Discussion of “CEO compensation and fair value

accounting: Evidence from purchase price allocation”

Daniel A. Cohen

CAPANA Conference

Chengdu, July 2 2010

General Comments

Primary Contribution: • Provide evidence that CEO bonuses leads to overstatement of

goodwill

• Interesting research question, well motivated paper• Timely and relevant topic – fair value accounting debate• Overall, well written and articulated

Main points:• Research design issues and its implications for inferences and

conclusions drawn• Relation to prior research and potential contribution to existing

literature

The Purchase Price Allocation (Shalev, TAR 2009)

Purchase Price Accounting Treatment

Net Tangible Assets,16%

In-Process R&D, 4.6%

Intangible Assets Separatefrom Goodwill

Finite-Life, 20%(Patents, Technology)

Indefinite-Life, 4% (Trademarks)

Goodwill,55.4%

Restated to Fair Value

Written-off at Acquisition

Amortized over Economic Useful Life

Not Subject to Amortization.Subject to a Mandatory Annual

Impairment Test

Assumed Relationship between executive compensation and accounting choices

Causality: a complex theoretical setting

Incentives Accounting Choices Private Benefits:

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.

Executive Compensation:

BONUS

Accounting

Choices Goodwill

Allocation

Design of Executive Compensation Packages

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 2003Microsoft, July 2003: discontinue granting stock options and replace such

plans with restricted stock.

Compensation Design, contd’

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

Bonus Contracts and Earnings Components

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

What does the proxy statement reveal?

A few points are in order 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, contd’

Compensation Over Time, 1992-2004

0

0.05

0.1

0.15

0.2

0.25

0.3

0.35

0.4

0.45

0.5

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Year

Co

mp

en

sati

on

SALARY

BONUS

OPTION

Research design: measurement issues and control variables

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

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)

Understanding the determinants of bonuses – research design implications

Relation to prior research

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 earnings-based compensation are preferring pooling to avoid the earnings ‘penalty’

Carter et al. (2007, RAST)

Food for Thought… 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….

Summary 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