Transcript No Slide Title

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
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
1
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
2
Some Problem U.S. Companies …
3
Some Problem Non-U.S. Companies …
8.1% of Non-U.S. Companies
Listed in the U.S. had an
earnings restatement in 2004
4
Corporate Governance …
Collection of Mechanisms to Control
Managers so that the Interests of
Shareholders and Stakeholders
are Protected
5
Corporate Governance …
External
Auditors
Customers
Unions
Inst
Owners
Stock
Holders
Board of
Directors
SelfInterested
Execs
Debt
Holders
Legal Tradition
Social and Ethical Values
Efficiency of Capital Markets
Comp &
Equity
Holdings
Suppliers
SEC
Analysts
6
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
7
The Corporate Library (TCL) …
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.
Source: http://www.thecorporatelibrary.com/Products-and-Services/board-effectiveness-ratings.html
8
The Corporate Library (TCL) …
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.
Source: http://www.thecorporatelibrary.com/Products-and-Services/board-effectiveness-ratings.html
9
Stock Returns Using TCL Ratings …
Return to $1 invested in "BAD" and "GOOD" governed firms - The Corporate Library
1.8
1.6
1.4
Cumulative Return
1.2
1
0.8
0.6
0.4
0.2
0
3
4
3
3
4
4
2
2
3
3
4
4
3
4
3
4
3
4
2
2
3
3
4
4
2
3
4
2
3
4
l-0 g-0 p-0 t-0 v-0 c-0 n-0 b-0 r-0 r-0 y-0 n-0 ul-0 g-0 p-0 ct-0 v-0 c-0 n-0 b-0 ar-0 pr-0 y-0 n-0 ul-0 g-0 p-0 ct-0 v-0 c-0
a
o
e
u
u
e
Ju Au Se Oc No De Ja Fe Ma Ap Ma Ju
J Au Se O No De Ja Fe M
J
A M
O N
J
A
S
D
Month
"BAD" Governance Portfolio
"GOOD" Governance Portfolio
Source: Larcker, Richardson, and Tuna, Financial Times
10
Academic Research …
Board Approved Takeover Defenses
(Maximum Score = 24)
Less than six
takeover defenses
Shareholder Focus
More than thirteen
Takeover defenses
Management Focus
+3.48% “excess”
return per year
-5.05% “excess”
return per year
However, recent research indicates these results are “fragile”
Source: Gompers et al., Quarterly Journal of Economics, 2003
11
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
12
Basic Research Question …
What is the Precise Structural Model?
SelfInterested
Executives
Determinants
of the
Corporate
Governance
Are These Variables Exogenous?
Influence of
Corporate
Governance
What are the Contextual Variables?
Make
Investment
and Financing
Decisions
Causing
Stock Price and
Operating
Performance
13
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”
14
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
15
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
16
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
17
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)
18
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 preexisting 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 limited liability)
Source: Armstrong, Larcker, and Su, working paper, 2006.
19
Mathematical Program …
20
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
21
Results for Selected Fortune 500 Firms …
 Estimated moral hazard (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 secondbest 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)
22
Results for Selected Fortune 500 Firms …
R2 (adjusted R2) = 8.41% (6.33%)
23
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?
24
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
25
Thanks to …
26
Academic Research …
“Excess” Executive Compensation is Related to:
 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)
Source: Core et al., Journal of Financial Economics, 1999
27
Academic Research …
A 40% Increase in “Excess” Executive Compensation:
“Excess”
Return on
Assets
“Excess”
Stock
Return
One-Year
Three-Year
Five-Year
- 1.36%
- 3.56%
- 4.88%
- 4.97%
- 8.47%
- 8.88%
Source: Core et al., Journal of Financial Economics, 1999
28