Daniel A. Cohen
CAPANA Conference
Chengdu, July 2 2010

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 Primary Contribution:
Provide evidence that CEO bonuses leads to overstatement of goodwill
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Interesting research question, well motivated paper
Timely and relevant topic – fair value accounting debate
Overall, well written and articulated
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 Main points:
Research design issues and its implications for inferences and conclusions drawn
Relation to prior research and potential contribution to existing literature

Purchase Price Accounting Treatment
Goodwill,
55.4%
Intangible
Assets
Separate from
Goodwill
Indefinite-Life , 4% (Trademarks)
Finite-Life , 20%
(Patents, Technology)
In-Process R&D , 4.6%
Net Tangible Assets ,
16%
Not Subject to Amortization.
Subject to a Mandatory Annual
Impairment Test
Amortized over Economic
Useful Life
Written-off at Acquisition
Restated to Fair Value

Executive
Compensation:
BONUS

Accounting
Choices
 Causality: a complex theoretical setting

 Incentives

Accounting Choices

Private Benefits:
Goodwill
Allocation



BONUS = F (AC, Performance, X);
AC = G (BONUS, Incentive-based Comp., Performance, X)
COMPENSATION MIX = Y (Incentives, Reporting costs, Performance, X)
“In this study we investigate the effects of the above aspects of compensation on managerial accounting choices.” versus
The effect of accounting choices (which are subject to managerial manipulation) on
CEO compensation.

 Compensation contracts are quite complex
 Different components will affect accounting choices in different ways
 Cash salary and bonus, options grants (existing and current), restricted stocks and long-term incentives plans
 If components of total compensation have different risk and incentive profiles, empirical analysis of compensation-decision making relations must consider the interplay between the different components.
 Can we expect that the recent reforms (e.g., SOX 2002, SFAS
123R) may alter the overall compensation mix in addition to changes in bonus payments:
 Microsoft, July 2003 : discontinue granting stock options and replace such plans with restricted stock.

 Compensation package is a function of numerous variables (Carter, Lynch and Tuna, 2007):
 Incentive levels
 Financial reporting costs
 Size
 Performance
 Risk-aversion
 Substitution effect between different components:
 Stock options vs. restricted stocks
 Weights on stock price and accounting based components
 Industry peers, competitors

 The bonus contracts are not explicitly observed
 As in Balsam (1998), earnings components are not distinguished ex ante.
 No guidance provided concerning the expected weights on earnings components in the compensation mix function (see
Gaver, 1998).
 Earnings components are measured with error, partitioning between cash flows, nondiscretionary and discretionary accruals is not observed:
 Interpretation of results is difficult:
 Efficient contracting vs. reflection of measurement error

 How are the CEO performance targets set?
 Annually vs. other periods? Short term vs. long term plans
 How does the acquisition affect the performance targets in place given the effect on reported earnings?
 Numerous performance measures
 Emphasis on peer performance
 Are the industry fixed effects included in testing H1 and H2 (2-digit
SIC) capturing the richness and importance of this significant issue?
 INDSAME variable in equation (2)?
 Emphasize more the use of cash-based measures versus earnings.
 Implication for discretion/flexibility in financial reporting
 Relates to recent regulation (e.g., SOX – see Carter et al., 2007)

Compensation Over Time, 1992-2004
0.5
0.45
0.4
0.35
0.3
0.25
0.2
0.15
0.1
0.05
0
1992 1993 1994 1995 1996 1997 1998
Year
1999 2000 2001 2002 2003 2004
SALARY
BONUS
OPTION

 Equation 1: what if bonus equals to zero?
 Use the log of (salary and bonus)
 BONUS = average over three years (footnote 13)
 Includes the year of acquisition – mechanical relation
 CEOs receive larger bonuses after completing M&A deals:
 Grinstein and Hribar (2004, JFE)


 Changes in bonus over time
Measuring Goodwill – Focus only on abnormal goodwill?
Scaling of variables
 Include equity-based incentives variable
 Stock options, restricted stock, etc.
 BONUS is only 19% of total compensation.

Research design: choice variables and sequence of events

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Numerous choices/decisions are made by the firm
 Design of compensation contracts
 Investment strategies: M&A deals. How much to pay for the target?
Is the compensation contract pre-determined before the acquisition? As a response to the acquisition?
 Heckman model uses three variables: Size, B/M, and long term analyst forecasts
Control for performance (accounting and stock returns)
 During the period that compensation is measured and goodwill allocated
Is the overall amount paid for the target company a function of the compensation structure in place?
 Prior research examining investments and compensation will argue - yes.
Future impairments – LACK_SLACK is included as a control variable
 Goodwill impairments have first order effect on compensation through earnings (Beatty and Weber,2006)

 Compensation contracts and investments
 Grinstein and Hribar (2004, JFE): investigate CEO compensation for completing M&A deals. More powerful CEOs get larger bonuses. Any implication for future impairments?
 Bizjak et al. (1993, JAE): stock-based incentive compensation and investment behavior
 Kang et al. (2006, JB): estimate jointly the relationship between investments and CEO incentive compensation structure while considering the strength of the corporate governance mechanisms
 Other related papers:
 Aboody et al. (1999, JAE): pooling versus purchase acquisitions.

 In acquisitions with large step-ups to targets’ net assets, CEO with earningsbased compensation are preferring pooling to avoid the earnings ‘penalty’
Carter et al. (2007, RAST)

 Complexity of compensation contracts
 How to differentiate between the incentive vs. measurement explanations of the relation between accounting choices, investment opportunities/economic conditions and compensation
 Importance of goodwill allocation as an overall component of firms’ investment strategies (especially, M&A).

The ‘Ceteris Paribus’ assumption: holding constant… .

 Overall, an interesting and well written study.
 The paper addresses a relevant, timely and important issue.
 Potential for contribution – emphasis on the importance of cash flows measures in compensation mix.
Thank you!
谢谢