Do Chinese listed firms actively alter the design of pay–performance sensitivity following financial restatement?^*

* Accepted by Jeong-Bon Kim upon recommendation by Oliver Rui

Abstract

The high sensitivity of management compensation to accounting performance could be an important driver of financial restatement, due to strong management incentives to manipulate earnings. This paper examines whether restating firms rearrange management’s annual compensation following restatement announcements to decrease management’s incentives to misreport. Based on observations between 2003 and 2011 in the Chinese capital market, this paper finds that accounting-based pay–performance sensitivity decreases and market-based pay–performance sensitivity increases in restating firms following restatement announcements. These findings indicate that active corporate governance in Chinese listed firms can redesign compensation packages to constrain management’s incentives to misreport. Furthermore, we find that the effect of financial restatement on pay–performance sensitivity is weaker in state-owned enterprises than in non–state-owned enterprises, indicating that compensation design as a tool to alleviate agency costs could, to some extent, lose its effectiveness in reducing management’s opportunistic behavior in state-owned enterprises.

Keywords:

• Financial restatement
• pay–performance sensitivity
• accounting-based performance
• market-based performance

Notes

* Accepted by Jeong-Bon Kim upon recommendation by Oliver Rui

1. Prior studies (Chakravarthy 1986; Hoskisson, Johnson, and Moesel 1994; Gentry and Shen 2010) argue that stock performance incorporates all relevant information and reflects future or long-term performance, unlike accounting measures, and are not limited to a single aspect of firm performance and are less subject to managerial manipulation.

2. NO 142 of ‘Company Law’ in China states that board members, supervisor board members and executives have to disclose their shareholdings in the listed firms, and that the stocks sold can not exceed 25% of their shareholdings during the tenure, and that the stocks held are not allowed to be sold during the first year of IPO. The law also states that these people are not allowed to sell their shareholdings until half a year since the leaving. Besides, Firth, Fung, and Rui (2006) conjucture that high CEO turnover may reduce the effectiveness of longer-term incentive schemes such as stock option in Chinese listed firms, and that managers do not like rewards that cannot be cashed immediately. They posit that stock returns are a function of macro-events. These factors lead to infrequent usage of stock options in CEO.

3. ST companies are those with a high risk of being delisted, which includes companies that report consecutive annual losses in the two most recent years; have serious errors, irregularities, or fraud detected in their financial statements; miss the deadline for the release of annual reports and semi-annual reports; or have other problems as determined by Chinese regulations.

4. Firth, Fung, and Rui (2006) argue that stock returns are a function of macro-events in China, less subject to specific event. They post that stock prices are very volatile and subject to major exogenous shocks, e.g. sudden policy shifts by the government to either stimulate or cool the economy, political crises, and international trade disputes.

5. Some restating firms have more than one control firm. Our findings are not altered after we make sure each restating firm is matched with only one control firm.

6. In this study, management includes executives, board members, and supervisor board members.

7. Annual cash compensation includes a base salary, bonuses, and commissions. While the CSRC, which regulates the content of listed firms’ annual reports, requires all listed firms to report executive compensation, including salaries and bonuses, firms are not required to report these separately. We are therefore unable to analyze these two main components of cash compensation separately. Our results are very similar, however, after we exclude commissions from cash compensation.

8. Which is an information disclosure website (http://www.cninfo.com.cn/) designated by CSRC.

9. We just focus on PPS and do not intend to test the impact of restatement on changes in compensation.

10. Misreporting observations are directly related to restatement observations. Misreporting during 2002–2009 in our sample just corresponds with restatement observations during 2003–2011.

11. Item no. 2 of the information disclosure by the CSRC (content and format of annual report) in 1999 states that firms ought to prepare and disclose their annual reports before May.

12. Prepared rule no. 19 of information disclosure (financial information correction and concerned disclosures) in 2003 states that restatement information approved by the board of directors has to be disclosed in the form of an interim report.

13. DIB commercially provides internal control and risk management data for listed firms in China.

14. These metrics include auditor size, the percentage of independent directors, board size, duality (CEO and chair), and the appearance of related parties among the top 10 shareholders, management shareholding, and the issuance of foreign shares.

15. The variable GOV_INDEX is a categorical variable, ranging from zero to five. Therefore, ordered logit regression is used here.

16. Thanks for one annoymous reviewer offering this valuable suggestion.

17. We use 2006 as the benchmark year instead of 2005, because split-share reform for lots of firms occurs in the middle or even later in 2005.