The timing of changes in CEO compensation from cash bonus to equity-based compensation: Determinants and performance consequences

Journal of Contemporary Accounting & Economics 8 (2012) 78–91

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Journal of Contemporary Accounting & Economics journal homepage: www.elsevier.com/locate/jcae

The timing of changes in CEO compensation from cash bonus to equity-based compensation: Determinants and performance consequences Zoltan Matolcsy a,⇑, Yaowen Shan a, Vinay Seethamraju b a b

University of Technology, Sydney, Australia KPMG, Australia

a r t i c l e

i n f o

Article history: Received 24 August 2011 Revised 18 June 2012 Accepted 19 June 2012 Available online 29 June 2012 Keywords: CEO compensation structure Cash and equity compensation Corporate governance Firm performance

a b s t r a c t This study examines the determinants and performance consequences of changes in CEO compensation structure. The study uses the unique setting when Australian companies have changed from cash bonus to equity-based compensation. While most US CEOs receive some form of equity-based compensation, Australian CEOs have not always been paid equity-based compensation. According to efficient contracting theories, we argue that the change to equity-based compensation is driven by changes in firm characteristics and by the occurrence of CEO turnover, the latter of which provides a less costly opportunity for such change. Our results are consistent with the above arguments. We also document a significant negative association between changes in compensation structure and subsequent firm performance in the following year, even after controlling for CEO turnover and poor governance environments. Overall, our results suggest that the initial change to equity-based compensation is part of an error learning process made by firms that leads them towards efficient CEO compensation contracts. Ó 2012 Elsevier Ltd. All rights reserved.

1. Introduction There has been extensive research in Chief Executive Officer’s (CEOs) compensation that addresses the association of CEO compensation with firm performance, ownership structure, board composition and financial reporting quality, amongst other issues. However, there is little evidence to date on why firms change CEO compensation from a purely cash-based compensation structure to an equity-based compensation structure. In this study, we seek to fill in this gap by investigating why firms change CEO compensation structure from cash-based compensation to equity-based compensation, and the performance consequences of these changes. The motivation is twofold. First, the Australian context provides a unique setting to study changes in compensation structure. The evidence of Matolcsy and Wright (2007) indicates that, even in the 2000s, there are two distinct CEO compensation structures in Australia: (1) CEO compensation, where CEOs receive only cash and cash bonuses (‘‘cash group’’ hereafter); and, (2) CEO compensation, where CEOs receive both cash and equity-based compensation (‘‘equity group’’ hereafter).1 This is in

⇑ Corresponding author. Tel.: +61 2 9514 3564; fax: +61 2 9514 3669. E-mail address: [email protected] (Z. Matolcsy). More precisely, the ‘‘cash group’’ refers to firms that have never approved an equity compensation scheme through their annual general meetings. The ‘‘equity group’’ refers to firms that have approved an equity compensation scheme, no matter whether equity compensation has been actually awarded to the CEOs or not. 1

1815-5669/$ - see front matter Ó 2012 Elsevier Ltd. All rights reserved. http://dx.doi.org/10.1016/j.jcae.2012.06.002

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contrast to the US market where mostly equity-based compensation has been adopted (Murphy, 1999). However, on average, more than 40 Australian companies moved from the cash group to the equity group every year during 2001–2009, leading to a reduction of firms in the cash group over time.2 This study explains the timing of this change in compensation structure in relation to firm characteristics and CEO turnover.3 Second, the recent global financial crisis renewed the debate about executive remuneration, both politically and professionally. For example, US President Obama criticised that executive compensation packages at financial firms encouraged excessive risk taking behaviour that in turn led to the practices responsible for the financial crisis.4 As a result of such concerns, the US and several EU governments have introduced legislation restricting executive compensation levels and structures.5 Enacted or proposed regulations involve restrictions on the total level of realised compensation on the ex-ante value of pay and on the percentage of cash compensation (Dittman et al., 2010).6 In contrast to the ‘‘one size fits all’’ approach suggested by politicians and regulators, academic literature suggests that companies with different firm characteristics should have different compensation design.7 The purpose of this study is to contribute to this debate by providing evidence on the economic determinants and performance consequences of changes in CEO compensation structure. Using a sample of firms between 2001 and 2009, we find the likelihood of changes in compensation structure is significantly related to changes in economic characteristics of a firm and CEO turnover. Firms with higher value of total assets, more business segments, and higher investment opportunities, are more likely to change their compensation structure. We also find that when there is a change in CEO, there is a significantly higher likelihood of changes in the CEO compensation structure. Our results also suggest that changes in compensation structure are associated with a decrease of 1.8% in return-on-equity, and a 14.1% decrease in stock returns in the following year. The results are qualitatively similar when comparing the full sample, the matched sample based on propensity scores, and the matched sample based on industry and performance. The negative consequences of changes in compensation structure on subsequent firm performance are both economically and statistically significant, after including additional controls. In addition, the decline in firm performance occurs by the end of the first year; changes in compensation structure have no ability to explain future firm performance beyond the first year following the change. When restricting the analysis to firms with relatively strong governance environments and firms that have not changed CEOs, we confirm that the negative association between changes in compensation structure and future firm performance is independent of governance environments (Core et al., 1999) or CEO turnover (Murphy and Zimmerman, 1993). The findings of this study contribute to the existing literature in a number of ways. First, our study, using the Australian setting where firms changed to equity-based incentives during the period 2001–2009, provides new evidence on why changes to CEO compensation structure are made and the economic consequences of those changes. Bushman and Smith (2001) observe the decline in the importance of cash compensation in the US context, and highlight the lack of literature explaining the reasons for such observed shifts in compensation design. In contrast to compensation literature that focuses on the level of compensation, our results suggest that changes in compensation structure are largely determined by changes in firm characteristics, such as business complexity, investment opportunities and operating risks, as well as CEO turnover. Second, our results show that firm performance declines only in the first year following changes in compensation structure, after controlling for CEO turnover and poor governance environments. The results indicate that the initial introduction of equity-based compensation by a given firm is part of a learning process8; Australian firms are dynamically learning and moving towards their optimal equity grant levels. Finally, this study contributes to the policy debate on the design of CEO compensation packages. Our evidence suggests that ‘‘one size’’ does not fit all firms and that CEO compensation structure is largely driven by changes in firm characteristics; hence, it is more efficient for companies with different firm characteristics to have different compensation structures. The remainder of this paper is organised as follows. Section 2 reviews the CEO compensation literature and outlines the research hypotheses. Section 3 discusses sample construction, variable measurement and descriptive statistics. Sections 4

2 See also Matolcsy and Wright (2007) and Productivity Commission (2010). Matolcsy and Wright (2007) suggest that the percentage of firms in the equity group has increased from 60.3% to 84.3% between 1999 and 2005. The Productivity Commission report (2010) on executive remuneration confirms the above patterns and presents descriptive evidence of ASX 300 firms’ compensation structure between 2003 and 2009. 3 Bushman and Smith (2001) suggest that this change could also be influenced by environmental changes over time, but our contention is that timing of this change is driven by firm-specific factors. 4 See Parsons and Puzzanghera (2009) and Johnston and Goldman (2010). 5 See Banks (2009) and Charter (2010) for some details. Similarly, the Australian public has questioned the CEO compensation practices in the business section (Grossman, 2009). Regulatory interest in this sphere is evident in Australia from the recent release of the Productivity Commission’s report on CEO compensation (Productivity Commission, 2010). 6 For example, in March 2011, regulators and lawmakers applauded Wall Street’s decision to pay employees less cash and more stock, a move aimed at reducing reckless risk-taking. The New York State comptroller’s report found that Wall Street disbursed an estimated $20.8 billion in cash in 2010, down 8% from 2009 and a significant drop from what was given out before the financial meltdown. 7 See for example, Demsetz and Lehn (1985), Smith and Watts (1992), and Core and Guay (1999). Restrictions on executive compensations may yield unintended consequences, including a disproportionate increase or decrease in risk-taking incentives, rewarding mediocre CEO performance and a reduction in firm value (Dittman et al., 2010). 8 An alternative interpretation of our results is that firms switching to equity-based compensation focus more on long-term incentives even at the cost of worse performance in the short run (i.e. 1 year). However, our additional analysis in Section 5 presents empirical evidence inconsistent with the alternative hypothesis.

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and 5 present the results for tests of determinants and the economic consequences of changes in compensation structure respectively. Section 6 presents the conclusions. 2. Literature review 2.1. CEO compensation structure, change in firm characteristics and CEO turnover The separation of ownership and control in a firm creates potential principal-agent conflict (Jensen and Meckling, 1976); firms adapt different corporate governance mechanisms to minimise this conflict (Shleifer and Vishny, 1997). One of those mechanisms is the CEO compensation structure; firms aim to design compensation contracts efficiently to reduce agency costs and to provide incentives to CEOs to maximise shareholder value. One of the key trends in executive compensation design in the US during the 1980s and 1990s is the relative decline of cash-based compensation for CEOs in favour of equity-based compensation; Bushman and Smith (2001) argue that this trend in executive compensation design could be due to both environmental and institutional changes, including the emergence of institutional shareholder activist groups, greater focus on corporate governance, and changes in firms’ operational environment. Against this background, Bushman and Smith (2001) suggest that researchers should aim to understand the cross-sectional variations in equity-based granting strategies by firms. They also suggest that much of the literature in this area focuses on the role of accounting information in cash-based and equity-based compensation design.9 There is also a significant body of research examining the association between a firm’s economic characteristics and CEO compensation. By assuming that CEO compensation contracts are, on average, efficient, the literature suggests that firms with different economic characteristics have different CEO compensation contracts.10 For example, prior studies suggest that firms that provide equity-based incentives tend to have complex business operations and operate in an uncertain environment, which makes it difficult to monitor CEO decision-making. In line with this argument, empirical studies find a positive association between a firm’s investment opportunity set, firm size, stock return volatility, and the use of equity-based compensation (Ryan and Wiggins, 2001; Core and Guay, 2001; Ittner et al., 2003). Given these findings, we demonstrate that an initial change in compensation structure, such as moving from cash-based to equity-based compensation, may reflect a firm’s tendency towards efficient compensation contracts, driven by changes in firm characteristics. However, contracting theory also suggests that contract negotiations, including renegotiation of CEO compensation contracts, are not ‘‘costless’’. Accordingly, whilst the economic characteristics of a firm may change, the CEO compensation contract remains the same as the costs of renegotiating the CEO’s contract could be greater than any benefits gained (Core et al., 2003; Demsetz and Lehn, 1985). Consequently, any change in CEO provides an opportunity (both contractually and financially) to align the new CEOs compensation contract with the interests of shareholders.11 A board may find it difficult to restructure an existing CEO’s contract due to inertia, complacency, and the CEO’s influence over the board and the compensation committee. Unless a sitting CEO is unhappy with the current arrangements, the CEO may use this influence to either stall the renegotiation process or to redesign the pay package to reflect his own interests. Therefore, changing the compensation package with the incumbent CEO may be difficult and costly, as it is likely to involve difficult negotiation and bring conflict between the CEO and the board. However, at the time of CEO turnover, the board has an opportunity to make changes without conflict with a possibly powerful incumbent CEO. Hence, CEO succession provides a less costly opportunity to restructure CEOs compensation. Principal-agent theories also argue that where a new CEO is appointed and their ability in the position is unknown, the company will prefer offering a contract related to some measure of firm performance (Harris and Holmstrom, 1982; Haugen and Senbet, 1981). Instances of CEO succession therefore present a unique opportunity for the firm to design a new compensation contract for the incoming CEO, addressing both ex-ante sorting and ex-post incentives. Therefore, we expect a positive relation between CEO turnover and the initial introduction of equity-based compensation for a firm.12 2.2. Changes in CEO compensation structure and performance consequences Equity-based compensation is argued to reduce agency costs as it provides incentives for CEOs to undertake riskier positive net present value (NPV) projects than they would otherwise undertake; hence, equity-based compensation should maximise shareholders wealth (Jensen and Meckling, 1976; Demsetz and Lehn, 1985; Shleifer and Vishny, 1997). However, 9 There is also a stream of the principal agency literature that examines the optimal structure of CEO compensation. For example, Dittman and Maug (2007) use first-order-conditions from the principal agent model to estimate the cost-effectiveness of equity (stock and options) incentives in observed CEO compensation. They show the model predicts that most CEOs should not hold any stock options, but have lower cash salaries and receive additional shares in their companies. On the other hand, Pandher (2011) studies CEO compensation in a unified principal-agent contracting framework that explicitly includes all three forms of compensation (salary, variable-cash, and equity). The model shows that cash incentives will dominate equity incentives for most firms, and that the CEO effort and firm profits are higher and more robust under the joint arrangements (than equity-only and cash-only incentives). 10 See Demsetz and Lehn (1985), Smith and Watts (1992), Gaver and Gaver (1993), and Core and Guay (1999). 11 Core et al. (2003) also suggest that firms experiment with alternative compensation contracts over time to achieve the optimal compensation contracts. 12 The appointment of a new CEO may also be driven by other considerations and it is a more dynamic process than we propose here. However, we do not have additional data readily available to model other influences and processes on the appointment of a new CEO.

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the empirical evidence on the association between equity-based compensation and firm performance is conflicting.13 A number of researchers find a positive association between equity-based compensation and firm performance (Mehran, 1995; Core and Larcker, 2002; Rajgopal and Shelvin, 2002), and between equity-based compensation and future earnings (Hanlon et al., 2003). On the other hand, Core et al. (1999) find that subsequent operating and market performance is negatively related to the abnormal total compensation, although they attribute their findings to less effective governance. Ittner et al. (2003) find that lower than expected option grants and/or holding of existing options also leads to poorer performance in subsequent years. Core and Guay (1999) find that annual option grants are consistent with efficient contracting, and that there is no association between annual incremental option grants and firm performance. Finally, Ittner et al. (2003) argue that the documented conflicting relation between CEO compensation and firm performance can be due to firms going through a learning process about their optimal contracts, the use of inadequate firm controls, the misspecification of variables, and/or measurement errors. Given the conflicting evidence in existing literature and the alternative argument about error learning by firms setting optimal contracts, we consider the association between initial introduction of equity-based compensation and subsequent firm performance as an empirical question. 3. Data and descriptive statistics 3.1. Sample composition The sample is initially obtained from the UTS-Accenture ‘‘Who Governs Australia’’ database for the period of 2001–2009, which includes the ‘‘Top 500’’ Australian firms (by market capitalisation) for the period. Accounting information and share price data are sourced from Huntley Aspect Financial Database and Share Price and Price Relatives Database (SPPR). After manually checking compensation descriptions, firm-year observations within the sample are classified into two compensation categories: (1) the change group which includes firms that introduce CEO equity-based compensation for the first time, hence move from the cash group to the equity group; and (2) the cash group which includes firms that provide only cashbased compensation to the CEO and do not have an equity-based compensation scheme in place.14 Firm-year observations are deleted if any of the following conditions are met: (1) the firm reports in foreign currencies; (2) the book value of assets, book value of equity or book value of sales is negative or missing; and (3) there are missing values for net income before extraordinary items. These restrictions reduce the sample to 2288 firm-years. Table 1, Panel A shows the distribution of the sample for the years 2001–2009. On average, there are more than 40 firms moving from the cash group to the equity group every year, with the highest occurrence of 82 firms in 2003. The number of firms in the cash group steadily reduces from 346 in 2001 to 78 in 2009, confirming that Australian companies increasingly introduced equity-based compensation to CEO pay during this period. The industry distribution in Panel B suggests that there is no obvious industry trend in changes of compensation structure. While firms in IT, telecommunications and health are most likely to change their compensation design (19%), the percentage of the change group is not significantly higher than firms in consumer discretionary and staple, or financial and real estate (15%). 3.2. Variable measurement 3.2.1. Change in CEO compensation structure We measure changes in CEO compensation structure (CHANGE) as a dummy variable equal to one if a firm changes its CEO compensation structure from a purely cash-based scheme to an equity-based scheme in a particular year, and zero otherwise. In other words, CHANGE is equal to one for firm-year classified as the change group, and zero for firm-year classified as the cash group. 3.2.2. Economic determinants of changes in CEO compensation structure Previous literature suggests that monitoring CEO behaviour becomes increasingly difficult and costly when firms become larger and more decentralised, face greater growth opportunities, and are subject to more uncertain operating environments (Demsetz and Lehn, 1985; Smith and Watts, 1992; Gaver and Gaver, 1993; Core and Guay, 2001). Equity-based compensation can reduce such difficulties as it aligns the interests of CEOs and shareholders. Accordingly, a change in compensation structure may reflect a firm’s tendency towards an efficient compensation contract. Therefore, changes in compensation structure should also be determined by changes in the firm’s economic characteristics. We consider a set of firm characteristics including the number of business segments, firm size, book-to-market ratio, financial leverage, prior operating performance, prior market performance, loss indicators, and firm-specific risk. Jensen and Meckling (1976) contend that agency costs of equity increase with firm size and operational complexity, because a larger span of operations allows for greater managerial opportunism and less effective external monitoring. Bryan et al. (2000) and Yermack (1995) find that bigger firms pay managers with significantly larger amounts of stock-based 13

For a review, see Armstrong et al. (2010) and Devers et al. (2007). Equity-based compensation schemes must be approved by the annual general meeting of shareholders. Firms were classified into the ‘‘cash’’ group where there had been no such scheme approved. 14

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Table 1 Sample composition. All year

2001

2002

2003

2004

2005

2006

2007

2008

2009

Panel A: Sample distribution across year Cash group Change group

1905 383

346 5

309 56

256 82

238 48

230 43

177 58

146 37

125 33

78 21

Total

2288

351

365

338

286

273

235

183

158

99

Industry

Cash group

% Cash

Change group

% Change

Total

Panel B: Sample distribution across industry Energy and utilities Consumer discretionary and staple IT, telecommunications and health Financial and real estate Mining Industrials

184 367 216 312 371 455

82 85 81 85 82 84

41 65 51 55 84 87

18 15 19 15 18 16

225 432 267 367 455 542

Total

1905

83

383

17

2288

This table presents the distribution of the sample, the cash group and the change group, across year (Panel A) and across industry (Panel B) respectively. The sample consists of 2288 firm-year observations between 2001 and 2009. The cash group includes firms that provide purely cash pay to the CEO, but have no equity-based compensation scheme in place. The change group includes firms that firstly introduce equity-based compensation to the CEO and move from the cash group to the equity group.

compensation. Thus, we predict a positive relation between firm size, complexity of operations and changes in compensation structure. Firm size (SIZE) is measured by the natural logarithm of total assets. Operational complexity (SEG) is proxied by the number of business segments in a firm.15 In addition, firms with greater amounts of growth options tend to have broader information asymmetries, and thus are more likely to call for equity compensation to mitigate agency problems (Smith and Watts, 1992; Core and Guay, 1999). Growth opportunities are measured by the book-to-market ratio (BM), defined as the book value of assets divided by the market value of assets. Standard agency models suggest that the level of pay is an increasing function of firm performance. Firm performance is measured using the accounting return-on-asset (ROA – computed as the ratio of earnings before interest and taxes to total assets), the annual stock market return on the common stock (RETURN), and a loss indicator (LOSS). The loss indicator is equal to one when a firm makes a loss in a particular year, and zero otherwise. We expect the coefficients on ROA and RETURN to be positive, but negative for LOSS. Debt also plays a disciplinary role in the CEO’s activities and assists in resolving agency conflicts between shareholders and managers (Jensen and Meckling, 1976). As equity-based compensation tends to encourage CEOs to engage in riskier projects at the detriment of debt-holders, highly levered firms are less likely to provide equity-based incentive compensation to its CEOs (Ittner et al., 2003).16 Financial leverage (LEV) is proxied using a firm’s total long-term book value of debt over its total assets. Firms with cash constraints are also expected to use equity-based compensations as a substitute for cash pay (Yermack, 1995; Dechow et al., 1996), as the former requires no contemporaneous cash payout. In line with the above argument, firms with cash constraints are more likely to move from cash-based compensation to equity-based pay.17 Following Yermack (1995) and Dechow et al. (1996), we measure the degree of cash flow shortfall as the 3-year average of common and preferred dividends, plus cash flow from investing, minus cash flow from operations (all deflated by total assets). To measure earnings constraints, we follow Dechow et al. (1996) and use the extent to which a lack of retained earnings constrains the firm’s ability to pay dividends and make stock repurchases. We categorise a firm as dividend constrained if its year-end retained earnings plus cash dividends and share repurchases during the year, divided by the prior year’s cash dividends and share repurchases, is less than two in any of the previous 3 years. If the denominator is zero for all 3 years, we also categorise the firm as dividend constrained. Finally, firms with greater stock return volatility, as a reflection of the firm’s information environment or the risk of its operating environment, also tend to increase the likelihood of adopting equity-based compensation schemes. Firms with volatile returns need to utilise incentive compensation with non-linear payoffs in order to protect the risk-averse CEO from downside risk, while increasing the incentive power of executive compensation (Smith and Watts, 1992; Core et al., 1999). We expect a positive relation between firm risk and changes in compensation structure. Firm-specific risk is measured as the standard deviation of a firm’s monthly stock returns over the past year. 15

We also use the number of subsidiaries or the number of foreign subsidiaries as an alternative measure of operation complexity. The results remain similar. However, some empirical studies suggest that there is no significant relation between firm leverage and the use of stock options (Yermack, 1995; Bryan et al., 2000). Such evidence is also confirmed in the Australian context, with firm leverage being considered irrelevant in terms of the use of stock options (Crease et al., 2004). 17 Another potential reason for why firms substitute equity-based compensation for cash-based compensation is that cash-based compensation is expensed, whereas the value of stock option grants is only disclosed in the footnotes to the financial statements. Therefore, ceteris paribus, firms with earnings constraints are more likely to adopt equity-based compensation. 16

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3.2.3. CEO turnover CEO turnover may also lead to a change in CEO compensation structure for at least two reasons. First, it may reflect the preference of the new CEO. A candidate that has a strong bargaining position may be able to construct the new contract according to his preferences. Second, the firm may actively change its compensation structure upon the appointment of a new CEO to achieve an optimal compensation structure. Whilst these two alternatives cannot be experimentally isolated, the occurrence of CEO turnover is expected to increase the likelihood of equity-based compensation for the new CEO, at least initially. CEO turnover is measured as a dummy variable equal to one when a firm-year experiences a change in CEO, and zero otherwise. A dummy variable is also used for hiring a new CEO from overseas and for appointing an internal employee as the new CEO to represent labour market competition. The association between CEO turnover and changes in compensation structure is expected to be stronger for firms hiring CEOs from overseas, given the evidence of Murphy (1999) that US CEOs have shown a preference for equity-based compensation since the 1990s.

3.2.4. Board of directors and ownership structure A firm’s governance environment, such as board structure and ownership structure, can also play an important role in determining changes in CEO compensation. Accordingly, we control for a number of corporate governance characteristics. The effectiveness of monitoring by the board of directors is proxied by using three measures to characterise the composition of the board. A number of empirical studies suggest that agency problems are higher when the CEO is also the board chair (Goyal and Park, 2002; Core et al., 1999).18 Given that board effectiveness diminishes with increased CEO involvement, boards with non-CEO chairs should be better at monitoring and develop compensation contracts more consistent with shareholder interests. We therefore presume that boards with CEO chairs be less likely to change their compensation structure. The dual CEO/Chair (CHAIR) is an indicator variable which is equal to one if the board chair is the CEO, and zero otherwise. On the other hand, contracting theories suggest that larger boards may be less effective in controlling management.19 Core et al. (1999) find that CEO compensation is higher when the board is larger, demonstrating an inverse relation between board size and board effectiveness in monitoring. As a more effective board should design a compensation structure to encourage management behaviour that is more consistent with shareholder interests, we expect that a smaller (more effective) board would be likely to change CEO compensation structure. The size of the board (BOARDSIZE) is measured by the total number of directors on the board. The literature also indicates that the affiliation of board members plays an important role in protecting shareholder interests. Specifically, outside directors are found to promote shareholder interests by helping control managerial opportunism, while inside directors (employees) may help to entrench management and therefore allow compensation contracts more consistent with the interests of managers (Shivdasani and Yermack, 1999; Cotter et al., 1997; Mayers et al., 1997). Accordingly, we expect that the degree of board independence is positively associated with changes in compensation structure. Board independence (INSIDE) is defined as the percentage of the total directors who are insiders (i.e. directors who are managers, retired managers, or family members of present or past management). We also employ two measures for a firm’s ownership structure of the firm: CEO ownership and block ownership. When CEOs hold a large proportion of their firms’ equity, the demand for further equity-based compensation is likely to be reduced since the interests of CEOs and shareholders are relatively aligned (Ryan and Wiggins, 2001).20 Therefore, we presume a negative relation between CEO ownership and changes in compensation structure. CEO ownership is measured by the number of shares the CEO owns deflated by the total number of shares. The presence of large shareholders, as an alternative monitoring mechanism, may also influence compensation structure. CEO entrenchment is found to be a decreasing function of the holdings of outside large shareholders with substantial equity holdings in the firm (Tosi and Gomez-Mejia, 1989; Finkelstein and Hambrick, 1989). However, the relation between block ownership and changes in compensation structure is not clear. The presence of block ownership can reduce the need to align the interests of shareholders, suggesting a negative relation with the adoption of equity-based compensation (Mehran, 1995; Ittner et al., 2003). However, block ownership may also promote the use of equity-based compensation if the owners believe that monitoring activities are inefficient or too costly. Block ownership is measured as the percentage of ownership held by the firm’s top 20 shareholders.21

3.2.5. Firm performance Firm performance is measured using market and accounting measures to explore whether changes in CEO compensation structure have an impact on firm performance. Consistent with literature, the accounting performance measure of return-on-equity is employed. The return-on-equity variable is measured as earnings before interest and tax deflated by 18 For example, Goyal and Park (2002) argue that CEO/Chair duality reduces the board’s flexibility by making it more difficult to replace a poorly performing chief executive. Core et al. (1999) report that CEOs receive higher total compensation if they also serve as the chair of the board. 19 For example, Jensen (1993) and Eisenberg et al. (1998) describe how larger boards encounter more severe problems involving communication, coordination, and decision-making. 20 Further, CEOs are typically unable to diversify away the risk associated with their wealth, since their human capital is largely invested in a single position of employment. This constraint on CEOs’ ability to reduce personal risk affects their tolerance for additional risk. 21 We also use an alternative measure of blockholder ownership, namely the percentage of ownership held by the firm’s blockholders that owns at least 5% of total outstanding shares. While the use of this measure significantly reduces the sample by 40%, the results remain qualitatively similar.

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Table 2 Summary statistics. Variables

Mean

Median

St. dev.

Q1

Q3

CHANGE SIZE BM LOSS LEV ROE SEG CFshort DIVconstraint CEOTURNOVER TOP20 CEOOWNERSHIP (%) BOARDSIZE INSIDE CHAIR RETURN VOL

0.166 17.970 0.830 0.083 0.380 0.036 1.518 0.087 0.806 0.121 51.355 0.145 6.202 0.330 0.100 0.211 0.147

0 17.754 0.636 0 0.389 0.064 1 0.122 1 0 59.455 0.063 6 0.333 0 0.069 0.122

0.372 2.149 0.696 0.276 0.244 0.180 1.358 0.618 0.395 0.326 31.796 0.197 2.391 0.177 0.302 0.745 0.097

0 16.512 0.345 0 0.162 0.054 1 0.239 1 0 30.515 0.006 5 0.200 0 0.242 0.077

0 19.258 1.097 0 0.552 0.144 2 0.013 1 0 77.600 0.198 7 0.429 0 0.435 0.188

This table presents summary statistics for selected variables used in the analysis. The sample consists of 2288 firm-year observations between 2001 and 2009. Changes in CEO compensation structure (CHANGE) is a dummy variable equal to one if a firm changes its CEO compensation structure from a purely cash-based scheme to an equity-based scheme in a particular year, and zero otherwise. Firm size (SIZE) is the natural logarithm of total assets. BM is the firm’s book-to-market ratio. Financial leverage (LEV) is the percentage of a firm’s total long-term book value of debt over its total assets. Accounting returnon-asset (ROA) and return-on-equity (ROE) is the ratio of earnings before interest and taxes to total assets and total shareholder’s equity respectively. Operation complexity (SEG) is the number of business segments in a firm. Cash flow shortfall (CFshort) is the three-year average of common and preferred dividends plus cash flow from investing minus cash flow from operation divided by total assets. Dividend constraint (DIVconstraint) is an indicator equal to one if the firm is dividend constrained in any of the 3 years prior to the year the structure of compensation changes. The occurrence of CEO turnover (CEOTURNOVER) is a dummy variable equal to one if the CEO of the firm changes in the current or previous year, and zero otherwise. CEO ownership (CEOOWNERSHIP) is the number of shares the CEO owns deflated by the total number of outstanding shares (in percentage). Top 20 ownership (TOP20) is the percentage of outstanding shares owned by the top 20 shareholders in the firm. The duality of Chair and CEO (CHAIR) is a dummy variable equal to one if the board chair is also the CEO, and zero otherwise. The size of the board of directors (BOARDSIZE) is the total number of directors on the board. Board independence (INSIDE) is the percentage of the total directors who are insiders (i.e. directors who are managers, retired managers, or family members of present or past management). Stock returns (RETURN) are the annual stock market return on the common stock. The loss indicator (LOSS) is a dummy variable equal to one if the firm experience operating loss, and zero otherwise. Firm-specific risk (VOL) is the standard deviation of a firm’s monthly stock returns over the past year.

the book value of shareholders’ equity. Market performance is measured as 1-year buy-and-hold return of the firm, after adjusting for capitalisation changes and dividends.

3.3. Descriptive statistics and correlation analysis Table 2 reports descriptive statistics for selected variables of interest. To mitigate the undue influence of outliers, we eliminate the top and bottom percentile of variables required as regression variables.22 About 16.6% of our sample firmyears initiate equity-based compensation to CEOs and move from the cash group to the equity group. The average firm has a book value of about $63.7 million in total assets,23 a book-to-market ratio of 0.83, more than one business segment, and financial leverage of 38% of total assets. About 10% of the CEOs in our sample firm-years serve as chair of the board. The average board consists of 6.2 directors, 33% of which are insiders. The average CEO owns 0.15% of the firm’s outstanding equity, with a median of 0.06%. On average, 51% of the firm’s outstanding shares are owned by the top 20 shareholders in the firm. We also calculate Pearson and Spearman correlations for selected regression variables, as reported in Table 3. Consistent with firms using new equity-based compensation to manage optimal incentives for CEOs, CHANGE is positively correlated with lagged SIZE and SEG, and negatively associated with lagged BM. This implies that larger firms and firms with more growth opportunities are more likely to introduce equity-based compensation in their CEO remuneration package. We also find that firms are more likely to change their compensation structure following the appointment of a new CEO, as suggested by a significantly positive correlation between CHANGE and CEOTURNOVER of 0.126. With respect to control variables, CHANGE is positively associated with BOARDSIZE and negatively correlated with CHAIR, suggesting that a firm’s board structure may also affect its decision to change CEO compensation structure. There is a negative correlation between CHANGE and CEOOWNERSHIP, indicating that CEOs with more ownership in the firm are better aligned with the interests of shareholders and are less likely to receive equity-based compensation. 22 23

The results remain qualitatively similar if we winsorize the top and bottom percentile of selected variables. The mean value of the natural logarithm of total assets is 17.97.

Table 3 Correlation matrix on selected regression variables. CHANGE

0.110* 0.126* 0.139* 0.123* 0.120* 0.062* 0.059* 0.139* 0.073* 0.084* 0.058 0.017 0.004 0.018 0.050* 0.022

0.132* 0.113* 0.137* 0.047* 0.079* 0.074* 0.009 0.001 0.100* 0.024 0.059* 0.046* 0.039 0.038

TOP20 0.092* 0.008 0.421* 0.016 0.108* 0.159* 0.369* 0.017 0.018 0.096* 0.030 0.131* 0.123* 0.036 0.074*

CEO OWNERSHIP

BOARDSIZE

INSIDE

CHAIR

SEG

SIZE

BM

LOSS

LEV

ROA

ROE

RETURN

VOL

0.139* 0.083* 0.355*

0.153* 0.167* 0.043 0.342*

0.063* 0.046 0.157* 0.312* 0.349*

0.081* 0.088* 0.187* 0.181* 0.223* 0.200*

0.058* 0.017 0.037 0.003 0.162* 0.074* 0.045

0.117* 0.025 0.066* 0.270* 0.544* 0.292* 0.097* 0.287*

0.061* 0.019 0.044 0.011 0.043 0.054 0.054 0.218* 0.093*

0.041 0.032 0.053 0.049 0.148* 0.009 0.067* 0.142* 0.180* 0.113*

0.007 0.035 0.075* 0.052 0.277* 0.152* 0.061* 0.281* 0.464* 0.003 0.206*

0.014 0.042 0.244* 0.094* 0.159* 0.037 0.062* 0.184* 0.515* 0.052 0.292* 0.311*

0.024 0.034 0.214* 0.088* 0.167* 0.056 0.037 0.198* 0.535* 0.106* 0.300* 0.394* 0.898*

0.056 0.087* 0.076* 0.022 0.006 0.037 0.012 0.032 0.153* 0.323* 0.042 0.024 0.243* 0.277*

0.038 0.031 0.056 0.116* 0.265* 0.199* 0.039 0.180* 0.561* 0.061* 0.223* 0.317* 0.515* 0.501* 0.025

0.265* 0.213* 0.203* 0.014 0.142* 0.068* 0.071* 0.039 0.161* 0.173* 0.006 0.006

0.333* 0.117* 0.269* 0.548* 0.017 0.129* 0.226* 0.163* 0.121* 0.038 0.220*

0.215* 0.084* 0.280* 0.004 0.009 0.108* 0.047 0.024 0.020 0.156*

0.030 0.084* 0.057* 0.055* 0.062* 0.007 0.004 0.005 0.053*

0.362* 0.074* 0.048* 0.241* 0.191* 0.175* 0.041 0.181*

0.011 0.140* 0.463* 0.513* 0.455* 0.018 0.476*

0.057* 0.023 0.057* 0.053* 0.290* 0.009

0.171* 0.222* 0.253* 0.070* 0.166*

0.269* 0.282* 0.057* 0.274*

0.824* 0.124* 0.435*

0.166* 0.406*

0.191*

This table presents the correlation matrix for selected variables used in the analysis. The sample consists of 2288 firm-year observations between 2001 and 2009. Person (Spearman) correlation coefficients are in the lower (upper) triangle. Changes in CEO compensation structure (CHANGE) is a dummy variable equal to one if a firm changes its CEO compensation structure from a purely cash-based scheme to an equity-based scheme in a particular year, and zero otherwise. Firm size (SIZE) is the natural logarithm of total assets. BM is the firm’s book-to-market ratio. Financial leverage (LEV) is the percentage of a firm’s total long-term book value of debt over its total assets. Accounting return-on-asset (ROA) and return-on-equity (ROE) is the ratio of earnings before interest and taxes to total assets and total shareholder’s equity respectively. Operation complexity (SEG) is the number of business segments in a firm. The occurrence of CEO turnover (CEOTURNOVER) is a dummy variable equal to one if the CEO of the firm changes in the current or previous year, and zero otherwise. CEO ownership (CEOOWNERSHIP) is the number of shares the CEO owns deflated by the total number of outstanding shares. Top 20 ownership (TOP20) is the percentage of outstanding shares owned by the top 20 shareholders in the firm. The duality of Chair and CEO (CHAIR) is a dummy variable equal to one if the board chair is also the CEO, and zero otherwise. The size of the board of directors (BOARDSIZE) is the total number of directors on the board. Board independence (INSIDE) is the percentage of the total directors who are insiders (i.e. directors who are managers, retired managers, or family members of present or past management). Stock returns (RETURN) are the annual stock market return on the common stock. The loss indicator (LOSS) is a dummy variable equal to one if the firm experience operating loss, and zero otherwise. Firm-specific risk (VOL) is the standard deviation of a firm’s monthly stock returns over the past year. * Significant at the 5% level.

Z. Matolcsy et al. / Journal of Contemporary Accounting & Economics 8 (2012) 78–91

CHANGE CEOTURNOVER TOP20 CEOOWNERSHIP BOARDSIZE INSIDE CHAIR SEG SIZE BM LOSS LEV ROA ROE RETURN VOL

CEO TURNOVER

85

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4. Results on the determinants of changes in compensation structure To examine the determinants of changes in compensation structure, we test the cross-sectional model to predict the timing of the introduction of CEO equity-based compensation. The econometric specification for the Probit estimation is as follows:

ProbðChange ¼ 1Þit ¼ a þ Rbi DEconomic determinantit1 þ g CEOTURNOVERit1 þ Rdi controlsit1 þ eit

ð1Þ

where Change is a dummy variable equal to one when a firm moves from the cash group to the equity group in a particular year, and zero if the firm remains in the cash group. We expect the change in compensation structure can be explained by changes in the firm’s economic determinants and any change in CEO. As the above factors are predictors of change in compensation structure, all explanatory variables except CEO turnover are lagged by 1 year. Since prior literature suggests that the grant of equity compensation is determined by a firm’s corporate governance environment, we include variables of board of directors and ownership structure as controls. We also include industry and year dummies in the regression to account for time-varying and industry differences in the demand for managerial talent.24 The regression results presented in Table 4 generally confirm our preliminary findings in the correlation analysis. Columns (1)–(3) of Table 4 display the restricted estimates of the determinants of changes in compensation structure, and Column (4) reports the results for the combined version. The results in Column (1) suggest that the likelihood of changes in compensation structure is cross-sectionally significantly related to changes in firm size, changes in investment opportunities, and the number of business segments. Firms becoming larger and with more investment opportunities (as proxied by the book-to-market ratio) are more likely to change their compensation structure, reflecting their demand for higherquality managerial talent. The correlation between CHANGE and operating complexity is positive (0.092) and significant (t = 3.37), confirming that the presence of equity-based compensation would help to mitigate the agency costs of equity. In Column (2), we find a significant positive association between the occurrence of CEO turnover and changes in compensation structure (coefficient = 0.345; t = 4.57). The point estimate indicates that the occurrence of CEO changes leads to a higher likelihood of changes in compensation structure by 34.5%. To examine whether the association between CEO change and the change in compensation scheme is a function of CEO characteristics, we also include a dummy variable for hiring a new CEO from overseas and a dummy variable for appointing an internal employee as the new CEO to represent labour market competition. The results in Column (3) indicate that firms appointing a new CEO internally or from overseas do not have a higher probability of changes in compensation scheme. When governance variables are included as controls, changes in economic characteristics, the number of business segments and CEO turnover continue to be important determinants. With respect to governance variables, the estimated coefficients of BOARDSIZE and CHAIR are generally consistent with our expectation. The significant coefficient on the indicator variable for CEO/Chair duality indicates that a CEO who also serves as the board chair reduces the likelihood of changes in compensation structure by 34%. The coefficient on BOARDSIZE is positive (coefficient = 0.054) and significant (t = 2.32), suggesting that firms with a larger board of directors are more willing to change their compensation structure (see Column (4)). Both variables capturing ownership structure are also statistically significant at conventional levels. The CEO equity ownership has a significantly negative coefficient of 1.090 (t = 3.51). The coefficient of the top 20 shareholder ownership is positive (coefficient = 0.006) and significant at the 10% level (t = 2.24). Considered together, the results in Columns (1)–(4) suggest that changes in CEO compensation structure are jointly determined by changes in economic characteristics and CEO turnover. Two additional tests are conducted to ensure the results are robust. First, we estimate the Probit model by excluding firms in the financial and mining industries due to their unique economic characteristics.25 The results are generally consistent with those reported above, although the coefficient for SIZE becomes less significant. Second, we examine the determinants of changes in compensation structure with the change group and a control sample. In particular, for each firm in the change group we identify firms from the cash group that are in the same industry and have the closest sales. Due to the availability of determinant variables, our final matching sample consists of 255 firms that change their compensation structure and 255 control firms. We re-run the Probit model and find the results for the matching sample are qualitatively similar to the above evidence.26 5. Results on the economic consequences of changes in compensation structure To examine the economic consequences of changes in compensation structure, we estimate the following cross-sectional regressions: 24 We also consider a firm’s liquidity constraints as an additional determinant of changes in compensation structure. Equity-based compensation conserves cash payment for CEO remunerations. We therefore expect firms with liquidity constraints to use relatively more equity-based compensation (Core and Guay, 2001; Ittner et al., 2003). We measure the firm’s liquidity constraint with a dummy variable (set to one if the firm pays cash dividends). When liquidity constraint is included, our main results remain similar and the coefficient on the liquidity constraint is statistically insignificant. Results are available upon request. 25 Mining exploration firms are considered to be ‘‘cash burning companies’’. Many of them do not earn revenues and operate with significant losses over years. Financial companies are often excluded because of their unique financial structure (high debt-to-equity ratios) and their regulatory environment. 26 For brevity, the results are not presented here but are available upon request.

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Z. Matolcsy et al. / Journal of Contemporary Accounting & Economics 8 (2012) 78–91 Table 4 Determinants of changes in CEO compensation structure. Variables

(1) Firm characteristics Coefficient (t-stat)

(2) CEO turnover Coefficient (t-stat)

(3) CEO turnover Coefficient (t-stat)

(4) All determinants Coefficient (t-stat)

Constant

1.296*** (6.22) 0.189*** (2.62) 0.117* (1.68) 0.056 (0.39) 0.031 (0.11) 0.223 (1.11) 0.092*** (3.37) 0.201 (1.44) 0.160 (1.45)

1.028*** (6.83)

1.027*** (6.83)

0.345*** (4.57)

0.407*** (4.80) 0.308 (1.20) 0.204 (1.20)

1.643*** (4.28) 0.156* (1.74) 0.246*** (3.39) 0.139 (0.82) 0.188 (0.55) 0.160 (0.59) 0.072** (2.14) 0.238 (1.34) 0.085 (0.55) 0.285** (2.36) 0.417 (1.24) 0.032 (0.15) 0.006** (2.24) 1.090*** (3.51) 0.054** (2.32) 0.208 (0.75) 0.344** (2.16) 0.112* (1.82) 0.664 (1.05)

Yes Yes 6.93% 143.73 (0.000) 2288

Yes Yes 7.06% 146.31 (0.000) 2288

DSIZE DBM DLOSS DLEV DROE SEG CFshort DIVconstraint CEOTURNOVER CEO_oversea CEO_internal TOP20 CEOOWNERSHIP BOARDSIZE INSIDE CHAIR RETURN VOL Industry dummies Year dummies Pseudo R2 LR v2 p-Value > v2 N

Yes Yes 5.64% 94.78 (0.000) 1759

Yes Yes 7.90% 94.27 (0.000) 1122

This table presents results of Probit regression of changes in CEO compensation structure on its economic determinants, CEO turnover, controls, and industry and year fixed effects. The sample consists of 2306 firm-year observations between 2001 and 2009. Changes in CEO compensation structure (CHANGE) is a dummy variable equal to one if a firm changes its CEO compensation structure from a purely cashbased scheme to an equity-based scheme in a particular year, and zero otherwise. Firm size (SIZE) is the natural logarithm of total assets. BM is the firm’s book-to-market ratio. Financial leverage (LEV) is the percentage of a firm’s total long-term book value of debt over its total assets. Accounting return-onasset (ROA) and return-on-equity (ROE) is the ratio of earnings before interest and taxes to total assets and total shareholder’s equity respectively. Operation complexity (SEG) is the number of business segments in a firm. Cash flow shortfall (CFshort) is the 3-year average of common and preferred dividends plus cash flow from investing minus cash flow from operation divided by total assets. Dividend constraint (DIVconstraint) is an indicator equal to one if the firm is dividend constrained in any of the 3 years prior to the year the structure of compensation changes. The occurrence of CEO turnover (CEOTURNOVER) is a dummy variable equal to one if the CEO of the firm changes in the current or previous year, and zero otherwise. CEO_oversea is a dummy variable equal to one if the new CEO of the firm is recruited from oversea, and zero otherwise. CEO_internal is a dummy variable equal to one if the new CEO of the firm is appointed from internal employees, and zero otherwise. CEO ownership (CEOOWNERSHIP) is the number of shares the CEO owns deflated by the total number of outstanding shares. Top 20 ownership (TOP20) is the percentage of outstanding shares owned by the top 20 shareholders in the firm. The duality of Chair and CEO (CHAIR) is a dummy variable equal to one if the board chair is also the CEO, and zero otherwise. The size of the board of directors (BOARDSIZE) is the total number of directors on the board. Board independence (INSIDE) is the percentage of the total directors who are insiders (i.e. directors who are managers, retired managers, or family members of present or past management). Stock returns (RETURN) are the annual stock market return on the common stock. The loss indicator (LOSS) is a dummy variable equal to one if the firm experience operating loss, and zero otherwise. Firmspecific risk (VOL) is the standard deviation of a firm’s monthly stock returns over the past year. Figures in parentheses are t-statistics. *** Significant at 1% level. ** Significant at 5% level. * Significant at 10% level.

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Performanceitþj ¼ a þ bChangeit þ Rci Controlit þ eit

ð2Þ

where Performance is proxied by return-on-equity (ROE) or stock returns in year t + j (j = 1 or 2) subsequent to changes in compensation structure. We also include industry and year dummies in the regression to control for time-varying and industry-specific effects. According to prior studies, the specification of control variables changes across different performance measures (Core et al., 1999; Chalmers et al., 2006). The log of sales, financial leverage and the standard deviation of ROE are included as controls in the regression of ROE. For the regression of stock returns, market capitalisation and the bookto-market ratio are used as controls. However, one main problem with determining the performance consequences of compensation is identification. Compensation arrangements are the endogenous outcome of a complex process involving the CEO, the compensation committee, the entire board of directors, and the managerial labour market. As a result, compensation arrangements are correlated with a large number of observable and unobservable firm and CEO characteristics.27 Our tests of the determinants of changes in compensation structure above indicate that firms self-select into changing their compensation scheme and they are found to be systematically different from other firms which do not change their compensation structure. To address the concern of endogeneity, we apply a propensity-score matching procedure following Armstrong et al. (2010) and allow for endogenous matching of executives and contracts. In particular, we model the probability of changes in compensation structure and use changes in size, book-to-market ratio and ROE, and CEO turnover, as independent variables in Eq. (1), as they are found to be statistically significant determinants.28 We then form matched pairs of firms with a similar propensity score. Due to data availability, we have successfully matched 352 treatment firms with 352 control firms. Table 5 presents the estimation results for the model described by Eq. (2) (subsequent performance measured via ROE or stock returns). The results in Panel A indicate that changes in compensation structure have a significant negative association with firm operating performance and stock returns in the following year. Changes in compensation structure are associated with a decrease of 1.8% in return-on-equity and 14.1% in stock returns in the following year. Given the mean of ROE and stock returns in the sample is 3.6% and 21.1% respectively, the negative consequences of changes in compensation structure on subsequent firm performance are both economically and statistically significant. However, the results in Panel B suggest that there is no significant decline in compensation structure and firm performance in the second year following the change. The coefficients on CHANGE are 0.008 for ROE and 0.018 for stock returns respectively. Overall, the results in Table 5 indicate that changes in compensation structure have no ability to explain future firm performance beyond the first year following the change, and the entire decline in firm performance occurs by the end of the first year.29 The above results are consistent with the view that the introduction of equity-based compensation does not lead to efficient compensation contracts, as the firms ‘experiment’ with the optimal structure (Core et al., 1999; Ittner et al., 2003). However, the negative association between changes in compensation structure and firm performance in the following year may also be due to the absence of control variables, such as CEO turnover and corporate governance variables. Therefore, we conduct additional tests to examine these alternatives. First, we examine whether poor firm performance, following changes in compensation structure, is a by-product of CEO turnover. In particular, incoming CEOs can take a ‘‘big bath’’; i.e. they boost future earnings at the expense of transition-year earnings by writing off unwanted operations and unprofitable divisions (Murphy and Zimmerman, 1993). However, empirical evidence on the consequences of CEO turnover with regard to subsequent firm performance in the literature is mixed. For example, Khanna and Poulsen (1995) find that the announcements of managerial turnover are associated with negative stock returns, while Bonnier and Bruner (1989) document significant and positive stock returns in response to turnover news. Denis and Denis (1995) and Huson et al. (2004) provide evidence of positive performance following CEO turnover, particularly for forced turnovers. We re-examine the performance consequences of changes in compensation structure, after excluding firms that change their CEO. Results in Table 5, Panel C are qualitatively similar to our previous evidence (though slightly weaker), indicating that the negative impact of changes in compensation structure on firm performance is not a byproduct of CEO turnovers. Second, Core et al. (1999) find that subsequent operating performance is negatively related to the abnormal CEO compensations predicted from board and ownership structure variables, indicating that firms with less effective governance environments tend to have weaker subsequent operating performance and stock price performance. The findings in Core et al. (1999) suggest an alternative explanation; if changes in compensation structure are a proxy for poor governance environments, then the negative relation between changes in compensation structure and future firm performance can be largely attributable to firms with weak governance environments. We therefore restrict our regression analysis to firms with relatively strong governance environments. If their argument is valid in our context, we should find little or no evidence of a negative association between changes in compensation structure and future performance in firms with relatively strong governance. The results for the restricted sample are reported in Table 6. 27 For example, CEO pay and firm performance may be correlated because compensation affects performance, because firm performance affects pay, or because an unobserved firm or CEO characteristic affects both variables. We also perform a sensitivity test by using a matched sample based on industry and performance. The results remain qualitatively similar. 28 We also estimate Eq. (1) by using all significant determinants (i.e. including Top 20 shareholding, CEO ownership, board size, CEO duality) reported in Table 4 and the results are generally consistent. 29 The results remain qualitatively similar when we examine the performance consequence by using the full sample or a matching sample based on industry and sales.

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Z. Matolcsy et al. / Journal of Contemporary Accounting & Economics 8 (2012) 78–91 Table 5 Performance consequences of changes in compensation structure. Variables

Constant CHANGE Log(sales) LEV Std(ROE)

Panel A: Performancei+1

Panel B: Performancei+2

Panel C: Firms without CEO changes

ROEt+1 Coefficient (t-stat)

RETURNt+1 Coefficient (t-stat)

ROEt+2 Coefficient (t-stat)

RETURNt+2 Coefficient (t-stat)

ROEt+1 Coefficient (t-stat)

RETURNt+1 Coefficient (t-stat)

0.231 (1.35) 0.018* (1.91) 0.019*** (5.49) 0.124*** (2.60) 0.001 (0.04)

0.585 (1.07) 0.141** (2.44)

0.191 (1.12) 0.008 (0.72) 0.020*** (5.30) 0.052 (1.01) 0.017 (0.50)

0.488 (0.85) 0.018 (0.29)

0.213 (1.22) 0.014* (1.78) 0.019*** (4.74) 0.075 (1.39) 0.014 (0.36)

0.830 (1.31) 0.127* (1.80)

MarketCap

0.012 (0.68) 0.228 (0.59) 0.047 (0.85)

VOL BM Industry dummies Year dummies N Adj. R2

Yes Yes 436 30.50%

Yes Yes 638 15.20%

0.023 (1.20) 0.001 (0.00) 0.044 (0.71) Yes Yes 365 29.30%

Yes Yes 550 14.00%

0.025 (1.13) 0.335 (0.73) 0.059 (0.94) Yes Yes 313 30.00%

Yes Yes 471 17.70%

This table presents results of regression of subsequent operating and stock return performance on changes in compensation structure and controls. The sample consists of firms changing their compensation structure from cash-based to equity-based pay, and control firms matched based on propensity scores. Changes in CEO compensation structure (CHANGE) is a dummy variable equal to one if a firm changes its CEO compensation structure from a purely cash-based scheme to an equity-based scheme in a particular year, and zero otherwise. Sales are a firm’s revenue in the year. MarketCap is a firm’s market capitalisation. BM is the firm’s book-to-market ratio. Financial leverage (LEV) is the percentage of a firm’s total long-term book value of debt over its total assets. Accounting return-on-asset (ROA) and return-on-equity (ROE) is the ratio of earnings before interest and taxes to total assets and total shareholder’s equity respectively. Stock returns (RETURN) are the annual stock market return on the common stock. Firm-specific risk (VOL) is the standard deviation of a firm’s monthly stock returns over the past year. The standard deviation of ROA (ROE) is the standard deviation of annual percentage corporate ROA (ROE) for the prior 5 years. Figures in parentheses are t-statistics. *** Significant at 1% level. ** Significant at 5% level. * Significant at 10% level.

We classify firms with strong governance environments as those whose top 20 shareholder ownership or CEO ownership is higher than the sample median, or whose CEO is not serving as the chair of the board. Inconsistent with the argument presented in Core et al. (1999), the results in Table 6 confirm a significant negative association between changes in compensation structure and future firm performance for firms with ‘strong’ governance environments. One possible explanation for our finding is that institutional investors and/or CEOs may be more aware of US compensation trends; hence, they aim to match the firm’s CEO compensation to US CEO compensation. In summary, the results in Table 6 confirm those documented in Table 5, suggesting that first-time introduction of equity-based compensation can be a learning process by the firm towards the efficient contracts. Finally, we examine an alternative explanation of our finding that firm performance declines in the first year following the change in compensation structure. A stream of literature examines how equity-based compensation provides longterm managerial incentives. In particular, equity-based compensation has been found to be connected to a wide variety of outcomes, including better operating performance (Core and Larcker, 2002), more and better mergers and acquisitions (Cai and Vijh, 2007), and larger restructurings and layoffs (Brookman et al., 2007). Accordingly, an alternative interpretation of our results is that firms switching to equity-based compensation focus more on long-term incentives even at the cost of worse performance in the short term (i.e. 1 year). To examine this hypothesis, we estimate Eq. (2) by using a proxy for long-run performance beyond the first year. Specifically, Performance is proxied by return-on-equity (ROE) or stock returns in year t + 2 to t + k (k = 3 or 5) subsequent to changes in compensation structure. The results (untabulated) indicate that changes in compensation structure are not significantly associated with long-term performance.30 Taking ROE as an example, the estimated coefficients on CHANGE are 0.019 for ROEt+2,t+3 and 0.028 for ROEt+2,t+5 respectively, both with insignificant t-statistics (t = 0.27 and 0.78 respectively). Overall, the results are inconsistent with the hypothesis that firms introducing an equity-based compensation scheme place more emphasis on long-term performance at the expense of shortterm profits. 30

The results are not tabulated here but are available upon request.

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Table 6 Performance consequences of changes in compensation structure: controlling for governance environments. Variables

Constant CHANGE Log(sales) LEV Std(ROE)

Panel A: CEO not Chair

Panel B: High TOP20

Panel C: High CEOOWNERSHIP

ROEt+1 Coefficient (t-stat)

RETURNt+1 Coefficient (t-stat)

ROEt+1 Coefficient (t-stat)

RETURNt+1 Coefficient (t-stat)

ROEt+1 Coefficient (t-stat)

RETURNt+1 Coefficient (t-stat)

0.219 (1.28) 0.019* (1.82) 0.018*** (5.01) 0.137*** (2.78) 0.001 (0.02)

0.649 (1.16) 0.132** (2.20)

0.310*** (4.76) 0.021* (2.04) 0.018*** (5.20) 0.121** (2.50) 0.002 (0.06)

0.616 (1.02) 0.140** (2.32)

0.287 (1.47) 0.020* (1.86) 0.023*** (4.32) 0.105 (1.56) 0.011 (0.26)

1.100 (1.52) 0.151* (1.77)

MarketCap

0.015 (0.80) 0.322 (0.78) 0.002 (0.03)

VOL BM Industry dummies Year dummies N Adj. R2

Yes Yes 407 30.80%

Yes Yes 586 17.00%

0.021 (1.12) 0.239 (0.60) 0.032 (0.57) Yes Yes 287 29.00%

Yes Yes 300 16.30%

0.029 (1.09) 0.338 (0.67) 0.072 (1.00) Yes Yes 206 31.50%

Yes Yes 327 18.80%

This table presents results of regression of subsequent operating and stock return performance on changes in compensation structure and controls for firms with a strong governance environment. The sample consists of firms changing their compensation structure from cash-based to equity-based pay, and control firms matched based on propensity scores. Changes in CEO compensation structure (CHANGE) is a dummy variable equal to one if a firm changes its CEO compensation structure from a purely cash-based scheme to an equity-based scheme in a particular year, and zero otherwise. Sales are a firm’s revenue in the year. MarketCap is a firm’s market capitalisation. BM is the firm’s book-to-market ratio. Financial leverage (LEV) is the percentage of a firm’s total long-term book value of debt over its total assets. Accounting return-on-asset (ROA) and return-on-equity (ROE) is the ratio of earnings before interest and taxes to total assets and total shareholder’s equity respectively. Stock returns (RETURN) are the annual stock market return on the common stock. Firmspecific risk (VOL) is the standard deviation of a firm’s monthly stock returns over the past year. The standard deviation of ROA (ROE) is the standard deviation of annual percentage corporate ROA (ROE) for the prior 5 years. The duality of Chair and CEO (CHAIR) is a dummy variable equal to one if the board chair is also the CEO, and zero otherwise. CEO ownership (CEOOWNERSHIP) is the number of shares the CEO owns deflated by the total number of outstanding shares. Top 20 ownership (TOP20) is the percentage of outstanding shares owned by the top 20 shareholders in the firm. CEO not Chair represents firms whose CEO is not the chairman of the board (i.e. Chair = 0). High TOP20 (high CEOOWNERSHIP) represent firms whose TOP20 (CEOOWNERSHIP) is higher than the median of the sample. Figures in parentheses are t-statistics. *** Significant at 1% level. ** Significant at 5% level. * Significant at 10% level.

6. Conclusion This study examines the determinants and performance consequences of changes in CEO compensation structure in Australia. While almost all CEOs in the US receive some form of equity-based compensation, Australian CEOs have not always been paid equity-based compensation. In fact, Australian companies are increasingly adopting equity-based CEO compensation schemes over time, coinciding with a reduction in the use of cash compensation. The Australian market thus provides a unique setting where changes in compensation structure are taking place; this allows for meaningful comparisons between firms and greater understanding of drivers and outcomes of such shifts. Using a sample of firms from 2001–2009, we find that changes in compensation structure are determined by changes in the economic characteristics of the firm and the occurrence of CEO turnover. On examining the economic consequences of changes in compensation structure, our results suggest that changes in compensation structure are associated with a decrease of 1.8% in return-on-equity and 14.1% in stock returns in the following year. However, the entire decline in firm performance occurs by the end of the first year; changes in compensation structure have no ability to explain future firm performance beyond the first year following the change. Overall, the results provide new insights into how the initial introduction of equity-based compensation may not lead to efficient compensation contracts, but it is part of a learning process by firms towards efficient CEO compensation contracts. Acknowledgements The authors are grateful for suggestions by Eli Bartov, Dan Dhaliwal, Vernon Richardson, Dan Simunic (the editor), Stephen Taylor, Peter Wells, an anonymous reviewer, as well as workshop participants at the University of Technology, Sydney. We also appreciate the research assistance of Dongjuan Zang. Yaowen Shan and Zoltan Matolcsy gratefully acknowledge the financial support through AFAANZ research grant.

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