||Level 3 Fair Values under SFAS No. 157 and CEO Compensation in the Banking Industry
||Department of Accountancy
Level 3 fair values
FAS no. 157
compensation committee quality
The Statement of Financial Accounting Standards No. 157 (FAS No. 157), Fair Value Measurements, prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. Compared to other earnings components, gains/losses from Level 3 fair values are likely to be noisier with regard to managerial efforts. This paper investigates the compensation adjustments in response to Level 3 fair values of SFAS 157 disclosures, including: (1) the compensation weights adjustments for the focal earnings components related to the gains/losses from Level 3 fair values, and (2) the asymmetric treatment of realized and unrealized gains/losses from Level 3 fair values in CEO compensation. In addition, this paper further examines whether the design of executive compensation in the presence of gains/losses from Level 3 fair values varies with the compensation committee quality. Using a sample drawn from the U.S. banking industry from 2007 to 2010, this paper finds that the weight on gains/losses from Level 3 fair values is partially downward adjusted. Further, the paper finds that CEO compensation is less sensitive to Level 3 unrealized gains/losses compared to Level 3 realized gains/losses. Finally, the study finds the compensation adjustments vary with compensation committee quality.
Chinese abstract ii
Table of contents iv
List of tables v
1. Introduction 1
2. Background, literature review, and hypotheses development 8
2.1 The background of FAS No. 157 8
2.2 Literature related to FAS No. 157 10
2.3 Executive compensation 12
2.4 Fair value accounting and CEO compensation 16
2.5 Hypotheses development 19
2.5.1 The decision to adjust compensation weights 19
2.5.2 The effect of compensation committee quality on CEO compensation adjustment 21
3. Research design 22
3.1 Regression models and variable definitions 22
3.1.1 Test of Hypothesis 1 22
3.1.2 Test of Hypothesis 2 23
3.1.3 Test of Hypothesis 3 25
3.1.4 Variable definitions 26
3.2 Sample selection and data sources 28
3.3 Distribution of the sample by year and industry 29
4. Empirical Results 30
4.1 Descriptive Statistics 30
4.2 Correlation Analyses 31
4.3 Regression analyses examining the relations between gains/losses from Level 3 fair
values and CEO compensation 32
4.4 Sensitivity analysis 35
4.4.1 Consideration of TARP recipients 35
4.4.2 Simultaneity considerations 37
4.4.3 Modified zero-order regression 37
4.4.4 Regression analysis examining the relations between gains/losses from Level 3 fair values and CEO equity compensation 38
4.4.5 Asymmetric treatment of gains/losses from Level 3 fair values in CEO compensation 38
5. Summary and Conclusion 40
Aboody, D., M. E. Barth, and R. Kasznik. 2006. Do firms understate stock option-based compensation expense disclosed under FAS 123? Review of Accounting Studies 11 (4): 429-461.
Adut, D., W. Cready, and T. Lopez. 2003. Restructuring charges and CEO compensation: A reexamination. The Accounting Review 78: 169-192.
Aggarwal, R. K., and A. A. Samwick. 2006. Empire-builders and shrikers: Investment, firm performance, and managerial incentives. Journal of Corporate Finance 12 (June): 489-515.
Aggarwal, R., and A. Samwick. 1999. The other side of the trade-off: The impact of risk on executive compensation. Journal of Political Economy 107(1): 65-105.
Ahn, S., Choi, W., 2009. The role of bank monitoring in corporate governance: Evidence from borrowers’ earnings management behavior. Journal of Banking and Finance 33, 425-434.
Anderson, R., and J. Bizjak. 2003. An empirical examination of the role of the CEO and the compensation committee in structuring executive pay. Journal of Banking and Finance, 27 (7): 1323-1348.
Andres, P., and E. Vallelado. 2008. Corporate governance in banking: The role of the board of directors. Journal of Banking and Finance 32: 2570-2580.
Baber, W., S. Janakiraman, and S. Kang. 1996. Investment opportunities and the structure of executive compensation. Journal of Accounting and Economics 21 (June): 297–318.
Baker, G., M. Jensen, and K. Murphy. 1988. Compensation and incentives: practice vs. theory. Journal of Finance 43: 593-616.
Balsam, S., A. L. Reitenga, and J. M. Sanchez. 2007. Corporate restructuring quality and CEO compensation. Working paper, Temple University.
Banker, R. D., R. Huang, and N. Ramachandran. 2009. Incentive contracting and value relevance of earnings and cash flows. Journal of Accounting Research 47 (3): 647-678.
Banker, R., and S. Datar. 1989. Sensitivity, precision, and linear aggregation of signals for performance evaluation. Journal of Accounting Research 27 (Spring): 21-39.
Barclay, M., D. Gode, and S. Kothari. 2005. Matching delivered performance. Journal of Contemporary Accounting & Economics 1: 1-25.
Barlev, B. and J. R. Haddad. 2003. Fair value accounting and the management of the firm. Critical Perspectives on Accounting 14: 383-415.
Barth, M. E. and G. Clinch. 1998. Revalued financial tangible, and intangible assets: Associations with share prices and non-market-based value estimates. Journal of Accounting Research 36(3): 199-233.
Barth, M. E., W. R. Landsman, and J. M. Wahlen. 1995. Fair value accounting: effects on banks’ earnings volatility, regulatory capital, and value of contractual cash flows. Journal of Banking & Finance 19: 577-605.
Barth, M. E., W. R. Landsman, and M. H. Lang. 2008. International accounting standards and accounting quality. Journal of Accounting Research 46: 467-498.
Bartov, E., P. Mohanram, and D. Nissim. 2007. Managerial discretion and the economic determinations of the disclosed volatility parameter for valuing ESOs. Review of Accounting Studies 12 (1): 155-179.
Bebchuk, L. A. and J. M. Fried. 2003. Executive compensation as an agency problem. Journal of Economic Perspectives 17(3): 71-92.
Benston, G. J. 2006. Fair-value accounting: A cautionary tale from Enron. Journal of Accounting and Public Policy 25: 465-484.
Bertrand, M., and S. Mullainathan. 2001. Are CEOs rewarded for luck? The ones without principals are. The Quarterly Journal of Economics 116 (August): 901-932.
Bigus, J. and J. Nesemann. 2011. Board compensation and fair-value accounting with commercial banks. Working paper, University of Bern.
Blanchard, O. J., F. Lopez-de-Silanes, and A. Shleifer. 1994. What do firms do with cash windfalls? Journal of Financial Economics 36 (December): 337-360.
Bushee, B. 1998. The influence of institutional investors on myopic R&D investment behavior. The Accounting Review 73: 305-333.
Bushman, R., and A. Smith. 2001. Financial accounting information and corporate governance. Journal of Accounting and Economics 32 (1-3): 237–333.
Carcello, J., and T. Neal. 2000. Audit committee composition and auditor reporting. The Accounting Review 75, 453-467.
Carcello, J., and T. Neal. 2003. Audit committee characteristics and auditor dismissals following ‘‘new” going concern reports. The Accounting Review 78, 95-116.
Chen, F., L. Kevin, W. Smieliauskas, and M. Ye. 2011. Fair value measurements and auditor versus management conservatism: evidence from the banking industry. Working Paper, University of Toronto.
Chen, L. 2006. Is CEO compensation shielded from overproduction? Working paper, Washington University.
Cheng S. 2003. Shielding executive annual pay from losses: empirical evidence of managerial entrenchment. Working paper, University of Michigan Business School.
Cheng S. 2004. R&D expenditures and CEO compensation. The Accounting Review 79(2): 305-328.
Choe C., G. Tian, and X. Yin. 2009. Managerial power, stock-based compensation, and firm Performance theory and evidence. Working paper, Monash University.
Conyon, M. J., and L. He. 2004. Compensation committee and CEO compensation incentives in U.S. entrepreneurial firms. Journal of Management Accounting Research 16: 35-56.
Conyon, M. J., and S. I. Peck. 1998. Board control, remuneration committees, and top management compensation. Academy of Management Review 41: 146-157.
Core J, W. Gua, and D. Larcker. 2003. Executive equity compensation and incentives: A survey. Economic Policy Review 9(April): 27-50.
Core, J., R. Holthausen, and D. Larcker. 1999. Corporate governance, chief executive officer compensation, and firm performance. Journal of Financial Economics 51: 371-406.
Daily, C., J. Johnson, A. Ellstrand, and D. Dalton. 1998. Compensation committee composition as a determinant of CEO compensation. Academy of Management Journal 41 (2): 209-220.
Daske, Q., H. Luzi, C. Leuz and R. Verdi. 2008. Mandatory IFRS reporting around the world: early evidence on the economic consequences. Journal of Accounting Research 46: 1085-1142.
Dechow, P. M., M. R. Huson, and R. G. Sloan. 1994. The effect of restructuring charges on executives’ cash compensation. The Accounting Review 69 (January): 138-156.
Dechow, P., L. Myers, and C. Shakespeare., 2010. Fair value accounting and gains from asset securitizations: a convenient earnings management tool with compensation side-benefits. Journal of Accounting Economics 49, 2–25.
DeFond, M. L., C. Y. Lim, and Y. Zang. 2012. Do auditors value client conservatism? Working Paper, University of Southern California.
Dorata, N. T. 2008. The shielding of CEO cash compensation from post-acquisition earnings’ charges. Managerial Finance 34 (5): 288-303.
Duru, A., R. J. Iyengar, and A. Thevaranjan. 2002. The shielding of CEO compensation from the effects of strategic expenditures. Contemporary Accounting Research 19 (Summer): 175-193.
Ertimur, Y., F. Ferri, and D. Maber. 2010. Reputation penalties for poor monitoring of executive pay: evidence from option backdating. Working paper. Duke University.
Fahlenbrach, R., and R. Stulz. 2011. Bank CEO incentives and the credit crisis. Journal of Finance and Economics 99: 11–26.
Ferris, S. P., K. A. Kim, P. Kitsabunnarat, and T. Nishikawa. 2007. Managerial power in the design of executive compensation: evidence from Japan. Advances in Financial Economics 12: 3-26.
Fiechter, P. and C., Meyer. 2011. Discretion in fair value measurement of banks during the 2008 Financial Crisis. Working paper. University of Zurich.
Financial Accounting Standards Board (FASB). 2006. Fair Value Measurements. Statement of Financial Accounting Standards No. 157. Norwalk, CT: FASB.
Finkelstein, S. and D. C. Hambrick. 1989. Chief executive compensation: A study of the intersection of markets and political process. Strategic Management Journal 10:121-134.
Gaver, J. J., and K. M. Gaver. 1998. The relation between nonrecurring accounting transactions and CEO cash compensation. The Accounting Review 73 (April): 235-253.
Geiger, S. W. and L. H. Cashen. 2007. Organizational size and CEO compensation: the moderating effect of diversification in down scoping organizations. Journal of Managerial Issues 2: 233-251.
Goh, B. W., J. Ng. and K. O. Yong. 2011. Fair value disclosures beyond SFAS 157. Working paper. Singapore Management University.
Goh, B., J. Ng, and K. Yong. 2009. Market pricing of banks’ fair value assets reported under SFAS 157 during the 2008 economic crisis. Working paper, Singapore Management University.
Gomez-Mejia, L. 1994. ‘Executive compensation: a reassessment and a future research agenda’ Research in Personnel and Human Resources Management 12: 161–222.
Greene, W. H. 2003. Econometric Analysis, 5th ed. New Jersey: Pearson Education Inc.
Grinstein, Y., and P. Hribar, P. 2004. CEO compensation and incentives – Evidence from M&A bonuses. Journal of Financial Economics 73: 119 - 143.
Hanlon, M., S. Rajgopal, and T. Shevlin. 2003. Are executive stock options associated with future earnings? Journal of Accounting and Economics 36, 3-43.
Harjoto, M. A., and D. J. Mullineaux. 2003. CEO compensation and the transformation of banking. Journal of Financial Research 26 (3): 341-354.
Harris, M., and A. Raviv. 1976. Optimal incentive contracts with imperfect information. Working Paper, Graduate School of Industrial Administration, Carnegie-Mellon University.
Hartzell, J., and L. Starks, 2003, Institutional investors and executive compensation. Journal of Finance 58: 2351-2374.
Henderson, B. C., A. Masli, V. J. Richardson, and J. M. Sanchez. 2010. Layoffs and Chief Executive Officer (CEO) compensation: Does CEO power influence the relationship. Journal of Accounting, Auditing and Finance 25: 709-748.
Himmelberg, C. P., R. G. Hubbard, and D. Palia. 1999. Understanding the determinants of managerial ownership and the link between ownership and performance. Journal of Financial Economics 53: 353-384.
Hitt, L. M., D. J. Wu, and X. Zhou. 2002. Investment in enterprise resource planning: Business impact and productivity measures. Journal of Management Information Systems 19: 71-98.
Holmstrom, B. 1979. Moral hazard and observability. Bell Journal of Economics 10 (Spring): 74-91.
Huson, M. R., Y. Tian, C. I. Wiedman, and H. A. Wier. 2012. Compensation committees’ treatment of earnings components in CEOs’ terminal years. Accounting Review 87 (1): 231-259.
Jensen, M. and W. Meckling. 1976. Theory of the firm: managerial behavior, agency costs, and capital structure. Journal of Financial Economics 33: 305-360.
John, K., and Y. Qian. 2003. Incentive features in CEO compensation in the banking industry. FRBNY Economic Policy Review (April): 101-121.
Johnson, S. (2007, June 7). PCAOB: Can auditors handle fair value? CFO. Retrieved from http://www3.cfo.com/
Kaplan, R. S., and A. A. Atkinson. 1989. Advanced Management Accounting. Prentice Hall, New Jersey.
Klein, A. 1998, Firm performance and board committee structure. Journal of Law and Economics 41: 137-165.
Klein, A., 2002. Audit committee, board of director characteristics, and earnings management. Journal of Accounting and Economics 33, 375-400.
Kleinbaum, D. G., L. L. Kupper, and K. E. Muller. 1988. Applied Regression Analysis and Other Multivariable Methods, 2nd edn. PWS-KENT Publishing Company, Boston.
Kobelsky, K. W., V. J. Richardson, R. E. Smith, and R. W. Zmud. 2008. Determinants and consequences of firm information technology budgets. The Accounting Review 83 (July): 957-995.
Kolev, K. 2009. Do investors perceive Marking-to-Model as Marking-to-Myth? Early evidence from FAS 157 disclosure. Working Paper, NYU Stern School of Business.
Kothari, S., T. Laguerre, and A. Leone. 2002. Capitalization versus expensing: Evidence on the uncertainty of future earnings from capital expenditures versus R&D outlays. Review of Accounting Studies 7: 355-382.
Lambert R. A., D. F. Larcker, and K. Weigelt. 1991. How sensitive is executive compensation to organizational size? Strategy Management Journal 12 (5): 395-402.
Lambert, R. A., and D. F. Larcker. 1987. An analysis of the use of accounting and market measure of performance in executive compensation contracts. Journal of Accounting Research 25 (Supplement): 85-125.
Lambert, R., C. Leuz, and R. E. Verrecchia. 2007. Accounting information, disclosure and the cost of capital. Journal of Accounting Research 45(2): 385-420.
Landsman, W. R. 2007. Is fair value accounting information relevant and reliable? Evidence from capital market research. Accounting and Business Research: 19-30.
Laux, C. and C. Leuz. 2009. The crisis of fair value accounting: making sense of the recent debate. Accounting, Organizations and Society, 34(6-7): 826–834.
Leone, A., Wu, J., Zimmerman, J., 2006. Asymmetric sensitivity of CEO cash compensation to stock returns. Journal Accounting Economics 42, 167–192.
Lev, B., and N. Zhou 2009. Unintended consequence: fair value accounting informs on liquidity risk. Working paper, New York University.
Liao, L., H. Kang, R. Morris, and Q. Tang. 2011. Information asymmetry of fair value accounting during the global financial crisis. Working paper, The University of New South Wales.
Livne, G., G. Markarian, and A. Milne. 2011. Bankers' compensation and fair value accounting. Journal of Corporate Finance 17 (4): 1096-1115.
Maddala, G. S. 1977. Econometrics. New York: McGraw-Hill, Inc.
Manchiraju, H. 2011. Fair value gains and losses in derivatives and CEO compensation. Working paper, State University of New York – Buffalo.
Masli, A., V. J. Richardson, J. M. Sanchez, and R. E. Smith. 2008. Information technology investments, CEO compensation and market valuation. Working paper, University of Arkansas.
Morey, M., Gottesman, A., Baker, E., Godridge, B., 2009. Does better corporate governance result in high valuations in emerging markets? Another examination using a new data set. Journal of Banking and Finance 33: 254-262.
Murphy, K. J. 1999. Executive compensation. In: Ashenfelter, O., Card, D. (Eds.), Handbook of Labor Economics, Vol.1: 2485-2563, North-Holland, Amsterdam.
Natarajan, R. 1996. Stewardship value of earnings components: additional evidence on the determinants of executive compensation. The Accounting Review 71: 1-22.
Newman, H. A., and H. A. Mozes. 1999. Does the composition of the compensation committee influence CEO compensation practices? Financial Management 28 (3): 41-53.
Paananen, M., A. Renders, and K. Shima. 2011. Management motivations for SFAS 157 reclassifications and the capital market consequences. Working paper, University of Hertfordshire.
Penman, S. H. 2007. Financial reporting quality: is fair value a plus or a minus? Accounting and Business Research: 33-44.
Perry, T., and M. Zenner. 2001. Pay for performance? Government regulation and the structure of compensation contracts. Journal of Financial Economics 62(3): 453-488.
Riedl, E. J. and G. Serafeim. 2011. Information risk and fair values: An examination of equity betas. Journal of Accounting Research 49 (4): 1083-1122.
Rosen, S. 1992. ‘Contracts and the Market for Executives. in Lars, W. and Hans, W. (Eds), Contract Economics, Blackwell, Oxford.
Ryan, S.G., 2008. Accounting in and for the Subprime Crisis. The Accounting Review 83(6): 1605-1638.
Shalev, R., I. Zhang, and Y. Zhang. 2010. CEO compensation and fair value accounting: Evidence from purchase price allocation. Working paper. Washington University.
Sloan, R. G. 1993. Accounting earnings and top executive compensation. Journal of Accounting and Economics 16 (April): 55-100.
Song, C. J., W. Thomas, and H. Yi. 2010. Value relevance of FAS 157 fair value hierarchy information and the impact of corporate governance mechanisms. The Accounting Review 85: 1375-1410.
Stephen, T. (2007, November 7). FAS 157 could cause huge write-offs. CFO. Retrieved from http://www3.cfo.com/
Steverman, B., and D. Bogoslaw. (2008, October 18). The financial crisis blames game. Bloomberg Businessweek. Retrieved from http://www.businessweek.com/
Story, L. (2008, December 17). On Wall Street, bonuses, not profits, were real. The New York Times. Retrieved from http://www.nytimes.com/
Sun, J., S. F. Cahan, and D. Emanuel. 2009. Compensation committee governance quality, chief executive officer stock option grants and future firm performance. Journal of Banking and Finance 33(8): 1507-1519.
Tosi, H. L., S. Werner., J. P. Katz, and L. R. Gomez-Mejia. 2000. How much does performance matter? A Meta-analysis of CEO pay studies. Journal of Management 26(2): 301-339.
Tsai, W. H., Y. C. Kuo, and J. H. Hung. 2009. Corporate diversification and CEO turnover in family businesses: self-entrenchment or risk reduction? Small Business Economics 32 (1): 57-76.
Vafeas, N. 2000. Operating performance around the adoption of director incentive plans. Economics Letters 68(2): 185-190.
Vafeas, N., 2003. Further evidence on compensation committee composition as a determinant of CEO compensation. Financial Management 32: 53-70.
Valencia, A. 2011. Opportunistic behavior using Level 3 fair-values under SFAS 157. Unpublished Doctoral dissertation, The Florida State University.
Watts, R. L., and J. L. Zimmerman. 1986. Positive Accounting Theory. Englewood Cliffs, NJ: Prentice-Hall.
Watts, R., 2003. Conservatism in accounting part II: evidence and research opportunities. Accounting Horizon 17: 287-330.
Weir, C., D. Laing and P. McKnigh. 2002. Internal and external governance mechanisms: their impact on the performance of large UK public companies. Journal of Business Finance & Accounting 29: 579–611.
White, H. 1980. A heteroscedasticity-consistent covariance matrix estimator and a direct test for heteroscedasticity. Econometrica, 48: 817-838.
Yermack. 1997. Good timing: CEO stock option awards and company news announcements. Journal of Finance 52 (June): 449-476.
Zhang, W., and S. F. Cahan. 2010. Nonrecurring accounting transactions and stock option grants. Journal of Business Finance and Accounting 37 (1-2): 93-129.