Abstract:

I examine whether the existence of severance agreements in an executive compensation package is consistent with providing insurance to the CEO for the reputation costs associated with termination, with the damage control hypothesis, or with the rent extraction hypothesis. Consistent with the insurance hypothesis, I find that severance agreements are more likely to be offered when firms are unprofitable, illiquid and operate in a risky environment.

Next, I examine the association between CEO severance agreements and the extent of earnings management. I hypothesize that an ex ante severance plan reduces CEOs' incentives to manipulate earnings for two reasons: First, severance pay mitigates CEOs' job security concerns by providing compensation and benefits while the CEO is unemployed. Second, in the event that the CEO is caught manipulating earnings, the potential loss of severance pay in addition to the other forms of compensation, increases the cost to the CEO of earnings manipulation. I hypothesize that the reduced earnings manipulation effect of severance pay also reduces earnings management motivated by other forms of incentive pay. I detect a lesser magnitude of earnings management when severance packages are offered to CEOs of firms facing distress. I further find that the association between earnings management and incentive compensation is significantly lower for those firms with severance plans.