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Faculty Insights

Landmark Accounting Research Helps Change Executive Compensation

By Wisconsin School of Business

September 14, 2016

Terry Warfield
Terry Warfield is PwC Professor of Accounting and chair of the Department of Accounting and Information Systems at the Wisconsin School of Business. PHOTO: PAUL L. NEWBY II

It was called “the crack cocaine of incentives” —the practice of stock options for executive compensation, which grew feverishly during the late 1990s.

For a long time, and even now, companies believed that equity incentives were a good way to align managers’ interests with shareholders’ interests. If managers held stock, the theory goes, they will act in ways that benefit the shareholders because they were now owners, too, and would not necessarily act solely for the benefit of themselves.

“If you, as an employer or board, are using stock options in compensation packages because you think you’re getting good incentive effects, you’re not,” says Terry Warfield, PwC Professor of Accounting of the Wisconsin School of Business at the University of Wisconsin–Madison.

A 2005 paper co-authored by Warfield found that equity incentives—stocks, stock options, or other ownership incentives—in some situations led to earnings management—using accounting techniques to produce a more positive view of a company’s finances. That earnings management was then followed by managers exercising stock options and selling stock.

In effect, what began as a way to help shareholders turned into opportunity for managers to “pump and dump”—managing the earnings for a gain that can be captured by the sale of the stock.

“A lot of people suspected this was going on and people were beginning to wonder, ‘If this is happening, why are we structuring pay packages this way?’” Warfield says. “This paper confirmed what people suspected was going on, and now compensation plans look very different than they did 10 years ago.”

An opposite effect

Theoretically, equity incentive compensation made sense. In practice, it turned out differently.

The paper, “Equity Incentives and Earnings Management,” published in The Accounting Review, established that there are factors at work that diminish the ownership advantage, a finding that continues to influence how compensation packages are designed for companies that plan to offer ownership incentives. Warfield and his co-author Qiang Cheng, then at the University of British Columbia, found that in some situations the very incentives that were supposed to benefit shareholders were actually creating an opportunity for managers to benefit themselves.

Qiang Cheng
Qiang Cheng, co-author with Terry Warfield of the research paper, is now dean of the School of Accountancy at Singapore Management University.

Warfield’s paper with Cheng, who had been a doctoral student working with Warfield at the Wisconsin School of Business, was the first to document that these compensation-based incentives for managers wouldn’t necessarily benefit shareholders. In fact, Warfield and Cheng’s research found, the presence of these options served to potentially benefit short-term investors, such as the managers themselves exercising stock options, and not long-term investors, as most shareholders are.

The highly cited paper was the second in a stream of research in which Warfield was involved that looked at compensation and principal-agent conflicts. In the 12 years since publication, it has been cited more than 1,000 times.

“You do all this work, and it’s great when it gets published but when it gets picked up by The Wall Street Journal, that’s really gratifying,” Warfield says. “That means we’re able to communicate with a really broad audience of people.”

Making the connections

In the research, Warfield and Cheng established the links between equity incentives, earnings management, and future manager trading.

“We came up with some unique measures to show this, and our methodology probably gets as much citation as the overall thrust of the paper,” Warfield says. “This paper establishes relationships, and if you’re going to study earnings management, you need to control for the variables we identify in this paper.”

Earnings management wasn’t simply a byproduct of management ownership. Warfield and Cheng identified a threshold of management ownership before patterns emerged.

“If you don’t have very much management ownership to begin with, those managers have very little incentive to dump the stock,” Warfield says. “But if managers are up to a certain amount of ownership, they don’t want to own more stock.”

Because of that, managers can become more concerned about short-term stock prices. In addition, Warfield and Cheng’s research showed that high-equity incentivized managers could make bigger gains by selling more shares after reporting earnings that meet or beat analysts’ forecasts.

While the “pump and dump” effect undermines the intended benefit to shareholders, there is potentially a logic at work with the managers who do it.

“If managers own 5 percent of the company, you’re not going to give them many more positive incentives to own more shares of stock,” Warfield says. “If I’m a manager, I don’t want all of my wealth tied up in the company. If the company goes out of business, I’m going to lose my salary, and I have all this stock that isn’t worth very much.”

Too much of a good thing

It’s not just ownership that is the issue, Warfield says, it’s also a pay plan that drives the managers to have more ownership than would make sense in good portfolio management.

“This pattern of ‘pump and dump’ is only going to happen to the managers who are too exposed to the company’s stock, and they’ll be the ones who dump it,” Warfield says. “We validate that thinking.”

Warfield and Cheng’s research confirmed the suspicion that these stock options weren’t working the way compensation committees wanted them to, so maybe it was time to do something different.

“People were speculating that managers were getting these options and not holding on to them for very long,” Warfield says. “Our paper confirmed that.”

Change came soon. The paper’s publication was followed a year later by a change in accounting standards that had a major effect on corporations. In 2006, a revised financial accounting standard became effective, requiring share-based payments that were part of compensation to be expensed based on an estimated fair value. The rule related to employee stock options and stock purchases.

Throughout the 1990s, particularly in the tech industry, stock options became a popular method of compensation because they connected employees and managers to the company and were not reported as an expense. After 2006, stock options gave way to restricted stock in compensation packages, a trend that continues.

A change in compensation practices

The new a
ccounting standard removed the financial incentive that made stock options popular as compensation; Warfield and Cheng’s research debunked the established theory that managers’ options would be an automatic benefit to shareholders.

“We think our paper got compensation committees to say more often, ‘Maybe we shouldn’t give them stock options, maybe we should give them restricted stock.’ Because then they’d have to wait before they can do anything,” Warfield says. “That change in compensation packages was motivated in part by compensation committees seeing they weren’t getting the benefits out of the options because managers weren’t thinking long term, they were thinking short term.”

Restricted stock requires the managers to hang on to the stock for a while, mitigating the behavior that Warfield and Cheng outlined in their paper.

“With stock options, the manager only gets the upside,” Warfield says. “Now, if they have a restriction that they can’t trade the stock for five years, they have to think like owners for the next five years. They’re also exposed to downside.

“What we’ve observed in the market today is that companies are big users of restricted stock, less so with plans that include stock options.”

Moving the research forward

The 2005 paper, which didn’t look at financial institutions or regulated industries, was a source for further research. A follow-up paper by Warfield, Cheng, and Minlei Ye of the University of Toronto examined equity incentives in a regulated industry. “Equity Incentives and Earnings Management: Evidence from the Banking Industry” was published in the Journal of Accounting, Auditing & Finance in 2011.

“The findings were the same,” Warfield says. “You had to measure it differently because you had to control for different competing incentives, but we got similar results.”

The work with Cheng underscores the strength of the Wisconsin School of Business, Warfield says. The collaboration between faculty and doctoral students helps drive research at the School.

“I’ve done a lot of work with my former doctoral students,” he says. “It’s like having two generations of scholars that move research forward. That’s our tradition.”

About the researchers

Warfield chairs the Accounting and Information Systems Department at the Wisconsin School of Business, where he has been a faculty member since 1989. He currently serves as a trustee for the Financial Accounting Foundation and served as a journal editor of Accounting Horizons. His primary research interests concern financial accounting standards and disclosure policies, including the effects of accounting information and disclosures on securities markets. His most recently published paper was “The Effects of Presentation Salience and Measurement Subjectivity on Nonprofessional Investors’ Fair Value Judgments” in Contemporary Accounting Research in 2014.

Cheng is dean of the School of Accountancy at Singapore Management University, where he has been since 2011. His area of research is on financial reporting and disclosure issues.

Learn more about Faculty & Research at the Wisconsin School of Business.