Paid to leave and paid for honesty

In effect, severance pay acted as insurance against job loss and as rewards for honest reporting.

Chief Executive Officers (CEOs) often have severance agreements in their contracts. If the company is taken over, or it fires the CEO “without cause,” then the CEO receives a severance payment. These payouts can be hefty: at major American corporations, they average nine times the executive’s annual pay.

Severance packages are controversial because they can encourage executives to take undue business risks. But do they influence executives in other ways? Do packages encourage CEOs to inflate reported profits, to boost the value of the payouts? Or do they encourage accurate reporting by making CEOs more secure in their jobs?

Assistant professor Kareen Brown decided to find out. She examined financial reports from 1992 to 2010 for large American firms with CEO severance packages.

Brown found that firms offering larger severance packages were less likely to “game” their accounting to make profits look higher. They made less use of optional accounting procedures to inflate reported income. They also experienced less trouble with the U.S. Securities and Exchange Commission over accounting irregularities.

It may be that the CEOs were worried less about losing their jobs over weak performance. Or they worried more about losing the severance payout if they got caught fudging the numbers and then fired “for cause.” In effect, severance pay acted as insurance against job loss and as rewards for honest reporting.

These results should interest compensation committees and investors. They show that severance pay is not just an executive “cash grab,” but may encourage more honest reporting by CEOs.

Kareen Brown is an assistant professor of accounting. In addition to her work on CEO severance contracts and how they affect earnings management and risk taking, Kareen Brown also studies the effect of mandatory stock ownership plans on firm’s investment, reporting and disclosure choices. She teaches introductory and intermediate accounting, and accounting theory.

Brown, K. (2015). Ex ante severance agreements and earnings management. Contemporary Accounting Research, 32(3), 897-940.