Executive Equity Compensation Drives Earnings Inflation

The economic crisis of 2008 put a bright spotlight on executive compensation and its effects on the behavior of top management. The critics have pointed to the unprecedented escalation in executive compensation, drawing a direct link to deteriorating business ethics, widespread excesses and abuses of power, and the lack of regard for customers’ and shareholders’ welfare.

We examine the effects of executive compensation on a specific type of mismanagement: myopic management (i.e., real activity manipulation, like cutting R&D and advertising spending, with the intent to artificially inflate current earnings).

Empirical research in accounting and other business disciplines has shown that under certain conditions, firms engage in real activity manipulation to temporarily inflate earnings, and such manipulation has significant negative consequences for the firm. It leads to significant declines in future profitability [1], a significant drop in the firm’s financial market valuation [2], and declines in the quality and quantity of innovative output. [3]

Little research exists on the drivers of myopic management practices. Academic research on accounting reporting practices (accruals manipulation) examined the responsibility of the CEO as key decision maker [4] and of the CFO as top manager with functional responsibilities for financial accounting choices [5].

We focus on myopic management related to the marketing function and on CEOs and CMOs. Our interest in myopic marketing management is driven by findings of prior research that the marketing domain is disproportionately affected by real earnings manipulation (cutting marketing, sales, advertising, or innovation expenses), with especially severe implications for future long-run performance. [2, 3, 6, 7] CMOs are interesting, because they are entrusted with maintaining customer focus in the organizations, supporting marketing function, and protecting marketing budgets. Are CMOs able to protect marketing assets and budgets from myopic cuts?

Studying myopic management has a few challenges. One, myopic behaviors are not directly observable, and we need some indicators to identify when myopia is taking place. We classify a firm as potentially engaging in myopia if it shows a positive earnings surprise (unexpectedly high earnings) and a simultaneous negative surprise (unexpected cut) in marketing spending. Another challenge is the lack of marketing spending data. Because marketing spending is not segregated in accounting reports, we use three proxies for marketing spending and replicate all our analyses with these three proxies: (1) a cut to marketing (defined as Selling, General & Administrative Expenses minus R&D) and a simultaneous cut to R&D at the time of unexpectedly high earnings, (2) a cut to marketing at the time of unexpectedly high earnings, and (3) a cut to advertising at the time of unexpectedly high earnings. We examine both the incidence (occurrence) and the severity (how much of a cut to marketing spending occurred to inflate current earnings to a given level) for these three marketing spending proxies.

In our empirical analyses we find that the mere presence of a CMO in the firm has no effect on either the incidence or the severity of myopic management across all three proxies for marketing spending. We also find that CEO equity incentives are largely unrelated to the incidence and severity of myopic marketing management. CMO equity compensation, on the other hand, is highly predictive of the incidence and severity of myopic marketing management. Contrary to the belief that the presence of a CMO in the organization can help maintain customer focus and support for marketing departments, we find that CMOs not only fail to prevent myopia, but further exacerbate the problem as the market-based (i.e., equity) portion of their personal compensation increases.

We confirm our findings by taking advantage of the enactment of regulation FAS 123R, which changed the accounting treatment of stock options: it eliminated firms’ ability to expense options at their intrinsic value and required expensing options-based compensation at a higher “fair” value. FAS 123R created an exogenous shock to the costs of options-based compensation while leaving the underlying economic benefits unaffected. The implementation of FAS 123R in 2005 effectively increased the costs and decreased the usage of option-based compensation. We find that firms where CMOs got fewer stock options following FAS 123R implementation were significantly less likely to engage in myopic marketing management than prior to FAS 123R as compared with the group of firms where CMOs did not receive any stock options prior to and after FAS 123R implementation. Interestingly, we do not find such an effect for CEOs. These results again emphasize the functional responsibility of the CMO for myopic management related to marketing function.

Further, consistent with the CMO’s personal enrichment motivation, we also find that CMOs take advantage of artificially inflated stock valuation by exercising more stock options and selling more of their personal equity holdings in the years when myopic marketing management occurs. This observation is robust to many alternative explanations such as firm-specific or management-team-specific reasons to trade equity.

Our findings highlight the pitfalls and limitations of overreliance on equity in managerial compensation packages and the relatively greater influence of lower-level executives in their functional domain.

Myopic management is a serious problem and a threat to firms, because it entails inefficient decision-making, which leads to a decline in future firm performance.

What are the solutions to the myopic management problem? One of the most commonly articulated proposals echoes Bizjak, Brickley, and Coles (1993), who suggested that firms with asymmetric information should pay their executives based on stock price performance but defer the payout until after an executive’s retirement in order to reduce the effects of equity compensation and provide optimal investment incentives during the latter part of the CEO’s tenure. Another proposal calls for tying executive compensation to long-run-oriented performance metrics (e.g., customer satisfaction or brand equity). Yet another proposal advocates expanding disclosure of value-relevant non-financial performance indicators to curtail myopic management.

In April 2015, the SEC issued a “pay versus performance” proposal (it has been moved from the 2017 SEC rulemaking agenda to the long-term action list by the current administration) to require greater disclosure on compensation and to draw a direct link to performance. Under this proposal, companies would be required to disclose the relationship between executive pay and a company’s financial performance and report executive compensation relative to their financial performance and relative to their peer group of firms. This is yet another potential solution to address the mis-alignment of executive compensation and firm performance. Whether the “pay versus performance” or the other proposals will be implemented and whether they can help remedy the managerial myopia problem remains to be seen.

ENDNOTES

[1] Cohen, Daniel A. and Paul Zarowin (2010), “Accrual-Based and Real Earnings Management Activities Around Seasoned Equity Offerings,” Journal of Accounting and Economics, 50 (1), 2-19.

[2] Kothari, S.P., Natalie Mizik and Sugata Roychowdhury (2015), “Managing for the Moment: Role of Real Activity Manipulation versus Accruals in SEO Over-Valuation,” The Accounting Review, 91 (2), 559-86.

[3] Bereskin, Frederick L., Po-Hsuan Hsu, and Wendy Rottenberg (2018), “The Real Effects of Real Earnings Management: Evidence from Innovation,” Contemporary Accounting Research, forthcoming.

[4] Shan, Yaowen and Terry Walter (2016), “Towards a Set of Design Principles for Executive Compensation Contracts,” Abacus, 52(4), 619-684.

[5] Jiang, John Xuefeng, Kathy R. Petroni, and Isabel Yanyan Wang (2010), “CFOs and CEOs: Who have the Most Influence on Earnings Management?” Journal of Financial Economics, 96 (3), 513-26.

[6] Chapman, Craig J., and Thomas J. Steenburgh (2010), “An Investigation of Earnings Management through Marketing Actions,” Management Science, 57 (1), 72–92.

[7] Mizik, Natalie (2010), “The Theory and Practice of Myopic Management,” Journal of Marketing Research, 47 (4), 594–611.

This post comes to us from Professor Martin Artz at the Frankfurt School of Finance and Management and Natalie Mizik at the University of Washington’s Foster School of Business. It is based on their recent paper, “How Incentives Shape Strategy: The Role of CMO and CEO Equity Compensation in Inducing Marketing Myopia,” available here.