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CEO and CFO Career Consequences to Missing Quarterly Earnings Benchmarks

By Harvard Law School Program on Corporate Governance

In a recent working paper co-written with Rick Mergenthaler and Shiva Rajgopal entitled CEO and CFO Career Consequences to Missing Quarterly Earnings Benchmarks, we investigate whether missing quarterly earnings benchmarks is associated with career consequences in the form of lower compensation (bonus, equity grants) and the dismissal of the Chief Executive Officer (CEO) and the Chief Financial Officer (CFO).

Prior research has found that a disproportionately large number of firms appear to meet or just beat quarterly earnings benchmarks relative to firms that just miss these benchmarks. Why do managers work this hard to meet or beat these quarterly earnings benchmarks? We propose that the CEO and CFO suffer negative career consequences if they repeatedly miss quarterly earnings benchmarks. We examine three earnings benchmarks - analyst consensus forecast, seasonally lagged quarterly earnings, and zero earnings. We evaluate a comprehensive set of career consequences such as the impact on compensation (bonus and equity grants) and dismissal from office for both CEOs and CFOs, conditioned on failure to meet quarterly earnings benchmarks.

Our sample includes CEOs and CFOs for the S&P 1500 firms covered in the ExecuComp database. We examine over 11,000 firm-year observations during the years 1993-2004 and investigate whether bonus changes and equity grants are associated with the failure to meet or beat quarterly earnings benchmarks after controlling for the known determinants of such compensation and for measures of firm performance such as stock returns, return on assets, and the magnitude of the earnings surprise. We use news articles to determine the circumstances surrounding each CEO and CFO’s departure to classify such turnover as forced dismissals. Our analysis seeks to predict CEO and CFO forced turnover as a function of the failure to meet earnings benchmarks. We find evidence that the failure to meet quarterly earnings benchmarks, especially the analyst consensus estimates, is associated with lower bonus and equity grants, and a higher probability of forced dismissal for both the CEO and the CFO, after controlling for several proxies for performance.

In economic terms, failing to meet two quarterly analyst consensus forecasts in a year is associated with a lower bonus equivalent to 14% (8%) of the CEOs (CFOs) salary, a lower equity grant of 24% relative to an equity grant with no misses for both the CEO and the CFO, and a 0.61% (0.62%) higher probability of being dismissed for the CEO (CFO). If the firm fails to meet all four consensus quarterly earnings forecasts in a year, the penalties jump to a lower bonus equivalent to 28% (16%) of the CEOs (CFOs) salary, a lower equity grant of 48% relative to an equity grant with no misses for both the CEO and the CFO, and a 1.51% (1.53%) higher probability of being dismissed for the CEO (CFO). Compared to the unconditional probability of forced dismissal (which is 3% for CEOs and 5% for CFOs), the dismissal penalty appears to be significant in an economic sense. We also find systematic cross-sectional and inter-temporal variation in the nature of these career consequences. In particular, career consequences for both the CEO and CFO are worse if they miss quarterly earnings benchmarks and their firms provide earnings guidance. Bonus cuts on missing quarterly benchmarks are greater if the firm has a history of consistently meeting or beating quarterly benchmarks in the past. In addition, career penalties to missing quarterly earnings benchmarks have increased in the post-Sarbanes-Oxley Act time period.

The full paper is available for download here.

Full post as published by The Harvard Law School Corporate Governance Blog on September 03, 2008 (boomark / email).