CITY UNIVERSITY OF HONG KONG

香 港 城 市 大 學

Managerial Myopia, CEO Compensation Structure

and Earnings Management by R&D Cuts

經理人員短期行為，薪酬結構

和通過減少研究發展費用進行的盈餘管理

Submitted to Department of Accountancy

會計學系

In Partial Fulfillment of the Requirements for the Degree of Doctor of Philosophy

哲學博士學位

by

He Wei Dong

何衛東

February 2004

二零零四年二月

ii

ABSTRACT

Prior studies show that linking executive compensation to current accounting

performance provides incentive for CEOs to manage earnings by cutting R&D

expenditure (e.g. Baber et al. (1991), Bushee (1998)). However, it has also been

suggested that tying executive compensation with stock price mitigates opportunistic

R&D cuts (e.g. Lambert and Larcker (1987)). This study contributes to this strand of

literature by testing empirically whether CEO compensation structure in terms of the

relative mix of cash-based vs. stock-based compensation affects R&D expenditure in

firms that could reverse earning decreases with a reduction in R&D expenditure.

Analysis of a sample of 7,246 publicly traded U.S. companies shows that CEOs are

more likely to cut R&D expenditure to meet earning targets when the percentage of

cash-based compensation in their total compensation is high or increased, and that a

change from a cash-dominated compensation scheme to a stock-dominated

compensation scheme is negatively related to the likelihood of R&D cuts, suggesting

that stock-based compensation may mitigate opportunistic R&D cuts.

This study also finds that the association between CEO compensation structure and

the likelihood of R&D cuts can be moderated by some governance mechanisms

including CEO dominance, CEO ownership and anti-takeover provisions.

Moreover, this study presents evidence that discretionary accruals are negatively

related to the likelihood of R&D cuts for firms rewarding their managers with

stock-dominated compensation schemes, indicating a substitution effect between

earnings management by R&D cuts and by discretionary accounting choices. Those

results are robust to a variety of sensitivity tests, including those that account for

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endogeneity between CEO compensation structure and firm-level discretionary R&D

expenditures.

Key Word: Managerial Myopia CEO Compensation Structure Earnings

Management R&D Cuts

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ACKNOWLEDGEMENT

I would like to thank my committee members, Bin Srinidhi (Supervisor), Sidney

Leung, Charles Chen for their guidance and support. I thank Professor Ferdinand Gul

and Dr Xijia Su for their helpful comments and suggestions. I also thank Robert

Morris for his invaluable editorial assistance. I am especially grateful to Dr Charles

Chen for providing me with data on CEO compensation.

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TABLE OF CONTENTS

ABSTRACT----------------------------------------------------------------------------------ii

ACKNOWLEDGEMENT-------------------------------------------------------------iii

TABLE OF CONTENTS---------------------------------------------------------------iv

LIST OF TABLES------------------------------------------------------------------------vii

CHAPTER 1 INTRODUCTION-----------------------------------------------------1

1.1 Motivation--------------------------------------------------------------------------------1

1.2 Main Finding -----------------------------------------------------------------------------6

1.3 Contribution------------------------------------------------------------------------------7

1.4 Overview----------------------------------------------------------------------------------9

CHAPTER 2 LITERATURE AND HYPOTHESIS-------------------------11

2.1 Explanation for Earnings Management by R&D Cuts-----------------------------11

2.2 Executive Compensation Components-----------------------------------------------16

2.3 R&D Cuts and CEO Compensation Structure--------------------------------------19

2.4 Change in CEO Compensation Structure--------------------------------------------27

2.5 Influence of CEO Dominance and CEO Ownership-------------------------------31

2.6 Impact of Anti-takeover Mechanisms------------------------------------------------33

2.7 Earnings Management by Discretionary Accounting Choices--------------------35

CHAPTER 3 RESEARCH METHODOLOGY------------------------------39

3.1 Defining Sub-samples-----------------------------------------------------------------39

3.2 Model Specification-------------------------------------------------------------------40

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3.3 Change Regression---------------------------------------------------------------------45

3.4 Measurement of CEO Dominance---------------------------------------------------46

3.5 Corporate Governance Score---------------------------------------------------------48

3.6 Calculation of Discretionary Accruals----------------------------------------------50

CHAPTER 4 SAMPLE DESCRIPTION---------------------------------------52

4.1 Data Source-----------------------------------------------------------------------------52

4.2 Descriptive Statistics------------------------------------------------------------------53

CHAPTER 5 EMPIRICAL RESULTS------------------------------------------60

5.1 Main Result----------------------------------------------------------------------------60

5.2 Result for Change Regression-------------------------------------------------------63

5.3 Moderating Effect of Corporate Governance--------------------------------------64

5.4 Substitution Effect of Earnings Management Methods--------------------------65

CHAPTER 6 SENSITIVITY TEST-----------------------------------------------67

6.1 Test for Simultaneous Determination-----------------------------------------------67

6.2 Institutional Ownership ----------------------------------------------------------------69

6.3 CEO Tenure-----------------------------------------------------------------------------70

6.4 Year-by-Year Result--------------------------------------------------------------------72

6.5 Redefining Change in Compensation Structure------------------------------------72

6.6 Alternative Measure of Discretionary Accruals------------------------------------74

6.7 Re-examining Earnings Target-------------------------------------------------------76

6.8 Result for R&D-Intensive Industry--------------------------------------------------76

6.9 Other Long-Term Investment---------------------------------------------------------76

6.10 R&D Cuts and Earnings Quality----------------------------------------------------79

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CHAPTER 7 SUMMARY AND FUTURE OPPORTUNITY-----------82

7.1 Summary of Findings------------------------------------------------------------------82

7.2 Caveat------------------------------------------------------------------------------------83

7.3 Future Opportunity---------------------------------------------------------------------84

BIBLIOGRAPHY-----------------------------------------------------------------------113

APPENDIX 1 CALCULATION OF STOCK OPTIONS---------------124

APPENDIX 2 GOVERNANCE SCORE--------------------------------------125

ENDNOTES-------------------------------------------------------------------------------128

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LIST OF TABLES

Table 1: Definition of Variables-----------------------------------------------------------85

Table 2: Sample Descriptions--------------------------------------------------------------86

Table 3: Distribution Pattern of Firm-year Observations------------------------------88

Table 4: Mean Difference for All Variables in the SD, LD and IN Samples--------89

Table 5: Descriptive Statistics of Main Explanatory Variables------------------------91

Table 6: Logistic Regression of Indicator for R&D Cuts on CEO Compensation

Structure--------------------------------------------------------------------------94

Table 7: Logistic Regression of Indicator for R&D Cuts on CEO Compensation

Structure Change---------------------------------------------------------------96

Table 8: Logistic Regression of Indicator for R&D Cuts on CEO Cash-based

Compensation (Controlling for CEO Dominance)------------------------98

Table 9: Logistic Regression of Indicator for R&D Cuts on CEO Cash-based

Compensation (Controlling for CEO Ownership)-------------------------99

Table 10: Logistic Regression of Indicator for R&D Cuts on CEO Cash-based

Compensation (Controlling for Anti-takeover Mechanisms)------------100

Table 11: Logistic Regression of Indicator for R&D Cuts on Discretionary

Accruals-------------------------------------------------------------------------101

Table 12: Simultaneous Determination of R&D Cuts and CEO Compensation

Structure-------------------------------------------------------------------------102

Table 13: Logistic Regression of Indicator for R&D Cuts on CEO Compensation

Structure (Controlling for Institutional Shareholding)--------------------103

Table 14: Logistic Regression of Indicator for R&D Cuts on CEO Compensation

Structure (Controlling for CEO Tenure)------------------------------------105

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Table 15: Year-by-year Logistic Regression of Indicator Variable for R&D Cuts on

CEO Compensation Structure in the SD Sample--------------------------106

Table 16: Logistic Regression of Indicator for R&D Cuts on CEO Compensation

Structure Defined by Different Cutoffs of COMSTRU-------------------107

Table 17: Logistic Regression of Indicator for R&D Cuts on Discretionary

Accruals Estimated by Different Methods--------------------------------108

Table18: Logistic Regressions of Indicator for R&D Cuts on CEO Compensation

Structure for R&D Intensive Industries-------------------------------------109

Table 19: Correlation Analysis of Indicator for Other Long-term Investment Cuts

and CEO Compensation Structure-------------------------------------------110

Table 20: Examination of Quality of Earnings for Firms in the SD and Total

Sample---------------------------------------------------------------------------111

1

CHAPTER 1 INTRODUCTION

1.1 Motivation

Inter-temporal choice is inherent in business practice, particularly in the issues

faced by top-level managers. Technology investment, workforce training, and entering

new market are basic examples. From a management perspective, the most important

problem involving inter-temporal choice are those decisions in which, with respect to

maximizing profit or achieving some other objectives, the course of action that is

most desirable over the long run is not best course of action in the short term. This is

the dilemma of “managerial myopia”, sparked by the contention that U.S. firms are

losing competitive advantages over overseas competitors because U.S. managers are

unwilling or unable to invest in the long run.

Managerial myopia generally refers to a type of sub-optimal investment behavior

that managers will forgo valuable long-term projects (especially investment in

intangible assets, such as R&D, advertising and employee training) in pursuit of

short-term profits at the expense of long-term interests of shareholders.

Many critics accuse managerial myopia of being responsible for the loss of

technological leadership and growth potential of U.S. companies and attribute it as

one of the main causes of economic malaise that has affected the United States for the

past two decades. For example, Drucker (1986) argues that everyone who has worked

with American management can testify to the need to satisfy the pension fund

manager’s quest for higher earnings next quarter, together with the panicky fear of the

raider, which constantly push top management toward decisions they know to be

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costly, if not suicidal, mistakes. The damage is greatest where we can least afford it: in

the fast-growing middle-sized high-tech or high-engineering firm that needs to put

every available penny into tomorrow1.

Managerial myopia has emerged as modern corporations have come into being. In

the 1980s, prominent CEOs and influential scholars voiced that U.S. corporate

managers were mainly driven by market forces to behave myopically. The Wall Street

Journal made a survey of CEOs of major U.S. corporations in 1986 and found that 82

out of 100 blamed the stock market’s attention to quarterly earnings and over-active

market for corporate control for contributing to a decline in long-term investment and

the loss of the United States’ competitive edge2.

During the 1990s, the U.S. stock market and business practice have experienced

significant structural changes. Two tendencies related to managerial myopia have

come out: One, hostile takeover activities slowed down dramatically and motivations

of managerial myopia from defending hostile takeovers decreased. Two, people

witnessed an extraordinary growth in executive compensation. From 1992 to 1998,

total CEO compensation for all U.S. listed firms has more than doubled, while CEOs

at S&P 500 firms have seen their total compensation rise by over 250%3.

The influence of the rapid growth of executive compensation on managerial myopia

is mixed. It may exacerbate managerial myopia because managers’ motivations for

maximizing compensation increase. Conversely, it may also alleviate managerial

myopia because the enormous growth in top executives’ total compensation is largely

in stock-based compensation that used to be employed as a governance mechanism to

discipline managerial myopia.

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Despite the level of attention paid to the debate and the critical nature of the subject,

the most fundamental issues related to the existence, cause and tendency of

managerial myopia remain unresolved. This study contributes to the progress on this

subject, sheds some light on the association between executive compensation structure

and managerial myopia, and tests competing views on the influence of change in

executive compensation structure on managerial myopia.

This study examines managerial myopia with respect to research and development

(R&D, hereafter) investment. R&D is a major type of long-term investment that

accounts for over 20 percent of gross investment expenditure in manufacturing

companies, and over half of gross investment expenditure in biotechnology and

electronic companies4. The U.S. Generally Accepted Accounting Principles requires

that R&D expenditure be fully expensed and this accounting treatment of R&D

expenditure may significantly affect current accounting earnings upon which cash

components (e.g., salary or bonus) of executive compensation are directly contingent.

R&D expenditure can also be linked with executive compensation through subjective

performance evaluation incorporating R&D activities or non-financial measures

related to R&D inputs or outputs.

Lagging R&D investment has triggered much concern over managerial myopia in

recent years (Jacobs, 1991). On the one hand, this concern reflects recent widespread

technological change, together with the dazzling growth of science and

knowledge-based industries, which generates great needs for R&D investment. On the

other hand, it is also triggered by the current corporate governance debate. Since R&D

projects are usually associated with high information asymmetry between managers

and shareholders, current stock prices may not fully reflect the benefits of R&D

4

investment (Lev and Sougiannis, 1996). Managers are likely to take this chance to

engage in managerial myopia because they believe that reductions in R&D investment

are possible without the awareness of investors5.

Shareholders should be very concerned with R&D cuts because R&D investment

plays a key role on establishing core competence and developing competitive

advantages over business opponents, and because R&D cuts caused by managerial

myopia may seriously impair firms’ growth potentials and ruin future profitability. As

appeals for shareholder rights protection rise increasingly, research on managerial

R&D cuts is indispensable and contains great opportunities to attain breakthrough.

One of the basic motivations of this study comes from the contentions that linking

executive compensation with current accounting performance creates incentives for

managerial myopia. This study expects that executive compensation structure is one

of the main explanatory variables to explain and predict managerial myopia. For

example, if accepting lower earnings today might result in a termination or a loss of

bonuses, substantially greater earnings tomorrow may not represent a desirable

trade-off. When earnings are near the unacceptable range, executives’ incentives to

manage them upward will be significant.

However, when bonuses are near maximum, further increase in earnings will be

rewarded little, generating an incentive to rein in current earnings that is, shifting

them forward and making future thresholds easier to meet. Furthermore, executives

may be reluctant to report large gains in earnings because they know their

performance target will be ratcheted up in the future. Earnings so poor as to put

thresholds and bonuses out of reach may be also shifted to the future, so executives

save for a better tomorrow.

5

Executive compensation structure here refers to the relative mix of cash-based

compensation vs. stock-based compensation. This study investigates both the static

relative mix and the time-series change in the relative mix of cash-based

compensation vs. stock-based compensation. Due to data availability and the

difference in incentive between Chief Executive Officer and other executives who

care about both promotion and compensation, this study is limited to compensation of

Chief Executive Officer.

From the perspective of accounting academics, myopic R&D cuts are also a type of

earnings management. One of the main results of R&D cuts is that managers

intentionally intervene in the financial reporting process and generate accounting

numbers that either mislead shareholders about the underlying economic performance

of the company or influence contractual outcomes that are contingent upon reported

accounting numbers by opportunistically deferring expenditures on R&D.

It is noteworthy that earnings management could be also efficient because

managers may use accounting judgment to make financial reports more informative

for users. For example, until recently some successful R&D firms created R&D

limited partnerships, which permitted them to effectively capitalize R&D outlays that

otherwise would have been expensed. However, the use of accounting judgment to

make earning numbers more informative for users is not explored in this study.

Earnings management by R&D cuts is more likely to occur when managers face a

trade-off between meeting earning targets and maintaining R&D expenditure. To

capture this context, I select a sample of firms with pre-R&D earnings below the prior

year’s level, but by an amount that could be reversed by cutting R&D expenditure.

For these firms, I examine (1) whether the likelihood of R&D cuts is associated with

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CEOs’ compensation structure, (2) whether a change from cash-dominated to

stock-dominated compensation scheme 6 after controlling growth 7 in total

compensation affects the likelihood of R&D cuts, (3) how the association between the

likelihood of R&D cuts and CEOs’ compensation structure is moderated by corporate

governance variables, including CEO ownership, CEO dominance and the adoption of

anti-takeover mechanisms and (4) whether CEOs use discretionary accounting choice

to manage earnings when the board rewards them with stock-dominated compensation

scheme (the cost of R&D cuts is high).

1.2 Main Finding

Analysis of a sample of US publicly traded companies shows that (1) CEOs are less

likely to cut R&D expenditure to meet earning targets when the percentage of

cash-based compensation (relative to stock-based compensation) in their total

compensation is low or is decreased, (2) when there is a change from cash-dominated

CEO compensation scheme to stock-dominated CEO compensation scheme, (3) the

positive association between the likelihood of R&D cuts and cash-based

compensation become stronger when the CEO also serves as chairman of the board,

(4) the adoption of anti-takeover provisions may increase incentive of CEOs rewarded

with cash-based compensation to cut R&D expenditure, (5) CEO ownership has

mixed influences on the association between the likelihood of R&D cuts and CEO

compensation structure and (6) discretionary accruals are negatively related to the

likelihood of R&D cuts for firms with stock-dominated CEO compensation scheme,

indicating a substitution effect between earnings management by R&D cuts and by

discretionary accounting choices. Overall, these results suggest that linking

managerial compensation with accounting earnings creates incentive for managers to

manage earnings by R&D cuts, rewarding managers with stock-based compensation

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mitigates this incentive, and the association between managerial compensation and

earnings management by R&D cuts is moderated by the effectiveness of corporate

governance mechanisms.

1.3 Contribution

The finding of this study contributes to the existing literature on the association

between executive compensation structure and earnings management by R&D cuts in

several important ways.

First, this study presents evidence which is consistent with Narayanan (1996) who

develops an analytical model to show that a cash-dominated compensation scheme

will induce managers to cut long-term investment, and that a stock-dominated

compensation scheme will motivate managers to increase long-term investment. Prior

research in this area tests for systematic under-investment in R&D by examining the

cross-sectional relation between the level of R&D intensity (e.g., R&D to sales) and

pay for performance sensitivity of different compensation components or the level of

cash-based (stock-based) compensation component. The evidence is mixed, though

largely supporting a positive association between R&D intensity and stock-based

compensation (e.g., Bizjak et al. (1993), Baber et al. (1996) and Eng and Shackell

(2001)). This study extends this line of inquiry by testing for period-specific reduction

in R&D investment in years when managers face a trade-off between maintaining

R&D expenditure and meeting earnings targets. In doing so, this study presents

evidence that the relation between executive compensation structure and change in

R&D expenditure depends on the firm’s current accounting performance.

Second, this study contributes to current research on the association between

executive compensation and earnings management. Since Healy (1985), most of

8

studies in this area examine compensation-motivated earnings management by

focusing on discretionary accounting choices (e.g., Holthauslen et al. (1995), Gaver et

al. (1995), and Guidry et al. (1999)). In contrast to those studies, this study focuses on

a more costly means of earnings management, R&D cuts. Such reduction has real

implications for long-term firm value and, therefore, is of great concern to investors.

This study also extends prior studies by documenting a substitution effect between

earnings management by R&D cuts and by discretionary accounting choices.

Third, this study also contributes to recent research on the governance role of

executive compensation contracts in earnings management. It provides direct

empirical evidence that the board adjusts CEO compensation structure to mitigate

R&D cuts as a means of earnings management. Prior studies, such as Dechow et al.

(1994) and Behn et al. (2002), identify the governance role of CEOs’ compensation

contracts but do not examine whether the board adjusts CEOs’ compensation contracts

when the reductions in R&D expenditure are more likely.

In addition, Bushee (1998) demonstrates the governance role of institutional

ownership in earnings management by R&D cuts. This study focuses on the

governance role of executive compensation contracts and extends Bushee (1998)’s

study because compensation contracting and institutional shareholding are

complementary governance mechanisms to monitor managers.

Fourth, this study extends prior literature by providing evidence that the association

between CEO compensation structure and earnings management by R&D cuts can be

moderated by three corporate governance mechanisms, CEO dominance, CEO

ownership, and the adoption of anti-takeover provisions, which suggests that the

interaction between executive compensation contracts and other governance

9

mechanisms may affects the effectiveness of executive compensation contracts as a

governance mechanism.

1.4 Overview

This thesis consists of seven chapters.

Chapter 1 presents a brief introduction of this study. Motivation, main finding and

contribution of this study are discussed.

Chapter 2 reviews literature and develops hypotheses by examining extant literature

on managerial myopia, CEO compensation structure, adjustments in CEO

compensation structure, the governance role of CEO dominance, CEO ownership and

anti-takeover mechanisms, and the substitution effect between earnings management

by R&D cuts and by discretionary accounting choices.

Chapter 3 illustrates the methodology used in the empirical tests. A logistic model

is developed to test the association between the likelihood of R&D cuts and CEO

compensation structure.

Chapter 4 describes the sample and presents descriptive statistics. A sample of U.S.

publicly traded companies covering a period from 1992 to 2001 is selected to

construct the sample. The total sample size is 7,246 firm-year observations.

Chapter 5 reports empirical testing results that support or reject main hypotheses on

the association between the likelihood of R&D cuts and CEO compensation structure.

Chapter 6 presents results of the sensitivity test. Some basic econometric problems,

including incomplete sampling, omitted variables, self-selection bias and endogeneity,

10

are examined.

Chapter 7 summarizes this study. Main caveats and future research opportunities

are also discussed.

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CHAPTER 2 LITERATURE AND HYPOTHESIS

2.1 Explanation for R&D Cuts

Based on a survey of existing literature on managerial myopia and earnings

management, this study generalizes five explanations for R&D cuts. They are:

shortsighted management practice, managerial opportunism, stock market pressure,

fluid and impatient capital, and information asymmetry.

One of the most frequently cited examples for shortsighted management practice is

the increased use of discounting techniques to evaluate investment projects resulting

in an under-valuation of the future returns from long-term projects. Johnson and

Kaplan (1987) state that R&D cuts results from an attempt to measure performance

over too brief a period, before the long-term adverse consequences from making

short-term decisions become apparent8. Kaplan (1984) argues that the ability of the

firm to increase reported earnings while sacrificing the long-term economic health of

the firm is the fundamental weakness in the accounting model.

Another target is the growth of the multidivisional form because it creates intense

pressures on division managers to perform in the present9. Loescher (1984) contends

that CEOs who rely on quarterly and annual reports for information on divisional

performance cannot motivate divisional managers to make investments that have only

long-term returns10.

Some critics focus on economic incentives for managers to engage in myopic

investment behavior and provide the second explanation for R&D cuts. They employ

an agency framework to explain R&D cuts and attribute it to managers’ opportunistic

12

behavior in an attempt to maximize their own compensation. For example, Narayanan

(1985) shows that (1) managers desire to make investments that offer relatively faster

paybacks in order to more rapidly enhance their reputations, (2) such enhancement

has a lasting effect and (3) high reputations link with high compensation. Therefore,

managers who have private information about long-term R&D projects will have

incentives to speed up the projects’ returns to the detriment of long-term performance.

Rumelt (1987) argues that managerial mobility (decision horizon problem) creates

a serious potential for myopia. Managers can display opportunism by choosing

projects that will pay off handsomely in the short term but will not fare well over the

long run. Such opportunistic managers can reap the rewards of associations with a

temporarily successful project as long as the success continues till they exit the firm

before the end of the project’s success11.

In sum, managers’ economic incentives for short-term interests are exacerbated in

some situations where a decision may represent an optimal personal choice for a

manager, but it may be a sub-optimal choice for shareholders.

The third explanation of R&D cuts is related to managers’ beliefs that capital

market participants undervalue investments that will pay off only in the long run. In

current stock markets, stocks are increasingly traded as common goods. Investors

have neither the interest nor the patience to wait for the long run. They are

increasingly responsive to the changes in current market performance (see Jacobs

(1991)). Stock prices (firm value) reflect market participants’ preference of short-term

profits over long-term interests. If managers ignore market participants’ preference for

short-term results, stock price will go down and the firm will be undervalued. Market

raiders will acquire the firm and hire new managers after taking over the firm. By

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inter-temporally shifting earnings from the future to the present, managers may boost

stock prices so that they can succeed in surviving hostile raiders’ takeover bidding.

Besides capital market participants’ shortsightedness, the U.S. capital market

structure characterized by fluid and impatient capital may also result in R&D cuts.

Porter (1992) states that funds supplied by external capital providers move rapidly

from company to company in order to grasp opportunities for near-term appreciation.

External funds are also impatient capital because their owners neither care about the

routine operation of the firm nor hold stocks for a long period12. One of the direct

problems resulting from fluid and impatient capital is that in U.S. firms, there is

over-investment in some activities, such as unrelated diversification, which traps

many fallen industry leaders, and there is under-investment in some complex

capabilities, such as research and development, which are necessary for the

establishment of competitive advantages.

The final explanation is that R&D cuts result from information asymmetry between

investors and managers. Some financial economists try to separate our explanations of

earnings management by R&D cuts from managerial opportunism arguments by

contending that earnings management by R&D cuts may not be a prevalent

phenomenon in an efficient market because the market can discipline opportunistic

managers. Jensen (1986) espouses this point of view by arguing that earnings

management by R&D cuts will only be a problem if managers do not care enough

about stock prices. He argues that R&D cuts occur when managers hold little stock in

their companies and are compensated in ways motivating them to take actions that

increase accounting earnings at the expense of shareholder wealth. They also occur

when managers make mistakes because they do not understand the forces that

14

determine stock prices13.

However, Stein (1989) shows that if there is information asymmetry between

managers and investors about the level or return of R&D investment, the preferred

cooperative equilibrium with no R&D cuts on the part of managers and no conjecture

of R&D cuts on the part of shareholders cannot sustain as a Nash-Equilibrium. If

managers have private information over investors, they are able to shift the timing of

earnings between periods without the awareness of investors. For the current period,

investors do not know how much is “true” earnings and how much is “borrowed”

earnings from future periods to make current results look better. Managers may not

want to make shortsighted decisions to increase current earnings, but investors

understand that any manager is able to move earnings around between time periods

without being detected. Because managers have no alternative signals of firm value,

the result is over-investment in projects that enhance short-term performance and

under-investment in projects that lead to long-term profits.

The first three explanations underscore motivation issues for earnings management

by R&D cuts. Both shortsighted management practices and managerial opportunism

originate from managers’ inherent desires to maximize their own interests. Stock

market pressure results from the market participants’ preferences for the short-term

returns. A combination of managerial behavior and stock market participants’

behavior is reinforcing. If the stock market has an apparent preference for the

short-term, firms may need analytical tools focusing on the short-term in order to

survive, and managers may prefer to shift earnings from the future to the present in

order to defend against hostile takeovers or increase compensation. A combination of

managers’ sub-optimal preferences for the short-tem and the stock market’s

15

preferences for the short-term may enhance a firm’s survival.

The last two explanations place emphasis on opportunities for earnings

management by R&D cuts. Information asymmetry, fluid and impatient capital

provide opportunities for managers to engage in myopic investment behaviors. If

investors have the same information about the level and return of long-term projects

as that of managers, a fixed-salary contract for managers may serve as the optimal

solution. However, if managers have private information about the level and return of

long-term investments, they may make use of these opportunities to increase or reduce

R&D investments to maximize their own compensation. This argument does not mean

that investors have no choice but to accept the loss from earnings management by

R&D cuts. In contrast, investors can anticipate earnings management by R&D cuts

and develop corresponding governance mechanisms to discipline managers. However,

because the stock market is fluid and impatient, investors favor quick profit and

short-term returns, and few of them hold shares for a long time or care about future

growth and corporate governance. Shortsighted market and weak corporate

governance set the stage for earnings management by R&D cuts.

When managers make discretion on R&D investment, they have to balance the

benefit and cost from earnings management by R&D cuts. Though managers have

strong motivations to maximize their compensation, and the market also provides

opportunities for them to make discretion on R&D investment, they may not cut R&D

expenditure when the cost from R&D cuts is high. Managers probably make a choice

among different ways of earnings management and cut R&D expenditure in a

situation where the marginal cost from doing so is the lowest.

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2.2 Executive Compensation Components

A typical U.S. firm’s executive compensation contract consists of five components:

salary, bonus, restricted stocks, stock options, and other long-term performance plans.

Salary is fixed payment to executives and usually set on an annual basis. Moreover, it

is well documented in prior literature that base salary is related to both the firm’s size

and accounting performance (e.g., Antle and Smith (1992) and Murphy (1999)).

Bonus awards are typically based on short-term performance measures such as

current-year profits or return on equity. Stock option plans award eligible participants

the right to purchase a fixed number of shares of common stock at a predetermined

exercise price over a finite horizon. Restricted stock awards endow managers with a

fixed quantity of shares of the firm’s equity with restrictions on resale or transfer and

a forfeiture clause that invalidates the award if the executive quits or is fired before

the restriction period elapses. Long-term performance plans set performance goals,

typically in terms of accounting measures such as the growth in earnings per share

over a specified horizon (normally ranging from three to five years).

Basically, salary and bonus are classified as cash components in total compensation

because they explicitly tie executive compensation to current accounting performance

and provide short-term incentives. Options and restricted stocks are categorized as

stock components in total compensation since they are based on firm market

performance and provide long-term incentives.

An explanation for offering both restricted stock arrangements and stock options

relates to their complementary nature (Milgrom and Roberts, 1990). If bonding a

manager to the firm through restricted stock reduces his willingness to take desirable

risks (such as risk associated with positive net present value investments), then there

17

are incremental gains to the firm from granting options concurrently with restricted

stock. Therefore, restricted stocks and stock options provide different incentives for

managerial R&D investment behavior. Because R&D investment is future-oriented

but risky by nature, stock options may induce managers to increase investment in

R&D, while restricted stocks may reduce managers’ incentives to invest in R&D

because return volatility caused by risky R&D investment may negatively affect firm

value in which managers have a great stake.

The enormous growth in top U.S. executives’ compensation during the last decade

has resulted largely from stock option awards. Partly due to the dramatic increase in

executives’ stock-based compensation, the SEC began in 1992 requiring firms to

disclose detailed information on CEO compensation in proxy statements. Information

on all five components of CEO total compensation is publicly available now.

Figure 1 illustrates average compensation levels for chief executive officers in a

sample of U.S. corporations chosen for this study from 1992 to 2001. Stock option

awards, valued by the Black-Scholes (1973) methodology as of the date of grant,

represented approximately 50% of CEO compensation in 2001, up from one-third in

1992. While other forms of incentive compensation also increased during this period,

the figure indicates that stock options accounted for the large majority of CEOs’

income from contingent instruments.

18

Figure 1: time-series pattern of compensation structure

00.10.20.30.40.50.60.7

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

Year

Com

pens

atio

nSt

ruct

ure

Cash-based compensaation Stock-based compensation

The use of options is pervasive but varies across industries. Core and Guay (2001)

document cross-sectional variation in the magnitude of corporate option plans. They

find that the median large firm has options outstanding that amount to 5.5% of

common shares outstanding. This percentage is relatively larger, 10-14%, for growth

industries with high R&D intensity such as computer, software and pharmaceutical

firms, and relatively smaller, 2-3%, for low growth firms such as utilities and

petroleum firms. The fraction of total outstanding stock options held by CEOs also

varies between industries. Murphy (1999) finds that the importance of options in CEO

annual pay is pervasive across manufacturing firms, but substantially less important

for utility firms.

Previous studies link the award of stock options to several explanatory variables,

including size, monitoring difficulty, managerial decision horizon, firm market

performance, growth opportunities, and managerial ownership, though these studies

do not always agree, and differences in time periods, sample selection, and

methodology make their results difficult to compare (e.g., Murphy (1985), Jensen and

Murphy (1990), Smith and Watts (1992), Kole (1997) and Mehran (1995)).

19

R&D investment is related to most of those explanatory variables14. For example,

high growth firms probably have high R&D intensity because their growth potentials

largely depend on research and development. R&D projects are more difficult to

monitor because of high information asymmetry between investors and managers.

Managers are more likely to make myopic decisions on R&D projects with high

information asymmetry when they approach retirement or they want to establish their

reputation earlier. Therefore, an effort to link executive compensation structure with

R&D investment has to consider all preceding variables.

2.3 R&D Cuts and CEO Compensation Structure

Much of the prior literature employs an agency framework to illustrate the

association between earnings management by R&D cuts and executive compensation

structure (e.g., Jensen and Meckling (1976) and Holmstrom (1979)). Under the basic

agency model with moral hazard and information asymmetry, managers’ actions are

unobservable. Shareholders offer compensation contracts based on observable

performance measures presumed to be correlated with managers’ actions. In general,

the conditioning of incentive compensation on performance measures increases as the

ability of shareholders to observe or monitor managers’ actions decreases.

Basically, performance measures could be either accounting performance measure

(e.g. earnings) or market performance measure (e.g. stock return). Sloan (1993)

argues that the advantage of including accounting performance measures in executive

compensation contracts is that they help shield executives from fluctuations in firm

value that are beyond their control15. The weakness of using accounting earnings as

performance measures in executive compensation contracts is that accounting

numbers are subject to managers’ manipulation and discretionary accounting choices

20

can distort accounting earnings as meaningful indicators of economic returns and, in

the extreme, could discourage positive net present value investments.

Linking executive compensation with stock prices can align managers’ interests

with shareholders’ interests. However, stock prices are also noisy measures of

managers’ performance because they are determined by many non-firm-specific

market factors that are not completely contingent upon managers’ efforts.

Based on the dichotomy of performance measures, total executive compensation

can be divided into two components, cash-based compensation, which is contingent

upon accounting performance measures, and stock-based compensation, which

depends on market performance measures. Typical cash components are salary and

bonus16. Stock components in this study refer only to stock options.

Restricted stocks are excluded in this study because they differ from stock options

in many important ways, leading us to have different expectations about their function

in CEO compensation package17. For example, Byran (2001) shows that restricted

stock awards provide relatively inefficient inducements for risk-averse CEOs to

pursue risky but value-enhancing long-term projects. To the extent that CEOs’ utility

functions are concave, the linear payoff mechanism of restricted stock awards cannot

mitigate CEOs’ aversion to risk-taking. Therefore, stock option awards, rather than

restricted stock awards, are likely to provide a more efficient incentive mechanism for

the CEOs to increase investment in long-term projects. Prior studies also show that

restricted stock awards are negatively related to the level of R&D investment (e.g.,

Ryan et al (2001), Byran et al (2001)). In contrast, stock option awards are positively

related to the level of R&D investment (e.g. Yermack (1995)).

21

Compensation structure in this study is defined as the relative mix of cash-based vs.

stock-based compensation. If the percentage of cash-based compensation is higher

than the percentage of stock-based compensation in total compensation, it is defined

as a cash-dominated compensation scheme. Otherwise, it is defined as a

stock-dominated compensation scheme.

In the standard agency model, managers are portrayed as being risk-averse, which

implies that they will want their compensation structured so that they bear less

personal risk (see Harris and Raviv (1978)). Given a certain level of compensation,

Managers should prefer fixed cash-based compensation to performance-contingent

stock-based compensation. This preference is reinforced because the value of

managers’ human capital will also vary with the firm’s market performance. In order

to reduce their compensation risk, managers may be involved in activities that reduce

the firm’s risk (see Jensen and Meckling (1979)). The benefits from R&D investment

are highly uncertain due to tough market competition and the irregular nature of

technology progress. Risk-averse managers therefore have inherent incentives to cut

R&D investment.

On the other hand, shareholders are considered risk-neutral with respect to any

particular stocks because they can eliminate firm-specific risk by holding a diversified

portfolio. Shareholders can anticipate that managers attempt to avoid risks in ways

that may reduce firm value. While there are several ways to alleviate this conflict over

risk, pervious literature suggests that tying managers’ compensation to firm market

performance motivates managers to make more value-maximizing decisions (see

Holmstrom (1979)), and that one specific way to tie executive pay to firm

performance is to make a greater percentage of a manager’s compensation

22

equity-based, such as through stock options awards.

Shareholders do not set executive compensation directly. They nominate directors,

who have the right under corporate law to craft executives’ compensation contract.

The board of directors seeks to both reward executives’ contribution to current firm

performance and motivate future profit-maximizing behavior. Both two goals may not

be simultaneously achieved because executive compensation structure is determined

by an array of factors, such as choice of performance measures, weight on different

performance measures, contract length, agency problems with the board, etc. Because

executives have different preference about their compensation structure from that of

shareholders, compensation contracts create incentive for executives to behave

myopically if the board increases the weight on cash-based compensation.

Once compensation structure is determined, executives have several choices to shift

earnings inter-temporally due to compensation-maximizing considerations, among

which deferring expenditure on long-term investment projects is one of prevalent

alternatives.

Narayanan (1996) develops an analytical model to specify the relationship between

executive compensation structure and long-term investment. In his model, while the

executive’s compensation is a function of the executive’s perceived ability alone,

stock price is a function of both the executive’s ability and his investment decision.

When investors do not know the executive’s investment decision, they might

mis-value both the executive’s ability and the future cash flows from the executive’s

investment decision. This combined effect creates incentives for increasing long-term

investment if the executive is rewarded with a stock-dominated compensation scheme.

By reducing short-term investments, the executive depreciates investors’ perception of

23

his ability and his wage, but is paid in stock that is undervalued largely, resulting in

being overpaid in the long term relative to his true ability. By contrast, if the executive

is remunerated with a cash-dominated compensation scheme, he has incentive to cut

long-term investment to boost his perceived ability on which his compensation

contract is contingent and is overpaid relative to his true ability. Narayanan concludes

that a cash-dominated compensation scheme will induce the executive to cut

long-term investment, and that a stock-dominated compensation scheme will motivate

the executive to increase long-term investment.

As an extension of Narayanan’s analytical model, this study attempts to shed light

on the influence of executive compensation structure on the level of R&D investment.

This study argues that cash-based compensation creates incentives for executives to

cut R&D expenditure to avoid earnings decrease that would trigger negative market

reaction and lead to undervaluing of executives’ perceived ability on which their

compensation is contingent. In contrast, if executives are offered stock-based

compensation, they have incentive to increase R&D investment and shift current

earnings to the future so that they can benefit from the current under-pricing of the

firm’s stocks.

Underlying assumptions for this argument are that (1) executives regard previous

period earnings as targets to meet or beat, (2) the market is sensitive to current

earnings announcement and react to it instantaneously and (3) executive

compensation structure is sensitive to the inter-temporal shift of accounting earnings

caused by R&D cuts.

This study is consistent with several cases to support the first underlying

assumption. In Tenneco’s 1994 annual report, CEO Dana Mead states, “I must

24

emphasize that all of our strategic actions are guided by and measured against this

goal of delivering consistently high increases in earnings over the long term”.

Similarly, for many years, Eli Lilly emphasized a string of earnings increase that

reached 33 years before it was broken. Similar examples can be found in many other

annual reports (e.g. ConAgra (1995), Bemis (1992) and Anhcuser-Busch (1994)).

Other examples are found in press releases or earnings announcements. In the release

of 1994 earnings, Bank of America’s CEO Richard Rosenberg commented

“Increasing earnings per share was our most important objective for the year.”18

Since Ball and Brown (1968), a lot of accounting literature has provided empirical

evidence to support the second underlying assumption, suggesting that the market will

instantaneously react to earnings announcement though the reaction may not be

complete (e.g., Lev et al.(1982) and Ball and Bartov (1996)).

For the third underlying assumption, Narayanan’s analytical model highlights its

rationality and empirical testing of this study presents evidence.

Existing literature documents incomplete and mixed empirical evidence on the

association between executive compensation structure and R&D investment. Bizjak et

al. (1993) report a significantly negative association between R&D investment and

CEO cash-based compensation, which is consistent with Narayanan’s prediction. In

contrast, Baber et al. (1996) find no significant association between investment

opportunity, of which R&D intensity is an important component, and CEO cash-based

compensation. Eng and Shackell (2001) provide evidence that the adoption of a

stock-based compensation scheme does not affect firms’ R&D investment. Bryan et al.

(2000) find positive relation between R&D investment and stock options, but negative

relation between R&D investment and restricted stocks.

25

One possible answer for mixed evidence of the association between executive

compensation structure and R&D investment is that executives have to balance the

benefits and costs from opportunistic behavior when they make a decision on R&D

investment. For example, by cutting R&D expenditure, executives may inflate current

earnings and increase cash-based compensation, while they take the risk of deflating

stock price and sacrificing growth potentials. Rational executives may not engage in

R&D cuts if the loss from cutting R&D investment outweighs the benefits from it.

R&D cuts only occur when the expected benefits from them are high and when the

likelihood to be detected by the market is low. That is why previous studies find

mixed evidence on the association between executive compensation structure and

R&D investment.

This study extends prior studies and examines earnings management by R&D cuts

by focusing on a sample of publicly traded U.S. firms that report a decrease in

pre-R&D earnings relative to prior year’s earnings, but that could reverse earnings

decrease by a reduction in R&D expenditure.

Prior literature suggests that when contracting on executive compensation, the

board usually uses expected earning numbers as one of the basic inputs (performance

measure). Those expected earning numbers are earning targets that executives attempt

to meet. Avoiding earnings decrease (compared to prior year earnings) is one of the

earning targets (e.g., Burgstahler and Dichev (1997). Degeorge et al (1999) argue that

the link between earning targets and executive compensation is straightforward

because investors depend on rules of thumb to reduce transactions costs. The

discreteness of actions, whether by investment analysts recommending sell, hold, or

buy, rating agencies better grades, bankers making or refusing loans, or boards

26

retaining or dismissing the CEO promotes the use of targets of acceptable accounting

performance. A report to shareholders that earnings have been up 6 years in a row is

cheaply communicated. A statement that they have been up 5 out of 6 years, and only

fell by 1 percent in the off year, is less easily understood, so that struggling across the

threshold of last year’s earnings becomes worthwhile. When a firm falls short of last

year’s earnings, the board may think that the executives do a poor job. Bonuses and

stock option awards may suffer.

R&D cut is one of the typical methods employed by executives to avoid earnings

decrease (Baber et al., 1991). Therefore, for firms that could reverse earnings decrease

by a reduction in R&D expenditure, the executive’s motivation to cut R&D spending

is stronger when he is faced with a trade-off between maintaining R&D investment

and meeting earnings targets, and because the possibility of benefits outweighing

costs is high.

By focusing on this sample of firms, this study may provide apparent and

convincing evidence that managers may be motivated by their compensation structure

to manage earnings by R&D cuts and thus contributes to existing literature on the

association between executive compensation structure and managerial R&D

investment behavior. Preceding arguments lead to the following testable hypotheses.

Hypothesis (H1a): Ceteris paribus, a higher percentage of cash-based compensation

in total compensation increases the likelihood that CEOs reduce R&D expenditure to

meet short-term earnings targets.

Hypothesis (H1b): Ceteris paribus, a cash-dominated compensation scheme

increases the likelihood that CEOs reduce R&D expenditure to meet short-term

27

earnings targets.

2.4 Change in CEO Compensation Structure

The standard agency model predicts that the ability of the board of directors to

observe the executive’s effort determines the structure of executive compensation.

When the executive’s actions are known and observable, the optimal incentive

contract pays the executive a fixed salary and charges him for sub-optimal behavior.

In contrast, linking compensation to outputs such as the value of the firm is necessary

to induce the executive to behave optimally when his actions are unobservable.

Holmstrom (1979) and Lambert and Larcker (1987) extend the standard agency

model and investigate whether the relative weight placed on a performance measure is

an increasing function of the amount of information it conveys about executives’

actions. They predict greater use of stock-based compensation when accounting

performance measure is noisy relative to market performance measure and when a

firm is in the early stage of investment as characterized by rapid growth in assets and

sales.

R&D investment is a typical long-term investment that may contribute to the firm’s

future profitability. Because there is uncertainty about the impact of R&D investment

on firm value, given the benefits of executives’ decisions on R&D investment are not

immediately observable, motivating executives to make optimal investment decisions

requires long-term contracting.

Bizjak et al. (1993) demonstrate that market participants’ excessive concerns about

current stock price can motivate executives to use observable investment decisions to

manipulate the market’s inferences about the firm, which results in either

28

over-investment or under-investment. Shareholders can induce optimal investment

choices by structuring executive compensation to balance both future and present

market performance. Therefore, firms with high information asymmetry between

executives and shareholders caused by R&D investment will tend to favor contracts

that focus on long-run stock returns over contracts that focus on near-term stock

returns alone.

All these theoretical works suggest that the board of directors will adjust executive

incentives to mitigate anticipated agency problems. High probability of R&D cuts will

lead to change in the executive compensation scheme from a short to a long-term

basis.

Empirically, Gibbons and Murphy (1992) provide evidence that the sensitivity of

CEO cash-based compensation to stock market performance increases as the CEO

approaches retirement. Similarly, Barber et al. (1998) find that the sensitivity of CEO

cash-based compensation to accounting earnings increases with earnings persistence

and executives’ age. Results from both of the two studies suggest that the board of

directors strengthen explicit incentives when they expect that the CEO’s implicit

incentives from career concerns diminish. Dechow et al. (1992) show that

compensation committees in the board adjust earning-based performance measures

when doing so improves incentive alignments. They present direct evidence that the

board of directors adjust CEO compensation structure in response to anticipated

agency problems.

However, most of those empirical works examine adjustment in CEO compensation

structure by investigating the sensitivity of CEOs’ compensation to different

performance measures. They focus on the cross-sectional difference of CEO

29

compensation structure, rather than on the time-series change in CEO compensation

structure. This study develops another method that is different from that of previous

studies by exploring how the time-series change in CEO compensation structure

relates to managerial R&D investment behavior. The basic argument is that, though

there is information asymmetry about the level or return of R&D investment between

investors and CEOs, investors (the board) still can anticipate CEOs’ motivations to cut

R&D investment, and hence, they will restructure CEOs’ compensation scheme to

balance short-term and long-term incentives and induce optimal R&D investment by

increasing the percentage of stock-based compensation in CEOs’ total compensation.

Prior literature shows that CEOs are more sensitive to the wealth effects which

result from the substitution of one compensation component (stock) for the other

compensation component (cash) when the total compensation holds constant (e.g.,

Jensen and Murphy (1990)). Therefore, a structural change in CEOs’ total

compensation from a cash-dominated compensation scheme to a stock-dominated

scheme after controlling for growth in total compensation is more likely to be initiated

by the board for firms that CEOs have stronger incentive to meet earning targets by

cutting R&D expenditure. The following testable hypothesis is developed.

Hypothesis (H2): Ceteris paribus, a change in CEOs’ compensation structure from a

cash-dominated scheme to a stock-dominated scheme after controlling for growth in

total compensation is negatively associated with the likelihood that CEOs cut R&D

expenditure to meet short-term earning targets.

It is noteworthy that because the adjustment of CEOs’ compensation structure also

involves costs, the board only adopts a new compensation scheme when earnings

management by R&D cuts is more likely. Most prior studies do not address this issue.

30

For example, Dechow and Sloan (1991) identify CEO stock and option holdings as a

mechanism to mitigate earnings management by R&D cuts, but they do not examine

whether the board increases CEO stock and ownership holdings as a response to the

problem. Similarly, Bushee (1998) finds that institutional ownership mitigates

earnings management by R&D cuts, but he does not investigate whether institutional

investors increase their shareholding when earnings management by R&D cuts are

more likely.

Cheng (2002) is an exception and attempts to solve this problem by regressing

changes in total compensation (or cash-based compensation) on indicator variables

presenting several situations where R&D cuts are more likely to happen. He

documents that R&D expenditure has a significantly positive effect on CEO

stock-based compensation when (1) the executive approaches retirement, and (2) the

firm face a small earnings decrease or a small loss. He interprets his results as

providing evidence that the board of directors adjusts CEO incentive as a response to

the anticipated opportunistic R&D investment behavior.

However, his focus is on how change in total compensation relates to managerial

incentive to cut R&D expenditure, rather than on how change in compensation

structure associates with managerial myopic investment behavior. Change in total

compensation could be driven by other factors, which is unrelated to mitigating

anticipated earnings management by R&D cuts. For example, the increase in

stock-based compensation could simply result from the change in the exercise price of

stock options.

This study distinguishes from prior studies by examining the influence of change in

CEO compensation structure on the likelihood of R&D cuts after controlling for

31

growth in total compensation.

This study also examines the simultaneous relationship between CEO

compensation structure and R&D cuts. The association between CEO compensation

structure and R&D expenditure may be subject to endogeneity, which makes the

results from cross-sectional regression analysis difficult to interpret. It could be that a

cash-dominated compensation scheme induces managers to cut investment on R&D.

Alternatively, it could be that R&D expenditure, which is required to be immediately

and fully expensed by the U.S. accounting rules, can significantly affect the

magnitude of accounting earnings and result in changes in CEO compensation

structure because accounting earnings is one of the typical performance measures on

which CEO compensation contracts are based. This study follows a two-stage least

square procedure that is free from endogenous problems to correct for the

endogeneity.

2.5 Influence of CEO Dominance and CEO Ownership

Critics of CEO compensation practice argue that if the board is dominated by the

entrenched CEO who may determine the agenda and the information given to the

board (Jensen, 1993), and can exert significant influence on the nomination and

removal of outside directors (Yermack, 1995), the board members may be unwilling

to take a position adversarial to the CEO, especially concerning the CEO’s

compensation (Crystal, 1991). CEOs, like most individuals, are portrayed as being

risk-averse, which implies that CEOs will want their compensation structured so that

they can bear less personal risk. Given a certain level of compensation, CEOs would

prefer fixed cash-based compensation to stock-based compensation19 (Harris and

Raviv, 1978). If CEOs are rewarded with cash-based compensation, they are more

32

likely to manage earnings by cutting R&D expenditure in order to maximize their

compensation.

Moreover, if the CEO dominates the board, governance mechanisms developed by

shareholders will become less effective, because the CEO will force the board to offer

a compensation contract with cash-dominated schemes preferred by him. The

entrenched CEO’s motivation to engage in earnings management by R&D cuts

becomes stronger. In this study, CEO duality is used as a proxy for CEO dominance

because prior literature suggests that if the CEO also serves as the Chairman of the

board, he is more likely to be entrenched and may have greater control over the board

(Core et al., 1999). The following testable hypothesis is developed.

Hypothesis (H3a): Ceteris paribus, if the CEO also serves as the chairman of the

board, the positive association between cash-based compensation and the likelihood

of R&D cuts becomes stronger.

However, if the CEO owns many shares of the company, his interests may be

aligned with shareholders’ interests. For example, Lambert et al. (1993) find that CEO

total compensation is lower when the CEO’s ownership is higher. The following case

highlights the role of CEO ownership on designing the CEO compensation contract.

Pfizer Corporation’s 2000 proxy statement asserts that its CEO is expected to own

company common stock equal in value to at least three times his annual compensation.

Similarly, NL industry Inc. encourages chief executive officer to own common stock

amounting to between two and four times his annual compensation. Finally, General

Motors encourages CEO ownership of common stock equal in value to a minimum of

two times his annual compensation20.

33

If a CEO who holds many shares of the company dominates the board, he is more

likely to encourage the board to come up with a compensation scheme linking his pay

with firm performance, rather than to prefer fixed cash-based compensation to

stock-based compensation given a fixed level of total compensation. When incentives

are aligned, the CEO’s motivation to engage in earnings management by R&D cuts

decreases. The following testable hypothesis is developed.

Hypothesis (H3b): Ceteris Paribus, CEO ownership mitigates the positive influence

of CEO dominance on the association between cash-based compensation and the

likelihood of R&D cuts.

2.6 Impact of Anti-takeover Mechanisms

Regarding the impact of anti-takeover mechanisms on earnings management by

R&D cuts, prior literature refers to two opposite arguments, management

entrenchment and efficient contracting. Some scholars who believe in management

entrenchment contend that anti-takeover provisions can be adopted without

shareholder approval, eliminate the disciplinary effect of the takeover market, and

consequently reduce executives’ incentives to act in shareholder’s interests and

exacerbate earnings management by R&D cuts (e.g., Malatesta and Walkling (1986)

and Ryngaert (1986)).

In contrast, others who espouse efficient contracting contend that anti-takeover

devices may benefit shareholders by increasing takeover premiums and facilitating

contracting through enhancing the efficiency of compensation contracts which bond

executives to the firm. This bonding can motivate executives to increase long-term

investments, suggesting that earnings management by R&D cuts could be mitigated

34

by anti-takeover mechanisms (e.g., DeAngelo and Rice (1993) and Knoeber (1986)).

Prior empirical works provide mixed evidence on the influence of anti-takeover

mechanisms on earnings management by R&D cuts. Borokhovich et al. (1997) find

that CEOs of firms that adopt anti-takeover provisions have higher levels of

cash-based compensation than CEOs at firms that do not adopt anti-takeover

provisions, which suggests that managers adopt anti-takeover provisions to entrench

themselves and to extract wealth from the firm.

In contrast, Bizjak and Marquette (1998) report that CEOs of firms that adopt

anti-takeover provisions will be more likely rewarded with stock-based compensation

than CEOs at firms that do not adopt anti-takeover provisions, and the adoption of

anti-takeover provisions is positively related to the pay for performance sensitivity,

which is one of the general measures for the degree of management alignment

developed by Jensen and Murphy (1990). They interpret their results as consistent

with the efficient contracting hypothesis.

This study attempts to disentangle these two opposite arguments by examining the

influence of the adoption of anti-takeover provisions on the association between

earnings management by R&D cuts and CEO compensation structure. If anti-takeover

provisions were adopted to entrench incumbent CEOs, we would expect to find

CEOs’ compensation contracts with increased agency problems within the firm

adopting anti-takeover provisions, and find that the percentage of cash-based

compensation in total compensation will increase to reflect risk-averse CEOs’

preference for fixed compensation. Consequently, R&D cuts will be more prevalent.

Alternatively, if anti-takeover provisions were adopted to enhance efficient

35

contracting, we would expect to find CEOs’ compensation contracts with reduced

agency problems within the firm adopting anti-takeover provisions, and find that the

percentage of cash-based compensation in total compensation will decrease to reflect

the alignment between CEOs and shareholders. The likelihood of R&D cuts reduces.

The following testable hypotheses are developed:

Hypothesis (H4): Ceteris paribus, the positive association between cash-based

compensation and the likelihood of R&D cuts becomes stronger when firms adopt

more anti-takeover provisions.

2.7 Earnings Management by Discretionary Accounting Choices

R&D cuts are a type of “real” earnings management, accomplished by timing

long-term investment to alter reported earnings or some subset of them (Schipper,

1989). From the perspective of investors, relative to other methods to manage

earnings, such as discretionary accounting choices, the loss of R&D cuts is rather

severe because R&D cuts may seriously impair firms’ growth potentials and ruin their

future profitability. However, because of information asymmetry on the level or return

of R&D investment between investors and managers, investors may not distinguish

myopic R&D cuts (driven by maximizing compensation) from strategic R&D cuts

(caused by change in growth opportunity or competition intensity).

From the perspective of a manager, R&D cuts are only one of the many ways

available to manage earnings. R&D cuts only occur when the personal cost of such

cuts to the manager is less than the benefit he expects to receive from the resulting

increase in reported profit. Typically, this situation occurs when the manager has a

direct stake in the reported numbers, and believes that investors lack enough

information to undo the effects of the manipulation. One of the personal advantages of

36

managing earnings by R&D cuts to the manager is that he may decide on the level of

R&D expenditure without constraints from auditors, board members and other

regulatory bodies. However, the manager has to decide ex-ante the extent of R&D

investment prior to year-end before observing the shortfall between pre-managed

earnings and the earnings target. The manager’s net personal cost of R&D cuts,

however, is likely to be less than the cost to the firm because of reduced cash flows in

future periods.

An alternative earnings management mechanism to cutting R&D that is available to

a manager is to use discretionary accounting choices (including both the change in

accounting procedures and the timing of expense and revenue recognition) or alter

capital expenditures. This earnings management method is not likely to result in a

direct reduction in future economic value of the firm. Indirectly, it could be costly to

the firm because of the resulting loss of investor credibility and the subsequent

increase in the expected cost of capital. As in the case of R&D cuts, the personal costs

and benefits to the manager are different. A manager could change accruals after

year-end after pre-managed earnings have been observed. In the long-term, the

increased expected cost of capital to the firm and the subsequent reduction in the firm

value could also affect the manager’s compensation. The manager also faces a direct

personal reputation cost because of GAAP constraints and possible disciplining by the

auditors and the board. Moreover, there are practical limits on the use of discretionary

accounting choices. At some point, to reach the desired level of earnings, some

adjustments that are not purely cosmetic must be made.

The personal costs to a manager of R&D cut might be higher in some contexts than

a corresponding change of discretionary accruals in some contexts and it might be

lower in some other contexts. In an effort to maximize their compensation, executives

37

consider the joint effect of discretionary accounting choices and R&D cuts on their

compensation components because different compensation components have different

risk and incentive profiles, which induce different earnings management behavior.

Being rewarded with a cash-dominated compensation scheme, executives would

intentionally postpone expenses or advance revenues to boost current earnings. For

example, Healy (1985) reports a strong association between total accruals and CEOs’

income-reporting incentives under their bonus plan. Holthausen et al. (1995) present

evidence consistent with Healy (1985) that CEOs make income-decreasing

discretionary accruals after they reach their maximum bonus level. However, contrary

to Healy (1985), they find no evidence that CEOs make income-decreasing

discretionary accruals when earnings are below the minimum necessary to earn a

bonus. Guidry et al. (1999) show that business-unit managers in the bonus range have

incentives to make income-increasing discretionary accruals relative to business-unit

managers who are not in the bonus range.

Contrarily, being rewarded with a stock-dominated compensation scheme,

executives would smooth earnings to avoid volatility because prior studies suggest

that, given executives with significant shareholding and stock-based compensation,

income smoothing leads to higher share prices (e.g., Hunt et al. (1995) and Trueman

and Titman (1988)).

Accounting procedure changes are also subject to executives’ discretion. Healy et al.

(1987) find evidence that the relationship between CEO cash-based compensation and

earnings will adjust following changes in accounting procedures that lower earnings

(FIFO to LIFO inventory valuation) and that raise earnings (accelerated to

straight-line depreciation). Hagerman and Zmijewski (1979) find a weak positive

38

relation between the probability that a company uses straight-line depreciation and the

probability that its executives have a cash-based compensation plan. Abdel-khalik and

Rashad (1985) estimate a cross-sectional regression of CEO cash-based compensation

on earnings for a treatment sample of firms that change to LIFO, and a control sample

of firms that remain on FIFO. They find that the elasticity of CEO compensation to

reported earnings is higher for the treatment group.

In conclusion, earnings management is pervasive. If rewarding executives with

stock-based compensation may mitigate earnings management by R&D cuts, as

suggested in Hypotheses 1 and 2, executives’ incentives to manage earnings by

discretionary accounting choices become stronger as their compensation schemes

gradually begin to be dominated by stock-based compensation. Therefore, a

substitution effect between earnings management by R&D cuts and by discretionary

accounting choices is predicted. This study employs discretionary accruals as a

general measure for intensity of earnings management by discretionary accounting

choices and develops the following testable hypothesis:

Hypothesis (H5): Ceteris paribus, the likelihood of R&D cuts is negatively related

to discretionary accruals for firms rewarding CEOs with a stock-dominated

compensation scheme.

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CHAPTER 3 RESEARCH METHODOLOGY

3.1 Defining Sub-samples

In the same vein as Burgastahler and Dichev (1997) and Degeorge et al. (1999), this

study assumes that CEOs use prior year’s earnings as their earnings target. If a

reduction in R&D expenditure can lead to positive change in annual earnings, R&D

cuts are more likely to happen. The total sample is divided into three sub-samples

based on the relationship between pre-R&D earnings and prior year’s R&D

expenditure21.

The first sub-sample, “Small Decrease” (SD), includes firms whose earnings before

tax and R&D have declined relative to the prior year, but only by an amount that can

be reversed by a reduction of R&D expenditure. This sample is most likely to exhibit

conditions under which the manager (in this case, CEO) finds using this method of

earnings management more cost-effective than using discretionary accruals or other

methods of earnings management.

This specification assumes that (1) reported earnings follow a “random walk” naïve

model, expected earnings for period t are the actual earnings for period t-1, (2) CEOs

have unbiased expectations of pre-R&D earnings early enough to make discretionary

decision on R&D expenditure and (3) there is information asymmetry between

investors and CEOs about R&D investment so that CEOs can inter-temporally shift

earnings without the awareness of investors. It is more likely that CEOs in the SD

sample to manipulate earnings by cutting R&D expenditure because they have

stronger incentives to do so.

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The second sub-sample, “Increase” (IN), consists of all firms that report positive

earnings growth even they maintain prior year’s R&D expenditure. The third

sub-sample, “Large Decrease” (LD), contains all firms with a decline in pre-R&D

earnings greater than the amount of prior year’s R&D expenditure. For these two

sub-samples of firms, it is less likely for CEOs to manage earnings by cutting R&D

expenditure22, because by doing so, they can neither meet earning targets, nor enjoy

long-term profits by investing in R&D projects.

3.2 Model Specification

The dependent variable that this study employs to test for R&D cuts is an indicator

variable (CUTRD) that is equal to one if the firm cuts R&D expenditure relative to the

prior year, and zero if the firm maintains or increases R&D expenditure. This study

uses an indicator variable rather than a continuous variable as dependent variable

because it is interested in whether the likelihood of change in R&D expenditure is

associated with change in CEO compensation structure, instead of how the magnitude

of change in R&D expenditure relates to CEO compensation structure.

The primary explanatory variable, CEO compensation structure, is defined in the

following two ways. In the first specification, a dummy variable (COMSTRU) is used

as a proxy for the relative mix of cash-based vs. stock-based compensation. If the

percentage of salary and bonus is higher than the percentage of stock options in total

compensation, it is equal to zero. Otherwise, it is equal to one. This specification can

facilitate measuring the relative incentives created by the compensation scheme23.

In the second specification, the proxies for CEO compensation structure are two

continuous variables, which are the percentage cash-based compensation or

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stock-based compensation in total compensation (CASH and STOCK). This

specification is advantageous because we can examine accumulated effects of

explanatory variables on dependent variable by defining explanatory variables as

continuous variables.

To control for motivations to reduce R&D expenditure that are not related to

myopic R&D cuts, this study includes several proxies for the R&D investment

opportunity set that have been identified in previous literature (e.g., Berger (1993) and

Bushee (1998)) as control variables.

This study uses the prior year’s change in R&D (PCRD) to control for changes in

the firm’s R&D opportunity set over time. A decline in R&D expenditure last year

makes a firm less likely to cut R&D expenditure again this year, indicating a negative

association between PCRD and CUTRD24.

The Herfindahl-Hirschman index (HHI) is a composite measure of intensity of

product market competition. For firms in a highly competitive market, the cost of

cutting R&D expenditure is high because it may result in the loss of competitive

advantage and market share. Therefore, a negative asso