Methodology and Explanatory Variables

94In a robustness check Bechmann and Hjortshøj (2009) also use the expected life but they only find weak evidence of underreporting in that case.

Since several companies do not provide all required data in every year, regressing devia-tions of stated option values from expected ones on some explanatory variables is subject to a potential selection bias. Companies that want to hide the true option values may be the ones that do not provide all required information in the first place. This will be dealt with by performing a two-stage Heckman (1979) correction, where at first a probit regression will be run to determine which characteristics explain whether a company provides full disclosure or not. The dependent variable will be coded one if all necessary parameters are disclosed and zero if not. Necessary parameters in this case does not refer to the ones listed in IFRS 2, but to the ones I require for my valuation. Those are also the ones without which it is not possible to check the parameters disclosed in the annual report.⁹⁵ The sign of the significant coefficients will reveal the impact of the variable on the likelihood of compliance with IFRS 2. Then, Heckman’s lambda (also known as the inverted Mill’s ratio) will be included in the second stage regression, which will contain the same explanatory variables, but the dependent variable will be the deviation ratio defined above.⁹⁶ If lambda is significant in the second regression, it is likely that there is a selection bias that is being corrected by the inclusion of the labmda.

Lennox, Francis, and Wang (2012) point out the importance of including relevant ex-clusion restrictions in the first stage that can be validly omitted from the second stage.

Ideally, this must be a variable that has explanatory value on the first stage of the selection model, but not the second one. The introduction of IFRS presents a funda-mental change in the way companies have to prepare financial statements in Germany.⁹⁷ Whether a company then fully and correctly complies with a new standard, such as IFRS 2, will depend on how adapt the accountants are at following the new system.

Prior literature has documented that accounting experience is positively related to the quality of financial statements (e.g., Abbott, Parker, and Peters, 2004) and so I try to measure the accounting experience by including a dummy that is one if the company has prepared at least one IFRS-based annual report prior to the year(s) in the analy-sis. Application of the new standards became mandatory in 2005, but companies were allowed to adopt them in earlier years. The question of any gathered IRFS-related ex-pertise is entirely different from the question of whether the options values have been

95 For example, a company might list all four input parameters, yet without knowing the grant date it is impossible to check if, for example, the volatility is calculated correctly.

96 This procedure follows Bechmann and Hjortshøj (2009) and, for the second stage, Johnston (2006).

97 See Ernstberger and Vogler (2008) for a description of the differences and Bae, Tan, and Welker (2008) for a formal analysis of “distances” between different international GAAPs.

correctly determined. Consequently, the variable IFRSexperience can be excluded from the second stage regression.

Explanatory Variables

According to Bebchuk et al. (2002), managers will engage in camouflaging the value of their pay to avoid outrage costs. This suggests that variables explaining underreport-ing can fall in two broad categories: managers must have the power to influence the underreporting and they must have an incentive to do so.

Managerial Power Variables

Managerial power has often been linked to both rent extraction and reduction of outrage costs through camouflage. A recent study by Abernethy et al. (2013), for example, finds that powerful managers use their influence in order to attach weak performance targets to their option grants and Morse, Nanda, and Seru (2011) show that the more powerful managers are, the more their compensation hinges on measures on which the company has traditionally performed well. In accordance with prior literature, I use the following variables to capture managerial power:

A high Free float is often synonymous with dispersed ownership, which has been shown to lead to less effective compensation control by shareholders, especially without large blockholders (Shleifer and Vishny, 1986). Elston and Goldberg (2003) have confirmed this relationship for Germany where highly concentrated ownership acts as a monitoring device for executive compensation. Since less oversight means more possibilities for man-agers to bias option valuations, high free float is expected to have a negative sign in both stages of the regression. The positive role of institutional investors in monitoring and influencing executive compensation is well established (e.g., Hartzell and Starks, 2003).

Moreover, Bechmann and Hjortshøj (2009) show that higher institutional ownership translates into better adherence to the disclosure requirements. I collect the percent-age held by institutional investors from company reports and expect it to counteract underreporting.

A more direct oversight function is to be carried out by the supervisory board, yet it has been found that larger boards more often experience communication and free-rider problems (Hermalin and Weisbach, 2003) which can lead to rent extraction (Jensen, 1993). Although most studies on this subject refer to one-tier board systems, there is no reason to doubt that these results can be transferred to the German two-tier system, especially because companies are free to go above the minimum number of supervisory

board members dictated by law. I expect Boardsizeto positively affect the likelihood of a company not disclosing all required information and/or biasing fair values downward.

Because of the two-tier system a CEO cannot concurrently serve as chairman of the board, yet a retiring CEO oftentimes will assume that position. Andres et al. (2012) have found that this represents a hidden cost to companies, as former CEOs will increase their former colleagues’ pay. It is possible that the former CEO will also adopt a more lenient way when it comes to supervision of the compensation reporting and I therefore include the dummy variable FormerCEOchair which I expect to be conducive to the underreporting.⁹⁸ In addition, CEOs will amass more influence the longer they serve in that position (Bebchuk et al., 2002) and Hill and Phan (1991) have shown that the influence associated with tenure leads to pay that is more aligned with CEO preferences, which in turn might need to be hidden. At the same time, Beasley (1996) finds that longer (board) tenure reduces instances of accounting fraud, which could mean that the experience accumulated by the CEO helps him or her to better monitor the financial reporting. The effect of CEOtenure is thus not clear.

Finally, I includeSize here, measured as the natural log of market capitalization. Aboody et al. (2004a) report that larger companies are more likely to voluntarily give option values under SFAS 123 and Bechmann and Hjortshøj (2009) find that size is positively linked to the likelihood of complete disclosure in Denmark. They surmise that it is easier for larger firms to have specialized and more experienced accounting divisions and that they are more scrutinized by the public.

Managerial Incentive Variables

Managers will engage in underreporting if they feel that they have something to hide, i.e., want to avoid outrage costs, or if they have reason to reduce information asymmetry.

A logical first step in this category is the salary that executives are paid because that will lead to outrage costs. Consequently,Salary will measure the average yearly remuneration of the members of the executive board and it is expected to be associated with less stringent adherence to the disclosure requirements. Similarly, if the number of new options is high, managers might want to hide valuation information or underreport the fair values. Aboody et al. (2006) find that the magnitude of option-based compensation does in fact work this way for the U.S. whereas Bechmann and Hjortshøj (2009) cannot

98 Because of this variable I exclude companies with a one-tier board system which leads to a loss of four observations.

show this relation in Denmark. I include OptionsGranted as the number of options granted in a particular year.

Executive compensation in general is often criticized in the media, especially when com-panies are performing badly. In years with negative profits, it is all the more difficult to argue in favor of high salaries. Aboody et al. (2004a), Hodder et al. (2006) and Bechmann and Hjortshøj (2009) have all found that companies that experience negative profits underreport more. For this reason I include the dummy variable Loss that is one if the company has a negative income.

Related to the previous point is the influence of the capital structure. Highly leveraged companies may want to avoid the appearance of overpaying executives in the face of financial difficulties (Aboody et al., 2004a). Therefore, I include Market Leverage mea-sured as total debt divided by the market capitalization. As Aboody et al. (2004a) also point out that high leverage can indicate that companies are active in capital markets, it may be the case that companies strive to disclose fully in order to reduce information asymmetry. Like Bechmann and Hjortshøj (2009) I include the dummy RaisedCapital which is one if the company has had a seasoned equity offering in that year.

I also include theBook-to-market (BTM) ratio as the book value of equity divided by the market value of equity. Bechmann and Hjortshøj (2009) find that this is significant in explaining underreporting in their sample. They surmise that companies with growths options, which are typically measured by the BTM, may want to reduce their information quality. Indeed, high growth companies exhibit more underreporting of ESO values in their sample.

Lastly, I use a dummy variable (Combined goals) that is one if the option plan has two combined exercise conditions. These plans have shown worse disclosure and higher underreporting than the other categories and it should therefore be ascertained if the plan design is a determining factor in this.