Earnings Warnings and CEO Welfare

• Author: Masako Darrough,Ping Wang,Linna Shi
• Published date: 01 October 2016
• DOI: http://doi.org/10.1111/jbfa.12213
• Date: 01 October 2016

Journal of Business Finance & Accounting

Journal of Business Finance & Accounting, 43(9) & (10), 1197–1243, October/November 2016, 0306-686X

doi: 10.1111/jbfa.12213

Earnings Warnings and CEO Welfare

PING WANG,MASAKO DARROUGH AND LINNA SHI∗

Abstract: Some CEOs decide voluntarily to issue a warning when they expect a negative

earnings surprise. Prior research suggests that warnings contain incremental information

beyond actual earnings; warning firms tend to experience permanent earnings decreases. This

paper investigates whether compensation committees take warnings into account in setting

CEO compensation. We find that warnings are significantly negatively (positively) associated

with CEO bonus (option grants), suggesting that compensation committees adjust CEO

compensation towards a more high-powered structure after warnings. However, the sensitivity

of bonus or option grants to earnings and stock returns is not affected except for bonus

sensitivity to stock returns. We also find weak evidence of an increase in forced CEO turnover

after warnings, accompanied by a significant increase in its sensitivity to stock returns. This

benefits CEOs with higher ability but imposes more risk on other CEOs. These findings provide

a partial explanation of why not every CEO facing a negative surprise decides to issue a

warning. Our results are robust to various specifications. In particular, the impact of warnings

on compensation appears invariant to the timing or the number of warnings. Overall, these

findings suggest that the signal from warnings is used in determining CEO compensation and

retention.

Keywords: management guidance, warnings, CEO compensation, CEO turnover

1. INTRODUCTION

When faced with an impending negative earnings surprise, CEOs have to decide

whether or not to voluntarily issue earnings warnings. A warning (defined as negative

earnings guidance) might be issued when a firm expects that its actual earnings will fall

short of existing market expectations. Such a warning is typically issued near or after

the end of a fiscal quarter, but before quarterly or annual earnings are announced.1

The extant literature on US firms documents a number of reactions to the issuance

of an earnings warning, including: an adjustment by the market of its expectations,

typically through a reduction in share prices (Kasznik and Lev, 1995; Tucker, 2007;

and Das et al., 2012); a decrease in litigation costs (Skinner, 1997); less information

asymmetry among investors (Coller and Yohn, 1997); increased analyst following

∗The first author is from Lubin School of Business, Pace University, New York, USA. The second author is

from Zicklin School of Business, Baruch College-CUNY, New York,USA. The third author is from Lindner

College of Business, University of Cincinnati. (Paper received June 2014, revised revision accepted June

2016).

Address for correspondence: Ping Wang, Lubin School of Business, Pace University, New York,NY.

email: pwang@pace.edu

1 Warnings are usually issued in the context of the results for a particular quarter. Warnings issued in the

fourth quarter, however, might pertain to results for the fourth quarter or to that of the whole year.

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1198 WANG, DARROUGH AND SHI

(Lang and Lundholm, 1996); and increased chances of meeting or beating analysts’

forecasts (Brown et al., 2005; Cotter et al., 2006; and Keskek et al., 2013).2Given that

these firms tend to be performing poorly (or at least below market expectations), the

issuance of warnings appears to be an integral part of the timely disclosure of bad

news.

Timely disclosure of news is important to investors, especially when firms expect

to fall short of market expectations. Issuing warnings ahead of actual earnings

announcements brings some benefits to firms in this position, such as reducing the

potential class period in the case of litigation, while incremental costs appear to be

small since negative market reactions are likely to occur anyway, at the time either

of warnings or of actual earnings announcements. One would expect that most firms

facing a negative earnings surprise would issue warnings so that investors would not

be caught off guard. Thus, it is surprising to find that a relatively small number

of companies issue these warnings when they face negative earnings surprises; prior

literature reports that less than 25% of firms preempt negative earnings surprises by

issuing warnings (Skinner, 1994; and Kasznik and Lev, 1995). This finding suggests

that the decision on whether or not to issue warnings is not as straightforward as one

might think. Since this decision is probably made by CEOs (and CFOs) rather than

firms as a whole (Bamber et al., 2010), an agency problem might exist.3In this paper,

we examine the consequences of warnings that might directly accrue to CEOs who

have to decide whether or not to issue these warnings. Our overall research question

is whether and how boards of directors make use of voluntary disclosures in the form

of warnings in determining CEOs’ compensation and retention/turnover.

Research that directly examines the relationship between management earnings

guidance and CEO compensation is limited.4De Franco et al. (2013) examine whether

firms that issue management guidance (favorable, neutral and negative guidance

combined) exhibit a higher sensitivity of CEO compensation to firm performance.

They argue that management guidance improves transparency, which enhances

the board’s ability to assess CEO activities, and find that firms with management

guidance indeed have higher pay-performance sensitivity (PPS) to both accounting

and stock returns. Research on the association between management guidance and

CEO turnover is also limited. The study by Lee et al. (2012) is an exception. They find

evidence that the probability of CEO turnover decreases with management guidance

accuracy, indicating that management guidance acts as a signal regarding the CEOs’

ability to handle business uncertainty.

While the above articles demonstrate that management guidance is associated with

PPS and CEO turnover, they do not explicitly examine how the issuance of warnings

affects CEOs’ compensation and turnover. Despite various benefits that firms as a

2 Houston et al. (2010) and Chen et al. (2011) study firms that stopped issuing earnings guidance

and find consistent results: forecast accuracy is reduced and forecast dispersion is increased after

firms cease to provide management earnings guidance. For a comprehensive review of the bene-

fits and costs of providing earnings guidance, see http://www.capmktsreg.org/pdfs/09-Sept-15 CCMR-

Miller Study on Earnings Guidance.pdf.

3 Some may argue that it is the board of directors that makes decisions on management guidance. If that is

the case, CEOs are unlikely to be penalized, which may lead to no results in our study.

4 Focusing on options that have fixed award schedules, Aboody and Kasznik (2000) show that CEOs are

more likely to issue negative earnings guidance prior to option grant dates. By timing the negative earnings

guidance, CEOs try to lower the strike price on the grant date and increase the value of their stock option

compensation. Nagar et al. (2003) argue that CEOs with greater levels of equity holdings have incentives to

issue earnings guidance in order to avoid equity mispricing which may adversely affect their wealth.

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whole receive from issuing warnings, only a relatively small percentage of firms issue

such warnings. This phenomenon cannot be explained unless we consider the welfare

consequence of those who must decide whether warnings should be issued. This study

tries to fill the void in the literature by examining how warnings affect both CEOs’

bonus and equity-based compensation and CEO turnover.

Although management guidance encompasses positive, neutral and negative guid-

ance, we focus on warnings in this study because: (1) prior literature has shown that

positive earnings guidance is less value-relevant and less credible compared to negative

earnings guidance; (2) warnings are more value-relevant than earnings guidance that

is simply neutral and confirming; (3) studies have shown that firms that issue warnings

tend to experience poor performance in the following years (discussed below), which

is more likely to affect CEO compensation. Item (3) is particularly important because

it suggests that warnings possibly provide information to compensation committees

about future firm performance that is incremental to the information contained in

actual earnings.

Using 1,320 firm-year observations of warnings and 8,969 firm-years of non-warnings

from 1996–2010, we examine the following issues: (1) how warnings affect bonus and

stock-based compensation of CEOs; (2) how warnings affect PPS; (3) how warnings

affect CEOs’ total compensation; and (4) how warnings affect CEO turnover. Both

warning and non-warning CEOs may expect negative earnings surprises, but the

former decide to warn, and the latter decide not to warn.

The first issue we study is whether warnings directly affect the level of CEO

compensation, as reflected both in bonus and in stock options. Warnings can provide

incremental information over and above actual earnings. Results from Kasznik and

Lev (1995), Tucker (2007) and Xu (2008) suggest that warnings tend to be issued for

permanent earnings decreases, while transitory ones go without warnings. Specifically,

Kasznik and Lev (1995) find that analysts adjust their forecasts of the next year’s

earnings downward for firms issuing warnings; Xu (2008) documents that firms that

issue warnings experience lower future earnings; and Tucker (2007) shows that the

performance of a firm in the following year of a warning is significantly lower than

that of firms that did not issue a warning. Thus, evidence suggests that the very act

of issuing warnings could provide incremental information about firm prospects over

and above the actual earnings shortly to be released. If warnings provide information

about CEOs’ performance that is incremental to that gleaned from actual accounting

and stock-based returns, then compensation committees might use this information

to adjust CEO compensation. On the other hand, it is possible that compensation

committees do not pay attention to warnings since actual earnings would be available

at the time they determine CEO compensation. Any information in the warnings could

be superseded by the actual earnings, which are more reliable. It is also possible that

in trying to encourage CEOs to be more forthcoming about impending bad news,

compensation committees shield CEOs from bad news; i.e., they do not “shoot the

messenger”. If so, a CEO’s compensation would not be affected by warnings. Taken

together, it is an empirical question as to whether and in what way warnings affect

CEO compensation.

While performance-based CEO compensation has several components, we focus on

bonus and stock options in this study. The bonus of CEOs is typically awarded, ex post,

based on past performance, while option grants are awarded, ex ante, to incentivize

CEOs to take future value-maximizing actions. The poor performance signaled by

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