentals (such as earning and book values) to market values are known to have systematically lower future stock returns. We document that short-sellers position themselves in the stock of such firms, and then cover their positions as the ratios mean-revert. We also show that short-sellers refine their trading strategies to minimize transactions costs and maximize their investment returns. Our evidence is consistent with short-sellers using information in these ratios to take positions in stocks with lower expected future returns.

Lack of timeliness and noise as explanations for the low contemporaneuos return-earnings association

We assess earnings lack of timeliness and value- irrelevant noise in earnings as explanations for the weak contemporaneous return-earnings association. Earnings lack timeliness because objectivity, verifiability, and conservatism conventions underlie the accounting measurement process. Noise in earnings is uncorrelated with returns in all periods. It likely gets introduced when estimates of future cash flows that differ from the markets estimates are included in earnings determined by accounting rules. Consistent with earnings lacking timeliness, we find current and future return earnings adjusted for expectational errors explain roughly 3-6 times as much of the annual return variation than current earnings alone.

Information in prices about future earnings: Implications for earnings response coefficients☆

Abstract Stock return over a period reflects the markets revision in expectation of future earnings. Accounting earnings over the same period, however, have limited ability to reflect such revised expectations. Therefore, returns anticipate earnings changes and the earnings response coefficient from a regression of returns on contemporaneous earnings changes is biased toward zero. We reduce this bias by including leading-period returns in price-earnings regressions. The resulting estimated earnings response coefficient magnitudes suggest that the capital market, on average, views earnings changes to be largely permanent. This is consistent with the random walk time series property of annual earnings.

Economic consequences of accounting for stock-based compensation

The Financial Accounting Standards Boards (FASB) project on employee stock-based compensation was one of the most controversial in the Boards 20-year history. In particular, the Boards 1993 Exposure Draft proposing the recognition of an expense for employee stock options generated predictions of dire economic consequences and prompted the threat of regulatory intervention from Congress and the White House. This study employs three complementary research approaches to evaluate the nature and extent of the predicted economic consequences. First, we examine the characteristics of firms lobbying against the 1993 Exposure Draft (FASB [1993]). Second, we examine the characteristics of firms using employee stock options under the original financial reporting rules. Finally, we examine stock price reactions to announcements concerning the new financial reporting rules.

The Persistence and Pricing of the Cash Component of Earnings

Prior research shows that the cash component of earnings is more persistent than the accrual component. We decompose the cash component into: (1) the change in the cash balance, (2) issuances/distributions to debt, and (3) issuances/distributions to equity. We find that the higher persistence of the cash component is entirely due to the subcomponent related to equity. The other subcomponents have persistence levels almost identical to accruals. We investigate whether investors understand the implications of the differential persistence of the three subcomponents. Our results suggest that investors correctly price debt and equity issuances/distributions but misprice the change in the cash balance in a similar manner to accruals. Our tests enable us to empirically distinguish the “accrual” and “external financing” anomalies with results implying that the accrual anomaly subsumes the external financing anomaly. Our results also suggest that naive fixation on earnings is unlikely to be a complete explanation for the accrual anomaly. Our findings are more consistent with investors misunderstanding diminishing returns to new investments. ∗Haas School of Business, University of California, Berkeley; †Barclays Global Investors. We are grateful for the comments of Todd Doersch, Wayne Guay, Abbie Smith, an anonymous referee, and workshop participants at Georgetown University, UCLA, the American Accounting Association 2005 meetings, the University of Utah Accounting Conference, and the Prudential Quantitative Research Conference 2006. We thank Seungmin Chee for research assistance.

Business unit innovation and the structure of executive compensation

Abstract We examine whether the structure of compensation for the divisional CEO is related to subsequent innovative activity within the division, and whether the divisional CEOs compensation is structured as a function of the expected innovation opportunity set facing the division. Both the expected innovation opportunity set and the divisional executives compensation contract are treated as endogenous variables by adopting a simultaneous equation approach. We find modest evidence that the proportion of total compensation tied to long-term components has a positive relation with future innovation, but no evidence that this proportion has a positive relation with the expected innovation opportunity set.

Financial accounting and corporate governance: a discussion

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