Sensitivity of Earnings to Compensation, Cost Behavior, and Corporate Governance

This paper examines the effect of CEO compensation contracts on asymmetric cost behavior. In addition to traditional explanation for SG&A cost stickiness phenomenon, recent studies provide managers’ incentives to maximize their personal wealth as another driver of current period resource adjustment decision. Since self-interested managers, whose interests are not perfectly aligned with those of the shareholders cost adjustment, are responsible for cost adjustments, cost behavior is likely to reflect agency consideration, as well as optimal forward looking resource planning based on adjustment cost. These deliberate decisions of self-interested managers either lessen the degree of cost stickiness (Dierynck et al. 2012; Kama and Weiss 2013) or induce cost stickiness (Chen el al. 2012).
When managers’ compensation is linked to earnings or stock prices that are related to reported earnings, cost behavior may be affected by the incentive of self-interested managers (Bushman and Indjejikian 1993). Managers with earnings-linked compensation might have an incentive to maximize their wealth through cost adjustments when sales go down. Reduction in committed resources beyond optimal level can increase firm’s earnings in periods of sales decline. Recent studies provide evidence that CEOs with higher sensitivity of earning to cash compensation are more likely to manage earnings upward (Healy 1985; Guidry et al. 1999; Aboody et al. 2004). Thus, compensation highly sensitive to earnings might encourage CEOs to accelerate cuts of slack resources in response to a sales drop. However, the influence of CEO compensation contracts on the degree of cost asymmetry has not yet been explored.
I investigate whether manager’s incentives to increase earnings-based compensation can affect asymmetric cost behavior. I find that the degree of SG&A cost asymmetry is negatively associated with the sensitivity of earnings to cash compensation. The empirical findings indicate that resource adjustments made to increase earnings-based compensation significantly lessen the degree of cost stickiness. Several analyses and robustness checks corroborate this evidence.
My second research question examines the roles of corporate governance, such as long term institutional ownership and firm’s non-dual structure, in mitigating the effect of earnings-based compensation scheme on cost stickiness.
Depending on their investment horizons, institutional investors can either encourage short-term managerial behavior, or constraining managerial discretion to meet short term goal (Koh 2007). Following these views, I classify institutional investors based on their investment horizons (Bushee 1998) as either transient or long-term investors. Long term institutional investors discourage managers from acting myopically and constrain managerial discretion (Bushee 1988; Koh 2007). Thus, effective monitoring by long term institutional investors may discourage managers from accelerating cuts of slack resources when sales drop for the purpose of increasing earnings-based compensation. To address my second research question I partition samples as having strong (weak) governance if they have high (low) levels of long institutional ownership and estimate the model. The findings support the prediction that the negative association between the degree of asymmetric behavior of SG&A cost and the sensitivity of cash compensation to earnings becomes less pronounced in strong governance firms, compared with weak governance samples, suggesting that effective monitoring by long horizon investors mitigates the effects of managerial incentives to increase earnings-based compensation on SG&A cost stickiness.
In addition, because CEO duality, the practice of one person heading both the management and the board, discourages the board from performing efficient monitoring against CEO due to absence of independence, proponents of splitting the roles of CEO and board chair argue that the separation of the two roles will decrease the agency cost and induce firms’ transparency and accountability (Weir and Laing 2001).
To test the effect of firm’s non-dual structure, I partition the test sample into firms that combine the roles of CEO and chairman of the board and those that separate them, and estimate the model. Consistent with my hypothesis, I find that the effect of agency-driven incentives to increase earnings-based compensation on manager’s cost adjustment decision is less pronounced in firms that split the roles of CEO and board chair than in the firms whose CEO heads the board simultaneously.
This study contributes to the literature in the following ways. First, this study integrates two typical management accounting research topics, cost behavior and CEO compensation by showing that earnings sensitive compensation influence managers’ decisions to adjust costs. Second, this study extends contemporaneous accounting research on agency-driven incentives which may diminish or reinforce cost stickiness. While some research document that agency-driven incentives induce the sticky cost behavior (Chen et al. 2011), my findings suggest that managerial incentives may lessen cost stickiness, consistent with the findings of Dierynck et al. (2012) and Kama and Weiss (2013). Third, the effect of incentives from earnings-based compensation on asymmetric behavior of SG&A cost has important implications for the design of executive compensation plans. Accounting based compensation has been viewed as a useful means to align the interests of managements with those of shareholders, together with stock options. (Huson et al. 2012; Dikolli et al. 2009; Duru et al. 2006) However, the assumption that the use of earnings-based compensation contributes to better incentive alignment has come under scrutiny. Recent studies show that earnings sensitive compensation provide incentives for managers to act for their own benefit in ways contrary to shareholders’ interests (e.g., Healy 1985; Guidry et al. 1999; Aboody et al. 2004). I add to the literature by examining whether self-interested managers who face incentives to increase earnings-based compensation cut resources beyond optimal level when sales decline, which is contrary to shareholder’s interest. Finally, my study expands research stream which examine the monitoring role of long term institutional ownership and the leadership structure that has separate chairman and CEO, in mitigating the agency problem. The findings of my study support the monitoring hypothesis that the effective monitoring of long term institutional investors lessens the agency conflicts between managers and shareholders. I also provide additional empirical evidence consistent with the entrenchment view of CEO duality.