Understanding earnings quality - MIT Sloan School of Management

Dechow, Myers and Shakespeare (2008), however, find that compensation is as sensitive to highly
discretionary securitization gains as it is to other components of earnings.
Bushman, Chen, Engel, and Smith (2004) conclude that firms use more equity-based
compensation when earnings are less informative. Their main proxy for earnings informativeness is
timeliness. Cheng and Farber (2008) find that the proportion of option-based pay in a CEO’s
package declines following a restatement.
The compensation results suggest that expected earnings quality is associated with ex ante
compensation contract composition, in levels, and changes in earnings quality are associated with ex
post recontracting. Boards also seem to incorporate the implications of discretionary accounting
choices on pay-for-performance such as bonuses when the accounting choice is transparent and
likely contractible. For example, Balsam (1998) interprets his evidence as follows: “…it appears
compensation committees distinguish between the components of income and reward managers
when their accounting choices achieve the firms' goals.”
6.2.3 Consequences of earnings quality for executive and director turnover
Desai, Hogan, and Wilkins (2006) find that at least one executive is terminated in 60% of the
sample firms that had restatements during 1997 or 1998, compared to a rate of 35% in a matched
sample. Only 15% of these executives are rehired in comparable positions. Beneish (1999) found
no evidence of abnormal turnover for CEOs or executives of the misstatement firms, although he did
not identify whether the executives were implicated in the fraud. Karpoff et al. (2008a) find that
93% of individuals identified as having responsibility for a misstatement leave their jobs by the end
of the enforcement period. Srinivasan (2005) reports a 48% turnover rate for directors following an
income decreasing restatement. A matched sample has a turnover rate of 33%. Technical and
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