innov manag_proquest_diss21.pdf

8/17/2019 innov manag_ProQuest_Diss21.pdf

1/131

ABSTRACT

Title of Dissertation: FIRM-INITIATED CLAWBACK

PROVISIONS: REAL ACTIVITIES

EARNINGS MANAGEMENT, ANALYST

COVERAGE, AND INNOVATION

Henry Kimani Mburu, Ph. D. May 2015

Dissertation chair: Alex P. Tang, Ph. D.

Accounting and Finance Department

“Clawback Provisions” have been defined as corporate governance mechanisms

intended to reduce executive risk-taking and opportunistic behavior. Although firm-

initiated clawback provisions have been associated with several positive

consequences in extant literature, there is little empirical evidence of their having a

diminishing effect on executive risk-taking and opportunistic behavior. Additionally,

there is a need to better understand the consequences of voluntary clawback adoption

as the debate on mandatory clawback provisions for all publicly traded companies in

the U.S. rages on. In this study, I focus on restatement triggered clawback provisions,

and examine two research questions: whether clawback adoption influences the

executive risk-taking behavior, and whether clawback adoption impacts the firm’s

information environment and innovation output. I use the difference-in-difference

research design on a propensity score-matched sample of 418 firms for the period

2010-2013. I find that despite the increase in manipulation of operational cash flows

to increase short-term earnings, which is a documented adverse consequence of

clawback adoption, executives significantly reduce manipulation of discretionary

expenses. In addition, executives in clawback firms earn higher total compensation,


2/131

earn lower proportion of bonuses to total compensation, exercise more in-the-money

exercisable options as a proportion of total compensation, and have lower Vega

overall. These findings suggest that executives of clawback firms are more risk-

averse than those in non-clawback firms. I also find that clawback firms have higher

analyst following and more accurate analyst forecasts, implying better information

environments, and have lower output from innovative activities compared to non-

clawback firms. I, therefore, make several contributions to the literature on voluntary

clawback adoption. I add to the list of the consequences of voluntary clawback

adoption, document evidence of the change in executive risk-taking behavior upon the

clawback adoption, and the impact of clawback adoption on a specific firm activity,

innovation. I also provide empirical evidence that adoption of voluntary clawback

provisions is better explained by the causal hypothesis than by the signaling

hypothesis. Overall, my study significantly adds to the on-going debate on whether to

require mandatory clawback adoption for all publicly traded firms in the U.S.


3/131

FIRM-INITIATED CLAWBACK PROVISIONS: REAL ACTIVITIES EARNINGS

MANAGEMENT, ANALYST COVERAGE, AND INNOVATION

By

Henry Kimani Mburu

A Dissertation Submitted in Partial Fulfilment of the Requirements for the Degree

Doctor of Philosophy

MORGAN STATE UNIVERSITY

May 2015


4/131

All rights reserved

INFORMATION TO ALL USERSThe quality of this reproduction is dependent upon the quality of the copy submitted.

In the unlikely event that the author did not send a complete manuscriptand there are missing pages, these will be noted. Also, if material had to be removed,

a note will indicate the deletion.

Microform Edition © ProQuest LLC. All rights reserved. This work is protected against

unauthorized copying under Title 17, United States Code

ProQuest LLC.789 East Eisenhower Parkway

P.O. Box 1346

Ann Arbor, MI 48106 - 1346

UMI 3707686

Published by ProQuest LLC (2015). Copyright in the Dissertation held by the Author.

UMI Number: 3707686


5/131

ii

FIRM-INITIATED CLAWBACK PROVISIONS: REAL ACTIVITIES EARNINGS

MANAGEMENT, ANALYST COVERAGE, AND INNOVATION

by

Henry Kimani Mburu

has been approved

March 2015

DISSERTATION COMMITTEE APPROVAL:

, Chair

Alex P. Tang, Ph. D.

Dina El-Mahdy, Ph. D.

Huey-Lian Sun, Ph. D.

Phyllis Keys, Ph. D


6/131

iii

Dedication

To my late father George M. Mbũgũa and my mother Julia W. Mbũr ũ who

taught me the virtue of hard work and inculcated in me the importance of education.

And to my wife Alice Njoki and our children for their tremendous sacrifices to have

me go back to school when they most needed my presence.


7/131

iv

Acknowledgments

I express my heartfelt gratitude to my committee chair Dr. Alex Tang and the

committee members: Dr. Dina El-Mahdy, Dr. Huey-Lian Sun, and Dr. Phyllis Keys

for their remarkable advising, guidance, professionalism, and impeccable supervision

during the entire dissertation process. I thank the Dean of the School of Business and

Management Dr. Fikru Boghossian, the chair of the Accounting and Finance

department, Dr. Sharon Finney, the Ph. D. program director, Dr. Leyland Lucas, and

the accounting Ph. D. advisor, Dr. Huey-Lian Sun for providing me with awesome

administrative support to successfully complete my doctoral studies. I am grateful for

their kindness and selflessness. I also recognize Dr. Frank Manu, Dr. Victor Teye,

Dr. Gazie Okpara, Dr. Nathan Austin, Dr. Jasper Imungi, Rev. Dr. John Maviiri, Rev.

Dr. Peter Gichure, and Br. Dr. Celestine Kakooza who directed me in the preparations

to go back to graduate school. I thank them for their encouragement and mentorship.

I also gladly appreciate family members and friends especially: Njoki, Chege,

Wambũi, G ĩ tuto, Mũmbi, Mbũr ũ, Mbũgua, Angelica, Kabat ĩ , Daniel, Geoffrey,

Gladys, Robert, Amos, Isaac, Kamande, K ĩ miti, K ĩ nyua, Mũtũra, Njũũgũ, Teresa

Ir ũngũ, Kobina Ghansah, Fr. Akesseh, the community of St. Matthew’s, and all the

Faculty and staff in the School of Business and Management for their wonderful

support during the entire period of my studies. I thank Dr. Monique Akassi, the

director of the Writing Center, for her highly professional direction in writing.

I also acknowledge with gratitude the financial support from The Catholic

University of Eastern Africa and Morgan State University. Specifically, I benefited

from the Class of 1957 Scholarship and the Business School Scholarship through the

Morgan State Foundation, without which I would not have completed the program.


8/131

v

Table of Contents

Dedication .................................................................................................................... iii

Acknowledgments......................................................................................................... iv

Table of Contents ........................................................................................................... v

List of Tables ...............................................................................................................vii

List of Figures ............................................................................................................ viii

INTRODUCTION ......................................................................................................... 1

LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT............................ 9

Clawback Provisions .................................................................................................. 9

Clawback Provisions and Corporate Governance .................................................... 15

Adoption of Firm-initiated Restatement Triggered Clawback Provisions ............... 17

Firm-initiated Clawback Adoption and Information Environment .......................... 27

Firm-initiated Clawback Adoption and Analyst Coverage ...................................... 32

Firm-initiated Clawback Adoption and Innovation ................................................. 33

Summary of the Related Literature and the Conceptual Model ............................... 36

RESEARCH DESIGN AND METHODOLOGY ....................................................... 38

Data Sources ............................................................................................................. 38

Sample Construction ................................................................................................ 38

Propensity-Score Matching Model ....................................................................... 41

Final Sample Distribution .................................................................................... 44

Research Design ....................................................................................................... 48


9/131

vi

Real Activities Earnings Management and Clawback Adoption .......................... 49

Executive Compensation Structure and Clawback Adoption ............................... 54

Information Environment of Clawback Adopting Firms ...................................... 56

Analyst Following and Clawback Adopting Firms............................................... 60

Innovation and Clawback Adopting Firms........................................................... 63

EMPIRICAL RESULTS AND DISCUSSION ........................................................... 65

Univariate Analysis .................................................................................................. 65

Test of Differences in Means and Medians .......................................................... 65

Pearson’s Correlation Analysis............................................................................ 70

Multivariate Analysis ............................................................................................... 75

Clawback Adoption and Real Activities Earnings Management .......................... 76

Clawback Adoption and Executive Compensation Structure ............................... 83

Clawback Adoption and Firm Information Environment ..................................... 87

Clawback Adoption and Analyst Following ......................................................... 89

Clawback Adoption and Innovation Output ......................................................... 92

Additional Analysis .................................................................................................. 94

CONCLUSIONS.......................................................................................................... 98

References .................................................................................................................. 103

Appendices ................................................................................................................. 114


10/131

vii

List of Tables

Table 1: Sample selection procedure ........................................................................... 39

Table 2: Binary logistic regression for propensity score matching ............................. 42

Table 3: Distribution of the propensity scores ............................................................. 43

Table 4: Distribution of the sample firms .................................................................... 45

Table 5: Descriptive statistics of the sample firms ...................................................... 47

Table 6: Test of differences in the dependent variables .............................................. 66

Table 7: Pearson’s correlation coefficients .................................................................. 72

Table 8: Clawback adoption and real activities earnings management ....................... 77

Table 9: Clawback adoption and executive Vega ........................................................ 82

Table 10: Clawback adoption and executive compensation structure ......................... 84

Table 11: Clawback adoption and analyst forecasts’ accuracy ................................... 87

Table 12: Clawback adoption and analyst following ................................................... 89

Table 13: Clawback adoption and patent applications ................................................ 92

Table 14: Test statistics for equality of coefficients .................................................... 96


11/131

viii

List of Figures

Figure 1: Conceptual framework of the study ............................................................. 36

Figure 2: Summary of extant literature related to the study and hypotheses ............... 37

Figure 3: Trend of adoption of firm-initiated clawback provisions, 2007-2013 ......... 40

Figure 4: Population propensity scores compared with Dehaan et al..’s (2013) ......... 44


12/131

1

INTRODUCTION

In this study, I extend the growing research on firm-initiated restatement

triggered clawback provisions in executive compensation. Specifically, I examine the

impact of firm-initiated, or voluntary restatement triggered clawback adoption on the

risk-taking behavior of executives. I focus on the executives’ engagement in real

activities earnings management and changes in their compensation structure.1 I also

examine the impact of firm-initiated restatement triggered clawback adoption on the

firm’s information environment, financial analyst following, and the output from the

firm’s innovative activities.

Executive compensation and its accompanying effects on managerial risk-

taking behavior has been an issue of great concern to researchers (Coles, Daniel, and

Naveen 2006; Cohen, Dey, and Lys 2013), market regulators and participants, and

legal and corporate governance practitioners among other interested constituencies.

At the heart of this issue is corporate governance, the mechanisms put in place by

boards of directors to reduce agency problems in firm management. Major scandals

and market failures have partly been blamed on problems associated with corporate

governance (Agrawal and Chandha 2005). The assumption is that existing

governance mechanisms failed to adequately deal with the attendant principal-agent

relationship problems.

Regulators have responded to these problems by enacting laws to ensure good

governance and disclosure. The Sarbanes-Oxley Act of 2002 (SOX) introduced many

regulations to enhance corporate governance. Additionally, the SOX introduced

1 Clawback adoption in this study refers to voluntary or firm-initiated adoption of restatement triggered

clawback provisions unless otherwise indicated. Furthermore, the terms voluntary and firm-initiated

are used interchangeably.


13/131

2

regulations in relation to executive compensation under Section 304. These

regulations are commonly referred to as clawback provisions. Also, the Dodd-Frank

Wall Street Reform and Consumer Protection Act (simply referred to as the Dodd-

Frank Act) which was enacted in 2010 made various recommendations that were

meant to enhance corporate governance and provide guidelines on executive

compensation in listed companies in the U.S.

Section 954 of the Dodd-Frank Act of 2010 makes further recommendations

as to how clawback provisions should be implemented. The Act recommends that the

Securities Exchange Commission (SEC) should provide implementation guidelines on

mandatory clawback provisions for all listed firms in the U.S. These guidelines have

not yet been made available at the time of this study. Although all financial firms

under the Troubled Assets Recovery Program (TARP) are required by law to adopt

clawback provisions, other firms are not yet mandated to adopt clawback provisions.

Nonetheless, many non-financial firms continue to voluntarily adopt clawback

provisions. In addition, under the amended regulation S-K of 2006, the SEC requires

all filers to make disclosure regarding such clawback provisions. Practitioners

continue to engage with the SEC and the Financial Accounting Standards Board

(FASB) as they look forward to guidelines as recommended by the Dodd-Frank Act

of 2010 (Burkholder 2013; Whitehouse 2013).

In the existing literature, researchers use two hypotheses to explain voluntary

clawback adoption, the causal hypothesis (Chan, Chen, Chen, and Yu 2012) and the

signaling hypothesis (Chan et al. 2012; Dehaan, Hodge, and Shelvin 2013; Iskandar-

Datta and Jia 2013). On the one hand, the causal hypothesis argues that clawback

adoption would lead to changes in executive behavior resulting in certain positive

outcomes as mentioned hereunder. On the other hand, the signaling hypothesis argues


14/131

3

that clawback adoption may be used either to signal the market about the high quality

corporate governance, or to manage the impression of management to outsiders.

Neither of these two reasons would be expected to lead to behavior change of the

executives.

Prior studies have documented that clawback adoption is associated with

positive outcomes including: higher earnings quality, reduction in restatements

(Dehaan et al. 2013), perception of lower audit risk (Chan et al. 2012), and better

quality corporate governance (Iskandar-Datta and Jia 2013). Other studies also find

that managers of clawback-adopting firms use less accruals earnings management, but

more real activities earnings management (Chan, Chen, and Yu 2013; Yu 2013; Chan,

Chen, and Yu 2014).

I extend this growing research by investigating two research questions. First, I

examine whether firm-initiated clawback adoption is associated with changes in

executive risk-taking behavior. Second, I examine whether firm-initiated restatement

triggered clawback adoption has an impact on the firm’s information environment,

and how that affects analyst coverage and investment in innovative activities. These

research questions shed light on voluntary clawback adoption from two perspectives,

that of the executives and that of the users of financial information. Prior research has

examined the association between earnings quality and two variables that are of

interest to my study: earnings management (Dechow, Ge, and Schrand 2010) and

clawback adoption (Chan et al. 2013; Dehaan et al. 2013). My study builds on this

research by examining the association between clawback adoption and executive risk-

taking behavior.

The first research question examines whether clawback adoption has an

impact on risk-taking behavior of executives. Assuming the causal hypothesis of


15/131

4

clawback adoption, change in the executives’ risk-taking behavior would be a

reasonable expectation. Specifically, I conjecture that in the presence of clawback

provisions, executives would engage less in real activities earnings management and

accept higher total compensation, but with lower stock options and bonus

components. My argument is motivated by the Prospect Theory (Kahneman and

Tversky 1979; Tversky and Kahneman 1986) and the Behavioral Agency Theory

(Wiseman and Gomez-Mejia 1998). These theories explain agents’ behavior when

governance mechanisms shift risk to the agent as in the case of restatement triggered

clawback provisions. I use real activities earnings management as a proxy for risk-

taking behavior. Moreover, I also use Vega, which is a more specific measure of

executive risk-taking (Coles et al. 2006; Low 2009), in additional analysis.

Executives with higher Vega are known to undertake higher risk policy decisions

(Coles et al. 2006). This provides additional evidence about the consequences of

voluntary clawback adoption.

Prior studies document conflicting findings in regard to total Chief Executive

Officer (CEO) compensation after clawback adoption (Dehaan et al. 2013; Iskandar-

Datta and Jia 2013). In spite of the conflicting findings, none of these studies have

focused on stock option and bonus components of executive compensation. Stock

options and bonus components would capture changes in executive risk-taking

behavior in the presence of restatement triggered clawback provisions which may not

be captured by total compensation.

Two recent studies (Yu 2013; Chan et al. 2014) have examined real activities

earnings management in clawback adopting firms from the perspective of substitution

with accruals earnings management. My study is similar to these studies to the extent

that I focus on the consequences of clawback adoption and examine real activities


16/131

5

earnings management. My study, however, differs from these studies in three major

aspects. First, I focus on real activities earnings management as a measure of

executive changing risk-taking behavior. Second, I examine information

environment, analyst following, and impact of innovative activities in addition to real

activities earnings management. Third, I focus on restatement triggered firm-initiated

clawback provisions. Therefore, the focus on these three aspects separates my study

from prior research studies which have examined real activities earnings management

in clawback firms.

Informed by the Prospect Theory and the Behavioral Agency Theory of

principal-agent relationship, I predict that the executives in clawback firms will be

more risk-averse and more concerned with the prospect of losing wealth in case of

restatement or any other behavior that would result in misleading investors, 2

compared to executives in non-clawback firms. In addition, clawback provisions

would increase the executives’ risk -bearing. The executives in clawback firms will,

therefore, engage less in real activities earnings management, prefer less bonuses, and

exercise more of the exercisable in-the-money stock options compared to the

executives in non-clawback adopting firms.

The second research question examines whether clawback adoption leads to

improvement in the firm’s information environment. Prior studies have documented

improvement in financial reporting quality (Dehaan et al. 2013), reduced audit risk

(Chan et al. 2012), and higher quality corporate governance (Iskandar-Datta and Jia

2013). Taken together, these findings suggest that clawback adoption is associated

2 The SEC emphasizes this point, “The SOX "clawback" provision deprives corporate executives of

money that they earned while their companies were misleading investors.” From Press Release 2009 -

167 available from http://www.sec.gov/news/press/2009/2009-167.htm.


17/131

6

with better corporate governance, and better corporate governance is also associated

with better information environment (Byard, Li, and Weintrop 2006; Armstrong,

Balakrishnan, and Cohen 2012). Two recent studies (Dehaan et al. 2013; Iskandar-

Datta and Jia 2013) have examined the information environment of clawback

adopting firms. Dehaan et al. (2013) find lower analyst forecast dispersion after

clawback adoption, suggesting an improved information environment. Iskandar-Datta

and Jia (2013) find lower bid-ask spread, a measure of liquidity, for restating

clawback firms compared to non-restating clawback firms. Dehaan et al.’s result is,

nonetheless, subject to an alternative interpretation. This is because differences in

dispersion may be due to other factors besides information availability, such as the

forecasting models employed. In addition, Sheng and Thevenot (2012) point to

econometric issues attendant to using the dispersion as a measure of information

environment. In times of economic shocks, dispersion will be understated, being

erroneously interpreted as improved information environment.3

My study builds on the findings of Dehaan et al. (2013) and Iskandar-Datta

and Jia (2013). However, it differs from both studies because I examine the

information environment of clawback adopting firms by investigating the extent of

financial analyst following and the accuracy of analysts’ forecasts. These direct

measures of information environment in clawback adopting firms have not been

examined in prior studies. Answering this question from an analyst’s perspective,

also affords me an opportunity to directly examine the management’s commitment to

3 Dehaan et al. (2013) use data for period 2005-2010. There is possibility that this result is partly driven

by effects of 2008-2009 economic meltdown.


18/131

7

implement voluntarily adopted clawback provisions. Moreover, this allows me to

directly examine the signaling hypothesis of clawback adoption.

I further investigate whether clawback adoption influences firm management

investment decisions in innovative activities. There are two reasons why it is

important to examine this question. One, prior research (Yu 2008) finds that analysts

can exert pressure on management, leading to emphasis on meeting short-term targets

and to myopic management decisions. To the extent that clawback adoption impacts

analyst following, this stifles management’s long-term investment decision making

resulting in a decline in innovative activities. In addition, Derrien and Kecskes (2013)

provide empirical evidence on the causal relationship between analyst following and

firm investment decisions. Two, assuming the causal hypothesis of clawback

adoption, it is possible that the executives would make changes to the corporate risk

policy in line with their own individual risk-taking behavior. This question also

indirectly tests the information environment of the clawback firms, because it assumes

the higher analyst following. This question has not been examined in prior clawback

studies.

My study contributes to the nascent but growing literature on voluntary

clawback adoption in several ways. First, it further informs our understanding of the

consequences of voluntary clawback adoption. Second, because financial analysts are

considered key and sophisticated users of financial information, this study provides

valuable insights into clawback adoption not previously examined. I use the

difference-in-difference research design to test for causal relationships between

clawback adoption and each of the five dependent variables: a.) real activities

earnings management, b.) analyst forecast accuracy, c.) analyst following, d.)

executive compensation, and e.) innovative output. This provides additional evidence


19/131

8

of the consequences of clawback adoption. The study also contributes to the debate

about the consequences of clawback adoption. Furthermore, the study contributes by

directly testing the reduction of managerial opportunistic behavior alluded to by

Iskandar-Datta and Jia (2013).

Third, my study adds to the on-going debate among stakeholders including the

SEC and the FASB on whether clawback provisions should be made mandatory for

all listed firms in the U.S. as recommended by the Dodd-Frank Act of 2010. It is not

possible to generalize findings from this study to mandatory clawback adoption,

nevertheless, more information is always advantageous.

Fourth, this study makes a contribution by examining the link between

clawback adoption and a specific firm activity, innovation, a link not previously

focused on. Fifth, my study makes a further contribution by examining the impact of

clawback adoption on executive risk-taking behavior. This is important because as

Cohen et al. (2013) indicate, there is a need to assess to what extent corporate

governance regulations impact operation and investment strategy through interaction

with the executives’ incentives. Although Dehaan et al. (2013) indicate that clawback

provisions are meant to discourage executive risk-taking, to date, there is little direct

empirical evidence to support this claim.

Sixth, I also contribute to the extant literature by directly testing the two

hypotheses of voluntary clawback adoption, the causal and the signaling hypotheses.

While prior studies have made inferences to these hypotheses from their findings, my

research design tests directly the plausibility of each hypothesis in explaining

clawback adoption.


20/131

9

LITERATURE REVIEW AND HYPOTHESES DEVELOPMENT

Clawback Provisions

Clawback provisions, also referred to as recoupment clauses or simply

clawbacks, have been used in executive compensation for a long time (Langevoort

2007). Clawback provisions are the rights of a firm to recoup from an executive of

the firm benefits already earned and paid following a predetermined triggering event

(Earlie and Wilkerson 2012). Such triggering events include: misconduct, breach of

restrictive covenants such as (e.g., non-competition and non-solicitation agreements),

influence on employees, termination of employment due to unethical behavior, and

financial statement restatement.4

The U.S. Securities and Exchange Commission (SEC, 2003) describes the

adoption of clawback provisions through enactment of the Sarbanes-Oxley Act (SOX)

Section 304 as an action to improve the “tone at the top.” According to Robert

Khuzami, Director of the SEC’s Division of Enforcement, clawback provisions are:

“An important incentive for senior executives to be vigilant in preventing misconduct

and ensuring that companies comply with financial reporting requirements.”5

Earlie and Wilkerson (2012) identify three main purposes of clawback

provisions: limiting the risk of manipulation, penalizing bad behavior, and preventing

windfall earnings.6 In addition, Earlie and Wilkerson (2012) indicate that, broadly

speaking, clawback provisions permit recovery of compensation regardless of

4 Each of the two examples of clawback provision clauses given in the next page have differenttriggers.5 The Director was commenting on the clawback enforcement case of Heazer Homes USA (seeAppendix C). Press Release 2011-61 available at http://www.sec.gov/news/press/2011/2011-61.htm.6 Emphasizing this point, Robert Khuzami, director of the SEC’s Division of Enforcement said, "The

personal compensation received by CEOs . . . can be clawed back. The costs of such misconduct neednot be borne by shareholders alone." In addition, a quote from filing DEF 14A of Mineral Technologies

Inc. dated 04/03/2013, “. . . ensure that our executives do not retain undeserved windfalls . . .”illustrates this point too.


21/131

10

misconduct on the part of the executive. Dehaan et al. (2013) add that clawback

provisions are corporate governance mechanisms meant to deter executives from risk-

taking behavior that would result in restatements, and at the same time penalize the

executives if they engage in such behavior. Furthermore, Iskandar-Datta and Jia

(2013) add that the key benefits of clawback adoption are reduction of managerial

opportunistic behavior and assurance of high quality financial reporting. Below are

two examples of clawback clauses extracted from the SEC DEF 14A filings:

We maintain clawback provisions relating to stock options, restricted stock units,

performance share units and market share units. Under these clawback provisions,

executives that violate non-competition or non-solicitation agreements, or otherwise

act in a manner detrimental to our interests, forfeit any outstanding awards, and any

accrued and unpaid dividend equivalents underlying these awards, as of the date such

violation is discovered and have to return any gains realized in the twelve months

prior to the violation. These provisions serve to protect our intellectual property and

human capital, and help ensure that executives act in the best interest of BMS and our

stockholders.7

Although the applicable rules have not yet been adopted, in February 2013 the Boardadopted a clawback policy under which the Board, or a committee of the Board, will

have the right to cause the reimbursement by an executive officer of the Company(including the NEOs) of all or a portion of certain incentive compensation if:

the compensation was predicated upon the achievement of certain financialresults that were subsequently the subject of a required restatement of theCompany’s financial statements,

the compensation was predicated upon the achievement of certain financialresults that were subsequently the subject of a required restatement of theCompany’s financial statements,

the executive officer engaged in fraudulent or intentional illegal conduct thatcaused the need for the restatement, and

a lower payment would have been made to the executive officer based upon therestated financial results.

The policy is applicable to the performance units and annual cash bonusescommencing with the year the policy was adopted, and provides for a look-back period of up to three years.8

Regulation concerning clawback provisions came into effect following the

enactment of the SOX Act in 2002. Under Section 304 ( Forfeiture of Certain Bonuses

7 Extract from Bristol Myers Squibb Co. filing DEF 14A dated 03/21/2013.8

Extract from Pioneer Natural Resources Co. filing DEF 14A dated 04/11/2013.


22/131

11

and Profits) of the Act, Chief Executive Officers (CEOs) and Chief Finance Officers

(CFOs) are required to repay back bonuses and profits deemed to have been earned

from misstated accounting numbers arising from culpable misconduct resulting in the

restatement of financial statements. Specifically, the onus of enforcing the Act is on

the SEC; it does not matter whether the firm has adopted clawback provisions or not

for the SEC to enforce clawback provisions (see Appendix A).

Appendix A lists five cases of clawback enforcement by the SEC under

Section 304. It is apparent from the concluded clawback cases that under Section 304

of the SOX Act, CEOs and CFOs do not have to be involved in misconduct

themselves;9 the only requirement is that they received incentive compensation at a

time when the firm restated earnings or misled investors. In cases in which they are

directly involved, the provisions equally apply.10

Following the 2008 economic meltdown, another Act, The Dodd-Frank Wall

Street Reform and Consumer Protection Act (simply referred to as the Dodd-Frank

Act), was signed into law on July 21, 2010. This Act recommends a new environment

under which clawback provisions would operate. Clawback provisions under Section

954 of the Dodd-Frank Act differ from those under the SOX Section 304 in three

aspects (Sharp 2012).

9

"CEOs should know that they can be deprived of bonuses or stock profits they received whileaccounting fraud was occurring on their watch," said Robert Khuzami, Director of the SEC's Divisionof Enforcement (available at http://www.sec.gov/news/press/2011/2011-243.htm). "Jenkins wascaptain of the ship and profited during the time that CSK was misleading investors about the company'sfinancial health," said Rosalind R. Tyson, Director of the SEC's Los Angeles Regional Office. Quotesare in reference to former CEO of CSK Auto, Mr. Maynard L. Jenkins available at

http://www.sec.gov/news/press/2009/2009-167.htm.

10 "Whenever a corporate officer misleads investors about a company's performance by secretly backdating stock options, the integrity of our markets is undermined," said SEC Chairman ChristopherCox. "As demonstrated in this case, the SEC is committed to holding corporate officers accountable forillegally backdating stock options and will seek the return of undeserved compensation." In referenceto the case of former UnitedHealth Group CEO William. W. McGuire, available at

http://www.sec.gov/news/press/2007/2007-255.htm.


23/131

12

First, while Section 304 only applies to CEOs and CFOs, Section 954 applies

to all current and former executive officers. Second, Section 304 requires material

noncompliance arising from misconduct, but Section 954 does not require

misconduct. Third, Section 304 requires a one-year look-back period while Section

954 requires a three-year look-back period.11 These differences have been deemed

potential improvements in clawback provisions (Chan et al. 2012). Moreover, the

board of directors rather than the SEC is the enforcer of clawback provisions under

the Dodd-Frank Act 2010. Appendix B lists one case of clawback enforcement by the

board of directors. The board of directors can only enforce clawback provisions if the

firm has adopted clawback provisions and incorporated them in the executive

compensation plan.

Due to the aforementioned differences and improvements, Chan et al. (2012)

posit that voluntary clawback provisions are stronger than those under the SOX

Section 304 but weaker than those under the Dodd-Frank Act Section 954.12

Furthermore, London, Zwick, and Witkowski (2011) argue that the Dodd-Frank Act

envisages broader requirements of clawback provisions compared to the SOX. These

differences between the two Acts have led to the contention that clawback provisions

under the two Acts may possibly result to different governance regimes (Addy, Chu,

and Yoder 2014). In addition, the Dodd-Frank Act recommends that clawback

provisions be made mandatory for all publicly traded firms in the U.S.

11 For example, the clawback provisions for Bristol Myers Squibb Co. have a one-year look back while

those for Pioneer Natural Resources Co. have a three-year look back period (see extracts for footnote 7

and footnote 8).12 In line with this argument, there has also been a felt need for an in-house clawback provision that

board of directors can use (Iskandar-Datta & Jia 2013, 175) when the SEC does not get to enforce all

cases that need recoupment. This need is also well articulated in some companies’ proxy statements,

e.g., “We have a formal “clawback” . . . that is broader in its reach than that imposed by Section 304 . .

. “(Quote from DEF 14A filing dated 01/17/2014 by Nordson Corp.)


24/131

13

The guidelines for implementing the mandatory clawback provisions are to be

provided by the SEC as envisaged in the Dodd-Frank Act (Dehaan et al. 2013). The

SEC is yet to provide those guidelines for the implementation of the Act (Whitehouse

2013). Stakeholders have also requested from the FASB accounting guidelines for

issues surrounding clawback provisions like the grant date for stock compensation

awards. The FASB has so far declined to take up this issue (Whitehouse 2013).

Thomas Linsmeier, the FASB chair explained that any rule on the clawback issue

would lead to unwarranted divergence from IFRS (Burkholder 2013).

Clawback provisions have thus created a growing interest in both research and

practitioner publications in accounting, law, and corporate governance in recent years.

This points to how critical clawback provisions are considered to be in executive

compensation today. A stream of accounting research has been evolving to better

understand both determinants (Brown, Davis-Friday, and Guler 2011; Addy et al.

2014; Brown, Davis-Friday, and Guler 2014) and consequences (Chan et al. 2012;

Chan et al. 2013; Dehaan et al. 2013; Iskandar-Datta and Jia 2013; Mariola and Ryan

2013; Chan et al. 2014) of voluntary or firm-initiated clawback provisions.

The majority of these studies have documented positive consequences of

clawback adoption. These include higher financial reporting quality and reduced

analysts’ forecast dispersion (Dehaan et al. 2013), positive stock-valuation effects

(Iskandar-Datta and Jia 2013), decline in restatements, and a perception of lower audit

risk (Chan et al. 2012). Furthermore, firms whose management has a monitoring

orientation are more likely to adopt clawback provisions compared to those whose

management has an entrenchment orientation (Addy et al. 2014). Adoption of

clawback provisions also results in an oversight impression and could reduce the cost

of recovery of paid compensation from errant executives (Addy et al. 2014). Beck


25/131

14

(2012) finds that, conditional on the quality of corporate governance, firms which

adopt clawback provisions are associated with lower income-increasing accrual

earnings management. She further argues that clawback adoption may be viewed as a

strong governance mechanism.

A few studies, though, have documented negative or undesired consequences

of voluntary clawback adoption. Though clawback adopting firms engage less in

accruals earnings management they engage more in real activities earnings

management (Chan et al. 2013; Chan et al. 2014). These results, nevertheless,

contradict prior findings that clawback adopters have higher actual and perceived

earnings quality (Dehaan et al. 2013), are perceived to have lower audit risk (Chan et

al. 2012), and are received positively by the market (Dehaan et al. 2013).

Additionally, Pyzoha (2014) argues that reduction in restatements in clawback

adopting firms may be due to executives refusing to amend prior financial statements

when they have a higher proportion of incentive-based pay.13

Along the same line of research, Chan et al. (2013) find that voluntary

clawback adoption may have undesired consequences notwithstanding the reported

higher earnings quality. Furthermore, in an earlier study Davis-Friday, Fried, and

Jenkins (2011) find no improvement in the financial reporting quality of mandatory

clawback adopting firms and indicate that clawback provisions may have unintended

consequences.

Research findings, nevertheless, generally concur that adoption of clawback

provisions influence activities of managers, analysts, investors, and auditors (Chan et

13 Iskandar-Datta and Jia (2013) also document reduction in restatements, but do not examine reasons

for the reduction. Nevertheless, they interpret this finding to suggest that clawback adoption leads to

reduction in incentives for earnings management.


26/131

15

al. 2012; Dehaan et al. 2013; Iskandar-Datta and Jia 2013) and have positive

consequences.

Clawback Provisions and Corporate Governance

Corporate governance is an important aspect of this study. This is because

clawback provisions have been referred to as corporate governance mechanisms (SEC

2003; Beck 2012; Sharp 2012; Dehaan et al. 2013; Iskandar-Datta and Jia 2013).

Dehaan et al. (2013) define clawback provisions as corporate governance mechanisms

meant to deter executives from risk-taking behavior. The SEC (2003) puts it that

clawback provisions improve the tone at the top. In addition, Beck (2012) argues that

clawback adoption may be viewed as a strong governance mechanism. Iskandar-

Datta and Jia (2013) add that this governance mechanism may signal the

determination of the management to address any past reporting failures. 14 In general,

research findings associate adoption of clawback provisions with better corporate

governance. This may partly be due to the improved perceived and actual financial

reporting quality associated with clawback adoption (Dehaan et al. 2013), and the

reduced likelihood of restatement (Chan et al. 2012). Prior research also views

earnings quality as a critical product of good governance (Srinidhi, Gul, and Tsui

2011).

Addy et al. (2014) document findings in support of this argument that

clawback adopters have a govenance tilt towards monitoring but away from

entrenchment. In other jurisdictions, clawback adoption is recommended as part of

governance best practice, for example, the Office of the Superintendent of Financial

14 The fact that some firms adopted clawback provisions after the SEC enforcement of clawback

provisions gives credence to this claim (see Appendix C).


27/131

16

Institutions (OSFI), which regulates financial institutions in Canada (Dehaan et al.

2013). In a similar vein, Iskandar-Datta and Jia (2013) argue that the threat of

clawback provisions can prompt managers to institute strong financial controls.

There is also anecdotal evidence that the corporate world views the adoption

of clawback provisions as part of the best-practices in corporate governance. The

following extract from a proxy statement supports this view.

In 2013, we decided to formalize and clarify our best practices in relation to our boardof directors and executive officers in a director policy and executive officer policyeffective as of the annual meeting including the following:

A Recoupment/Clawback Provision. The Company's executives will be required to pay back incentive awards erroneously awarded to them on the basis of restated financial

statements, if they participated in fraud or misconduct leading to the restated financialstatements.15

Corporate governance refers to the controls and procedures applied to ensure

that managers act in the interest of the shareholders (Kanagaretnam, Lobo, and

Whalen 2007). Further, corporate governance has also been defined as the set of

mechanisms that protect outside investors against expropriation by insiders (Hab,

Vergauwe, and Zhang 2014). Corporate governance affects the flow of information

from firm insiders to outsiders and may, therefore, reduce the firm’s agency costs

(Armstrong et al. 2012). Firms with high quality corporate governance are associated

with lower earnings management (Dechow, Sloan, and Sweeney 1996). In addition,

corporate governance mechanisms can be classified as an internal mechanism

(including board structure, debt financing, and percentage of outside directors) or an

external mechanism (including effective takeover market and legal infrastructure)

15 This extract is from the proxy statement of Ethan Allen Interiors Inc. filed on October 25th 2013.


28/131

17

(Hab et al. 2014). In this classification, clawback provisions would be considered an

internal corporate governance mechanism.

Contemporaneous research focusing on voluntary clawback adoption suggests

that clawback adopters have better corporate governance compared to non-adopters.

For example Chan et al. (2012) find that managers of clawback adopters have superior

internal controls thus pointing to improved governance. Yu (2013) argues that

adoption of clawback provisions may signal improved corporate governance. Addy et

al. (2014) examine the relationship between a firm’s governance structure and the

adoption of clawback provisions, and argue that directors are interested in those

activities that portray them as having better governance. Dehaan et al. (2013) show

that adoption of clawback provisions leads to improved corporate governance and

better perceived and actual financial reporting quality. Furthermore, Hunton, Hoitash,

and Thibodeau (2011) find that firms with higher quality boards are associated with a

better perception of tone at the top and actual higher earnings quality.16

Adoption of Firm-initiated Restatement Triggered Clawback Provisions

Although clawback provisions are currently mandatory for all financial firms

under the Troubled Assets Relief Program (TARP) following enactment of the

Emergency Economic Stabilization Act of 2008, it is not so for other publicly traded

firms. Non-financial publicly traded firms may exercise discretion on whether to

adopt clawback provisions in their compensation contracts or not. The number of

non-financial firms that voluntarily adopt clawback provisions has been on the rise

since 2006 partly due to the SEC’s requirement of disclosure of such provisions

16 The SEC considers Section 304 as an action towards ‘improving the “tone at the top.”’ From Press

Release 2003-89a available at http://www.sec.gov/news/press/2003-89a.htm.


29/131

18

(Chan et al. 2012).17 Notwithstanding this increase, only a few enforcement cases

appear in literature.18

Fried and Shilon (2011) attribute this dearth of enforcement to the limited

resources available to the SEC. Furthermore, Dechow et al. (2010) argue that due to

lack of resources, the SEC only gets to charge the most egregious violators in court.

Another reason that has been floated for this small number of enforcement cases is

that courts have interpreted Section 304 as only applicable to the government (Addy

et al. 2014).

Firm-initiated clawback provisions have many different triggers, including but

not limited to: restatements, breach of non-solicitation and non-competition

covenants, termination for cause, resignation, change of control, intentional

misconduct, fraud, negligence, and breach of fiduciary duty. In this study, I focus

only on restatement triggered clawback provisions, which are the subject of the SOX

Section 304 and Section 954 of the Dodd-Frank Act.

Extant literature presents two competing hypotheses to explain the voluntary

adoption of clawback provisions; the causal hypothesis and the signaling hypothesis.19

The causal hypothesis contends that voluntary adoption of clawback provisions can

17 The SEC altered Section 402(b) (2) (iii) of Regulation S-K in 2006 following recommendations from

Council of Institutional Investors and required disclosure of clawback provisions. This encouraged

firms to adopt and disclose clawback provisions (Mariola and Ryan 2013).

18 For example Addy et al. (2014) observe that in 2007 four firms were charged by the SEC under

Section 304 among other violations following restatements due to option backdating (also see the cases

of CEO/CFO clawback enforcement appearing in the SEC website in Appendix C).19 Dehaan et al. (2013, 1031) argue that signaling in the context of clawback adoption would be to

make market participants aware of the quality and reliability of the firm’s financial statements.

Similarly, Iskandar-Datta and Jia (2013, 173) use the term signaling to refer to the board’s commitment

to address past failures and improve financial reporting. Hence the term signaling in this context seems

to take a different meaning from the conventional meaning in Watts and Zimmerman (1986, 166-167)

where firms incur costs to reduce information asymmetry between insiders and outsiders as part of

corporate disclosure.


30/131

19

change management behavior, leading to observable consequences. On the other

hand, the signaling hypothesis argues that firms with superior reporting indicators can

use clawback adoption to provide such information to investors without necessarily

changing the management behavior (Chan et al. 2012). Largely, prior research

findings support more the causal hypothesis rather than the signaling hypothesis.

Still, whichever hypothesis explains voluntary clawback adoption, sophisticated users

of financial information, like financial analysts, would respond favorably to clawback

adoption. This is true so long as the management is committed to the implementation

of clawback provisions.

Pertaining to the signaling hypothesis research findings are scanty, but a study

by Iskandar-Datta and Jia (2013) find a positive and significant market reaction to

voluntary clawback adoption.20 In addition, Yu (2013) examines the effect of

voluntary adoption of clawback provisions on accrual based and real activities

earnings management strategies. Yu (2013) finds that adoption of clawback

provisions may signal management’s commitment to improve financial reporting.

She documents results consistent with the signaling hypothesis, but also supports the

argument that the adoption of clawback provisions decreases managerial opportunistic

behavior. Furthermore, Addy et al. (2014) argue that adoption of a governance

mechanism, like clawback provision, is different from its implementation. Addy et

al. (2014) cite prior literature that supports the possibility for managers to develop and

20This result has to be interpreted with caution. This is because capital market research finds that

market reaction may be due to two categories of investors: sophisticated and naïve (Lakonishok,

Shleifer and Vishny 1994). I use financial analysts who, being sophisticated users of financial

information, avail a unique interpretation of findings.


31/131

20

disclose governance features as part of image management without imposing any

actual consequences.

In support of this latter argument, Elsbach, Sutton, and Principe (1998), argue

that management has salient image concerns and managers can take actions to manage

their impression to external stakeholders. In this connection, adoption of clawback

provisions would reflect independence and portray a picture of concurrence between

the board and outsider interests. Chan et al. (2012), however, find that clawback

adoption does lead to improved reporting integrity besides simply serving as a signal.

Prior research documents a decline in restatements, reduced likelihood to

report internal material control weaknesses, lower audit fees, and a shorter audit

report issuing lag (Chan et al. 2012) following the voluntary clawback adoption.

Furthermore, adopters of clawback provisions are associated with reduced meet-or-

beat behavior and unexplained audit fees, increase in ERC, and decrease in analyst

forecast dispersion compared to non-adopters, as well as increase in CEO cash

compensation responsiveness to accounting performance measures (Dehaan et al.

2013). Taken together, these research findings support the contention that the

adoption of clawback provisions has an effect on executive behavior. This in turn

affects the perception of financial reporting by investors and analysts.

A behavioral approach to clawback adoption may help to extend the causal

hypothesis and directly link it to executive risk-taking behavior. According to the

Prospect Theory (Kahneman and Tversky 1979), there exists decision choices that

violate the expected utility theory, which is the dominant theory applied in the

analysis of decision making under uncertainty. Specifically, the Prospect Theory

identifies two phases in the process of decision making (Tversky and Kahneman

1986) whose outcomes are expressed as positive (gains) or negative (losses) based on


32/131

21

a neutral reference outcome assigned the value of zero. Thus, according to the

Prospect Theory, agents behave differently depending on whether their prospects are

gains when they are said to be in a loss domain, or losses when they are said to be in a

gain domain. Accordingly, agents’ risk -taking behavior does not remain constant

with changing prospects as would be predicted by the expected utility theory. Agents

are risk-averse in the gain domain and risk-seeking in the loss domain according to

the Prospect Theory.

The Prospect Theory underlies the Behavioral Agency Theory that better

predicts executive risk-taking behavior in agency relationships outlined in Jensen and

Meckling (1976). According to the Behavioral Agency Theory (Wiseman and

Gomez-Mejia 1998), executives will avoid risky activities that potentially threaten

their endowed wealth and will make a choice of activities depending on the contract

framing. Wiseman and Gomez-Mejia (1998) explain that contracts are positively

framed when the available options generally promise desirable outcomes and are

negatively framed when the options generally promise undesirable outcomes.

Executives can, therefore, exhibit both risk-seeking and risk-averse behavior

depending on whether the contracts are positively or negatively framed.

Restatement triggered clawback provisions introduce negative framing in

executive compensation contracts, placing managers in a gain domain according to

the Prospect Theory (Tversky and Kahneman 1986). Restatement triggered clawback

provisions also increase the executives’ risk-bearing. Risk-bearing results when

corporate governance mechanisms transfer risks to the agent and places part of the

agent’s income at risk (Wiseman and Gomez-Mejia 1998). Agents with high risk-

bearing would be more risk-averse.


33/131

22

Accordingly, from a behavioral perspective, executives in restatement

triggered clawback adopting firms would be expected to change their risk-taking

behavior. This is because restatement triggered clawback provisions effectively place

the executives in a gain domain exposing them to the risk of losing their endowed

wealth. Such executives would, therefore, behave in such a manner to protect their

potentially endowed wealth and general welfare. This argument is consistent with

Tversky and Kahneman (1986) who indicate that risk-averse agents are more sensitive

to losing than to gaining wealth. Hence the adoption of restatement triggered

clawback provisions would directly affect the executive risk-taking behavior

consistent with the causal hypothesis of voluntary clawback adoption. Specifically, I

conjecture an attenuation in earnings management.

Earnings management is a risk-taking behavior as it can lead to an executive’s

loss of wealth and reputational capital (Chan et al. 2012). Furthermore, earnings

management can lead to firm overvaluation. To sustain this overvaluation some firms

engage in non-GAAP reporting (Badertscher 2011). Badertscher (2011) finds that

managers of overvalued firms first engage in accruals-based earnings management,

then proceed on to real activities earnings management which in turn segues to non-

GAAP manipulation. Engagement in earnings management, therefore, always has the

potential of triggering clawback provisions. Clawback provisions may be triggered

either because of the ensuing restatement or because of misleading investors.

Furthermore, earnings management is likely to lead to SEC investigation and

enforcement action. Prior research also finds empirical evidence for the fact that

executives are incentivized to engage in earnings management by high proportions of

stock options in their compensation (Cheng and Warfield 2005; Cheng and Farber

2008). And therefore, because benefits earned from exercising stock options increase


34/131

23

the risk of triggering clawback provisions, earnings management behavior would

most likely be affected.

Prior research documents two causes of restatements: one, fraudulent

accounting due to the use of non-GAAP reporting, and two, non-fraudulent

accounting. In addition, restatements due to non-fraudulent accounting may be due to

either unintentional or intentional errors that may mislead investors (Plumlee and

Yohn 2010). Ettredge, Scholtz, Smith, and Sun (2010) further document empirical

evidence to show that the non-fraudulent restatements may also result from

purposeful accruals or real activities earnings management.

Ettredge et al. (2010) also find empirical evidence to show that purposeful

income-increasing earnings management is achieved by use of real economic

activities that affect core earnings accounts including sales, cost of sales, and

operating expenses. According to Ettredge et al. (2010), firms may, therefore, file

non-fraudulent financial statements, but still end up restating. This finding lends

credence to the argument that real activities earnings management can lead to

restatements and, therefore, trigger clawback provisions.21 Notwithstanding this

possibility, clawback provisions may also be triggered by the mere fact of misleading

investors. Real activities manipulation misleads investors about the real position of

the firm as regards future earnings expectations.

Extant literature also documents that in the post-SOX era managers use both

accruals and real activities to manage accounting numbers (Cohen and Zarowin 2010;

21 Clawback provisions impose additional penalties on the CEOs and the CFOs who engage in

activities that may lead to earnings manipulation (Ettredge et al. 2010, 182). In addition, if fraud or

activities that mislead investors occur on their watch, even if they were not involved, clawback

provisions would be triggered; hence under Section 304, CEOs and CFOs are culpable for other

officers’ engagement in such activities.


35/131

24

Badertscher 2011; Zang 2012) but more of real activies in the post-SOX period

(Cohen Dey, and Lys 2008). The literature also documents that accruals earnings

management is easily detected by auditors and is reversible after year-end.

Conversely, real activities earnings management is less likely to be detected by

auditors, cannot be reversed, and has a long term effect on the firm-value (Cohen and

Zarowin 2010).

It is, therefore, reasonable to argue that keeping accruals-based earnings

management constant, executives of clawback firms are less likely to use real

activities earnings management compared to non-clawback firms. This is because

real activities earnings management, which requires a longer time horizon compared

to accruals manipulation, cannot easily be detected and yet results in overvaluation,

misleads investors, and potentially ends in misstatement. This view finds support in

the related literature (Ettredge et al. 2010; Plumlee and Yohn 2010; Badertscher 2011;

Presley and Abbott 2013) and is consistent with improved earnings quality by

clawback adopting firms.

Furthermore, Ettredge et al. (2010) find empirical evidence that real activities

earnings management would result in restatement within a period of three years even

in the absence of non-GAAP manipulation. In the same vein, Plumlee and Yohn

(2010) and Presley and Abbott (2013) document empirical evidence suggesting that

most of the restating firms usually do not have internal material control weaknesses

that would provide opportunity for fraudulent reporting. Moreover, executives have

huge incentives to deliver earnings that maintain or increase their stock prices

(Graham, Harvey, and Rajgopal 2005; Lefebvre and Vieider 2014). As executives’

risk-taking behavior changes, there would be declining use of real activities


36/131

25

manipulation to avoid overvaluation. Therefore, I state my first hypothesis as

follows:

H1: All else being equal, clawback firms are less likely to engage in real

activities earnings management compared to non-clawback firms.

The causal hypothesis of clawback adoption envisages a change in executives’

behavior. Such a change would most likely result in a change in the executive risk-

taking. I, therefore, contend that CEOs’ and CFOs’ Vega, a measure of executives’

risk-taking, would also change. Hence, to further examine the association between

executive risk-taking behavior and clawback adoption, I test for the association

between clawback adoption and Vega.

Besides changing the earnings management behavior, executives of clawback

firms are also likely to adopt other risk-decreasing behaviors. These executives, being

risk-averse, would not easily accept compensation contracts with clawback provisions

due to their high risk-bearing nature (Wiseman and Gomez-Mejia 1998). The board

compensation committee would, therefore, be more likely to make higher pay offers

for the executives. Alternatively, the executives would bargain for higher pay

themselves.

Contemporary research documents conflicting findings concerning the CEO

compensation in clawback adopting firms compared to that in non-adopting firms.

Overall, executive compensation of clawback adopters compared to non-adopters,

therefore, remains an open empirical question.

On the one hand, Dehaan et al. (2013) predict that to encourage CEOs to

accept the additional risks attached to clawback provisions, CEOs are likely to

demand additional pay to compensate for the increased risk. Consistent with their

prediction, Dehaan et al. (2013) find an increase in CEO compensation after clawback


37/131

26

adoption. This finding supports the view that CEOs of clawback firms have a higher

risk-bearing compared to those in non-clawback firms.

On the other hand, Iskandar-Datta and Jia (2013) predict differences in

compensation from another perspective. They argue that voluntary clawback

adoption involves costs and can only be value-enhancing if it results in higher

benefits. Iskandar-Datta and Jia (2013) further argue that firms voluntarily adopting

clawback provisions would find it harder to retain high quality and reputable

executives due to the perceived risk engendered by clawback provisions. To counter

this potential loss of executives, firms may resort to higher CEO compensation.

However, in their study Iskandar-Datta and Jia (2013) do not find significant

differences in CEO compensation between clawback adopters and non-adopters.

It is not clear from the arguments or research designs why the aforementioned

studies find conflicting results. Nevertheless, I conjecture two possible reasons for

the conflicting findings. One, while Iskandar-Datta and Jia (2013) construct their

study (control) sample on the basis of a propensity score and with restating (non-

restating) firms, Dehaan et al.’s (2013) sample does not specifically focus on restating

firms. Focusing on restating firms may be one reason for the conflict, given that

restating firms are associated with weaker boards (Presley and Abbott 2013) who can

easily acquiesce to CEO higher pay demands. Two, it is not clear whether both studies

use similar models for computing the matching propensity-scores, which is another

factor that would confound the results. This leads to the first part of my second

hypothesis:

H2a: All else being equal, CEOs and CFOs in clawback firms are more likely

to have higher total compensation compared to those in non-clawback firms.


38/131

27

Accounting research has also examined components of executive

compensation in relation to executive risk-taking behavior. Results show that

executives who have higher stock option components in their compensation have

higher incentives to engage in earnings management. Cheng and Warfield (2005) and

Bergstresser and Philippon (2006) find a positive and significant association between

executive stock options and earnings management. In addition, finance research

documents that rational risk-averse executives exercise more in-the-money stock

options earlier than the risk-seeking executives (Huddart 1994; Hall and Murphy

2002; Brisley 2006). Hence, for the risk-averse executives who sign compensation

contracts with clawback provisions, reasonable strategies of lowering risk would be to

reduce the proportion of stock options and bonus components of their compensation

and exercise more of the exercisable in-the-money stock options at the earliest

opportunity. This meaningfully protects their endowed wealth according to the

Behavioral Agency Theory and reduces their risks consistent with their risk-

averseness. Prior research also finds that executive behavior is affected by contract

framing (Christ, Sedatole, and Towry 2012). Executive compensation contracts in

clawback firms are negatively framed. This leads to part two of my second

hypothesis:

H2b: All else being equal, CEOs and CFOs in clawback firms are more likely

to have lower proportion of stock option and bonus components to totalcompensation compared to those in non-clawback firms.

Firm-initiated Clawback Adoption and Information Environment

Many financial reporting scandals in the U.S. have largely been traced to poor

corporate governance (Agrawal and Chandha 2005). Regulators and stock exchanges

have responded to this situation by requiring mandatory corporate governance

mechanisms and disclosures. For example, the SEC and major stock exchanges


39/131

28

require majority independent directors on the board and independent board members

in audit and compensation committees.22 Furthermore, the SOX Section 404 requires

attestation and disclosure of internal control weaknesses, and the Dodd-Frank Act

recommends mandatory clawback provisions for all publicly traded companies.

The assumption underlying these regulatory changes and recommendations is

that improved corporate governance results in better information environment. The

better information environment in turn leads to better quality information for users of

financial reports, including investors and financial analysts. Overall, financial

scandals in recent years have led to more focus on corporate governance solutions for

improved financial reporting quality (Iskandar-Datta and Jia 2013).

Prior literature documents that higher quality corporate governance is

associated with a better information environment. Good corporate governance is also

associated with better monitoring and lower information asymmetry (Srinidhi et al.

2011). The association between corporate governance and a firm’s information

environment has been of interest to policy makers, regulators, and academic

researchers (Armstrong et al. 2012). Therefore, it is important to understand the

extent to which adoption of clawback provisions is associated with improved

information environment. Furthermore, clawback provisions will only be valuable to

investors if they lead to an improvement in the quality of information available to

them.

22 For example, Rule 4350(c) (5) of the NASDAQ Marketplace Rules require majority a of independent

directors on the board, compensation, and nominating committees consisting of solely independent

directors and audit committees of not less than three directors all of whom should be independent.

Similarly the AMEX company guide requires a majority independent directors on the board, and the

NYSE company guidelines and listing standards (Section 303A.01) require that a majority of board

members be independent. Controlled companies are, nonetheless, exempted from these rules (NYSE

Rule 303A) except for entirely independent directors on the audit committee.


40/131

29

Kanagaretnam et al. (2007) find that firms with higher quality of corporate

governance have lower information asymmetry around quarterly earnings

announcements. In addition, Kanagaretnam et al. (2007) explain that better corporate

governance quality has a significant influence on both quantity and quality of

corporate disclosures. Furthermore, Richardson (2000) examines the association

between information asymmetry and earnings management and finds empirical

evidence that the presence of information asymmetry is a necessary condition for

earnings management.

Firms with better information environment are associated with lower earnings

management (Jo and Kim 2007). Given that clawback adopters are associated with

higher earnings quality, it is to be expected that they engage less in earnings

management and thus have a better information environment. Iskandar-Datta and Jia

(2013) examine the association between voluntary adoption of clawback provisions

and the firms’ information environment from the market perspective using the bid-ask

spread. Iskandar-Datta and Jia (2013) find empirical support consistent with

voluntary clawback adoption being associated with better information environment.

Examining the properties of financial analyst coverage is another perspective

from which to better understand a firm’s information environment. This perspective

is aligned with the FASB’s view that financial reporting has a decision usefulness role

to users. Several studies have used financial analyst properties to examine the

information environment of a firm. For example, Byard et al. (2006) examine the

relationship between corporate governance and quality of information available from

financial analysts. Byard et al. (2006) find that better governed firms have higher

quality information environment.


41/131

30

Furthermore, Lang and Lundholm (1996) find that firms with higher

information disclosure policies are associated with higher analyst following, more

accurate analyst forecasts, and lower analyst dispersions. Similarly, Hab et al. (2014)

use analyst following as a proxy for information environment and find empirical

evidence that firms with better corporate governance have larger analyst following

and more accurate forecasts. In addition, Barron, Kim, Lim, and Stevens (1998)

present a model associating the properties of a firm’s analyst forecasts and their

information environment. Bansal, Seetharaman, and Wang (2013) also find that

executive compensation can influence non-GAAP disclosure incentives which affect

the firm’s information environment. Taken together, this stream of research suggests

that improvement in governance and information environment can attract higher

financial analyst following and is associated with more accurate analyst forecasts.

Some studies have, however, documented conflicting results. Frankel and Li

(2004) find that firms with less value-relevant earnings numbers are associated with

higher analyst following. Frankel and Li (2004) argue that if financial statements have

low usefulness, that should increase the cost of information processing and hence lead

to a low analyst information supply.

Notwithstanding the above conflicting results, contemporaneous research

largely suggests that clawback adopters have better quality corporate governance.

Clawback adopters would, therefore, be expected to have better information

environment. Firms with better information environment are associated with

decreased analyst forecast errors (Armstrong et al. 2012). Xu and Tang (2012) also

find that firms with poor governance are associated with lower analyst forecast

accuracy.


42/131

31

Because information provided by firms is a critical input to financial analyst

models, analyst accuracy would be expected to respond to the quality of corporate

governance and information environment. Like Iskandar-Datta and Jia (2013), I

argue that higher information quality associated with clawback adoption should lead

to lower information asymmetry and better information environment. Iskandar-Datta

and Jia (2013) examine the firm’s information environment from the perspective of

liquidity, measured by the bid-ask spread. I examine the information environment

from the perspective of financial analysts. I measure analyst forecast accuracy using

two different models: the Byard et al. (2006) model, which uses forecast errors, and

the Sheng and Thevenot (2012) model, which uses a combined measure that is a sum

of conditional forecast error variances and forecast dispersions.

I contend that analysts following clawback firms would make more accurate

forecasts compared to those following non-clawback firms. Additionally, corporate

governance affects earnings quality, which is important for analyst forecasts, and

current accounting numbers have persistence if they are of high quality. Furthermore,

the superior quality of financial information already documented to be associated with

clawback adopters should affect all users (Irani and Karamanou 2003) and especially

sophisticated users like financial analysts.

Dehaan et al. (2013) find that clawback adopting firms are associated with

lower analyst forecast dispersion and they interpret this as an improvement in the

information environment. Nevertheless, Dehaan et al.’s (2013) result may have

alternative interpretations because the change in dispersion may be due to such other

factors as differences in forecasting models (Lang and Lundholm 1996). Therefore,

in my study, I use a more apt proxy, that of analyst forecast accuracy. Iskandar-Datta

and Jia (2013) examine the bid-ask spread of restating firms after clawback adoption;


43/131

32

they find evidence for improved information environment for restating clawback

firms but not for non-restating clawback adopters.

I build on the above studies. I conjecture that clawback firms are more likely

to be associated with a better information environment compared to non-clawback

firms for two reasons. One, there is both empirical and anecdotal evidence that firms

which voluntarily adopt clawback provisions are associated with better corporate

governance. Two, extant literature documents that firms which voluntarily adopt

clawback provisions have higher earnings quality compared to those firms which do

not (Chen et al. 2012; Dehaan et al. 2013). Addy et al. (2014) also document that

managers of firms that voluntarily adopt clawback provisions are more oriented

towards monitoring than towards entrenchment contradicting the impression

management view of clawback adoption. Moreover, prior research finds a positive

association between quality of corporate governance and information environment.

This leads to my third hypothesis:

H3: All else being equal, clawback adoption would more likely be associated

with more accurate analyst forecasts.

Firm-initiated Clawback Adoption and Analyst Coverage

Current literature documents that financial analysts are attracted to higher

earnings quality firms (Lang, Lins, and Miller 2003; Byard et al. 2006) and firms with

better information environment (Anantharaman and Zhang 2011). Furthermore, a

superior information environment is better for financial analysts due to the integrity of

ensuing disclosures, and the reduction of uncertainty in a firm’s future performance

(Bhat, Hope, and Kang 2006). However, Dehaan et al. (2013 p.1032) argue that if

investors and analysts do not view clawback provisions as a credible signal, then they

will not change their views about the firm’s financial reporting quality.


44/131

33

If clawback provisions are not credible signs, or are used for impression

management, I would expect sophisticated users, like financial analysts, to see

through it and hence not respond to clawback adoption. However, if management is

committed to clawback implementation, and wishes to convey certain internal

information to outsiders, financial analysts would respond favorably to clawback

adoption with higher following. This would hold notwithstanding any changes in

executive behavior as predicted by the causal hypothesis of voluntary clawback

adoption.

Prior research has used the level of analyst following as a measure of

corporate disclosure (Bowen, Chen and Cheng 2008) and analysts’ information

environment (Barron et al. 1998). The existing literature also documents that analysts

seek to make accurate reports by relying on firm-provided disclosures (Byard et al.

2006). Research findings further show that more informative disclosures are more

likely from firms with better governance (Chang and Sun 2010). Furthermore, firms

with superior corporate governance have been reported to have more credible

disclosures. These disclosures result in higher analyst following and higher analyst

forecast accuracy (Lang and Lundholm 1996). I contend that clawback adopters will

attract higher analyst following due to their documented better financial reporting

quality and corporate governance. I, therefore, state my fourth hypothesis as follows:

H4: All else being equal, clawback adoption would more likely be associated

with increased financial analyst following.

Firm-initiated Clawback Adoption and Innovation

Adoption of firm-initiated restatement triggered clawback provisions has the

potential to impact a firm’s investment in innovative activities in a number of ways.

First, prior studies find an association between analyst coverage and innovative


45/131

34

activities (He and Tian 2013). Second, prior research also finds that clawback

adoption can influence managerial behavior (Iskandar-Datta and Jia 2013). This

influence may result in alteration of corporate risk policy leading to variations in

investment decisions. Third, Cohen et al. (2013) find an association between

corporate governance mechanisms, investment decisions, and risk-taking. Together,

these findings point to a potential impact of voluntary clawback adoption on

innovative activities through one or more mechanisms.

In regard to analyst coverage, Yu (2008) finds an association between analyst

coverage and managerial behavior. He applies two hypotheses to explain this

association, a monitoring hypothesis and a pressure hypothesis. Under the monitoring

hypothesis, financial analysts who are considered as key sophisticated users of

financial information, with expert training in accounting and finance, and who interact

with management on a continuous basis, act as external monitors. On the other hand,

the pressure hypothesis holds that financial analysts create excessive pressure on

managers due to their targets and recommendations resulting in myopic behavior and

earnings management. According to the pressure hypothesis, managers would be

interested more in meeting analysts’ targets than in investing in long-term innovative

projects.

He and Tian (2013) examine and establish causality between financial analysts

and firm innovation output. They find that firms with larger analyst following have

lower innovation output measured by the number of patent application filings and

patent citations compared to those with smaller analyst following. These results are

consistent with the pressure hypothesis of analyst following. Furthermore, Derrien

and Kecskes (2013) document empirical evidence to support the view that financial

analyst coverage can influence the choice of policies that managers make, for


46/131

35

example in regard to investment in research and development. Hence, if v

innov manag_proquest_diss21.pdf

Documents