Managerial myopia, CEO compensation structure and earnigns management by R&D cuts

Abstract

Prior studies show that linking executive compensation to current accounting performance provides incentive for CEOs to manage earnings by cutting R&D expenditure (e.g. Baber et al. (1991), Bushee (1998)). However, it has also been suggested that tying executive compensation with stock price mitigates opportunistic R&D cuts (e.g. Lambert and Larcker (1987)). This study contributes to this strand of literature by testing empirically whether CEO compensation structure in terms of the relative mix of cash-based vs. stock-based compensation affects R&D expenditure in firms that could reverse earning decreases with a reduction in R&D expenditure. Analysis of a sample of 7,246 publicly traded U.S. companies shows that CEOs are more likely to cut R&D expenditure to meet earning targets when the percentage of cash-based compensation in their total compensation is high or increased, and that a change from a cash-dominated compensation scheme to a stock-dominated compensation scheme is negatively related to the likelihood of R&D cuts, suggesting that stock-based compensation may mitigate opportunistic R&D cuts. This study also finds that the association between CEO compensation structure and the likelihood of R&D cuts can be moderated by some governance mechanisms including CEO dominance, CEO ownership and anti-takeover provisions. Moreover, this study presents evidence that discretionary accruals are negatively related to the likelihood of R&D cuts for firms rewarding their managers with stock-dominated compensation schemes, indicating a substitution effect between earnings management by R&D cuts and by discretionary accounting choices. Those results are robust to a variety of sensitivity tests, including those that account for endogeneity between CEO compensation structure and firm-level discretionary R&D expenditures. Key Word: Managerial Myopia CEO Compensation Structure Earnings Management R&D Cuts