, Week 2 – Financial Performance Management
Lecture Papers
Dechow & Sloan (1991)
Executive incentives and the horizon problem: An empirical investigation.
The paper looks at accounting earnings, and that accounting earning encourage executives to focus on
short- term performance. That is because accounting typically says “investment uncertain to what
extent it generated future benefits, so we have to immediately expensive it”. This is especially a
problem if people will only be there for the short term. An executive that plays little value in future
earnings will then have strong incentives to improve short-term financial performance. That is the
declining investment that is very lucrative for the firms but only generates benefits in the long run
when they are no longer around. They wanted to investigate this, what they did is that they look at
CEOs and trace down that at a certain point the CEO left, and then they look back one or two years.
Because most of the CEOs then predict that they opposing the end of the term. The authors look back
at their behaviour in the final year before they left. We focus on CEOs that are rewarded based on
earnings because when you are rewarded based on earnings, in especially you have an incentive to
reject investments because investments lower earnings because they generate future benefits on long-
term, but lower earnings in the short term due to an expense. So, managers may reject those long-
term investing in the final year.
To what extent do these CEOs get compensated with stock prices? If, on average, investments make
sense, then they would have to increase stock price and they immediately increases CEO
compensation. From this, we see that CEOs in the final years of office lower their R&D when
compensated based on earnings. When compensated on stock price, they increase their investment.
This is exactly what we would expect. If we (also) get compensated on the stock price. Then you will
increase R&D investment because stock price will react to these investments and then be able to
financially benefit from the increased stock value. Advertisement will in accounting immediately be
expensed. So, a CEO will cut down on advertising in the final year. We also have capital expenditure
(Buy PP&E), which is not directly expensed in the income statement and is recorded on the balance
sheet, it thus does not impact the earnings number. It doesn’t have a negative impact on the final year
of the CEO.
Question: Accounting performance measures are often criticized because of weak congruence.
Dechow and Sloan (1991) find that CEOs in their final years of office reduce R&D and advertising
expenditures but do not reduce their capital expenditures. Is their finding consistent with the weak
congruence of accounting measures? Answer: Yes, because accounting measures do not map firm
value in a very good way. Accounting treatment lower the current profit because it has to be
immediately expensed incentives to lower R&D and advertising But not a capital expenditure
4
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