External Pay Gap and Corporate Policy

Description

Several recent studies have found that implicit executive incentive contracts can influence firm policies significantly. For example, Coles, Li, and Wang (2013) show that pay gap among CEOs in the same industry can serve as a tournament incentive and motivate managers to work better and take more risk. In this project, we will examine the influence of such industry tournament incentives on corporate financial disclosure and acquisition policies.When CEOs in the same industry are paid differently, they will have incentive to compete for the position with the highest pay. We hypothesize that CEOs with stronger external tournament incentives are more likely to engage in earnings management activities, so as to boost their reputation in the labor market and enhance their upward mobility. On the other hand, if managers manipulate earnings too aggressively and trigger fraud charges, they will suffer substantial reputation loss in the labor market. Therefore, we conjecture that CEOs with stronger external tournament incentives are more likely to manage earnings within the Generally Accepted Accounting Principles (GAAP) framework but less likely to experience financial restatements.Regarding a firm’s acquisition policy, we hypothesize that CEOs facing stronger external tournament incentives are more likely to engage in acquisitions, since doing so can increase their monetary rewards as well as their visibility in the labor market. However, it is not clear how external tournament incentives affect acquisition performance. If CEOs are concerned about reputation loss resulting from making bad deals, tournament incentives may motivate managers to make better acquisitions. However, some theoretical studies also argue that compensation disparity may induce lower paid CEOs to undertake value-destroying acquisitions by overpaying the target. Therefore, this is an important empirical question to be answered.To test all of these hypotheses, we will follow Coles, Li, and Wang (2013) to construct three industry tournament incentive measures. We will also adopt a GMM-IV approach to address the endogeneity concern. Preliminary results show that firms have higher abnormal accruals when their CEOs have stronger industry tournament incentives, which is consistent with our conjecture. This study can help further our understanding of the impact of such implicit incentive contracts on firm policies, and contribute to the literature on both finance and accounting.