Discussion of “CEO compensation and fair value accounting: Evidence from purchase price allocation”

1. Discussion of “CEO compensation and fair value accounting: Evidence from purchase price allocation” Daniel A. Cohen CAPANA Conference Chengdu, July 2 2010

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

3. The Purchase Price Allocation (Shalev, TAR 2009) Purchase Price Accounting Treatment Goodwill, 55.4% Not Subject to Amortization. Subject to a Mandatory Annual Impairment Test Intangible Assets Separate from Goodwill Indefinite-Life, 4% (Trademarks) Finite-Life, 20% (Patents, Technology) Amortized over Economic Useful Life In-Process R&D, 4.6% Written-off at Acquisition Net Tangible Assets, 16% Restated to Fair Value

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

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

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

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

8. What does the proxy statement reveal?

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

11. Compensation, contd’

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

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

15. Understanding the determinants of bonuses – research design implications

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

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

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