Stephen M. Ross School of Business, University of Michigan, Ann Arbor, MI 48109, USA

a b s t r a c t

Accounting rules for valuing retained interest from securitizations require management

to make assumptions concerning discount rates, default rates, and prepayment rates.

ldingse of005,tion,

s aresold to a special purpose entity (SPE), a moral hazard exists whereby managers face incentives to lower credit standards

Contents lists available at ScienceDirect

journal homepage: www.elsevier.com/locate/jae

Journal of Accounting and Economics

ARTICLE IN PRESS

Journal of Accounting and Economics 49 (2010) 2250165-4101/$ - see front matter & 2009 Elsevier B.V. All rights reserved.

doi:10.1016/j.jacceco.2009.09.006 Corresponding author. Tel.: 15106422708.E-mail addresses: patricia_dechow@haas.berkeley.edu (P.M. Dechow), lmyers@walton.uark.edu (L.A. Myers), shakespe@umich.edu (C. Shakespeare).1 Tel.: 14795755227.2 Tel.: 17346476984.since the rm no longer bears the full cost of defaults. This can result in adverse selection such that rms want to sell theirlower quality receivables. Securitizations can also change the nature of business risk since a securitizing rm can becomesecuritizing long-term receivables provides the issuer with an immediate source of cash and eliminates the risk of hothe receivables. This risk is diversied among many investors who can have the pay-offs tailored to their needs. Becauthese advantages, securities resulting from securitizations were one of the largest segments of the debt market in 2totaling $7.4 trillion. By comparison, the Treasury market was valued at $4.1 trillion in 2005 (Bond Market Associa2005).

Securitizations can also have unanticipated costs, as exemplied by the current nancial crisis. Since receivableGovernance

1. Introduction

Securitizations are complex, involve multiple parties, and produce a host of risk and valuation issues. However,a r t i c l e i n f o

Article history:

Received 8 March 2008

Received in revised form

28 August 2009

Accepted 23 September 2009Available online 4 October 2009

JEL classication:

G20

G30

M41

Keywords:

Securitizations

Fair value

Earnings management

CompensationThese assumptions provide management with discretion to determine the gain on

sale of the receivables. We investigate whether CEO compensation is less sensitive to

securitization gains than to other earnings components in the presence of proxies for

how independent (outsiders, females, fewer CEO-selected directors) and informed

(nancial expertise) directors are. Overall, our results do not suggest that better

monitoring reduces earnings management or CEO pay-sensitivity to reported

securitization gains. Our results suggest that CEOs are rewarded for the gains they

report and boards do not intervene.

& 2009 Elsevier B.V. All rights reserved.Fair value accounting and gains from asset securitizations:A convenient earnings management tool withcompensation side-benets

Patricia M. Dechowa,, Linda A. Myers b,1, Catherine Shakespeare c,2

a Haas School of Business, University of California, Berkeley, Berkeley, CA 94709, USAb Sam M. Walton College of Business, University of Arkansas, Fayetteville, AR 72701, USAc

cash constrained very quickly should the demand by investors for securitized securities slow. Finally, accounting rulesgoverning securitizations require derecognition of the receivables once they are transferred to a qualifying SPE. This createsasymmetric information problems because the rms risk exposure is opaque to its owners.

We focus on the accounting for securitizations and examine consequences of accounting rules that allow for thederecognition of receivables. When a rm sells its receivables, it receives cash and, possibly, some of the securities issued,and any difference is recorded as a gain or loss. Throughout, we refer to this income effect as a gain since gains aretypical. (Indeed, the Wall Street term for the SFAS No. 140 rules governing securitization accounting is gain on saleaccounting.)

Our sample consists of rms that retain an interest in the receivables sold (i.e., less than 100 percent of the future cashows are sold), as is very typical for securitizations. We argue that allowing derecognition in such cases provides ampleopportunity to manipulate earnings because the retained cash ows must be recorded at fair value even though no activemarket value is likely to exist. For example, a recent New York Times article describes how the Chief Financial Ofcer of NewCentury Financial presented the details of gain on sale accounting at industry seminars and conferences, and promoted it toWall Street analysts as an insiders look at New Century. Industry specialists state [t]he thing about gain on saleaccounting is that you can create a machine that just manufactures earnings out of thin air (see Accounting said to hide

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 225 3lender losses in The New York Times, May 1, 2007).We have three objectives in this paper. Our rst is to determine whether managers use the discretion obtained from fair

value accounting rules to report larger gains. This is not costless because over-optimism in the current period increases theprobability of recording future impairments. Therefore, managers likely time discretionary gains to periods in whichexpected benets are larger. We examine two circumstances inwhich we expect their incentives to be relatively strong. Therst is when pre-securitization earnings (i.e., earnings before the securitization gain) is low. Here, managers likely facegreater scrutiny from investors and regulators, are less likely to receive bonuses and options, and will have more troubleattracting employees and customers. Thus, the benets of reporting higher current earnings are likely to exceed thepotential cost of a future write-down. Likewise, when pre-securitization earnings are high, managers have less incentive torecord gains and could even prefer to report a loss. The second circumstance is when pre-securitization earnings are belowthe prior years level. Research suggests that rms are rewarded for reporting positive earnings changes (e.g., Barth et al.,1999) and that managers provide earnings comparisons which emphasize improvements (e.g., Schrand andWalther, 2000).Our evidence is consistent with reported gains being relatively larger in both of these cases.

We also investigate how managers can inuence the size of the gains. The discount rate is a key assumption indetermining the fair-value of the retained interest but ambiguity over which rate should be used exists.3 We nd that, onaverage, discount rates are lower when rms report securitization losses thanwhen they report gains. Lower discount ratesincrease the fair value of retained interest, resulting in smaller losses. We also nd clustering of the discount rates chosenat 10% and 12%, suggesting that rate choice can be arbitrary. Finally, rms selecting high discount rates (greater than 18%)tend to report extremely large gains or losses, suggestive of upper and lower bound bonus plan incentives (e.g., Healy,1985).

In a typical asset sale, managers can cherry pick the assets to record gains or losses. Securitizations also offer thistransaction-based earnings management with added discretion from fair-valuing the retained interest. In fact,securitizations are more frequent at quarter-end, giving managers exibility in determining which receivables to sell toachieve desired accounting outcomes (Dechow and Shakespeare, 2009). Financial statement users have difcultyevaluating the reasonableness of reported gains because their accuracy can be determined only as future events unfold.Recent events in the subprime mortgage industry illustrate this problem.4 When subprime mortgage companiesunderestimate future defaults (intentionally or unintentionally), they boost current period gains. It can take several yearsfor the underestimates to be revealed because it can take years for rms to realize the full extent of their incorrectforecasts.5 Meanwhile, management compensation is based on earnings affected by their forecasts, and their rms are ableto raise additional nancing to lend to new subprime customers. For example, Countrywide Financial reported

3 A 2004 Securities Exchange Commission (SEC) Enforcement Action against Conseco suggests that discretion over the assumptions can be used to

manage earnings (Account and Auditing Enforcement Release No. 1973/March 10, 2004 File No. 3-11428). Here, top management managed the

assumptions underlying the value of Consecos retained interest to increase earnings and avoid writing down the retained interest.4 Credit losses and asset write-downs recorded by large banks and securities rms related to subprime mortgages exceed $150 billion. Because

mortgage loans are often securitized, loan originators had incentives to grant risky loans, and investors could not effectively monitor the quality of these

loans (see Securitization: When it goes wrong in The Economist, September 20, 2007). Wall Street rms that sold asset-backed securities had strong

incentives to increase volume because many securitizations costs are xed. Moreover, credit-rating agencies, which are paid by securitizers rather than by

investors, had incentives to provide high ratings to new securities and had little incentive to review their ratings subsequently (see FBI probes accounting

in subprime securitization in Financial Week, January 30, 2008 and SEC drift said to prevent action on credit crunch in Investment News, February 25,

2008). Currently, the Federal Bureau of Investigation (FBI) is investigating 16 unnamed companies for possible accounting (valuation-related) fraud and/or

insider trading related to the subprime lending crisis, and the Securities Exchange Commission (SEC) has made more than three dozen inquiries and has

added reforming credit-rating agencies and examining suitability requirements for selling complex asset-backed securities to its regulatory agenda.

The companies involved in FBI and SEC probes include subprime lenders, major investment banks that securitize the loans, and banks that hold the

mortgage-backed securities (see FBI widens new around subprime industry in Business Week, January 30, 2008, p. A13).5 For example, Countrywide Financial stated that its computer models did not take into account the possible effects of exceeding the loss levels that

cut-off reimbursements from the SPE (see Countrywide posts $421.9 million loss for quarter; results underscore challenges facing Bank of America in

The Wall Street Journal, January 30, 2008).

securitization gains of $22.6 billion from 2001 through 2006. During this period, Countrywides Chief Executive Ofcer(CEO), Angelo Mozilo, was compensated nearly $400 million.6 However, in the second half of 2007, Countrywide recordedlosses of $1.6 billion related to its loans, and more losses followed, including a $704 million loss to cover the costs ofobligations on its lines of credit. Compensation and retirement packages of CEOs of corporations deeply involved in thecurrent mortgage crisis were the subject of recent regulatory hearings by the Committee on Oversight and GovernmentReform.7 However, to our knowledge, no executives have been forced to pay back bonuses based on earnings inated bysecuritization gains.8

rules for securitizations provide ample opportunity to manage earnings. We then document that the pay-sensitivity for

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 2254these gains is similar to that for regular earnings components. Evenwithout earnings management, securitization gains canbe highly uncertain and are not realized in cash ows until future periods. Note that the impact of securitizations onearnings is large. In our sample, 13 percent of rms report gains of a large enough magnitude to convert an accounting lossto a prot, and the average gain increases reported earnings by more than 38 percent.

Our third objective is to investigate whether boards play a monitoring role in determining either the size of the reportedgains or the sensitivity of CEO compensation to these gains. We investigate several aspects of corporate governance that webelieve correlate with director independence and the boards ability to monitor management. These include whether thecompensation or audit committee includes a nancial expert that is likely to understand the accounting for securitizations;whether a female director sits on the board; whether the directors were board members before the CEO took ofce; andwhether the proportion of outside directors is in the top quartile of the distribution for our sample (i.e., more than 90percent of directors are non-executives).

Our results suggest that governance along the dimensions that we measure had little inuence in terms of the size ofthe reported gains or CEO pay-sensitivity to gains. We nd weak evidence that gains are smaller and are less likely to besmoothed when more than 90 percent of directors are outsiders. However, other governance variables do not appear to playa role in determining the size of the gains. In addition, we nd no reliable evidence of lower CEO pay-sensitivity to the gainin the presence of any of our governance variables. Therefore, our results can be interpreted as suggesting that: (i) our testssuffer from low power; (ii) the governance mechanisms we examine have little inuence on earnings management or pay-sensitivity (e.g., Larcker et al., 2007); or (iii) contracts are written efciently to incorporate the extent of earningsmanagement (e.g., Core et al., 2005). Note however, in order for (iii) to hold, boards and compensation committees mustunderstand fair value accounting rules and securitizations. This is questionable since even some auditors do not appear tofully understand the applications of fair value accounting rules (Johnson, 2007).

Our results build on concurrent research by Karaoglu (2005) who investigates whether rms cherry pick loan sales toimprove regulatory capital and engage in securitizations to improve earnings. However, Karaoglu (2005) focusesexclusively on banks and their regulatory reports and uses data under SFAS No. 125 (i.e., 1997 through 2000) (FASB, 1996)while our sample covers a broad range of industries and uses data under SFAS No. 140 (i.e., 2000 through 2005) (FASB,2000b). SFAS No. 140 requires rms to disclose their gains and so we are able to identify more securitizers and measuregains with less error. We also build on Hand et al. (1990) who examine motivations for rms engaging in insubstancedefeasances. In the 1980s, many rms removed debt from their balance sheets and reported gains by setting up irrevocabletrusts to pay off the debt. Managers had discretion over the timing and amount of the debt defeased, and hence thereported gains. Securitizations are comparable but relate to assets rather than liabilities. Similar to Hand et al. (1990), ourndings suggest that rms undertake real transactions, at least in part, for their accounting benets.

In the next section, we discuss accounting rules for securitizations and how gains are created. In Section 3, we makepredictions. Section 4 describes our sample selection and earnings management tests. Sections 5 and 6 examine executivecompensation and the role of governance. Section 7 concludes.

2. Understanding the securitization process and the reporting of gains

Securitizations typically occur in the nancial services industry (e.g., the repackaging of corporate loans, home loans,personal loans) but are also common in retail (e.g., store credit cards), manufacturing (e.g., auto leases), and real estate

6 See In search of a subprime villain: Countrywides Mozilo is being cast for the part, but its hard to pin this mess on one man in Business Week,

February 4, 2008.7 See the Committee on Oversight and Government Reform hearing entitled Executive Compensation II: CEO Pay and the Mortgage Crisis on March

7, 2008 at http://oversight.house.gov/story.asp?ID=1762.8 During our sample period, most securitizations resulted in reported gains. However, because of the credit crisis in latter 2007, many rms have

recorded large write-offs related to these transactions. Interestingly, Washington Mutuals board of directors decided to exclude these losses when setting

management compensation, even though the gains were included in earlier periods (see WaMu Board shields executives bonus in The Wall Street

Journal, March 5, 2008, p. A3).Our second objective is to examine CEO pay-sensitivity to securitizations gains. Research shows that managementcompensation is sensitive to accounting earnings (e.g., Sloan, 1993) and that boards of directors will look behind theearnings number and adjust compensation in certain circumstances. For example, Dechow et al. (1994) show that boardsappear to lter out the effects of restructuring charges when setting cash compensation, and Gaver and Gaver (1998) nddifferent compensation sensitivity for reported gains versus losses. We build on this research by showing that accounting

(e.g., time-shares, loans for land, domestic and commercial properties). Selling receivables to obtain cash to relend to newcustomers is an integral part of the business model for many of these rms.

In a typical securitization, a rm sells the rights to a cash ow stream from a pool of nancial assets (such as mortgages,loans, and leases) to a SPE. The SPE issues securities (usually bonds) to outside investors and uses the proceeds to pay therm for the rights to the cash ow stream. Investors are repaid by the SPE when cash ows related to the securitizedassets are collected. Accounting rules require cash ow streams retained by the rm to be fair valued.9 This is a

can easily comply with the sale requirements of SFAS No. 140 even when they retain signicant risk, so almost all rmsstructure securitizations to meet the requirements for sale accounting treatment.11

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 225 5The fair value calculation required by SFAS No. 140 uses management estimates of default rates, prepayment rates, anddiscount rates. In many cases, such as banks selling mortgages, credit card-based loans, long-term installment payments onproducts such as car leases, and land leases, receivables are sold within a few days, weeks, or months of the contractinitiation. Thus, differences between the market and book values of the receivables due to interest rate uctuations aresmall. Given this, how are securitization gains derived?

To better understand the source of the gains, we discuss three scenarios that have the same underlying cash ows andrisk, but are accounted for differently. For simplicity, we focus on the role of the discount rate and its effect on the size ofthe gain. Note, though, that when a rm treats a securitization as a sale, managers must also make assumptions aboutprepayment rates and default risk. These are also subject to management discretion and could, in fact, have a greaterimpact on the size of the gain. However, for simplicity, we assume these are accurately forecasted and so are ignored in ourdiscussion below.

In Exhibit 1, Firm ABC initially raises $3.08 (cash) from investors at time zero. In Scenario A, it borrows from creditorsand uses this cash plus the equity investment to make home loans that are simplied to have a pay back period of threeyears. In Scenario B, the rm immediately renances the loan by creating an SPE and securitizing the receivables. Thisshows the effect of the off-balance sheet arrangement. Scenario C is the same as B, but the retained interest is valued at a10% discount rate and a gain is recorded.

2.1. Scenario A: Collateralized borrowing and the receivables on the books

ABC identies customers that require nancing for new homes. It organizes a contract where homeowners will receive$24.87 and make repayments in three equal installments of $10.00. It arranges to borrow $21.79 and to make repaymentsin three equal installments of $8.00 so the implied interest rate is 5%. The borrowing is collateralized against thereceivables so as homeowners pay their mortgages, the rst $8.00 is paid to the creditors. ABCs prot is the spreadbetween the lending rate of 10% and the borrowing rate of 5%. The greater the leverage, the greater the return to equityholders. ABC has found a prot opportunity where it has identied homeowners whose true risk is lower than theinterest rate charged. Exhibit 1 provides the cash ows. The deal creates undiscounted cash ows of $2.92 for equityholders and generates an internal rate of return (IRR) to equity holders of 42%. Thus, as long as equity holders have a cost ofcapital of less than 42%, the rm should enter into the deal. Scenario A provides the balance sheet and income statement. InYear 1, the return on equity (ROE) is 45% and is close to the IRR. The balance sheet reveals that these high returns areobtained through the use of leverage (debt/assets is 77 percent) and therefore involve business risk.

9 Firms often retain servicing rights and SFAS 156 allows for fair-valuing these rights. However, this standard was not in effect during our sample

period.10 In September 2006, the Financial Accounting Standards Board issued SFAS No. 157 in part to address the lack of guidance in applying the denition

of fair value and to clarify the implementation of fair value rules (FASB, 2006). SFAS No. 157 denes fair value as the price at which two willing market

participants would exchange the asset or liability and establishes a three-level framework for measuring fair value.11 Based on our discussions with structured nance groups at the large accounting rms, it is extremely unusual to structure a securitization as a

collateralized borrowing.difcult calculation requiring considerable management judgment because active markets for the retained assets do notexist.

During our sample period, SFAS No. 140, paragraphs 68 through 70 provided implementation guidance for measuringfair values of nancial instruments. However, ambiguity remains even with this guidance. For example, SFAS No. 140,paragraph 70 refers to reasonable and supportable assumptions and projections without dening what these might be.10

SFAS No. 140 requires a transfer of nancial assets to be treated as a sale when the following three conditions have beenmet: (1) the transferred assets have been isolated from the transferor; (2) unless the transferee is a qualied SPE, thetransferee has the right to pledge or exchange the assets; and (3) the transferor does not maintain effective control over theassets (SFAS No. 140, paragraph 9). This approach uses the concept of surrender of control to determine when toderecognize the assets. If the rm retains control over the assets, then it must account for the transaction as a collateralizedborrowing. Here, the receivables remain on the books until the customers pay, and any cash received from securitizations isrecorded as borrowings. If the rm is deemed to have surrendered control over the assets, sale accounting is used. Here, thereceivables are removed from the books and the cash is recorded. Typically, rms retain some interest in the securitizedassets. Thus, a conceptual issue is what degree of involvement is permissible to qualify for sale accounting. However, rms

2.2. Scenario B: Off-balance sheet arrangements and the creation of the SPE

ABC decides immediately after borrowing from the initial creditors and making the loan to homeowners to securitize.Fig. 1 presents the transaction. The rm (the securitizer) transfers the receivables to a SPE which then sells classes ofsecurities representing parts of the cash ow stream (i.e., tranches) to outside investors.

The rm sells 80 percent of the cash ows to outside investors as Tranche A (the senior tranche) and retains 20 percentin Tranche B (the subordinated tranche). Tranche A is approved by a credit rating agency and given an AAA rating, soinvestors are willing to pay $21.79 to earn a 5% return. Firms typically retain the default risk and prepayment risk inTranche B. The journal entry thus far is:

DR cash 21.79

CR receivables 24.87

How should the rm value the retained interest? When managements estimates are the only available information,the objective is to estimate the price likely to exist in the marketplace, if there were a marketplace (SFAC No. 7,

ARTICLE IN PRESS

Cash flows Related to the Transaction (for All Scenarios)

year 0 year 1 year 2 year 3 Sum swolfni hsaC $10.00 $10.00 $10.00 30

%01 @ VP $24.87 9.09 8.26 7.51 PV of future CF $24.87 17.36 9.09 0.00

Cash outflows $8.00 $8.00 $8.00 24 19.6 62.726.7 %5 @ VP

PV of future CF 21.79 14.88 7.62 0.00

Cash profit (spread) ($3.08) $2.00 $2.00 $2.00 6PV @ 42.42% $3.08 1.40 0.99 0.69 PV of future cash flows 2.39 1.40 0.00

%24.24 RRIExcess cash flows for equity investors ($6.00 - 3.08 = $2.92)

Scenario A: Receivables and Loan on the Balance Sheet Balance Sheet as of THE end of: year 0 year 1 year 2 year 3 Initial Investment Receivables $24.87 $17.36 $9.09 $0.00

00.6 00.400.2 00.080.3$ hsaCTotal Assets $24.87 $19.36 $13.09 $6.00

00.0$ 26.7$ 88.41$ 97.12$ naoL

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 2256Income Statement SumInterest Income $2.49 $1.74 $0.91 5.13Interest Expense 1.09 0.74 0.38 2.21Net Income $1.40 $0.99 $0.53 $2.92

ROE (Net Income/beginning Equity) 45% 22% 10% Leverage (Debt/Assets) 88% 77% 58% 0% ROA (Net Income/average Assets) 6.32% 6.11% 5.53%

Exhibit 1. 80.3 80.380.380.380.3$ ytiuqERetained Earnings 0 1.40 2.39 2.92 Total Equity 3.08 4.48 5.47 6.00 Total Liabilities and Equity $24.87 $19.35 $13.09 $6.00

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 225 7Scenario B: Refinance the Loan by Securitizing the Receivables No Gain Balance Sheet as of the end of: year 0 year 1 year 2 year 3

Retained Interest $3.08 $2.39 $1.40 $0.00 Retained Interest account

Cash $3.08 0.00 2.00 4.00 6.00 Beg $3.08 $2.39 $1.40 Total Assets $3.08 $4.39 $5.40 $6.00 + int 1.31 1.01 0.60

-cash $2.00 $2.00 $2.00 Equity $3.08 $3.08 $3.08 $3.08 $3.08 End $2.39 $1.40 $0.00 highlights). Since nothing has happened to alter the receivable cash ow stream, the price of the entire stream should equalthe carrying value of the receivables on the rms books ($24.87 using the market rate of 10%). Similarly, in their commentletter on the accounting for securitizations, the American Accounting Associations Financial Accounting StandardsCommittee (1996, p. 181) argue that yunless a fundamental attribute of the underlying asset has changed, the fair value of theitems exchanged should be equal to their carrying amounts, implying no gain at transfer.

Scenario B follows the recommendation implied by Concept Statement No. 7 and suggested by the Financial AccountingStandards Committee (FASB, 2000a). It assumes that the fair value of the receivables is $24.87 and prorates this between thetwo securities. The difference between the fair value and the cash received is $3.08 ($24.8721.79). Therefore, Tranche B

Retained Earnings 0.00 1.31 2.32 2.92 Total Equity $3.08 $4.39 $5.40 $6.00

Income Statement Interest Income $1.31 $1.01 $0.60 Interest Expense 0.00 0.00 0.00 Net Income $0.00 $1.31 $1.01 $0.60 Total income recognized from transaction Gain (interest rate of 42.42%) $0.00 Interest Income 2.92

29.2$ ROE (Net Income/beginning Equity).00% 42.46% 23.11% 11.03% Leverage (Debt/Assets) 0.00% 0.00% 0.00% 0.00% ROA (Net Income/average Assets) 0.00% 35.02% 20.72% 10.45%

Scenario C: Refinance the Loan by Securitizing the Receivables Recognize a Gain Balance Sheet as of the end of: year 0 year 1 year 2 year 3 Initial Investment Retained Interest $4.97 $3.47 $1.82 $0.00 Retained Interest account

00.6 00.4 00.2 00.0 80.3$ hsaC Beg $4.97 $3.47 $1.82 Total Assets $4.97 $5.47 $5.82 $6.00 + int 0.50 0.35 0.18

-cash 2.00 2.00 2.00 Equity $3.08 $3.08 $3.08 $3.08 $3.08 End $3.47 $1.82 $0.00 Retained Earnings 1.89 2.39 2.74 2.92 Total Equity $4.97 $5.47 $5.82 $6.00

Income Statement Interest Income $0.50 $0.35 $0.18 Gain on Securitization $1.64 Fair Value Retained Interest 0.25 Comprehensive Income $1.89 $0.50 $0.35 $0.18 Total income recognized from transaction Gain (interest rate of 10%) $1.64 Fair Value Retained Interest 0.25 Interest Income 1.03 $2.92 ROE (Net Income/beginning Equity) 61.40% 10.01% 6.35% 3.13% Leverage (Debt/Assets) 0.00% 0.00% 0.00% 0.00% ROA(Net Income/average Assets) 61.40% 9.53% 6.15% 3.08%

Exhibit 1. (Continued)

ARTICLE IN PRESS

Tranche A: 80% of cash flows

Retained Interest

Credit rating agency determines that Tranche A

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 2258has a fair value of $3.08. ABC uloan from its books:

DR retained interest

DR original loan

CR cash

In Scenario B, the ROE ovenow appears to have been creto 35% in Scenario B. For a growno gain recognition.

2.3. Scenario C: Retained inter

Most securitizers report gretained interest was 42%. Inretained cash ow stream. Wdealing with a highly leveredvalue of Tranche A ($21.79) to(cash and retained interest) re($4.97/$26.76) of this total. Treceivables and receives $21.7it fair values the retained inincome.12

How can management justrequires rms to allocate therelative fair values (paragraph

12 The rm could classify the reta

unlikely since active markets generalFig. 1. A typical asset-backed securities issue.Tranche B: (Retained Interest) 20% of cash flows transferred back

to the firm

recorded on books [value determined by firm]

Value Retained Interest at $4.97 (based on 10% rate) sold to investors at riskfree rate of 5%

SPEFirm -Securitizer

Receivables Carrying Value = $24.87

$21.79 Cash Received

is AAA rated based on level of cash flows retained by firm (as well as other factors)

Pay $21.79 Receive securities worth $21.79 ses the cash from Tranche A to pay off its loan of $21.79 and removes the receivables and the

3.08

21.79

21.79

r the 3-year period is very similar to that in Scenario A. However, this high return in year 1ated with no leverage. In addition, in year 1, return on assets improves from 6% in Scenario Aing company, the off-balance sheet arrangement gives the appearance of less risk even with

est is valued at 10 percent and a gain is recorded

ains; in fact, 76 percent of our sample rms report gains. In Scenario B, the IRR on theScenario C, we arbitrarily select a discount rate of 10% to determine the value of thee do this to highlight the impact of a change in the discount rate assumption whentransaction. Using a 10% rate, retained interest is valued at $4.97. Adding the presentthat of the retained interest ($4.97) gives a value of $26.76. Therefore, the total proceedsceived have a value of $26.76, and the value of the retained interest represents 19 percenthe book value of the portion retained is $4.72 (.19 $24.87). The rm transfers $24.87 in9 cash and retained interest with a book value of $4.72, resulting in a gain of $1.64. Finally,terest, resulting in an additional $0.25 ($4.97$4.72) recorded into other comprehensive

ify an increase in the value of receivables when interest rates have not changed? SFAS No. 140previous carrying value between the assets sold and the retained interest based on their10). The examples in SFAS No. 140 all show gains being recorded (e.g., paragraph 57).

ined interest security as trading, in which case the $0.25 would be recognized directly into income. However, this is

ly do not exist for these securities.

One justication for the gain is that by splitting up the cash ows, the rm nds new creditors (e.g., pension funds that canonly invest in AAA rated securities) who can have the cash ows tailored to their needs and are therefore willing to pay apremium (i.e., receive a low interest rate) for these cash ows. Thus, the sum of the parts is worth more than the whole.Alternatively, it could be argued that Tranche B is not as risky as 42% because the rm has identied unique homeownerswho are less risky than the 10% rate they are charged. The lower discount rate could reect the true discount rate, whichin the case of our simple rm, is just ABCs ability to borrow at lower rates than it lends.

Note that the total cash ows paid to the retained interest are $6.00. All that differs between Scenarios B and C is thetiming of income recognition. In Scenario B, the rmmust wait until cash is received to record the gain (as interest income).

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 225 9In Scenario C, the gain is front-loaded and immediately recognized in earnings. The benets of the accounting are revealedby comparing the ratio calculations across the two scenarios. In Scenario C, ROE increases to 61% at the time of thetransaction and another 10% is received in year 1. There is no leverage and ROA is reasonable. The rm has discretion overthe timing of the transaction, hence when the gain will be recorded, as well as over the discount rate, and other assumptions,and hence the size of the reported gain. A rm that continues to grow (and undertakes more securitizations) will showcontinued securitization gains, but if growth slows, earnings will decline (as in years 2 and 3).

Scenarios B and C highlight the off-balance sheet nature of the receivables and debt. Landsman et al. (2008) suggest thatinvestors treat securitizations as loans rather than sales. Niu and Richardson (2006) show that the off-balance sheet debtfrom securitizations has, on average, the same risk-relevance for explaining the capital asset pricing model beta as on-balance sheet debt, that securitization gains are perceived as less reliable than other earnings components for valuation,and that gains are less reliable when rms engage in more off-balance sheet securitizations. Our discussions with debtrating agencies also suggest that in evaluating ABCs risk, rating agencies would consolidate the SPE. However, requireddisclosures during our sample period do not provide sufcient information to reconsolidate the receivables and loans, andare therefore not sufcient to undo the accounting. Given the front-loading nature of gains as well as their inherentuncertainty, we test whether directors, acting in the interest of shareholders, place less weight on securitization gainswhen compensating management.

3. Predictions

We predict that mangers have incentives to report securitization gains when earnings are low or negative. As pre-securitization income rises, there is less incentive to securitize assets in the current year, or if a securitization is undertakento generate cash ow, to report a gain. Managing the assumptions to report a gain is costly because in future years,optimistic assumptions will have to be reversed with the adjustment being reported in income.13 Thus, we predict anegative relation between the size of the gain and pre-securitization earnings.

P1. Discretionary gains are larger in rms with low pre-securitization income.

We also predict that rms have stronger incentives to boost discretionary gains when pre-managed earnings fall short ofprior year earnings and to record discretionary losses when pre-managed earnings exceed prior year earnings.

P2. Discretionary gains are larger in rms that have more negative changes in their pre-securitization earnings.

An alternative approach to investigating the effect of managements incentive to boost or smooth earnings is to analyzeanalyst forecast errors. Research suggests that managers face incentives to meet or just beat analyst forecasts (e.g.,Degeorge et al., 1999; Burgstahler and Eames, 2006) but we do not use forecast errors because of problems withmeasurement error and interpretation.14

We also investigate the relation between the discount rates and the size of the gain. Scenario C reveals, ceteris paribus,that a lower discount rate increases the size of the securitization gain (i.e., a negative relation between the size of the gainand the discount rate). However, if managers face upper and lower bounds on their bonus contracts (e.g., Healy, 1985), theycould desire to reduce the size of large gains and increase the size of large losses. This would result in a positive relationbetween discount rates and extreme gains and losses. In addition, economic factors are likely to inuence discount ratechoice and nancial statement disclosures of discount rates are noisy. Therefore, the relation between discount rates andgains is contextual and so our tests are descriptive in nature.

P3. Managers use their discretion over discount rates to obtain the desired gain or loss from securitization.

13 Any subsequent adjustments to the reported gain would show up as a change in the value of the retained interest which is typically classied as an

available for sale security. Thus, for most rms, this change would be reported as a component of other comprehensive income rather affecting net

income.14 First, we do not have clear predictions on the sign of discretionary gains for rms that just meet or beat expectations since rms can meet by

managing the gain up or down depending on pre-managed earnings, and small sample sizes make developing powerful tests difcult. Second, we do not

know whether analysts include forecasted gains in their earnings forecasts. If they correctly forecast gains or losses (including any earnings management

of the gain), then we will mechanically nd a negative relation between the size of the gain and forecast errors (where forecast errors are calculated as

actual pre-managed earnings less the forecast) since our measure of actual pre-managed earnings will be too low for rms with gains and too high for

rms with losses.

Under P3, we implicitly assume that all sample rms other than those reporting a zero income effect are managingsecuritization gains/losses.15

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 22510If directors understand that gains are highly discretionary and that their realization depends on future outcomes,they could place less weight on gains than on other earnings components when compensating executives.

P4. CEO pay is less sensitive to securitization gains than to other earnings components.

However, the extent to which boards intervene in determining CEO pay likely depends on their power relative to the CEO,their accounting knowledge, and their level of independence. Therefore, we test whether boards that appear to be strongerwith respect to the above characteristics intervene to a greater extent. Alternatively, directors could inuence the size ofthe gains by questioning accounting choices. Thus, we could observe smaller gains and less income smoothing in rmswith more informed or more independent directors.

P5. CEO pay is less sensitive to securitization gains than to other earnings components when the rm has more informedor more independent directors.

4. Sample selection and earnings management results

4.1. Sample section and descriptive statistics

We used Edgar to search the 10-K lings of all rms ling with the SEC (other than quasi-government agencies such asFreddie Mac and Fannie Mae) from September 2000 through December 2005. SFAS No. 140 became effective in September2000 and requires detailed disclosures about securitizations. We read each 10-K and required sample rms to disclosegains, proceeds from securitizations in the year, the fair value of retained interest, and adverse changes at the year-end.We collected additional nancial statement data from Compustat or directly from rm nancial statements when the datawere unavailable from Compustat. Finally, we collected annual returns from the Center for Research in Security Pricesmonthly les. This yielded a sample of 305 rm-year observations, representing 96 rms that report securitization gains.Combined, these rms average $1 trillion in securitizations annually. We performed regression analyses using themaximum number of observations available.

Table 1 describes the industry composition and the size of the recognized gains for our sample. Not surprisingly,nancial institutions make up the largest portion, with the top ve (4-digit SIC code) industries being nancial institutions(SIC codes 6020, 6141, 6162, 6035, and 6199). However, approximately 41 percent of sample rms are from other industrieswhere rms securitize a range of nancial assets including store credit cards (e.g., SIC codes 5311 and 5621) andautomobile loans and leases (e.g., SIC codes 3711 and 5500).

In our tests, we scale the gain by the book value of prior year equity (which is positive for all sample observations)because our objective is to examine the economic importance of the gains effect on income. We do not deate by revenuebecause revenue is difcult to identify for nancial institutions. In addition, for these institutions, equity is a moremeaningful measure of capital than assets because assets under management can be very large. The average magnitude ofthe securitization gains varies widelyfrom a loss of 1.4 percent to a gain of 52.3 percent of equity. In our sample,76 percent of rm-years report securitization gains, 9 percent report no gain or loss, and 15 percent report losses.

Table 2, Panel A provides descriptive statistics on the gain divided by prior year equity and for the economicdeterminants of securitization gains. The mean (median) gain is 10 (1) percent of equity. Pre-securitization earnings aredened as earnings before the gain and the change in pre-securitization earnings is the difference in pre-securitizationearnings from the current year to the previous year, scaled by prior year equity. Earnings are bottom-line net income fromthe 10-K.

We use two measures of the managed or discretionary component of the gain. Concept Statement No. 7 and letterscommenting on the accounting for securitizations suggest that gains should be rare. Therefore, our rst measure assumesthat the entire securitization gain is discretionary. Our second measure assumes that the gain reects the spread betweenthe rms cost of capital and the interest rate charged to customers. We therefore expect the gain to vary with economicdeterminants such as the industry in which the rm operates (Indust_Gain), the discount rate used (Discount_Rate), theunderlying receivable volatility (Adverse_Change/RI and MKt_Vol), and the extent to which securitizations dominate theircash ow generation and business model (Pre_Sec_FCF and Segment). Appendix A provides details on the motivation andcalculations of control variables.

The average industry gain is approximately 5 percent of equity. The adverse change averages 13 percent of retainedinterest, implying that for a 20 percent change in a key assumption (e.g., the discount rate), retained interest changes by 13percent. The average discount rate is 11.78%. Segment is an indicator for whether the rm has more than one segment; 87percent of rms have more than one segment. Regulate is an indicator set equal to one for rms in SIC codes 6020, 6035 or6036; 36 percent of observations are in regulated industries.

15 Our private discussions with investment bankers and accountants who structure securitization deals provide anecdotal support for the use of

discount rates as a dependent variable. These practitioners stated that discount rates are selected after determining the desired size of the gain.

ARTICLE IN PRESS

Table 1Industry frequency by rm-year observations.

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 225 11SIC code SIC name N Frequency (%) Gain/prior equity

6020 National Commercial Banks 92 30.16 0.011

6141 Personal Credit Institutions 24 7.87 0.413

6162 Mortgage Bankers and Loan Correspondents 17 5.57 0.523

6035 Savings Institutions, Federally Chartered 14 4.59 0.032

6199 FinanceServices 14 4.59 0.068

6798 Real Estate Investment Trusts 14 4.59 0.205

3711 Motor Vehicles and Passenger Car Bodies 13 4.26 0.041

5311 Department Stores 9 2.95 0.004

6211 Security Brokers, Dealers, and Flotation Companies 9 2.95 0.005

2086 Bottled and Canned Soft Drinks and Carbonated Waters 6 1.97 0.0023523 Farm Machinery and Equipment 6 1.97 0.0113721 Aircraft 6 1.97 0.011

6111 Federal and Federally Sponsored Credit Agencies 6 1.97 0.154

9997 Conglomerates 6 1.97 0.015

2631 Paperboard Mills 5 1.64 0.0053751 Motorcycles, Bicycles, and Parts 5 1.64 0.031

5063 Electrical Apparatus and Equipment, Wiring Supplies 5 1.64 0.0207510 Auto Rent and Lease, No drivers 5 1.64 0.097

3531 Construction Machinery and Equipment 4 1.31 0.001Table 2, Panel B presents correlations. As expected, the gain is positively correlated with the industry gain and withmarket volatility. We also observe a positive correlation with the discount rate. The reason that we do not observe anegative correlation could be because assumptions concerning prepayment rates, default rates, and cash ow duration alsoaffect the size of the gain and we do not have information on these variables. In addition, economic factors are also likely toinuence discount rates. We nd a positive correlation between discount rates and Indust_Gain (0.23) and measures ofrisk: Adverse_Change/RI (0.19) and Mkt_Vol (0.11). We provide a more detailed analysis of discount rates and securitizationgains later in the paper. As expected, both measures of the importance of securitization activity (Pre_Sec_FCF and Segment)are negatively correlated with the gain.

4.2. Earnings management

Table 3 examines the relation between securitization gains and incentives to manage earnings. We control forheteroskedasticity and possible correlation of the residuals within rm clusters using Rogers standard errors (Petersen,2009).16 Panel A reports results when the independent variable is pre-securitization earnings. Consistent with ourprediction, the coefcient on pre-securitization earnings is negative. Specically, regression (1), which assumes that theentire gain is managed, supports this prediction. Regressions (2) through (5) include various controls intended to isolate

3714 Motor Vehicle Parts and Accessories 4 1.31 0.0065500 Auto Dealers, Gas Stations 4 1.31 0.046

5731 Radio, Television, and Consumer Electronic Stores 4 1.31 0.056

6036 Savings Institutions, Not Federally Chartered 4 1.31 0.110

6172 Finance Lessors 4 1.31 0.256

7200 Personal Services 4 1.31 0.223

2451 Mobile Homes 2 0.66 0.017

3842 Orthopedic, Prosthetic, and Surgical Appliances and Supplies 2 0.66 0.0094911 Electric Services 2 0.66 0.008

5065 Electronics Parts and Equipment, Not Elsewhere Classied 2 0.66 0.0035621 Womens Clothing Stores 2 0.66 0.031

6311 Life Insurance 2 0.66 0.000

6799 Investors, NEC 2 0.66 0.042

7374 Computer Processing and Data Preparation and Processing Services 2 0.66 0.006

3823 Industrial Instruments for Measurement, Display and Control of Process Variables 1 0.33 0.0145070 Hardware, Plumbing, Heating Equipment Wholesale 1 0.33 0.014

5812 Eating Places 1 0.33 0.000

6153 Short-term Business Credit Institutions, Except Agricultural 1 0.33 0.006

6531 Real Estate Agents and Managers 1 0.33 0.109

305 100%

16 We rerun our analyses controlling for heteroskedasticity and possible correlation of the residuals within rm and year clusters. The results are

qualitatively the same. In some cases the corrected t-statistics are stronger than those reported so our inferences remained unchanged.

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 22512Table 2Descriptive statistics and correlations.

Panel A: Descriptive statistics

N Mean Median Std. dev. 25% 75% Min. Max.

Gain 305 0.10 0.01 0.31 0.0005 0.04 0.25 2.76the discretionary component of the gain; again, the coefcient on pre-securitization earnings is negative. In all models,we include the industry gain and then add various proxies for volatility, discount rates, and securitization volume, and in allmodels, the negative relation between securitization gains and pre-securitization earnings holds.

Panel B presents results using the change in pre-securitization earnings as the incentive to manage earnings. There arefewer observations because our time-series is relatively short and we require that sample rms have securitized assets.Consistent with prediction P2, the coefcient on the change in pre-securitization earnings is negative. This relation issignicant in regression (1), where we assume that the entire gain is managed, and across regressions (2) through (5),

Pre-securitization earnings 305 0.05 0.13 0.40 0.03 0.19 3.01 1.15Earnings 305 0.15 0.16 0.24 0.09 0.22 2.65 1.14Change in pre-securitization earnings 209 0.00 0.0002 0.19 0.05 0.04 0.71 1.21ControlsIndust_Gain 305 0.05 0.005 0.11 0.002 0.06 0.04 0.48Adverse_Change/RI 293 0.13 0.07 0.20 0.03 0.13 0.00 1.02

Mkt_Vol 305 0.09 0.08 0.06 0.06 0.11 0.02 0.46

Discount_Rate 284 11.78 11.62 5.33 9.05 14.26 0.00 34.90

Pre_Sec_FCF 296 4.57 1.26 9.69 3.49 0.28 74.06 2.97Segment 305 0.87 1.00 0.34 1 1 0 1

Asset 305 130,427 24,304 250,991 3530 94,456 97 1,494,040

Regulate 305 0.36 0 0.48 0 1 0 1

Panel B: Correlations

(1) (2) (3) (4) (5) (6) (7) (8) (9) (10) (11)

Gain 0.80 0.07 0.34 0.50 0.03 0.39 0.17 0.49 0.01 0.12 0.19305 305 209 305 293 305 284 296 305 305 305

Pre-securitization earnings (1) 0.65 0.51 0.34 0.08 0.46 0.11 0.31 0.03 0.13 0.18305 209 305 293 305 284 296 305 305 305

Earnings (2) 0.41 0.06 0.10 0.26 0.04 0.11 0.04 0.07 0.06209 305 293 305 284 296 305 305 305

Change in pre-securitization earnings (3) 0.17 0.12 0.09 0.10 0.10 0.04 0.03 0.02209 202 209 198 205 209 209 209

ControlsIndust_Gain (4) 0.07 0.21 0.23 0.44 0.01 0.09 0.36

293 305 284 296 305 305 305Adverse_Change/RI (5) 0.11 0.19 0.03 0.20 0.04 0.06

293 277 286 293 293 293Mkt_Vol (6) 0.11 0.09 0.15 0.30 0.27

284 296 305 305 305Discount_Rate (7) 0.25 0.00 0.18 0.00

279 284 284 284Pre_Sec_FCF (8) 0.01 0.09 0.18

296 296 296Segment (9) 0.14 0.18

305 305Asset (10) 0.12

305Regulate (11)

Notes: Each cell in panel B contains the correlation and number of observations for the sample period September 2000 through December 2005. Bolded

cells are signicant at 10 percent or higher. Gain is dened as securitization gains (from the 10-K lings) divided by prior year equity (Compustat item 60);

Earnings is net income scaled by prior year equity; Pre-securitization earnings is earnings before the gain scaled by prior year equity; Change in pre-

securitization earnings is pre-securitization earnings for the year less pre-securitization earnings from the prior year, divided by prior year equity.

Indust_Gain is dened as the median level of securitization gains deated by equity in the industry by year, where industries are dened at the 2-digit SIC

code level; for industries with fewer than ve observations, the median is set to zero; Adverse_Change/RI is dened as Adverse_Change divided by

retained interest (from the 10-K lings); Mkt_Vol is dened as the idiosyncratic standard deviation of each rms stock returns; each rms annual

volatility is calculated by regressing the monthly returns in year t1 on the value-weighted NYSE/AMEX index monthly returns for the same year andtaking the standard deviation of the residuals of this regression; Discount_Rate is from the 10-K lings; Pre_Sec_FCF is cash from operations (Compustat

item 308 ) plus cash from investing (Compustat item 311) minus the proceeds from the securitization (from the 10-K lings) deated by prior year equity;

Segment equals one for rms with more than one segment, zero otherwise; Assets is total assets (Compustat item); Regulate equals one for rms in SIC

codes 6020, 6035, and 6036.

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 225 13Table 3Regressions examining the relation between securitization gains and earnings performance.

Panel A: Relation between securitization gains and earnings levels

Securitization Gain=a1b1 Pre-securitization earningsbi Controlsewhich include various controls so that only a portion of the gain is assumed to be discretionary. Thus, the results in Table 3are uniformly consistent with managers using the discretion allowed under fair value accounting to report securitizationgains to manage earnings.

Fig. 2 graphs the impact of reported securitization gains on earnings. For 8 percent of sample observations, income isnegative after the gain, for 13 percent, income switches from negative to positive, and 13 percent of observations report a

Dependent variable is: Securitization Gain Predicted sign (1) (2) (3) (4) (5)

Intercept 0.13 0.05 0.06 0.09 0.08(9.70) (1.80) (3.32) (3.20) (6.54)

Pre-securitization earnings 0.61 0.51 0.52 0.55 0.52(12.42) (10.78) (10.37) (12.24) (10.80)

ControlsIndust_Gain 0.50 0.50 0.75 0.52

(2.65) (2.63) (3.66) (2.67)Adverse_Change/RI 0.08 0.08

(1.49) (1.67)Mkt_Vol 0.21

(0.74)

Discount_Rate 0.003(0.16)

Pre_Sec_FCF 0.01 0.01 0.01(3.02) (2.63) (2.82)

Segment 0.002(0.06)

Number of observations 305 296 279 293 286

Adjusted R2 0.6438 0.7348 0.7304 0.7002 0.7357

Panel B: Relation between securitization gains and earnings changes

Securitization Gain=a1b1DPre-securitization earningsbi Controlse

Dependent variable: Securitization Gain Predicted sign (1) (2) (3) (4) (5)

Intercept 0.11 0.15 0.001 0.08 0.01(3.28) (2.33) (0.04) (1.00) (0.70)

Change in pre-securitization earnings 0.57 0.38 0.42 0.45 0.42(1.66) (1.90) (1.57) (1.66) (1.60)

ControlsIndust_Gain 0.72 0.91 1.29 0.93

(2.26) (2.18) (3.00) (2.23)Adverse_Change/RI 0.17 0.12

(1.21) (0.98)Mkt_Vol 1.80

(2.34)Discount_Rate 0.0001

(0.03)Pre_Sec_FCF 0.01 0.01 0.01

(2.91) (2.47) (2.66)Segment 0.05

(0.54)Number of observations 209 205 196 202 199

Adjusted R2 0.1092 0.4985 0.3995 0.3246 0.4020

Notes: T-statistics for two-tailed tests are in parentheses. We control for heteroskedasticity and possible correlation of the residuals within rm clusters

using Rogers standard errors (Petersen, 2009). Gain is dened as securitization gains (from the 10-K lings) divided by prior year equity (Compustat item

60); Earnings is net income scaled by prior year equity; Pre-securitization earnings is earnings before the gain scaled by prior year equity; Indust_Gain is

dened as the median level of securitization gains deated by equity in the industry by year, where industries are dened at the 2-digit SIC code level (for

industries with fewer than ve observations, the median is set to zero); Adverse_Change/RI is dened as Adverse_Change divided by retained interest

(from the 10-K lings); Mkt_Vol is dened as the idiosyncratic standard deviation of each rms stock returns; each rms annual volatility is calculated

by regressing the monthly returns in year t1 on the value-weighted NYSE/AMEX index monthly returns for the same year and taking the standarddeviation of the residuals of this regression; Discount_Rate is from the 10-K lings; Pre_Sec_FCF is cash from operations (Compustat item 308 ) plus cash

from investing (Compustat item 311) minus the proceeds from the securitization (from the 10-K lings) deated by prior year equity; Segment equals one

for rms with more than one segment, zero otherwise.

ARTICLE IN PRESS

26%

30%

pre s f

ro lo

ssSe

cun g

a

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 22514 is ne

gativ

e

ome s

witch

e

ecuri

tizati

on

Secu

ritiza

tio8%

13% 13%

8%10%

7%

5%

1% 2% 1% 1% 2%0% 0%

1% 0% 1%

0%

5%

10%

15%

20%

25%

and p

ost s

ecuri

tizati

on

m ne

gativ

e to p

ositiv

e

es bu

t pos

itive i

ncom

e

ritiza

tion i

mpac

t is 0%

in 0%

to 5%

of in

come

5% to

10%

10%

to 20

%

20%

to 30

%

30%

to 40

%

40%

to 50

%

50%

to 75

%

75%

to 10

0%

100%

to 15

0%

150%

to 20

0%

200%

to 30

0%

300%

to 40

0%

400%

to 50

0%

Grea

ter th

an 50

0%

Perc

ent o

f Firm

-yea

rssecuritization loss. The mean (median) impact of the gain on earnings is a 38 (3) percent increase, suggesting that for manyrms, the gain materially affects reported earnings.

4.3. Management discretion and discount rate choice

Recall from Exhibit 1, all else equal, lower discount rates should be associated with larger gains (or smaller losses).However, discount rates are affected by economic factors as well as by management discretion. In Table 4, we analyze therelation between securitization gains and discount rates. We assume that managers know the gain they would like toreport and select discount rates to achieve that goal. However, discount rates are also affected be economic factors and weattempt to control for some of these factors in our regression analysis.

Table 4, Panel A reports the average discount rate (11.78%). However, for the securitization loss observations (41 rm-years), the discount rate is 8.68%, while for gain observations (243 rm-years), it is 12.38%. Had loss rms used a 12%discount rate, reported losses would have been unconditionally larger. We separately report correlations between discountrates for gain and loss observations. There is a strong negative correlation (r=0.49) for loss rms, suggesting that rmsthat report large losses use higher discount rates. However, we observe a positive correlation between discount rates andgains (r=0.29), suggesting that rms that report large gains also use higher discount rates. These correlations are conrmedin Panel B, where we control for other factors that can affect discount rate selection.

We provide further analyses of gain and loss observations in Figs. 3a and b, respectively. In Fig. 3a, 17 percent ofobservations (7 rm-years) use a discount rate of zero. This discount rate will minimize reported losses.17 Another 17percent of the loss sample use a discount rate of less than 5%, and a few rms (11 percent of the sample) use very high ratesof 18% or greater. In contrast, Fig. 3b reveals that very few rms reporting a gain use discount rates of less than 5% (3percent of observations). Interestingly, 33 percent of the gain sample use either a 10% or 12% rate. These rates are the onescommonly used in accounting classes, but there is no a priori reason why they should theoretically be over-represented inthe securitization population. Fig. 3b also reveals that 12 percent of gain observations use discount rates of 18% or greater.

Incom

eInc S

Securitization gains as a percent of pre-securitization earnings

Fig. 2. The distribution of the impact of reported securitization gains on earnings. N=305 rm-year observations.

17 Pepsico was one of the rms reporting a zero discount rate. Managers justied the choice on the basis that the cash ows would be received within

1 year. However, since short-term debt typically pays interest, this justication does not seem appropriate.

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 225 15Table 4Securitization assumptions and reported gains and losses.

Panel A: Average discount rate and correlation of the discount rate with the securitization income effectAll rms Securitization

loss rms

Securitization

gain rms

Average discount rate (%) 11.78 8.68 12.38These rms also tend to report large gains. Overall, Figs. 3a and b reveal that rms using high discount rates (18% or higher)report large losses or large gains. These high discount rates will magnify losses and minimize gains. This is suggestive ofincentives created by upper and lower bounds in earnings-based bonus plans (e.g., Healy, 1985). However, a lack ofcompensation disclosures limits our ability to analyze extreme gains or losses.

In Table 4, Panel C we provide further evidence suggesting that assumptions underlying securitizations are used tomanage reported gains. We analyzed all rms that led a restatement with the SEC from 2002 through 2006 where thereason for the ling was related to accounting for asset securitizations under SFAS 140. We identied 25 such restatement

Correlation between discount rate and securitization loss or gain (p-value) 0.17 0.49 0.29(0.004) (0.001) (0.001)

Observations 284 41 243

Panel B: Relation between the discount rate on securitizations and gains from securitization

Discount rate=ab1 Loss Indicatorb2 Securitization Gainb3 Securitization Gain Loss Indicatorbi Controlse

(Regression)

Independent variable

(1)

Discount_Rate

(2)

Discount_Rate

Intercept 12.01 10.33(26.39) (9.71)

Loss indicator 5.21 4.47(2.94) (2.71)

Securitization Gain 2.57 2.40

(1.38) (1.19)

Securitization Gain Loss Indicator 65.41 57.81(5.52) (4.73)

ControlsAdverse_Change/RI 3.81

(2.43)Mkt_Vol 6.27

(0.75)

Assets 0.00(1.77)

Regulate 0.01(0.01)

F-test(p-values)

Loss IndicatorSecuritization Gain Loss Indicator=0 22.80 16.91(0.001) (0.001)

Number of observations 284 277

Adjusted R2 0.1323 0.1725

Panel C: Firms ling restatements with the SEC that relate to SFAS 140 and asset securitizations from 2002 through 2006

Number of rms where the restatement results in changes to reported gains 18Restatements due to changes in assumptions on fair value of retained interest 9

Restatements due to piercing of the legal structure of the SPE 8

Restatement disclosures that are ambiguous about the reason for the change 1

Number of rms where the income effect is not disclosed 7Restatements involving changes in cash ow classications 4

Restatements involving changes in balance sheet classications 1

Restatements involving other features (call options and borrowings) 2

Total number of restating rms 25

Notes: T-statistics for two-tailed tests are in parentheses. For F-tests, two-tailed p-values are in parentheses. We control for heteroskedasticity and possible

correlation of the residuals within rm clusters using Rogers standard errors (Petersen, 2009). Discount_Rate is from the 10-K lings; Securitization Gain

is gains from securitization deated by prior year equity; Adverse_Change/RI is dened as Adverse_Change divided by retained interest (from the 10-K

lings); Mkt_Vol is dened as the idiosyncratic standard deviation of each rms stock returns; each rms annual volatility is calculated by regressing the

monthly returns in year t1 on the value-weighted NYSE/AMEX index monthly returns for the same year and taking the standard deviation of theresiduals of this regression; Asset is total assets; Regulate equals one for rms in SIC codes 6020, 6035 and 6036.

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 2251617%

14%

16%

18% -0.20

-0.18

-0.16

Percent of FirmsAve. Loss/Equityrms, and found that 18 rms (72 percent) restated earnings to report lower gains. Thus, misstatements related tosecuritization accounting tend to increase income. Nine of these 18 rms directly state that the restatement involved achange in assumptions concerning the calculation of the fair value of the retained interest, 1 rms disclosures wereambiguous about the cause of the restatement, and the remaining 8 appeared to have set up the qualifying SPE incorrectly,and so had not met the Financial Accounting Standards Boards requirements for derecognition. These rms should havereported no gains and kept the asset and liabilities on their books. The remaining seven restating rms did not disclose themisstatements income effect but reported balance sheet and cash ow reclassication issues.

0%

2%

5%

10%

5%

0%

7%

12%

2%

10%

2%

5%

0%0%

2%

7%

0%

2%

4%

6%

8%

10%

12%

Discount Rate

Perc

ent o

f Firm

s

-0.14

-0.12

-0.10

-0.08

-0.06

-0.04

-0.02

0.00

Loss

/Equ

ity

0%1%

2%

3%

2%

5%4%

4%

16%

9%

17%

6%5%

7%

4%

2%2%

2%

8%

0%

2%

4%

6%

8%

10%

12%

14%

16%

18%

20%

0Discount rate

Perc

ent o

f Firm

s

00.020.040.060.080.10.120.140.160.180.20.220.240.260.280.3

Gai

n/Eq

uity

Percent of Firms Ave. Gain/Equity

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 >=20

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 >=20

2% 2%

5%

2%

0% 0%

Fig. 3. Distribution of disclosed discount rates. (a) Discount rates for 41 observations reporting losses from securitizations. The histogram reports theproportion of observations reporting each discount rate and the line graph reports the average securitization loss scaled by equity for rms reporting a

given discount rate. The average discount rate is 8.68 percent, and the average securitization loss is 2.8 percent of equity. (b) Discount rates for 243observations reporting securitization gains. The histogram reports the proportion of observations reporting each discount rate and the line graph reports

the average gain from securitization scaled by equity for rms reporting a given discount rate. The average discount rate is 12.38 percent, and the average

securitization gain is 12 percent of equity. Note: Gain/equity is truncated at 0.31 for the 13 percent discount rate. (The actual value is 0.64.)

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 225 17Table 5Tests examining the relation between CEO compensation and gains from securitization.

Panel A: Descriptive statistics

N Mean Median Std. dev. 25% 75% Min. Max.

TotComp 305 10.08 5.99 14.47 2.38 13.83 0.024 176

Log TotComp 305 15.42 15.60 1.47 14.68 16.44 3.20 18.99

Annual_Return 303 0.16 0.08 0.54 0.10 0.29 0.94 3.96

Panel B: Regression of the sensitivity of total compensation to earnings and securitization gains

(Regression)

Independent variable

Predicted sign (1)

Log TotComp

(2)

Log TotComp

(3)

Log TotComp

(4)

Log TotComp

Intercept ? 15.22 10.76 15.29 10.71(110.80) (18.98) (105.64) (17.54)

Earnings 1.37 0.51(3.41) (2.51)

Securitization Gain 0.73 0.66(1.52) (2.33)

Pre-securitization earnings 1.31 0.51(3.06) (2.61)

ControlsLog of Asset 0.48 0.48

(8.58) (8.26)Regulate ? 0.43 0.42

(2.73) (2.67)5. The sensitivity of CEO compensation to reported securitization gains

We next test whether securitization gains are treated as regular income or whether compensation committeesplace less weight on this earnings component. In tabulated regressions, we assume that the entire gain is discretionary.Our results (untabulated) are similar when we add the control variables.

We hand-collect CEO compensation variables directly from rm proxy statements for all observations becausecompensation and governance data are unavailable from machine-readable databases for a large portion of our sample.We measure total compensation as the sum of the option grant value and annual compensation (i.e., salary and bonus) andall other compensation, obtained from the Summary Compensation Table. Table 5, Panel A provides descriptive statistics onthis measure and on annual returns (a control variable in our regressions). Total compensation averages $10.08 million.The dependent measure is the log of total compensation (as in Perry and Zenner, 2001; Engel et al., 2002; Hall and Murphy,2002; Harford and Li, 2007; Core et al., 2008, among others). We control for heteroskedasticity and possible correlation ofthe residuals within-rm clusters using Rogers standard errors (Petersen, 2009). We also control for whether the rm is ina regulated industry (but make no prediction about its effect on compensation) and for stock price performance (which wepredict to have a positive relation with compensation).

Panel B presents the results for the following regressions:

LogTotComp a b1 Earnings e 1

LogTotComp a b1 Earnings controls e 2

LogTotComp a g1 Securitization Gain g2 Pre-securitization earnings e 3

LogTotComp a g1 Securitization Gain g2 Pre-securitization earnings gi controls e 4

Annual_Return 0.14 0.14(1.81) (1.75)

F-testGain=Pre-securitization earnings 4.90 0.46

(0.03) (0.50)Number of observations 305 303 305 303

Adjusted R2 0.0474 0.5107 0.0595 0.5098

Notes: T-statistics for two-tailed tests are in parentheses. For F-tests, two-tailed p-values are in parentheses. We control for heteroskedasticity and possible

correlation of the residuals within rm clusters using Rogers standard errors (Petersen, 2009). TotComp is total compensation and consists of salary,

bonus, and equity compensation as reported in the rms proxy statement for the year that corresponds to the scal year of reported earnings; Log is the

natural log; Earnings is net income deated by prior year equity; Gain is gains from securitization deated by prior year equity; Pre-securitization

earnings is net income before gains from securitization deated by prior year equity; Securitization GainGain is total assets; Regulate equals one for rms

in SIC codes 6020, 6035 and 6036; Annual_Return is the compounded monthly return for the scal year, if a month return is missing it is set equal to the

value weighted market return.

We scale earnings-related measures by book value of equity in the prior year because ROE is a common performancetarget in the nancial industry (which comprises a signicant portion of our sample) and because it is a preferable measureto ROA in our setting due to the large variation in asset composition and leverage across sample industries. We includeassets to control for compensation related to rm size.

Regression (1) indicates that CEO compensation is positively associated with earnings (b1=1.37). Regression (2) showsthat the compensation sensitivity to earnings holds controlling for size (Log of Assets), whether the rm is regulated

18

Tbegovthe

(a)

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 22518(d) The proportion of directors who joined the board before the CEO took ofce: Directors who joined the board under thecurrent CEO are likely to have views and opinions which are more in line with those of the CEO, making directors whojoined before the CEO likely to be more independent (Wade et al., 1990; Boeker, 1992; Zajac and Westphal, 1995;Shivdasani and Yermack, 1999; Adams et al., 2005).21 Elected before CEO Indicator equals one when more than one halfof the directors were already board members when the CEO took ofce, and zero otherwise.

Table 6, Panel A provides descriptive statistics. Fifty (63) percent of sample observations have a nancial expert on thecompensation (audit) committee. The average board has 12 members and of these, 82 percent are outsiders, 11 percent arefemale, and 63 percent were directors before the current CEO took ofce, on average.

Panel B provides correlations. Note that Panel A reveals that there is little variability in the proportion of outsiders sinceeven at the lower quartile of the distribution, outsiders comprise approximately 77 percent of the board and the median isapproximately 86 percent. Therefore, we form an indicator for boards in the upper quartile since these should be moreindependent, and so more likely to intervene. Unconditionally, securitization gains are negatively associated with the log oftotal compensation. However, earnings are positively associated with total compensation, and pre-securitization earningsare negatively associated with securitization gains. Therefore, to examine the relation between securitization gains andcompensation, we must control for earnings. The existence of a nancial expert on the compensation committee ispositively correlated with the gain (r=0.23) but a nancial expert on the audit committee has no relation to the gain. Gainsare smaller when more than 90 percent of directors are outsiders (r=0.17), when a female sits on the board (r=0.27),and when more than half of the directors were elected before the CEO took ofce (r=0.21).

18 Our inferences remained unchanged using earnings before taxes.19 Our denition differs from that in the Sarbanes-Oxley Act of 2002 because we posit that understanding securitizations requires a strong nancial

background, and so a director should be considered to have nancial expertise only if (s)he is likely to understand securitizations and their effect on the

nancial reports.20 Also see Casting a wider net in The Wall Street Journal, June 21, 2004.21 This variable has a correlation with CEO tenure (number of years as CEO) of 0.68, consistent with CEOs with longer tenures appointing more

directors and so likely having more power over boards.Existence of a female director: Female directors are more likely viewed as outsiders so are more likely to question theCEO (Kesner, 1988; Bilimoria and Piderit, 1994; Talmud and Izraeli, 1999; Hillman et al., 2002; Adams and Ferreira,2004).20 Female Indicator equals one when there is a female director on the board, zero otherwise.(c)The proportion of non-executive directors: Outside directors generally face fewer conicts of interest in monitoring theCEO (Beasley, 1996; Dechow et al., 1996; Klein, 2002). Outside Directors Indicator equals one when more than 90 percentof the board are outsiders (where this is the upper quartile of the % Outside Director distribution), and zero otherwise.(b)Financial expertise of the compensation or audit committee: We consider directors with backgrounds in nance orbanking to be nancial experts (DeFond et al., 2004).19proxhe results in Table 5 suggest that compensation is sensitive to reported securitization gains and these gains appear totreated as a regular earnings component. However, the sensitivity of CEO compensation to the gain may vary withernance structures. In addition, more informed or more independent directors may intervene and inuence the size ofreported gain. Thus, we examine the effect of the following governance characteristics using information from rmy statements.(Regulate), and stock price performance over the prior scal year (Annual_Return).We next examine the compensationweight placed on earnings components. A zero coefcient on the securitization gain

implies that the compensation committee ignores these gains when setting compensation, a coefcient equal to thecoefcient on pre-securitization earnings implies that the committee treats the gain like any other earnings component,and a coefcient greater than zero and less than the coefcient on pre-securitization earnings implies that the committeeplaces less weight on the gain, possibly due to reliability concerns.

In regression (3), which decomposes earnings but excludes the control variables, the gain receives signicantly lower,but still positive, weight relative to other earnings components. In regression (4), where we include control variables, thecoefcient on the gain is 0.66 and the coefcient on pre-securitization earnings is 0.51. An F-test indicates that we cannotreject that the two coefcients are equal. Thus, in contrast to regression (3), regression (4) indicates that compensation is assensitive to securitization gains as to other earnings components.

6. The role of corporate governance

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 225 19Table 6Descriptive statistics and correlations.

Panel A: Descriptive statistics

N Mean Median Std. dev. Lower quartile Upper quartile Min. Max.

Financial Expert on Compensation Committee 303 0.50 0 0.50 0 1 0 1

Financial Expert on Audit Committee 303 0.63 1 0.48 0 1 0 1

% Outside Directors 303 82.4 85.71 10.77 76.92 90.91 40.00 95.45

% of Females on the Board of Directors 299 11.48 11.11 9.03 5.88 16.67 0.00 57.14

% of Directors elected before the CEO 291 62.94 68.18 28.95 50.00 87.50 0.00 100.00

Panel B: Pearson correlations (p-values in parentheses)Board characteristics can vary with rm characteristics, so in Table 7, we test whether governance plays a role aftercontrolling for other factors that affect the size of the gain.

In Table 7, Panel A, we present results for the following regression:

Securitization gain=ab1 Pre-securitization earningsb2 Corporate Governanceb3 Pre-securitization earnings*Corporate Governancebi controlse

Ceteris paribus, if better governed rms report lower securitization gains, then we expect b2 to be negative. If there isless smoothing in better governed rms, then we expect b3 to be positive and to offset the negative b1 coefcient. We usean F-test to determine whether b1b3=0; an insignicant F-statistic suggests that the governance mechanism eliminatessmoothing of the gain. Predictions in Panel B, which uses the change in pre-securitization earnings, are the same. For testsin Table 7, our nancial expertise variable depends on whether a nancial expert sits on the audit committee (rather than

Pre-

securitization

earnings

Change in Pre-

Securitization

Earnings

Earnings Log

TotComp

Financial

Expert

Compensation

Financial

Expert

Audit

Outside

Directors

Indicator

Female

Indicator

Elected

before CEO

Indicator

Gain 0.77 0.27 0.06 0.12 0.23 0.09 0.17 0.27 0.21(o0.0001) (o0.0001) (0.3110) (0.0406) (o0.0001) (0.1374) (0.0025) (o0.0001) (0.0002)

Pre-securitization

earnings

0.45 0.66 0.22 0.17 0.04 0.15 0.27 0.28(o0.0001) (o0.0001) (0.0001) (0.0030) (0.4648) (0.0102) (o0.0001) (o0.0001)

Change in Pre-

Securitization

Earnings

0.39 0.04 0.005 0.13 0.02 0.08 0.11(o0.0001) (0.5747) (0.9447) (0.0658) (0.7298) (0.2359) (0.1244)

Earnings 0.21 0.001 0.04 0.03 0.11 0.19

(0.0523) (0.0007)(0.0003) (0.9856) (0.5362) (0.6246)

Log TotComp 0.03 0.12 0.26 0.29 0.19(0.5599) (0.0347) (o0.0001) (o0.0001) (0.0009)

Financial Expert

Compensation

0.35 0.12 0.30 0.07(o0.0001) (0.0299) (o0.0001) (0.2397)

Financial Expert

Audit

0.09 0.22 0.01(0.1208) (0.0001) (0.8847)

Outside Directors

Indicator

0.24 0.04

(o0.0001) (0.5188)

Female Indicator 0.03

(0.6547)

Notes: Financial Expert Compensation equals one when there is a nancial expert on the compensation committee, zero otherwise; Financial Expert Audit

equals one when there is a nancial expert on the audit committee, zero otherwise; % Outside Directors is the percent of outside directors on the board;

Outside Director Indicator equals one when more than 90 percent of the board are outsiders (i.e., the observation is in the upper quartile of the

distribution); % of Females on the Board of Directors is the percent of females members on the board of directors; Female Indicator equals one if there is a

female on the board of directors, zero otherwise; % of Directors elected before the CEO takes ofce is the percent of directors on the board that were there

before the CEO was took ofce; Elected before CEO Indicator equals one if more than 50 percent of the board was elected before the CEO took ofce, zero

otherwise; TotComp is total compensation and consists of salary, bonus, and equity compensation as reported in the rms proxy statement for the year

that corresponds to the scal year of reported earnings; Log is the natural log; Earnings is net income deated by prior year equity; Gain is gains from

securitization deated by prior year equity; Pre-securitization earnings is net income before gains from securitization deated by prior year equity; Asset

is total assets.

ARTICLE IN PRESS

Table 7Tests Examining the relation between gains from securitization and corporate governance.

Panel A: Relation between securitizations gains and earnings and corporate governance

Securitization Gain=ab1 Pre-securitization earningsb2 Corporate Governanceb3 Pre-securitization earnings*Corporate Governancebi Controlse

(Regression)

Independent variable

Pred.

sign

(1)

Financial Expert on

Audit Committee

(2)

Outside Directors

Indicator

(3)

Female

Indicator

(4)

Elected

before CEO

Indicator

Intercept 0.09 0.08 0.05 0.07(4.26) (6.07) (1.92) (3.26)

Pre-securitization earnings 0.70 0.53 0.55 0.57(4.90) (11.32) (15.78) (14.92)

Corporate Governance 0.02 0.08 0.01 0.02(0.65) (5.99) (0.45) (1.05)

Pre-securitization*Corporate Governance 0.27 0.44 0.09 0.33(1.38) (6.94) (0.58) (3.83)

ControlsIndust_Gain 0.53 0.50 0.54 0.49

(2.61) (2.62) (2.79) (2.50)Adverse_Change/RI 0.08 0.09 0.06 0.08

(1.54) (1.95) (1.43) (1.58)Pre_Sec_FCF 0.01 0.01 0.01 0.01

(2.83) (2.78) (2.84) (2.61)F-testPre-securitization earningsPre-securitization *Corporate Governance=0

219.36 0.25 101.78 16.07

(o0.0001) (0.6182) (o0.0001) (o0.0001)

Number of observations 286 286 286 286

Adjusted R2 0.7624 0.7404 0.7372 0.7573

Panel B: Relation between securitizations gains and earnings changes and corporate governance

Securitization Gain=ab1DPre-securitization earningsb2 Corporate Governanceb3DPre-securitization earnings*Corporate Governancebi Controlse

(Regression) Pred.

sign

(1) (2) (3) (4)

Independent variable Financial Expert on

Audit Committee

Outside

Directors

Indicator

Female

Indicator

Elected before

CEO Indicator

Intercept 0.01 0.04 0.11 0.01(0.29) (1.67) (1.12) (0.67)

Change in pre-securitization earnings 0.81 0.48 0.86 1.12(1.38) (1.56) (1.30) (2.06)

Corporate Governance 0.02 0.07 0.10 0.10(0.65) (2.60) (1.01) (2.02)

Change in pre-securitization earnings *Corporate Governance 0.53 0.38 0.64 1.12(0.94) (1.20) (0.89) (2.04)

ControlsIndust_Gain 0.93 0.89 0.82 0.91

(2.16) (2.23) (2.27) (2.70)Adverse_Change/RI 0.14 0.13 0.12 0.14

(1.02) (1.03) (0.92) (1.15)Pre_Sec_FCF 0.01 0.01 0.01 0.01

(2.67) (2.59) (2.59) (2.41)F-testChange in pre-securitization earningsChange in pre-securitization earnings*Corporate Governance=0

6.11 0.15 4.05 0.00

(0.0143) (0.6944) (0.0456) (0.9606)

Number of observations 199 199 199 199

Adjusted R2 0.4161 0.4121 0.4389 0.5439

Notes: T-statistics for two-tailed tests are in parentheses. For F-tests, two-tailed p-values are in parentheses. We control for heteroskedasticity and possible

correlation of the residuals within rm clusters using Rogers standard errors (Petersen, 2009). Securitization Gain is gains from securitization deated by

prior year equity; Pre-securitization earnings is net income before gains from securitization deated by prior year equity; Financial Expert on Audit

Committee equals one when there is a nancial expert on the audit committee, zero otherwise; Outside Directors Indicator equals one when the

observation is in the upper quartile of the distribution, zero otherwise; Female Indictor equals one if there is a female on the board of directors, zero

otherwise; Elected before CEO indicator equals one if more than 50 percent of the board was elected before the CEO took ofce, zero otherwise.

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 22520

ARTIC

LEIN

PRESS

Table 8Tests examining the sensitivity of CEO compensation to gains from securitization and the inuence of corporate governance monitors.

Notes: T-statistics for two-tailed tests are in parentheses. For F-tests, two-tailed p-values are in parentheses. We control for heteroskedasticity and possible correlation of the residuals within rm clusters using

Rogers standard errors (Petersen, 2009). TotComp is total compensation and consists of salary, bonus, and equity compensation as reported in the rms proxy statement for the year that corresponds to the scal

year of reported earnings; Securitization Gain is gains from securitization deated by prior year equity; Pre-securitization earnings is net income before gains from securitization deated by prior year equity; Asset

is total assets; Regulate equals one for rms in SIC codes 6020, 6035 and 6036; Annual_Return is the compounded monthly return for the scal year, if a month return is missing it is set equal to the value weighted

market return.

P.M.Dech

ow

etal./JournalofAcco

untin

gandEconomics

49(2010)225

21

ARTICLE IN PRESS

P.M. Dechow et al. / Journal of Accounting and Economics 49 (2010) 22522Regressions (1) and (2) include only observations with and without a nancial expert on the compensation committee,respectively. We run separate regressions to facilitate interpretation of the relative weights on the gain versus the pre-securitization earnings for each subgroup. Regressions where the monitor is present are shaded. In regression (1), CEOcompensation is sensitive to both the gain and pre-securitization earnings. The F-test indicates that the componentsreceive the same weight. Regression (2) suggests that when there are no nancial experts on the compensation committee,earnings components are given no weight in determining CEO compensation (since the coefcients on both variables areinsignicant). However, we also nd no weight on stock returns, so this regression provides no evidence as to how CEOs arecompensated for this subset of rms.

Regression (3) includes only observations where the proportion of outside directors is in the upper quartile of thedistribution, while regression (4) includes the remaining observations. Regression (3) indicates that when the proportion ofoutsiders is high, gains receive no weight but pre-securitization earnings are weighted positively. However, the F-testreveals that the difference between the weights placed on these components is not signicant. Regression (4) reveals thatboth earnings components are given positive and equal weight when the proportion of outsiders is low since bothcoefcients are positive and signicant and the F-test for a difference between these two coefcients is not signicant.

Regression (5) includes only observations with a female director and regression (6) includes the remaining observations.In both regressions, compensation is sensitive to both the reported gains and other earnings components, andbecause the F-test does not reject that the coefcients are equal, earnings components seem to be equally weighted in CEOcompensation.

Finally, regre