ATJ Asian Tax Journal

Asian Tax Journal

Print ISSN 1738-3323 Online ISSN 2733-9270

A Valuation Role of Cash flows and Incentive Contracting

  • Kwon, Dae-Hyun Sookmyung Women's University

Asian Tax Journal Vol. 15 No. 2 (2014), pp. 47-69

Abstract

In this study, I investigate the role of cash flow from operation (CFO) in performance evaluationpurposes. Earnings and CFO are the recognized accounting indicators of firm performance. Anecdotal and research evidence have established that earnings and cash flows have differentialimplications for firm performance. While the literature is replete with research that show thecontracting role of earnings, evidence on the relevance of CFO in incentive contracting is sparseand weak. The incentive plans of noted companies justify the link between CFO and executivereward on the logic that CFO is a key driver of success and stock return. From a valuation pointof view, CFO is useful because it is one of a key component of the firm performance. Marketparticipants, therefore, use the signal to update their beliefs about the outcome. So from acontracting point of view, management cash compensation would be sensitive to value relevanceof CFO. Using compensation and accounting data for a number of Korean firms over an 9－yearperiod from 2001 to 2009, I find that pay－sensitivity of CFO is higher for firms that exhibit highvalue relevance of CFO. Next, I examine whether the association between value relevance andcompensation weights of CFO is different between chaebol firms and non－chaebol firms. Thecontrolling families of a chaebol group have been criticized for running the affiliated firms as avehicle to enrich their own personal wealth, and not necessarily the wealth of shareholders in thoseindividual companies. It has been alleged that a chaebol sometimes instructs its member firm totransfer wealth to a member firm under financial distress via illegal related－party transactions. Such ‘tunneling’ may be consistent with the interest of the controlling family and the group as awhole yet it is done at the expense of the minority shareholders of the firm. There are two papersclosely related to my second project. Campbell and Keys (2002) show that chaebol firms underperformnon－chaebol firms financially and that top executive turnover is not significantly relatedto firm performance for chaebol firms whereas it is for non－chaebol firms, suggesting that ifgroup chairman or controlling shareholder mandates top executives to pursue the interest ofchaebol as a whole, executive turnover might be insensitive to individual firm－level performance. Kato et al. (2007) have found that cash compensation of Korean executives is significantly relatedto stock market performance only for non－chaebol firms, not for chaebol firms. Such evidencesuggests that if top executives of chaebol are mandated to pursue the interests of the overall group, and not the shareholders’ interest of the firm they work for, their cash compensation would be lesssensitive to value relevance of CFO, compared to those firms unaffiliated to any chaebol group. I find that the association between value relevance and compensation weights of CFO remains stillsignificant only in non－chaebol firms, whereas the significance disappears in the chaebol firms,supporting for the hypothesis.

Keywords

  • value relevance
  • cash flow from operation
  • compensation
  • chaebol

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Asian Tax Journal

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