Yoshie Saito

The Value and Incentive Relevance of Nonrecurring Items: Under Conservative Accounting

I find that the value relevant components of special items and discontinued operations at the industry-level provide useful information to assess the performance of intangibles. Special items send noisy signals about future growth opportunities for firms within an industry, while discontinued operation send clear signals about the values of intangibles in the sector. I also find a significant positive (negative) link between CEO market-based compensation and the signals sent by discontinued operations (special items). My results suggest that compensation committees in firms across an industry consider the information about intangibles relayed by discontinued operations and special items, and selectively alter the level of incentives to encourage managers to send informative signals when reporting these items.

The effect of nonrecurring items on goodwill and CEO market-based compensation

Purpose This paper aims to analyze the association between goodwill defined as difference between market and book value of equity and reports of nonrecurring items, namely, special items, discontinued operations and extraordinary items to suggest information related to restructuring activities measured by these items can link the valuation and incentive roles of accounting. Economic intuition suggests that successful managerial efforts should increase firm value. Yet, the link between the valuation and stewardship roles of earnings has been difficult to verify. Design/methodology/approach The author first estimates whether nonrecurring items have an incremental ability to explain goodwill, measured as the difference between market and book value of equity, at the industry level and then estimates whether firm-specific accounting bias is associated with the industry-level signals sent by nonrecurring items. The author then analyzes whether these items are associated with the use of chief executive officer (CEO) market-based compensation. Findings The author’ results show that information contained in special items increases firm-specific goodwill, indicating that it sends signals to investors about future growth opportunities, while that of discontinued operations reduces goodwill, suggesting that it provides signals about the adjustments of book value. She does not find any significant informational role for extraordinary items. She also finds that the signals sent by special items are negatively associated with the use of CEO market-based compensation, while those relayed by discontinued operations are positively associated with the use of market-based pay. Research limitations/implications Contrary to prior studies, the results show special items and discontinued operations are both value and incentive relevant. There are two caveats to this analysis. First, owing to the frequent changes in the definition of discontinued operations, the analysis is conducted using data between 1992 and 2003. Second, some might argue that industry-level incremental R2 might not be appropriate for a compensation analysis. However, entities often use industry norms as a benchmark to set CEO compensation. Thus, it is reasonable to think that industry-level signals matter for executive pay. Originality/value The author’s findings suggest that compensation committees in firms across industries consider the information contained in special items and discontinued operations, and selectively alter the level of incentives to encourage managerial efforts.

Efficient Contracting or Rent Seeking for Long-Tenured CEOs

Uncertainty about a CEO’s ability is related to his/her length of service to a firm. Accordingly, monitoring systems should vary depending upon CEOs’ tenure. Long-tenured CEOs require less monitoring because their ability has been revealed over time. However, as CEOs advance in their careers, they are more likely to acquire power to influence board decisions. To analyze this implication, I examine whether the competing rent-seeking or efficient contracting hypotheses can explain long-tenured executives’ disposal decisions. I use the previously reported differential sensitivity of CEO cash compensation to income-increasing and -decreasing discontinued operations. Contrary to prior findings, I find that cash compensation for long-tenured CEOs is positively associated with both income-decreasing and -increasing discontinued operations. These results suggest that compensation committees provide opportunities for them to demonstrate their abilities, and these executives are willing to swallow the one-time negative effect to improve future operating performance. Therefore, my results for long-tenured CEOs support the efficient contracting hypothesis. I also analyze whether market participants scrutinize CEOs’ disposal decisions, and find that they react favorably to managerial decisions on both income-increasing and -decreasing DCs, consistent with the notion that they view these DCs as value-enhancing activities. Lastly, the post-period analysis shows that income-decreasing DCs improve future firm performance, and there is no evidence that income-increasing DCs cause long-term detrimental effects. These findings are consistent with the notion that boards implement systems that force long-tenured CEOs to continue to demonstrate their ability to make value-enhancing decisions.

Performance Before and After Discontinued Operations

Discontinuing an operation is a major decision for a manager, and requires approval from the board of directors. We provide valuable insights into these strategic choices. First, we document changes in reports of discontinued operations in recent decades. There is a major increase in divestitures after the implementation of new SFAS statements in 1998 and 2002. After the change in reporting requirements, the portion of firms discontinuing operations more than doubles in almost one-third of the industries that we analyze. Second, we use three multinominal logit models to determine the reasons for discontinuing an operation, and to gain insight into the signs and magnitudes of the reports. Three factors have the strongest effect on the decision. The firms that divest are unusually widely diversified, have high financial leverage, and have low values of Tobin’s Q. Undervalued firms are particularly likely to discontinue negative valued operations. Tightening corporate focus and improving performance seem to be very powerful motives for discontinuing an operation. Firms that divest often have also recently made large acquisitions, employ low levels of R&D and advertising, and slow historical sales growth. Finally, we examine operating efficiency after a discontinuation, and find evidence of marginal improvement in performance. Tobin’s Q rises, suggesting that markets approve. Revenue growth is better than for typical firms, and there is some evidence that operating profit margins improve. Overall, our results suggest that firms that discontinue an operation experience below average performance before, and improve marginally after, and markets reward them for these changes.

The Role of Transitory Earnings for Managerial Effort Allocation to Intangibles

There is a concern about the ability of earnings to adequately reflect managerial efforts to intangible-based activities. Agency theory suggests that when core earnings relay little information about managerial effort to certain activities, effort allocation will be insufficient. Risk averse managers consider costs of investing in RD they can send signals about the future and security prices reflect information about them. This means that even though the accounting system creates weak value relevant core earnings concerning intangibles, if transitory earnings can provide some additional information, they can play a vital incentive role. For example, unsuccessful prior intangible investments or obsolete inventory would be reported as transitory earnings (e.g., disposal of a poorly performing line of operation, asset write-downs, inventory write-offs), which can send signals to markets about managerial effort to tackle problems. These can be useful to convey information about managerial efforts exerted on intangibles. I show that under these conditions, market-based compensation helps to mitigate inefficient effort allocation to intangible-based activities. However, the reflection of transitory earnings in market-based compensation can also encourage earnings management. Managers may allocate their effort to a nonproductive activity such as shifting operating expenses to non-operation expenses to avoid a sharp decline in security price or/and meet analyst forecasts. Such activities do not increase economic value. Thus, the ability of transitory earnings to produce proper managerial effort allocation has to be weighed against the possibility of encouraging earnings manipulation.