EWHA's Research Power for Humanities, Arts & Social Sciences
January, 2025
EWHA's Research Power for Humanities, Arts & Social Sciences

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Bonus incentives and losses from early debt extinguishment

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by Prof. Sewon Kwon
Division of Business Administration
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k4js1@ewha.ac.kr

Prof. Sewon Kwon’s recent research, published in International Review of Financial Analysis, and entitled “Bonus incentives and losses from early debt extinguishment,” examines how CEOs engage in real earnings management through debt repurchases to align with their bonus incentives.

In recent years, U.S. firms have increasingly engaged in debt repurchases, with the total value rising from $6 billion in 1996 to $85 billion in 2016. Prior studies attribute debt repurchases to motives such as interest savings, debt overhang mitigation, and maturity management. However, less attention has been given to the role of managers’ income-reporting incentives in these decisions. When firms repurchase debt before maturity, they must recognize gains or losses from early debt extinguishments (EDE) based on the difference between the carrying amount and repurchase price. These accounting effects can influence managerial decision-making.

Some research suggests managers use EDE gains to inflate earnings and meet analysts’ expectations. For instance, studies show that firms often employ open market repurchases to maximize reported gains. However, from 2006 to 2016, 78% of Compustat firms with EDE reported losses due to record-low interest rates. These losses present a dilemma for managers, as they may reduce earnings-based bonuses. Research indicates that managers avoid value-enhancing activities, such as debt buybacks, when non-recurring losses negatively impact bonus calculations. Compensation committees increasingly consider these losses, exacerbating the issue.

This study explores the conditions under which managers undertake debt repurchases despite recognizing EDE losses. It draws on theories of earnings management and the ratchet effect. Managers may accept EDE losses if they exceed the bonus maximum—a performance threshold where additional earnings no longer increase bonuses. In such cases, EDE losses are unlikely to reduce current bonuses and may improve future performance by lowering interest expenses. Additionally, reporting lower earnings can prevent excessively high bonus targets in the next period, aligning with the ratchet effect theory.

Using detailed data on CEO bonus contracts from 1,135 firm-year observations between 2006 and 2016, the study finds that managers are more likely to recognize EDE losses when earnings before EDE adjustments exceed the bonus maximum. On average, these firms record $12.33 million more in EDE losses than firms at other performance levels. Regression discontinuity analysis confirms that these findings are not driven by firm performance alone.

The research also examines repurchase methods, finding that managers with income-decreasing incentives prefer tender offers over open market repurchases. Tender offers often involve paying premiums, resulting in higher EDE losses. Additional tests reveal that EDE-related losses are weakly associated with higher future bonuses, indicating some compensation benefits for managers. However, the study finds no significant link between bonus-driven debt repurchases and shareholder value, as measured by future stock returns, profitability, or dividend payouts.

Further analysis shows that EDE losses complement income-decreasing discretionary accruals but have no significant relation to share repurchases. Propensity score matching and Heckman’s two-stage procedure confirm the robustness of these findings. Moreover, managers with high earnings above the bonus maximum tend to pay higher premiums for bond repurchases, aligning with income-decreasing incentives.

This study contributes to the literature by highlighting the role of income-decreasing incentives in debt repurchases. Unlike prior research that emphasizes income-increasing motives, it underscores how managers use EDE losses strategically to align with compensation structures. The findings also shed light on the nuanced relationship between bonus incentives and non-recurring losses, suggesting that managers are not always penalized for value-enhancing activities. Lastly, the research adds to the broader discussion on bonus-related reporting incentives, revealing how managers leverage real financing transactions for compensation benefits.

* Related Article
Jae Hwan Ahn, Sunhwa Choi, Gi H. Kim, Sewon Kwon,Bonus incentives and losses from early debt extinguishment, International Review of Financial Analysis, Volume 91, 103018, January 2024




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