Journal of Avuunting aud Economics 14 (1991) 51-89, North-Holland Executive incentives and the horizon problem An empirical investigation Patricia M. Dechow and Richard G. Sloan* University of Rochester, Rochester, NY 14627, USA Received August 1990, final version received January 1991 ‘This paper investigates the hypothesis that CEOs in their final years of office manage discre- tionary investment expenditures to improve short-term earnings performance. We examine the behavior of R&D expenditures for a sample of firms in industries that have significant ongoing R&D activities. The results suggest that CEOs spend less on R&D during their final years in office. However, we find the reductions in R&D expenditures are mitigated through CEO stock ‘ownership. There is no evidence that the reduced R&D expenditures are associated with either poor firm performance or reductions in investment expenditures that are capitalized for accounting purposes. 1, Introduction Top-executive compensation contracts generally contain incentive provi- sions designed to encourage executives ta maximize firm value [see Smith and Watts (1982)]. These provisions link executive compensation to firm perfor- mance, which is usually measured using both stock-price performance and accounting-earnings performance. For example, top-executive compensation is frequently tied to accounting-earnings performance through an annual bonus plan and to stock-price performance through an incentive stock-option "We would like to acknowledge the helpful comments of Kay Ball, Dave Chapman, Andrew Christie, Stephen Fisher, Mark Huson, §.P. Kothari, Tom Lys, Kevin Murphy, Cliff Smith, Any Sweeney, Jerry Zimmerman, and especially Paul Healy (the referee) and Ross Watts (the edito.). ‘We remain responsible for the contents. (0165-4101 /91 /$03,50°© 1991 —Elsevier Science Publishe:s B.V. (North-H ind)3 P.M, Dechow and RG. Sloan, Incentives and the horizon problem plan! The co-existence of hath performance measures in tap-executive compensation con‘rarts suggests that neither measure alone provides for optimal incentive contracting. This, in turn, suggests that each measure possesses its own costs and benefits from a compensation perspective. This paper conducts an empirical investigation of one frequently cited cost of using annual accounting earnings as a measure of executive performance. A common criticism of performance measures based on annual earnings is that they cncourage management to focus on ‘short-term’ performance rather than long-term value creation. This criticism has been made by business journalists, compensation consultants, research and development (R&D) directors, and top executives.’ It is also frequently raised by academics. Examples include Kaplan and Atkinson (1989, pp. 724-725), Merchant (1989, pp. 59-65), Smith and Watts (1982, p. 146), Rappaport (1978), and Rappaport (1990, p. 103). This paper tests the hypothesis that earnings-based performance measures provide executives with incentives to focus on short-term performance. Fol- lowing Smith and Watts (1982), we refer to this hypothesis as the ‘horizon problem’. We investigate a sample of CEOs whose incentive compensation is based on earnings. Our investigation focuses on the behavior of R&D expenditures during the CEOs’ final years in office. The results suggest that executives who are in their final years as CEO spend less on R&D. In addition, we identify two mechanisms that mitigate the incentives of execu- tives to reduce R&D expenditures. The first is the provision of stock-price- based incentives. We find that the more stock and options executives own in their firm, the less likely they are to reduce discretionary expenditures prior to their departure. The second mechanism is through what Vancil (1987) refers to as the ‘relay process’ of CEO succession. Additional tests are also conducted to discriminate between the horizon problem and two competing hypotheses for the reductions in R&D expendi- tures. The first competing hypothesis is that the CEOs are dismissed due to poor firm performance, with the reductions in R&D expenditures accompa- nying poor firm performance. We find no evidence of poor firm performance in the years leading up to our sample of CEO departures, The second vonpeting hypothesis is that the departing CEOs reduce investment expendi- tures in order to Icave new investment initiatives to their successors. We investigate investment expenditures that are not expensed immcdiatcly for "The Conference Board's (1989) survey of top-executive compensation in major U.S, manufac- turing companies reports that 99% have an annual bonus plan and 84% have an incentive stock-option plan, 2For some examples of this criticism, see Dean (1974), Crystal (1978, pp. 10-11), Nix and Peters (1988), Stewart (1989), ‘Companies that Rob the Future’ (Fortune, pp. 84-89, 7/4/88), and °So What is the Best Way to Pay’ (Fortune, pp. 109-112, 6/5/89).PM, Dechow and R.G. Sloan, Incentives and the hurizon problem 3 accounting purposes and find no evidence that they are reduced prior to CEO departures, Our evidence suggests that executives respond to earnings-based incen- tives. The results are consistent with the view that firms’ contracting prace- dures do not completely eliminate opportunistic managerial behavior [see Jensen and Meckling (1976)]. Executives and stockholders minimize agency problems by incurring bonding and monitoring costs, such as the use of incentive compensation plans and the appointment of a board of directors. Because these bonding and monitoring activities are costly, executives’ op- portunistic behavior is not completely eliminated. The reductions in R&D expenditurcs around CEO departures are part of the residual loss in the cost-minimizing contracting equilibrium. However, we can not unambiguously attribute the lower R&D expenditures to the rejection of valuable invest- ment opportunities. For example, our results are also consistent with an ‘efficiency’ view. Under this view, the reduced R&D expenditures represent the firm’s value-maximizing investment strategy. However, we consider this view as less plausible. It requires, for example, that the board of directors makes advance plans for the incentives created by the CEO's compensation, stock holdings, and retirement data to coincide with the firm’s optimal investment schedule. The paper makes three contributions to cxisting rescarch. First, it docu- ments the existence of the horizon problem. Second, it identifies mechanisras that mitigate the horizon problem. Third, the results add to evidence in the accounting literature on earnings management. Previous research suggests that executives have incentives to choose between alternative accounting techniques io systematically manage reported earnings [see Watts and Zimmerman (1984) for a review of this literature]. Our results suggest that incentives to manage reported earnings also influence the investment deci- sions made by executives. The next section provides a more detailed discussion of the horizon problem and develops our rescarch hypothescs. Our sample-selection proce- dure is described in section 3. The empirical results are reported in section 4, and competi:g hypotheses are examined in section 5. Section 6 contains a summary and our conclusions. 2, Hypothesis development Accounting carnings encourage executives to focus on short-term perfor- Mance because generally accepted accounting principles (GAAP) do not always reflect changes in firm value on a timely basis.’ The problem is *Kothari and Sloan (1990) privide evidence that three yours to reflect changes in firm value ccounting earnings commonly take up 1054 PM. Dechon and RE Stoan, Incentives and the horizon problem succinctly described by Smith and Watts [(1982), p. 146]: Bonus plans can affect the real investment and financing decisions of the firm, For example, because they are typically tied to annual profits, bonus pians give managers incentives to turn down positive NPV pro- jects with long pay back and to take negative value projects that impose expenses only after the manager retires. GAAP require investments in intangible assets, such as R&D and advertis- ing, to be expensed in the period in which they are incurred. In contrast, the expected future payoffs associated with these expenditures cannot be recog- nized until the period in which they are realized. As a result, executives whose compensation is tied to earnings can boost their short-term compensa- tion by rejecting investments to develop intangible assets.’ However, the rejection of positive net-present-value investments will reduce long-term cumulative earnings. Executives who place little value on future earnings relative to current earnings face stronger incentives to improve short-term earnings performance. One class of executives who are likely to place little value on future earnings are those who have a short horizon because they are expecting to leave their position in the near future. These executives have incentives to boost their short-term earnings-related compensation by reject- ing positive nct-present-value investments to develop intangible assets. We refer to this as the horizon problem, Empirical evidence on the impact of earnings-related incentives on firms’ investment and financing decisions is sparse. Two recent papers suggest that managers manipula‘c investment and financing decisions to ‘smooth’ re- ported income over time. Baber and Haggard (1987) present evidence consis- tent with the hypothesis that managers time R.&D expenditures to smooth reported income. Similarly, Hand’s (1989) evidence suggests that managers time debt-equity swaps to smooth income. The horizon problem is empiri- cally investigated by Butler and Newman (1989). They examine a sample of firms that had CEO departures in 1982 and focus on changes in finished-goods inventory, capital expenditures, and R&D expenditures surrounding the CEO departures. Butler and Newman find no evidence that the departing CEOs systematically manipulate these variables tw increase short-term earn ings performance. They suggest that their inability to document evidence in support of the horizon problem could be due to their failure to isolate the circumstances under which the rroblem is most pronounced. “We emphasize that this should not be interpreted as a criticism of GAAP. The alternative practice of allowing managers to capitalize R& D expenditures and to charge these expenditures against future earnings at their discretion may lead to more severe incentive problems. Watts and Zimmerman (1986, pp. 207-209) provide a more detailed discussion of the trade-off between relevance and objectivity in accounting.P.M. Dechow and R.G. Sloun, Incentives und the horizon problem 35 We conduct a more powerful test of the horizon problem by focusing on the circumstances in which managements’ incentives to cut discretionary expenditures are the strongest. Specifically, we expect the horizon problem to be more pronounced: (i) the greater the negative impact of the discretionary-investment decision on short-term profitability, (ii) the stronger the link between CEO compensation and earnings perfoi- mance, Gii) the weaker the link between CEO wealth and changes in firm valuc. The first criterion requires that the discretionary-investment decision un- der examination results in an immediate and significant negative impact on short-term profitability. Investments in R&D satisfy this criterion. Since 1974, the Financial Accounting Standards Board (FASB) has required firms to expense R&D expenditures during the year in which the costs are incurred [see SFAS 2 (1974)]. However, firms are not permitted to accrue the expected future cash flows that the investments in R&D are expected to generate. As a result, annual earnings are decreased by the amount of the year’s R&D expenditures. Short-term profitability can therefore be improved by reducing R&D activities even when the projects rejected have positive net present values. To ensure that our sample consists of firms with significant expenditures on R&D, we focus exclusively on firms in industries that are characterized by high ongoing R&D activities.’ The second criterion re- quires CEO compensation to be a function of reported earnings. This criterion is satisfied by focusing exclusively on firms that have a top-executive compensation plan that is tied to earnings. The horizon problem generates the following testable hypothesis: H1: Ceteris paribus, reductions in expenditures on R&D activities are mare likely during the years immediately prior to a CEO's departure. We have nv eaplivit theory concering the expected level of R&D expendi- tures in the absence of manipulation. The implicit assumption underlying this hypothesis is that, in the absence of manipulation, the expected change in R&D expenditures (appropriately scaled) is constant over time. As a result we predict that with manipulation present, expenditures on R&D are more likely to be reduced during CEOs’ final years. If the expecied change in “An alternative selection criterion would be to directly choose firms that have high R&D. expenditures. We decided against this alternative because it involves selecting the sample on the same variable that later becomes the dependent variable in our empirical analysis. This would bias our sample toward firms that have high R& D expenditures ex post. However, our intention is to focus on firms that have high expected levels of R&D ex ante.56 P.M. Dechow and R.G. Sloan, Incentives and the horizon problem R&D expenditures is also a function of other omitted variables that are correlated with CEO departures. then our tests will be misspecitied. Ball (1980) recognizes this problem in the context of testing the impact of SFAS 2 on the level of R&D expenditures. However, unlike the mandated change considered by Ball, our sample of CEO departures is not clustered in calendar time, This reduces the likelihood that our tests are biased due to the omission of variables that are correlated in calendar time.‘ The third criterion concerns the existence of stock-price-based incentives. If stock prices incorporate expected future cash flows, then the rejection of positive net-present-value projects involves foregoing stock-price gains. To the extent that the CEO's wealth is linked to the firm's stock price, incentives to opportunistically cut R&D expenditures are mitigated. We incorporate these incentives into our empirical analysis by controlling for cross-sectional differences in CEO holdings of stock and executive stock options. This leads to our second hypothesis: H2: Ceteris paribus, reductions in R&D expenditures during the years immedi- ately prior to a CEO's departure are less likely if the CEO's wealth is sensitive to firm value. Another potential mechanism for controlling the horizon problem is through the process of CEO succession. The mechanics of CEO succession are extensively analyzed by Vancil (1987). He finds that the ‘relay process’ of CEO succession is the most common method of CEO succession in his sam 'e. Under this process, a successor is selected to the position of President or Chief Operating Officer several years before the incumbent CFO is expected to step down. The President and CEO work cogether far several years with the incumbent CEO gradually delegating more control to the President. When the title finally changes hands, it is almost a nonevent. The old CEO remains with the firm as Chairman of the Board and continues to work with the new CEO for an average of three to four years before retiring. Uur third hypothesis predicts that the horizon problem 1s less severe in cases where the relay process of CEO succession is used: H3: Ceteris paribus, reductions in R&D expenditures during the years immedi- ately prior to a CEO's departure are less likely if the relay process of CEO succession is used. “Our objective is not to model R&D expenditures, but rather to investigate the impact of a predetermined event (i. a CEO departure) on R& D expenditures. We expect that our ‘naive’ ‘model, that the change in R&D expenditures is constant, suffers from uncorrelated omitted variables. However, this reduces the efficiency of our tests, therefore biasing the results against rejecting the null hypothesis of no change in Ree D expenditures.PM, Dechow and RG. Sloan, Incentives and the horizon problem 37 We also consider two alternative hypotheses that are consistent with reductions in R&D expenditures around CEO departures. The first alterna- tive hypothesis is that CEO departures and R&D expenditures are both a function of firm performance. Existing research suggests that management turnover is more likely following periods in which a firm has performed poorly in the stock market [e.g., Warner, Watts, and Wruck (1988)]. If poor performance also leads to lower expenditures on R& D activities, then poor firm performance provides an alternative explanation for our empirical findings. We discriminate between the horizon hypothesis and this alternative hypothesis in three ways. First, we find no evidence of poor stock-price performance in the years leading up to our sample of CEO departures. Second, we show that stock-price performance is unable to explain the behavior of R&D expenditures around CEO departures. Finally, we find that our results are stronger for firms in which the CEO steps down as a result of reaching mandatory retirement age. A second alternative hypothesis is that CEOs delay new investment initia- tives when a CEO change is imminent in order to allow their suecessor flexibility. Under this hypothesis, CEOs take investment initiatives early in their tenure and then becoue ‘lame ducks’ as they prepare to hand over to their successor. We discriminate between the horizon hypothesis and this hypothesis in two wavs. First. we find that CEOs with stronger stock-price- based incentives are less likely to cut R&D expenditures. Second, we find that investment expenditures that are capitalized for accounting purposes do not decline during CECs’ final years. 3. Sample-selection procedure Our sample-selection procedure is summarized in panel A of table 1. The sample is zestricted to manufacturing companies on the COMPUSTAT Annual industrial File [SIC codes from 2000 to 3999]. To identify industries in which large R&D expenditures are common, we compute the ratio of anrual R&D expense to sales for all firm-years from 1974 to 1988. The mean of this ratio is then calculated across all firm-years in the same three-digit SIC industry classifications. All three-digit SIC industry classifications in which this ratio is less than 5% are climinated from the sample. This leaves 405 firms in 14 different three-digit SIC industry classifications. The distribu- tion of the final sample of firms by three-digit SIC classification is shown in panel B of table 1. The pharmaceutical industry and the computer industry are strongly represented in the final sample. ‘The sample is narrowed further by considering only those firms that also appeared in the 1989 Forbes executive-compensation survey. This serves two purposes. First, the Forbes surveys provide tenure data on CEOs, which we use to locate years in which CEO changes take place. Second, it biases our38 PM. Dechow and R.G. Sloan, Incentives and the horizon problem Table 1 Selected information on the sample of $8 CEO changes occurring between 1979 and 1989, ‘ranel A: Sample-selection screening results ‘Number of observations Firms in three-digit SIC code industries with the average industry R & D/Sales > 5% 405 Firms in Forbes 1989 compensation survey 1 ‘Clean’ CEO changes taking place after 1978 538 Panel B: Distribution of sample across three-digit SIC codes Industry deseription SIC code ‘Number of observations Chemical and Allied Products 280 4 Indll Inorganic Chemicals oat 1 Plastic, Synth Materials; excl Glass 282 4 Drugs 283 2 Soap. Detergent. Toilet Prens Ord 5 Paints, Varnishes, Lacquers 285 1 Misc Chemical Products 289 3 Computer and Office Equinment 397 8 Electronic, Oth Elec Eq; ex ! Comp 360 4 ‘Communication Equipment 306 2 Electronic Comp. Accessories 367 4 Lab App, Optic, Meas, Ctl Instr 382 5 Surgical, Med, Dental Instr 384 1 Photographic Equip and Supply 386 4 Total 58 Panet C. Distribution uf sample by yeur uf the CEO change ‘79 ‘80 81 828} BES 8H BT 8B 8D Total Number cf CEO changes 3 3 4 7 4 6 7 7 9 8 1 88 sample toward larger firms, in which agency conflicts between stockholders and management are likely to be more pronounced.’ This condition reduces the sample size to 91 firms. It also biases our sample toward firms that continued to operate as public corporations following their CEO changes. This ‘survival’ bias suggests that our sample consists of firms with relatively efficient production and contracting technologies. "The Forbes surveys provide compensation data for the CEOs of over 800 of the largest corporations in the USA. Holmstrom (1989) argues that the agency costs in large firms put them at a comparative disadvantage in conducting innovative research,PM. Dechow and RG. Stoan, Incentives and the horizon problem 39 We next identify all ‘clean’ CEO changes in the sample of 91 firms. A clean change must satisfy each of the following criteria: (i) No other CEO change takes place in the five years prior to the change. (ii), The CEO change takes place after 1978. (iii) The proxy statement in the year of the CEO change contains explicit reference to a top-executive incentive compensation plan based on earnings performance. The first posed to provide a sample of ‘control’ years in which the horizan problem is less acnte. We stop at five years ta prevent the sample size from becoming too small. The second criterion excludes CEO changes before 1979. SFAS 2 mandated the immediate expensing of R& D expendi- tures in 1974, and so this criterion ensures that R&D expenditures are expensed immediately for all firm-years in our sample. These selection criteria result in a final sample of 58 ‘clean’ changes. Table 1, panel C demonstrates that these changes are not clustered in calendar time. TI reduces the likelihood that our results are affected by cross sectional depen dence or correlated omitted variables. We focus an an eleven-year window around each of our CEO changes. which gives us a total of 517 usable firm-years.’ Financial data is obtained from the COMPUSTAT Annuai Industrial File and CEO compensation data is collected from the annual Forbes compensation surveys. All remaining executive-specific data is collected from firms’ proxy statements or annual editions of Who's Who in America. Dollar values are converted into 1988 dollars using a CPI adjustment. CEO stock holdings are estimated by taking the shares of stock owned by the CEO plus 60% of the number of executive stock options held. The 60% adjustment factor for stock options controls for the smaller dollar change in the value of a stock option for a given dellar change in the value of the underlying stock. The 60% figure is based on the simulation evidence discussed in Jensen and Murphy (1990) and approxi- mates the value sensitivity (delta) of an ‘at the money’ option in a typical large manufacturing firm. Our analysis requires a measure of the incentives provided by CEO stuck holdings. The market value of CEO stock holdings provides a measure of the sensitivity of CEO wealth to a given percentage change in firm value. If “This criterion is applied using the tenure data supplied in the Forbes compensation surveys. Subsequent verification of the departure dates. through examination of the proxy statements, revealed that two of the sample CEO changes did not satisfy this criterion. However, excluding these two changes from the sample had no material effect on the empirical results Firm-years beyond 1988 are excluded from the empirical analysis due to the nonavailability of data. The loss in firm-years from 638 (11 years times 58 CEO changes) to 517 stems largely from CEO changes taking place after 1984, for which we lose firm-years beyond 1988.0 P.M, Dechow unud R.C. Stour, Incentives ural dhe horizon problem Table 2 tics; 517 firm-year observations pooled from 1974 through 1988.* Descriptive sta Upper Variable Mean deviation Median —quartile_—_quartile Sales Gil) 630021 0806.32 264290 —1401.5R 6018.17 R&D expense (Smil) 329.72 610.39 148.69 59.58 315.45 R&D/Sales 0.059 0.034 0.055 0.029 0.078 Value of CEO stock holdings (incl. options) (Smid) 3022 68.42 4.98 2.69 10.75 Value of CEO stock holdings (incl. options) scaled by lagged salary and bonus compensation (Smil) 89.66 259.89 875 3.85 20.00 Perceni of firm owned by CEO (incl. options) 1.70 4s7 019 0.08 0.60 ‘All dollar amounts stated in 1988 dollars. departing CEOs reduce R & D expenditures to increase their carnings-related incentive compensation, then we expect them to trade off the expected increase in wealth from their earnings-related compensation against the expected decrease in the value of their stock holdings. Our empirical tests focus on percentage changes in R& D expenditures in CEOs’ final years. The incentives of a CEO to reduce R&D expenditures are predicted to be decreasing in CEO stock holdings and increasing in the effect of a given change in earnings on CEO compensation. We assume that the expected dollar effect of a given percentage change in R&D on CEO compensation proportional to the level of the CEO's past salary and bonus compensation. We therefore deflate the value of CEO stock holdings by the CEO's lagged salary and honus compensation to measure the incentives provided by CEO stock holdings, [(CEO stock), + (0.0 X CEO options),] x (Stock price), Holdi | (CEO's salary and bonus compensation) ,-, Summary statistics for the sample are presented in table 2. Our sample is biased toward large firms, with annual sales revenue averaging six billion 1988 dollars R&D expenditures average 330 million dollars a year, or around 6 percent of sales. To put this in perspective, annual earnings average about 10 percent of sales for the firms in our sample. A 10 percent reduction in R&D will therefore increase earnings by an average of 6 percent. The summary statistics on CEO stock and option holdings indicate median holdings of five million dollars. This represents about 0.2 percent of theP.M, Dechow and R.G. Sloan, Incentives and the horizon problem 61 outstanding common cquity or nine times the CEO’s annual saiary and bonus compensation. The table also reveals trat the distribution of CEO stock holdings is right-skewed. The horizon problem is expected to he most acute during CFOs’ final years. The year of a CEO departure is initially identified from the tenure data published in the annual Forbes compensation surveys. The fiscal year in which the change takes place is then confirmed by examining each firm’s proxy statements. Examination of the proxy statements always enables us to identify the fiscal year ot the CEU change, but the day and month of the change are not always reported. We thus adopt the following convention. Final years are defined as both the year in which the change takes place (year 0) and the year immediately preceding the change (year ~1). This means that our definition always includes the departing CEO's last full fiscal year in office. For use in our empirical analysis, we create an additional variable, DUM. The variable DUM takes on the value of one in a final year and zero in other years. 4, Empirical results 4.1. Initial results In table 3, the 517 firm-years are reported in a coniingeucy table. Firm-years are classified by whether or not they fall in a final year and by the sign of the change in R&D expenditures. Each cell contains both the observed fre- Table 3 _ Contingency table showing the observed frequencies classified by the sign of the change in R&D expenditures and by whether it is a CEO's final year; 517 firm-year observations pooled from 1974 through 1988." ign of the change of R&D expense ‘Year relative to CEO departure = + Total CEO not in a final year” ‘Actual frequency 81 321 402 (Expected frequency) (89.4) G26) CEO in a final year” ‘Actual frequency u ns (Expected frequency) (256) = Total HS 402 517 Chi-square test for inocpendence = 4.584° *The change in RED expence for firms j in year 1 ie computed at (R&D exponen), — (R&D expense),,_), where R&D expenditures are expressed in 1988 doliars. YA CEO's final year includes the year of und the year precediag the CEO's departure, “Significant at the 5 pereent level. JAE. D62 P.M. Dechow and R.G. Sloan, Incentives and the horzon problem Table 4 Estimated coefficients from ordinary-least-squares regressions testing the hypothesis that CEOs reduce R&D expenditures during their final years in office (r-statistics in parentheses); 517 firm-year observations pooled from 1974 through 1988." R&D) — 4 | PyDUMy + SARE may, |e White's test® 8 RY) pw> 65 Toral abnormal returns in the year of the change and each of the three years prior to the change. None of these abnormal reiurns are significantly diferent from zero at conventional significance levels. Our results contrast with those of previous research that has found evidence of negative abnormal performance in the year of a management change and in the three years prior to the change. A possible explanation for the contrasting results is that our sample of CEC departures differs systemat- ically from the samples used in previous research. For example, Coughlan and Schmidt only find cvidence of poor performance for CEOs departing before reaching the age of sixty-four. Table 8 shows that less than half our sample were under sixty-four at the time of their departure. Similarly, Warner, Watts. and Wruck find the greatest evidence of poor performance for ‘forced departures’ in which top manageinent is forced to leave the firm. In comparison, panel A of table 6 indicates that over 80% of the departing CEOs in our sample stayed on with their firm as Chairman of the Board or as a director.n P.M. Dechow and R.G. Sloan, Incentives and the horizon problem To investigate this possibility in more detail, we examine the sensitivity of our results to the type of CEO departure. Under the poor-performance hypothesis, the CEO is forced to depart prematurely as a result of poor firm performance. In contrast, the horizon problem is expected to be most severe when the CEO’s departure is predetermined and is anticipated by the CEO. Departures resulting from the CEO reaching mandatory retirement age provide an opportunity for an empirical test that discriminates between the two hypotheses. The poor-performance hypothesis predicts that these depar- tures are Jess likely to be associated with reductions in R&D expenditures. In contrast, the horizon hypothesis predicts that these departures are more likely to be associated with reductions in R&D expenditures. Many firms have mandatory retirement for executives at the age of sixty- five.!” Table 8 presents the age distribution for our sample of departing CEOs. The ages are collected from the proxy statements, which are released toward the beginning of the fiscal year in which the CEO departs. Because the proxy date and the date of the departure do not generally cvincide, we are nut able ty asceitain Ue CEO's age at the departure date. CEOs who retire at age sixty-five can be listed as either age sixty-four or sixty-five on the proxy statement. Consequently, we assume that CEO departures for which the CEO is aged sixty-four or sixty-five at the proxy date are mandatory retirements. The following specification is used to investigate the impact of the type of departure on the behavior of R&D expenditures around CEO departures: AR&D,, = a + B, DUM, + B,( Holdings, x DUM,,) + y\( Age-dum,, X DUM;,) + 8, AR&D iy - (3) The variable Age-dum takes ol tie vaiue uf ene for CinUs aged sixty-four on sixty-five in their year uf departure aud ze1u utherwise. The horizon hypo- thesis predicts that CEOs who retire as a result of reaching mandatory retirement age are more likely to cut R&D expenditures. Therefore, the coefficient on the interactive variable ( Age-dum x DUM) is expected to be negative. The poor-performance hypothesis makes the opposite prediction. Table 9 reports the results for this regression. Consistent with the horizon hypothesis, the coefficient on the interactive variable (Age-dum x DUM) is negative. The point estimates provided by the coefficients B, and y, in panel B suggest that sixty-four and sixty-five year old CEOs reduce R&D expendi- tures by over twice as much as the other CEOs in our sample. However, !”Vancil (1987, pp. 80-81) finds that 47 percent of the 421 firms in his sample have mandatory retirement at sixty-five, with the CEO relinquishing the title between the age of sixty-two and sixty-sixPLM. Dechow and R.G. Sloun, Incentives und the horizon problem B Table 9 Estimated coefficients from ordinary-least-squares regressions investigating the impact of ex- pected retirements on the behavior of R&D expenditures around CEO departures (¢-statistics in parentheses); 517 firm-year observations pooled from 1974 through 1988.° AREDy a | PyDUM,, + Py Holdingsy, x DUM,.) + 7 Age-durn, DUM) $5 ARED iy, + Ey ‘White's test® a By Bs n 4 RW (pwalue) Panel A: AR&D is the change in R& D expense scaled by sales revenue 0.004 = -0.0001 0005 0.239 1S 182 0.02 @s2) (0.04) C170 (44yt 0.004 0.002 0.00002 -0.003. «0.230 4341.79 oa 61) (-134 a3) (= 1.1) (af Panel B* AR&D 1s the continuously compounded growth rate in R&D expenses 0.064 0.016 - 0055 0s21 1921.82 032, (2.03) (-081) (- 1.82 (1.58)! 0.044 = 0.034 «9.00016 «= - 0.044 «0318 3.36 1.80 056 (2.06) (= 1.65 = (2.76) (=1.43)) 5798 “DUM = 1 in the CEO's final year or the year preceding the CEO’s final year, DUM = 0 in all other years. Age-dum = 1 for CEOs who are sixty-four or sixty-five years of age in their year of departure, and zero otherwise. AR&D,, is the change in R&D expense for firm é from ycar #1 to & In panel A, AR&D, is measured as R&D,,~ RED, ,/Sales,,_ enc in panel B, AR&D,, is measured as IN RED,,)~ In(RAD,,-,). ARLDyyy, = Ly 8p AR&D,,, where ¢ (Market value),/Ly - (Marker value),,, and is a value-weighted index of AR&D. Hoisings,, we stock), + (0.6 X CEO options),.1 x (stock price),.1/(CEO's salary anc’ bonus con*oensa~ tion jy. “DW = Durbin-Watson statistic. White's test for heteroskedasticity [see White (1980) “Significant at the 1 percent level, using a one-tailed test, {Significant at the 5 percent level, using a one-tailed test ‘Significant at the 10 percent level, using a one-tailed test. these point estimates should be interpreted with caution due to their low statistical significance. As a final test of the poor-performance hypothesis, the annual abnormal return is included in our regression model as an additional explanatory variable. The regression model takes the following form: AR&D,, =a + B,DUM,, + B,( Holdings, X DUM,,) + QAR + B,ARED my» (4)” P.M. Dechow and R.G. Sloan, Incentives and the horizon problem Table 10 Estimated coefficients from or inary-least-squares regressions investigating the impact of stock- price performance on the behavior of R&D expenditures around CEO departures (statistics in parentheses); 483 firm-ycar observations pooled from 1974 through 1988.* R&D, — a + P,DUM), | Py Holdings;, DUM) | 72ARy, 1 SAREDmy 6; White test® e A n $F DW (pvalue) Panel A: AR&D is the change in R&D expense scaled by sales revenue 0.002 -0.003 - 0.0007 0372, 208155 019 ss) (=2.000° (029) 2.60" 0.002 =0004 0.00002 0.0008 0375, 7.50.64 048 1.46) 37% (5,29)8 0.30) (2.6994 Panel B: AR¢.D is the continuously compounded growth rate in R&D expenses 0.028 = 0.087 - -0007 0.429 2.39202 033 G3 (-2808 (-0.20) 9.13) 0.028 = 0.060 0.00019 0.007.424 4.20 2.08 054 134) (=352) G00) (= 0.20) (2.12 “DUM = 1 in the CEO's final year or the year preceding the CEO's final year, DUM = 0 in all other years. AR,, is the abnormal stock return for firm i in year t. AR&D,, is the change in R&D expense for firm { from year 11 t0 f. In panel A, AR&D,, is measured as (R&D,, R&D, ,)/Sales,, y. and in panel B, AR&D,, is measured as in(R&D,,)—In(R&D,,) ARED yoy = Lj oily ARKD,,, where v,,=(Market value),,/L, . (Market value),,, and is a value-weighted lndeX of AR&D. Holdings, = (((CEO stock), + 40.6 x CEO options), } x (Stack price),\/ACEO's salary and bons comnencation “DW = Durbin-Watson statistic. “White's test for heteroskedasticity (see White (1980)]. Significant at the 1 percent level, using one-tailed test. “Significant at the 5 percent level, using a one-tailed test. where AR,, denotes the abnormal return to firm i over fiscal vear ¢. If decreases in R&D expenditures are associated with unexpectedly poor *rm performance, then the coefficient on AR,, will be positive. The results are reported in table 10. The coefficient on the abnormal return is insignificantly different from zero. This result is consistent across alternative definitions of the dependent variable. Furthermore, dhe inclusion of stock-price perfor- mance actually increases the significance of the coefficient on DUM. This improvement is largely attributable to a reduction in the sample size from 517 observations to 483 observations. The loss of observations stems from the requirement that stock returns must be available and tends to eliminate the observations of the smaller firms in our sample. Overall, these results suggest that the decreases in R&D expenditures observed around our samole of CEO departures cannot be explained by poor stock-price performance.PM. Dechow and RG. Sloun, Incentives und the horizon problem 5 5.2. The lame-duck hypothesis The second competing hypothesis for reductions in R&D expenditures before CEO departures is that major new investment initiatives are deferred until after a CEO departure. This gives the incoming CEO an opportunity to influence the investment process. We call this hypothesis the ‘lame-duck’ hypothesis. This term is frequently applied to successions in the political arena, where outgoing political leaders are viewed as ‘lame ducks’ and do not usually initiate new programs.'* We provide two tests to discriminate between the horizon hypothesis and the lame-duck hypothesis. The first test involves the impact of CEO stock holdings on the reductions in R&D prior to CEO departures. The results of this test have been presented and discussed in section 4.2. Hypothesis H2 predicts that CEOs large stock holdings arc less likely to cut R&D expenditures. In contrast, the lame-duck hypothesis makes no clear piedic- tion concerning the impact of CFO stack holdings. As discussed in section 4.2, the results are consistent with the horizon hypothesis. CEOs with large stock holdings are less likely to cut R&D expenditures prior to their departure. Our second test examines the behavior of other investment expenditures prior to CEO departures. The horizon hypothesis predicts that reductions will be made in expenditures that are charged to income immediately, but not in expenditures thet arc capitalized and matched against their expected future benefits, In contrast, the lame-duck hypothesis predicts that all investment expenditures on new projects will be cut, regardless of their accounting treatment. To help disc.:minate between these two hypotheses, we examine the behavior of two additional classes of investment expendi- tures. The first is advertising expenditures. Advertising expenditures are similar to R&D expenditures in that they must be expensed in the period in which they are incurred. Yet advertising expenditures are also expected to yield benefits that extend beyond the period in which the investment is made. The sccond class of investment expenditures that we investigate are capital expenditures. Unlike R&D expenditures, capital expenditures are not imme- diately charged to earnings, but are capitalized and amortized over their useful life. GAAP allow management to carry forward these expenditures and matcn them against expected future revenues. Therefore, the hcrizon hypothesis does not predict that capital expenditures will be reduced as a CEO departure approaches. In contrast, the lame-duck hypothesis predicts 'SThere is little available empirical evidence on the lame-duck hypothesis. Vancil (1987, pp. 86-87) argues that even CEOs with a mandatory retin it date and an heir apparcnt are nor lame ducks until they publicly announce their successor. This usually takes place within two or three months of their departure.10 P.M. Dechow ural RG. Stour, Incentives ural che horizon problem Table 11 Estimated coefficients from ordinary-leastsquares regressions testing the hypotheses that CEOs manipulate advertising expenditures, capital expenditures, and accruals during their final years in office (statistics in parentheses); frm-year observations pooted from 1974 through 1968.4 Dependent variable;, ~ a + B,DUM,, + 8. Holdings,, x DUM,,) + 8 Index paiy + 7 ‘White's test® « a B: 3 Re Dw ~—(pvalue) Panel A: Dependent variable is che change in advertising expense scaled by soles revenue 0.000 = 0.002 _ 0.682, 237 1 016 40.03) 1.70 2.92% 0.000 0,002 0.00001 0.653 4.57 147 oot (0.16) (-23578 (3.22)¢ (2.82)¢ Panel B: Dependent variable is the change in capital expenditures scaled by sales revenue = 0.001 0.002 - 0947 6.77 134 ous (-047) (0.59) (6.0998 = 0.001 0.001 0.00001 004s 6.95 194 on (-0.46) (0.27) (1.00) (6.08)" Panel C: Dependent variable is the change in accruals scaled by sales revenue 0.001 0.002 - 0.473 3.64 238 0.26 (-030) (6.26) (4.40) 0.001 0.005 0.00003, 0.482 387 238 0st (-032) os?) (= 1.10) ane in all other years. Change in advertising = Advertsing expense ,— Advertsing expense,,_y. Change in capital expenditure = Capital expenditure, ~ Capital expenditure, ,. Change in. accruals = Accruals, ~ Accruals,,.,. The dependent variable is measured as (%,, ~X,,1)/Sals,-, where X denotes advertising expense in panel A. capital expenditures in panel By and accruals in panel © Inder nia = Eye ytl Xy — Xp V/Salesy, yy where ey, = (Market value)y/ Sy «Market talue),,.. Holdings, = (CEO stock), + (0.6 X CEO options),,} x (Stack price),)/(CEO"s salary and bonus compensation),,_.. The number of firm-year observations in panel A is 454, in panel B is $17, and in panel C is $16. "DW = Durbin—Watson statistic. “White's test for heteroskedasticity [see White (1980)]. “Significant at the 1 percent level, using a one-tailed test. “Significant at the 5 percent level, using a one-tailed test “DUM = 1 in the CEO's final year or the year preceding the CEO's final year, DU! that capital expenditures will be reduced, along with other investment expen- ditures. as a CEO departure approaches. Panel A of table 11 investigates the behavior of advertising expenditures around CEO departures. The regressions reported are the same as those reported for R&D expenditures in tables 4 and 5, except that the dependert variable and the index are computed using the change in advertising expendi- tures scaled by sales. The sample size is reduced to 454 observations, as notP.M. Dechow and RG. Sloan, Incentives and the horton problem n all firms in the sample separately disclose advertising expenditures. The patierns observed in the coefficients are strikingiy similar (o those reported for the R&D regressions. B, is consistently negative, indicating that advertis- ing expenditures are lower during CEOs’ final years in office. B, is consis- tently positive, indicating that incentives to reduce advertising expenditures are mitigated through stock and option holdings. These results are consistent with the horizon problem and the predictions of hypotheses Hi and H2." Panel B of table 11 investigates the behavior of capital expenditures around CEO departures. Consistent with the horizon hypothesis, the results provide no evidence that capital expenditures are reduced before CEO departures. In fact, the evidence suggests that capital expenditures increase slightly prior to CEO departures, although the increases are statistically insignificant at conventional levels. This raises the possibility that the reduc- tions in R& D expenditures may be partially attributed to the reclassification of R&D expenditures as capitai expenditures rather than to ‘real’ reductions in R&D expenditures. SFAS 2 gives management the discretion wo treat R&D machinery, equipment, and facilities that have ‘alternative future uses’ as capital expenditures. It is therefore possible that the CEOs in our sample exercise this discretion and capitalize a greater proportion of R& D expendi- tures in their final years. To provide further evidence to discriminate between these two hypotheses, we examine the accrual component of earnings. Accounting earnings can be manipulated through the management of discretionary accruals. Healy (1985) provides evidence that managers systematically manipulate accruals to maxi- mize the value of their accounting-related bonus compensation. Acciuals are defined as the difference between reported annual curnings and annual operating cash flows.”” For a given level of operating cash flows, earnings can be increased by increasing the level of accruals. Accordingly, the horizon hypothesis predicts that accruals will be increased during CEOs’ final years in office (a positive coefficient on DUM). If incentives to manipulate accruals are mitigated through equity ownership, then the coefficient on the interac- tive variable (Holdings x DUM) will be negative.” In contrast, the lame-duck "The regression diagnostics reported for these regressions provide evidence of model mi specification. We also computed standard errors and r-statistics using White's (1980) het- ‘eroskedasticity-consistent covariance matrix. 7he resulting standard errors are almost identical to the ordinary-least-squares standard errors that are reported. and are slightly smaller in most Operating cash flows are defined as (Operating income before depreciation — st expense ~ Tax expense ~ Change in all noncash current assets * Change in all current liabilities) It is not clear that incentives to mznipulate accounting accruals will be mitigated through stock ownership. While the manipulation of a firm's investment decisions has direct conse- quences for firm value, th. “clue onsequences of manipulating accounting accruals are less obvious. JAE-E8 P.M. Dechow and R.G. Sloan, Incentives and the honzon problem hypothesis makes no clear predictions concerning accruals, since they do not represent either investment expenditures or cash flows. Panel C of table 11 presents the results of our accrual analysis. The signs of the coefficients reported in panel C are consistent with the predictions of the horizon hypothesis. The percentage increases in accruals are of approxi- mately ‘he same magnitude as the reductions we document for R&D expenditures. However, the increases in accruals do not attain statistical significance at conventional levels and the null hypothesis of no change in accruals is not rejected. One possible explanation for our accrual results is that our sample is nonrandom and biased toward firms where CEOs have opportunities to manipulate discretionary investment expenditures. More- cver, there is no independent third party with the specific knowledge neces sary to monitor the CEO's decisions concerning discretionary investment expenditures. This is not so with accounting accruals. The firm’s accounting accruals are monitored each year by the firm’s auditors. An important step in the audit procedure is to check that accruals are not systematically manipu- lated. 6, Summary and conclusions This papcr investigates the hypothesis that CEOs manage investment expenditures to improve short-term earnings performance during their final years in office. We investigate the hehavior of R&D expenditures for a sample of firms in industries that have significant ongoing R&D activities. The results indicate that the growth in R& D expenditures is reduced during CEOs’ final years in office. We also find that the reductions in R&D expenditures are mitigated through CEO holdings of stock and executive stock options and, to a lesser extent, through: the relay process of CEO succession. Additional tesis indicate that the reductions in R&D are not associated with either poor firm performance or reductions in investment expenditures that arc capitalized for accounting purposcs. The evidence supports the hypothesis that earnings-based incentives encourage executives to focus on: shurt-term performance. One interpretation of the results is that contracting costs are large enough to permit opportunistic behavior that produces detectable cor.sequences on firms’ investment activities. However, while we fiad that R&D expenditures are reduced during CEOs' final years in office, we also find that they increase during the incoming CEO's first year in office. Therefore, the reductions in R&D expenditures during CEOs’ final years may largely reflec the delay of investment expenditures rather than the loss of real investment opportuni- ties. The results can also be given an ‘efficicncy’ interpretation. Under this interpretation, the reductions in the growth of R&D expenditures around CEO departures represent the firm’s optimal investment policy. This inter-P.M, Dechuw ural RG. Sloan, in-enttves and the honzon problem ” pretation, however. seems less plausible. For example, it requires the board of directors to anticipate the value-maximizing level of R&D expenditures well in advance and to plan the CEO's incentive compensation. stock holdings. tenure and method of succession to correspond with the optimal R&D investment schedule. ‘Ihe paper also raises several questions for future research. First, can our results be extended beyond the sample of firms examined here? For example, do other investment and firaucing activities display similar behavior during CEOs’ final years in office? Second, does executive incentive compensation move away from earnings-based incentives and toward stock-price-related incentives as executives approach retirement? If so, this would provide evidence that compensation committees recognize, and attempt to control for, the horizon problem.” Finally, why are earnings-based compensation plans so prevalent in top-executive compensation contracts? While there has been much criticism of earnings-based performance measures, relatively little work has examined why they are used.* Appendix: The case of Merck & Co Inc. A.1. Introduction The empirical results presented ia the preceding study provide evidence that CEOs spend less on R&D during their final years in office. This case study provides a more detailed analysis of R&D expenditures around a single CEO change. Our purpose is to provide a more thorough investigation of the circumstances surrounding one of our sample CEO departures, and to ‘cxaminc how thesc circumstances influcnce discretionary investment cxpen- ditures. The case-study approach enal:les us to examine the details of a firm's compensation plans and the incentives these plans create. It also allows us to focus on ‘soft’ data, such as management discussions and press reports, that can provide new insights into CEOs’ actions. This more detailed investigation of the institutional evidence supplements our preceding empirical results. When combined, these two types of evidence lead us to conclude that compensation plans provide CEOs with incentives to reduce R& D expendi- ures prior (o their depai‘ures, and that under appropriate circumstances, CEOs respond to these incentives. “Givbony and Murphy (1990) provide evidenve Consistent with, this conjecture. Their evidence suggests that CEOs" cash compensation becomes more sensitive to stock-price performance as CEOs near retirement. Two exceptions ‘Watts and Zimmerman (1986, pp. 201-203) and Sloan (1991),80. P.M, Deckiw and RG. Sloan, Incensives and the horizon problem A.2. The selection of Merck & Co Since the horizon hypothesis is the central focus of this paper, our sample-selection criteria are designed to select a firm with the conditions in which the horizon problem is expected to be relatively pronounced. This is accomplished by applying the following selection criteria to our sample of 58 CEO changes: + The market value of the firm's equity is above the sample median. + The outgoing CEO's stock holdings are less than the sample median.” + The relay process of CEO succession is not used. + The CEO departs at sixty-four or sixty-five years of age. The reasuns for capecting the horizon problem to be more pronounced under these circumstances are described in the preceding study. Applying these criteria narrows the sample to seven CEO changes. from which the CEO change at Merck & Co in 1985 was randomly selected. A.3. Profile of Merck & Co Merck & Co is a worldwide pharmaceutical firm engaged in marketing products and services for the maintenance and restoration of health. The company’s business is divided into two industry segments: Human and Animal Health products and Specialty Chemical products. Health products include therapeutic and preventative agents, generally sold by prescription, for the treatment of human disorders. The company's Specialty Chemical products have a wide variety of applications, such as in water treatment, oil field drilling, food processing, and skin care. Merck’s worldwide sales rev- enues in 1985 were $3,548 million dollars. Merck has a reputation for high-quality management and for being a market leader in performing innovative research. In 1987, Merck replaced IBM as ‘America’s most admired corporation’ in the annual Fortune maga- zine survey and has maintained this status for four years Merck has a reputation for investing ‘big bucks’ in researching, developing, and promoting new products. Merck’s R&D spending exceeded that of any other U.S. drug company in 1981. At that time it had tripled its spending since 1976, Merck has consistently been one of the highest spenders on R&D in the pharma- ceutical industry. “The definition of CEO stock holdings employed corresponds to the definition used in the study, mamtely, Holdings, = (CEO stock, + (0.9 x CEO opttons),] x (Stock price),) (CEO'S salary and bonus compensation),PLM. Dechow unit RG. Stoun, Incenstves and the honzon proba BL A4. CEQ succession at Merck & Co In April 1985, Merck & Co announced that its top scientist, P. Roy Vagelos, 55, was to become its new Picsidem and Chief Executive Officer. Dr. Vagelos had been promoted to the position of Executive Vice President in 1984. He was considered to be the driving force behind Merck’s research operations, which he had directed from 1976. Dr. Vagelos replaced John J. Horan, Chairman and Chief Executive Officer since 1976. who retired in July 1985 at the age of sixty-five. Mr. Horan remained a Director of the Board following his retirement. Concurrently with Dr. \‘agelos’ appointment, John L. Huck, sixty-two years old, who had been President and Chief Operating Officer since 1978, became Chairman of the Board. However, Mr. Huck had already informed the Board of Directors that he wished to retire in 1986. In July 1986, Mr. Huck joincd Nova Pharmaceutical Corp as Chief Executive Officer. Upon Mr. Huck’s retirement, Dr. Vagelos assumed the titles of both Chief Fxecutive Officer and Chairman of the Board. Dr. Vagelos reaches mandatory retirement axe in 1994 and has recently shifted four key executives into important aew jobs in a move to identify his successor. AS. Merck's top-executive incentive plans Merck had three top-executive incentive compensation plans in effeci a the time of Mr. Horan’s departure. AS.1. Executive incentive plan The Executive Incentive Plan provides for awards to top executives based on individual contributions to company performance. Awards are made annually from an Award Fund that is hased on the firm's accounting-carnings performance. The Plan, as described in appendix B of the Company's 1982 Proxy statemeni, contains the following definitions and provisions: ‘Incentive Earnings’ shall mean. for any calendar year, tiie excess 0” Net Income for such year over the greater of (a) an amount equal to 10% of Average Net Capital, or (b) an amount equal to the dividend requ ments on all Preferred Stock for such year and $2.50 multiplied by tne average number of shares of Common Stock outstanding durizg » ich year as determined by averaging the number of shares outstanding a: the close of business on the last business day of each calendar month during such year. Nova Piaimaceutical Corp is a relatively small firm. Its total revenues in 1987 were seven r'llion dollars.8 P.M, Dechow und RG. Stoun, Incentives aut dhe horizon problem ‘Net Income’ shall mean, for any calendar year, the amount reported in the Company's Annual Report to stockholders as the net income after taxes of the Company and its consolidated subsidiaries for that year, adjusted, however, by adding any amount which has been deducted in computing such net income after taxes with respect to any provisions under the plan. The amount credited to the Award Fund for cach calendar ycar shall not exceed 12% of Incentive Earnings for such year or 100% of the aggregate Base Compensation of the participants for such year, whichever is less. A.5.2. Strategic performance awards Strategic performance awards are designed to reward long-term perfor- mance. They are also based on accounting-earnings performance. The Strate- gic Performance Award Plan is described as follows on page 23 of the Company's 1982 proxy statement: A five-year Award Cycle will begin every two years, with a transitional three-year Award Cycle started at the same iime as the first five-year Award Cycle. Awards may become payable to the extent that perfor- mance objectives established by the Committee have in its judgement been accomplished. The Committee has established goals based on a comparison of the Company's growth rate in earnings per share, return ‘on investments and growth rate in sales compared to other corporations selected by the committee, ard on other qualitative factors deemed important to the strategic health of the Company. 5.3. Stock-uption plan A second long-term incentive plan used by Merck is its Stock Option Plan. Stock options and stock-appreciation rights are granted to executives and other key employees at an exercise price equal to the market value of the sonnuun stuck on the grant date. The Incentive stock options cannot be exercised in the first six months of their term and have a maximum term of ten years. At the end of 1983. Mr. Horan beneficially owned 65,026 shares in Merck, with a market value of around $5 million. This holding declined to 24,207 shares, valued at about $2 million, by the end of 1985. Mr. Horan’s cash compensation (salary plus bonus} was $804,000 in 1983 and increased to ‘$93U,UUU in 1984, His 1985 cash compensation up to his retirement date in July was $502,547. He also held 95,500 unexercised executive stock options at the time of his retirement.P.M. Dechow ard .G. Sloun, Incentives and the horizon problem 83 ASA. Retirement benefits In aduition to the three incentive compensation plans, Merck also has a retirement benefit plan. This plan is of interest because pension benefits are based on cash compensation, defined to include incentive awards Mr. Horan’s annual retirement benefits are based on the years of credited service up to age sixty-five (32 years and 6 months). Average pension compensation is based or the highest five consecutive years compensation (salary and executive incentive plan awards credited for the year) in the last ten years before retirerent. Mr. Horan’s compensation for 1985 was not used for the calculation of his retirement benefit because he was not an employee for the full calendar year. Assuming he receives retirement benefits for fifteen years, a $1 increase in his final full year's compensation increases the net present value of his rctircment benefits by between $0.59 and $1.04. Thus a one-dollar increase in compensation also yields up to a one-dollar increase in the net present value of retirement benefits. A.6. Investment expenditures at Merck & Co 4.6.1. The horizon problem The horizon problem leads to the prediction that investment expenditures that are expensed immediately for accounting purposes will be abnormally low prior to CEO departures, Expenditures on R&D and marketing are examples of such investments. Table A.! provides fnancial-statement data on these expenditures from 1980 to 1987. The numbers indicate that the growth in R&D expenditures is abnormally low in the two years immediately preceding and in the year of the CEO change. Growth in marketing and administrative expenses displays a similar pattern. Annual reports around the time of the change were analyzed to determine the reasons given by the Company for the reductions in growth, The decline in the growth of R&D and marketing expenditures can be at least partially attributed to a cost-containment program introduced in 1983. The impact of the program on Merck's discretionary cxpenditures is de- **Under the provisions of the retirement benefit plan. the five years immediately prior to th= year of retirement were used to calculate Mr. Horan’s pension compensation. Anplying the pension henefit formula, a one-dollar increase in Mr. Horan’s final year's compen.ution trans lates te a $0.10 increase in annual pension benefits. An annuity of $0.10 for fifteen years using a 15 percent discount rate gives a present value of $0.59, while using a 5 percent discount rate gives a present value of $1.04, The fifteen-year pension period is based on the life tables reported in Vital Statistics of the United States 1987 (U.S. Department of Health and Human Services, Hyattsville, MD, 199%),84 P.M, Dechow end RG, Sloan, Incentives and the horizon problem Table A.l Key financial variables for Merck &Co from 1980 to 1987.* "CEO's final years CEO’ final CEO change full year July 1985 198019811982 19831984 198519861987 Growth in R&D(%) 3 172 168 2104 a4 25179 Growth in mkt &admin(%) 140,98 6H 4s 259 324 A Accruals/Sales 0.011 0.040 -0.056 0.029 0.028 0.012 0.021 Stock return 021 003 003 010 0.08 ogs 0.30 Industry average stock return 035 003 030 0.38 -0.02 oat 0.23 0.06 Market return 033 -C04 020 023 0.0s oat 017 0.03 Net income /Assets 0.143 0.120 0.114 0.107 0.107 Qt 0.132 0.160 Net income /Sales 0.152 G.130 0.136 0.139 138 O1sz 0.184 0.179 Growth in capital exp.(%) 508 25.8 -86 -7.6 06 -134 0-114 205 New projects. authorized (S millions) 279.5341. 2821-3014 208.7 1799 248.1 3593 “all financial data are obtained from the 1987 annual report. ‘Selected Financial Data’. except for accruals and new projects authorized. Accruals are obtained from COMPUSTAT Annual Ingustrial tape, New projects authorized are obtained from the “Facts in Brief" Merck’s annual reports. Growth in 2 variable is calculated as the percentage change variable from the previous year. Stock returns are calculated from the CRSP monthly returns Ale. The industry average stock return is c-iculated using an equal-weighting of all fins (excluding Merck) in the same two-digit SIC ode classification as Merck. The market return is, calculated using the CRSP monthly value-we ghted index. scribed on page 36 of the 1983 annual report: Marketing, Adminisiraiwve, and Kesearch expenses increased 1% in 1983 versus a 9% increase in 1982, reflecting the impact of a cost containment program initiated in carly 1983. Rescarch and Development spending increased 11% in 1983 and 17% in 1982, Other Marketing and Adminis- tration expenses were up only 1% in 1983 compared to a 7% increase in 1982. (italics added) The program was continued into 1984 and its impact on discretionary expenditures is descrited on page 32 of the 1984 annual report: Marketing, administrative, and research expenses increased 6% in 1984 versus a 4% increase in 1983. Excluding acquisitions, marketing, admin- istrative, and research expenses in 1984 were essentially level with thePM, Dechow and RG. Stoun, sventives and the f prowiem 3s preceding year, reflecting the continuation of the cost containment program instituted in 1983. Research and development spending in- creased 10% compared with an 11% increase in 1983. Other marketing and administrative expenses decreased 1% in 1984 and increesed less than 1% in 1983. The emphasis of the cost containment program was refocussed once Dr. Vagelos assumed control. Reporting on his first full year as CEO, Dr. Vagelos made the following statement in his letter to the stockholders (see Merck’s 1986 annual report, page 4): We continued to emphasize cost-control programs in 1986. These were carried out selective.s. however. without cutting marketing and promo- ti port of products or other projects designed to raise revenues or to reduce operating costs over the long term. The increased focus on long-term value creation once Dr. Vagelos’ assumed control in consistent with the prediction of the horizon problem. Table A.1 also reports the change in accruals scaled by sales. The horizon problem predicts that the change in accruals will be positive during CEOs final years. Mr. Horan’s final full year as CEO is 1984, The change in accruals is positive in this year, but is more than counteracted by the negative changes in accruals in surrounding years. The 1984 annual report was investigated to find specific reasons for the 1984 accruals increase. Almost one quarter of the increase ir. accruals can be attributed to a revision in the firms actuarial assumptions in accounting for pension liabilities. These revisions are de- scribed on page 32 of the 1984 annual report as follows: Expenses for private retirement plans decreased from $38.1 million in 1983 to 22.6 million in 1984. The decrease in costs in 1984 resulted from a change in cost method to the projected unit credit method and changes in actuarial assumptions to reflect the high rate of earnings of the principal domestic pension trust over the past ten years. The timing of this discretionary change in accounting for pension liabilities and its impact on reported income are also consistent with the existence of the horizon problem. A.0.2, The poor-performance hypothesis Table A.1 presents Merck’s stock-price performance from 1980 to 1987. Merck's stock-price performance was below the industry and market average in 1980, 1982, and 1983. Ho'vever, there is no evidence that Mr. Horan was86 PM. Dechow and R.G. Sloan, Incentives and the horizon problem forcibly removed from his post due to poor performance. Mr. Horan retired at the age of sixty-five after ten years as CEO and retained his position as a Director of the Board. He also remained on the Executive Committee and the Treasury Stock Committee, and joined the Audit Committee in 1986. A Wall Street Journal article covering the announcement of the CEO change described Mr. Horan’s term as CEO as follows:?” Mr. Horan is credited with beefing up Merck’s sales force and aggres- sively pushing into forcign markets, including Japan, where it is the biggest drug marketer. Table A.l contains some evidence that earnings were lower relative to sales and assets during the 1981-1984 period but increased from 1985. There are two reasons for this increase. First, the strong U.S. dollar in the early 1980s reduced profits on Merck’s foreign sales. Second, several new products that were developed during Mr. Horan’s tenure were successfully introduced in the years immediately following his departure. In his letter to the stock- holders on pages 3 and 4 of the 1984 annual report. Mr. Horan describes the situation as follows: Throughout the first half of this decade, our international business has been adversely affected by the strong dollar and pricing pressuies. Despite these problems, we continued to invest for the future by strengthening our marketing and manufacturing facilitics worldwide. As a result we are in a strong position to accelerate grow:h in the balance of the decade, with that growth coming primarily from important new products to be introduced in the next few ycars. We believe currency problems experienced in recent years will moderate significantly. ‘The accelerated growth predicted by Mr. Horan was realized soon after his retirement. A special report in the December 1988 issue of Business Month commented that by 1988 Merck had 14 drugs that brought in $100 million a year or more in revenues, with five of them having been introduced since 1985. Profits had more than doubled since 1985 as a result of these new products. To summarize, there is no evidence that Mr. Horan was forcibly removed fiom office due to poor performance. Aithough profitability increased follow- ing his retirement, a significant proportion of this increase in profitability can be attributed to the introduction of new products developed during Mr. Hu u ¢ as CEO. Furtheimurc, Mi. Horan played an active role on Merck’s Board of Directors following his retirement. "Quoted from "Merck & Co. Elects Vagelos President, Chief Executive’, Wall Street Journal, 24th April 1985, p. 40.PM. Dechow and R.G. Sloan, Incentives and the horizon problem: 87 A.6.3. The lame-duck hypothesis The lame-duck hypothesis predicts that outgoing CEOs reduce all discre- tionary investment expenditures in order to leave new investment initiatives to their successors. We investigate this hypothesis by examining significant acquisitions, capital expendicures, and new project authorizations in the years surrounding Mr. Horan’s departure. The lame-duck hypothesis predicts that fewer acquisitions will occur to- ward the end of a CEO's tenure. However, Mr. Horan made his largest acquisitions as CEO durixg his final years in office. in August 1983, an agreement was reached wiih Banyu Pharmaceutical Co Ltd in Japan, under which Merck purchased 3313 million newly issued common shares and debentures convertibic to additional common shares of Banyu. On October 1, 1984, Merck converted ihe debentures into common shares of Banyu and obtained 2 majority interest. Also in 1983, the Company purchased Laborato- ios Abello, the seventh largest pharmaceutical manufacturer in Spain, and a maiority interest in Torii & Co Ltd, a Japanese pharmaceutical company. Annual reports reveal that half of the growth in sales in 1984 resulted from i n of these acquisitions. These major investments were undertaken to establish Merck’s presence in Japan and were part of a long-term strategy to increase Merck's future growth opportunities worldwide. They suggest that, at least up to the end of 1984, Mr. Horan was uot a ‘lame duck’ and was actively cngaging in new acquisitions. in contract to acquisitions, tures show large declines in years preceding the CEO’s final full year (1982 and 1983). One possible reason for this is that company funds and management's time were being devoted to the major acquisitions being made over this period. Capital expenditures increase slightly in 1984, but show a large decline in the year of the CEO change. Merck’s annual report also discloses capital-expenditure avthorizations for new projects in each year (reproduced in table A.1). These authorizations are abnormally low in 1984 and 1985, Mr. Horan’s final years. They rcach an cight-year low in 1985, the year of his departure. This is consistent with Vancil’s claim that the period between the announcement of the incoming CEO (April 1985) and the retirement of the incumbent CEO (July 1985) is the only period during which the incumbent CEO is really a ‘lame duck’. A.7. Conclusions The facts uncovered in this case study lend suppert to the conclusions reached in the preceding study. A detailed analysis of the incentive compen- sation plans in place at Merck & Co indicates a well defined link between CEO incentive compensation and accounting-carnings performance. Further-88 P.M. Dechow und R.G. Stour, Incentives urud die horizon problem more, because executive retirement benefits are based on the compensation received in executives’ final years, departing CEOs face even greater incen- tives to increase their earnings-relaied incentive compensation in these years. CEO actions surrounding the departure are consistent with the predictions of the horizon problem. Reductions in the growth of R&D and marketing expenditures in the CEO's final years were traced to the initiation of a “cost-containment’ program two years prior to the outgoing CEO's departure. Increases in the growth of these expenditures following the CEO change were traced to the incoming CEO's modification of the cost-containment program. These modifications were aimed at increasing firm value in the long term. Mr. Horan is, however, credited with developing several lucrative drugs that generated earnings only after his departure. In contrast, the case facts provide mixed support for the competing hypotheses for the reductions in R&D expenditures. We found no evidence that Mr. Horan was forcibly removed from office as a result of poor firm performance and he continued to serve as an active board member following his departure. In addition, the aggressive acquisition program initiated during his final years as CEO suggests that he was not a ‘lame duck’. Overall, the empirical evidence in the preceding study and the institutional details uncov- ered in this case study suggest that the horizon problem is a contributing factor to the documented reductions in the growth of R&D expenditures prior to CEO departures. References Baber. W. and J. Haggard. 1987, Management use of discretionary spending to manipulate financial accounting income: The case of research and development, Working paper (Col- umbia Unversity, New York, NY Ball, R., 1980, Discussion of accounting for research and development costs: The impact on research and development expenditures. Journal of Accounting Research 18, 27-37. Belsey. D., E. Kuh, and RK. Welsch, 1980, Regression diagnostics: Identifying influential data and sources of collinearity (Wiley. New York, NY). Butler, S. and H. Newman, 1989, Agency control mechanisms, effectiveness and decision making in an executive's final year with a firm, Journal of Institutional and ‘Theoretical Eronomics 14S, 451-466. Christie, A., 1987, On cro Economics 9, 251-258, The Conference Board. 1989, Top executive compensation: 1989 edition (New York, NY). Cota, G. 1978, Executive compensation: Money motivation and imagination (AMACOM. New otk, NY). wighlan, A. and R. Schmidt, 1985, Executive compensation, management turnover, and firm performance: An empirical investigation, Journal of Accounting and Economics 7, 43-66. Dean, K.. 1974. The temporal mismatch ~ Innovation’s pace vs. management's time horizon, Research Management 17. 12-15. DeAngelo, L., 1988, Managerial competition, in* » mation costs, and corporate governance: The use of accounting performance measures in proxy contests, Journal of Accounting and Economics 10, 3-36 Dhaliwal, D., G. Salamon, and E, Smith, 1982, The effect of owner versus management control fon the choice of accounting methods. Journal ot Accounting and Economics &, 41-53. -sectional analysis in accounting research, Journal of Accounting andPM. Dechow ural RG. Stoun, Incenti-es ural the horizon problem 89 Financial Accounting Standards Board, 1974, Statement of financial accounting standards, No. 2 (SFAS 2): Accounting for research and development costs (Stamford, CT). Gibbons, R. and K. Murphy, 1990, Optimal incentive contracts in the presence of career conceins: Theory and evidence, Working paper (University of Rochester. Rochester. NY). Hand, J., 1989, Did firms undertake debt~equity swaps for an accounting paper profit or for true financial gain?, The Accounung Review 64, 587-623. Healy, P., 1985, The effect of bonus schemes on accounting decisions, Journal of Accounting and Economics 7, 85-107. Holmstrom, B., 1989, Agency custs and innovation, Journal of Economic Behavior and Organiza- tion 12, 305-327. Jensen, M. and W. Meckling, 1976, The theory of the firm: Managerial behavior, agency costs and ownership structure, Journal of Financial Economics, 3, 305-360, Jensen, M. and K. Murphy, 1990, CEO incentives: It's not-how much you pay, but how, Harvard Business Review, May-June, 138-153. Kaplan, R. and A. Atkinson, 1989, Advanced management accounting (Prentice Hall, Engle- ‘wood Cliffs. NJ). Kothari, SP. and R. Sloan, 1990, The price-earnings lead-lag relation and earnings response coefficients, Working paper (University of Rochester, Rochester, NY). ‘Maddala, G.. 1988, Introduction to econometrics (Macmillan, New York, NY), Merchant, K., 1989, Rewarding results: Motivating profit cenicr managers (Harvard Business ‘School Press, Boston, MA). Moore. M.. 1973, Management changes and discretionary accounting decisions, Journal of ‘Accounting Research 10, 100-107. Nix, P. and R. Peters, 1988, Accounting for R&D expenditures, Research Technology Manage- ‘ment 31, 39-1 Plosser, C. and G. W. Schwert, 1978, Money, income and sunspots: Measuring economic relationships and the effects of differencing, Journal of Monetary Economics 4, 637-660. Rappaport, A.. 1978, Executive incentives vs. corporate growth, Harvard Business Review, Suly-Aug., 81-88, Rappaport, A., 1990, The staying power of the public corporation, Harvard Business Review, Jan.Feb., Yo-i04. Sloan, R., 1991, An empirical examination of the role of accounting earnings in top executive compensation contracts, Working paper (University of Rochester, Rochester, NY). Smith. C. and R. Watts. 1982, Incentive and tax effects of executive compensation plans, Australian Journal of Management 7, 139-157. Stewart, G., 1989, Performance measurement and management incentive compensation, in: J. Stern, G. Stewart. and D. Chew. eds., Corporate restructuring and executive compensation (Ballinger, Cambridge, MA) 339-346. ‘Vancil, R., 1967, Passing the baton: Maiaging the piucess uf CEO succession (Harvard Business ‘School Press. Boston. MA). ‘Warner, J., R. Watts, and K. Wruck, 1988, Stock prices and top management changes, Journal ot Financial Economics 20, 461-492. ‘Watts, R. and J. Zimmerman, 1986, Positive accounting theory (Prentice Hall, Englewood Clif, ND). Weisbach, M., 1968, Outside ireciurs aud CEO turnuver, Jouinal of Financial Economics 20, 431-460, White, H., 1980, A heteroskedasticity-consistent covariance matrix estimator and a direct test for heteroskedasticity, Econometrica 48, 817-838, JAE G