Wayne R. Guay

The use of equity grants to manage optimal equity incentive levels

We predict and find that firms use annual grants of options and restricted stock to CEOs to manage the optimal level of equity incentives. We model optimal equity incentive levels for CEOs, and use the residuals from this model to measure deviations between CEOs’ holdings of equity incentives and optimal levels. We find that grants of new incentives from options and restricted stock are negatively related to these deviations. Overall, our evidence suggests that firms set optimal equity incentive levels and grant new equity incentives in a manner that is consistent with economic theory.

The sensitivity of CEO wealth to equity risk: an analysis of the magnitude and determinants

Abstract To control risk-related incentive problems, equity holders are expected to manage both the convexity and slope of the relation between firm performance and managers’ wealth. I find stock options, but not common stockholdings, significantly increase the sensitivity of CEOs’ wealth to equity risk. Cross-sectionally, this sensitivity is positively related to firms’ investment opportunities. This result is consistent with managers receiving incentives to invest in risky projects when the potential loss from underinvestment in valuable risk-increasing projects is greatest. Firms’ stock-return volatility is positively related to the convexity provided to managers, suggesting convex incentive schemes influence investing and financing decisions.

A Market-Based Evaluation of Discretionary-Accrual Models

Considerable research in accounting focuses on the role of accruals in capital market valuation and in contracting. The research shows accruals enable managers to improve on cash flows as a mesure of firm performance. However, since accruals provide managers with a means of managing reportedearnings, previous research also documents evidence of opportunistic accrual management. Opportunistic accruals are estimated using discretionary-accrual models that seek to separate earnings into discretionary accruals and nondiscretionary earnings.

The cash-flow permanence and information content of dividend increases versus repurchases

We hypothesize that firms choose dividend increases to distribute relatively permanent cash-flow shocks and repurchases to distribute more transient shocks. As predicted, we find that post-shock cash flows of dividend increasing firms exhibit less reversion to pre-shock levels compared with repurchasing firms. We also examine whether the stock market uses the announcement of the payout method to update its beliefs about the permanence of cash-flow shocks. Controlling for payout size and the markets expectation about the permanence of the cash-flow shock, the stock price reaction to dividend increases is more positive than the reaction to repurchases.

Accounting for Employee Stock Options

Accounting for employee stock options (ESOs) is controversial, with many arguing that it has substantial economic consequences. Such arguments rely on the assumption that one or more interested parties fixate on accounting numbers and fail to understand the real costs and benefits of ESOs. We review the various accounting issues and economic consequence arguments created by ESOs. We conclude that the accounting should facilitate a clear and consistent understanding of the costs of doing business, and that expensing ESOs best achieves this objective.

The Other Side of the Trade-Off: The Impact of Risk on Executive Compensation: A Revised Comment

In contrast to a body of research starting with Demsetz and Lehn (1985) that predict and find a strong positive association between firm percent return variance and incentives, Aggarwal and Samwick (1999) predict and find a strong negative association between firm dollar return variance and incentives. A key assumption of Aggarwal and Samwicks analysis is that firm risk is the sole determinant of the pay-performance sensitivity, and that expected dollar return variance (the product of expected percent return variance and firm market value) is the correct proxy for risk. We demonstrate that dollar return variance is a noisy measure of firm market value and argue that A&S re-documents a size effect that is already well-known from prior literature. Because dollar return variance is shown to be a noisy proxy for firm size, the A&S empirical specification does not include an appropriate proxy for firm risk. The data consistently show that it is important to examine market value and percent return variance as separate determinants of the effects of size and risk on CEO incentives, as is done in the managerial ownership literature. In a model of CEO incentives that includes market value and risk as separate explanatory variables, we find that, contrary to the results in A&S, percent return variance is positively associated with incentives. The A&S empirical work cannot be interpreted as evidence of a negative relation between risk and incentives.

Does Tax Aggressiveness Reduce Corporate Transparency

This paper investigates whether aggressive tax planning firms have less transparent information environments. Although tax planning provides expected tax savings, it can simultaneously increase the financial complexity of the organization. And, to the extent that this greater financial complexity cannot be adequately communicated to outside parties, such as investors and analysts, transparency problems can arise. Our investigation of the association between a newly developed measure of tax aggressiveness and information asymmetry, analyst forecast errors, and earnings quality suggests that aggressive tax planning decreases corporate transparency. We also find evidence, however, that managers at tax aggressive firms attempt to mitigate these transparency problems by increasing the volume of tax-related disclosure. Overall, our results suggest that firms face a trade-off between financial transparency and aggressive tax planning thereby potentially explaining why some firms appear to engage in more conservative tax planning than would otherwise be optimal.

When Contracts Require Risk-Averse Executives to Hold Equity: Implications for Option Valuation and Relative Performance Evaluation

A growing body of literature suggests that because an executive is risk-averse and undiversified, he values equity compensation and incentives at less than market value. This discount on valuation is driven by the assumption that the executive is constrained from rebalancing his portfolio following an equity grant, and as such, the payment of equity compensation permanently increases the risk and incentives borne by the executive. We relax this exogenous assumption, and assume that firms contract with their executives and agree upon a specified level of risk. Firms expect and require that executives rebalance their portfolios when equity risk rises above or falls below the contracted level. Under these assumptions, we show that the executive does not discount the value of equity compensation or changes in the value of his equity portfolio. The notion that firms write contracts that require executives to hold equity also suggests that executive contracts are more consistent with relative performance evaluation than has been found in prior empirical research. Specifically, this type of contract requires executives to reduce the fraction of their total wealth held in a well-diversified portfolio and to increase their investment in firm equity.

Is There a Case for Regulating Executive Pay in the Financial Services Industry

Since at least as early as the 1950s, the press, general public, politicians, and academic researchers have remarked on the high levels of US CEO pay and questioned whether these levels are fair and appropriate, as well as whether executive compensation provides proper incentives. Undoubtedly, executive compensation and incentives will continue to be a hotly debated issue for years to come and we do not contend to settle these disputes in this article. Rather, we begin by highlighting some basic descriptive analysis of CEO pay levels and incentives, in general, as well as a comparative analysis of CEO pay and incentives in the financial services industry. We then describe recent proposals to regulate executive pay in the financial services industry (and more generally), and discuss the merits of such regulation. In summary, although we agree broadly with regulators’ views on the principles that should guide executive compensation practices, we believe that many of these principles are already engrained in the typical executive compensation plan. We also have serious reservations about whether several of the regulatory proposals would achieve their stated objectives.

The Usefulness of Long-Term Accruals

Though empirical evidence strongly supports the role of short-term operating accruals in improving operating cash flows as a measure of performance, there is little support or consensus with respect to the effect of long-term accruals. We provide evidence that long-term accruals do reduce timing and matching problems in cash flows. In return-earnings regressions, long-term accruals are found to improve earnings as a measure of firm performance, although not to the same extent as short-term accruals. Further, our analysis highlights differences in economic and statistical properties between short-term and long-term accruals and demonstrates how these differences impede the ability of long-term accruals to improve earnings as a performance measure in a return-earnings context. The incremental explanatory power of long-term accruals is shown to be hampered by the lack of present-value considerations in the existing accounting model, timeliness problems, and measurement error in the indirect method of computing cash flows and accruals.