Do managers perform for perks

Do Managers Perform for Perks? - Evidence from a Regime with Regulated Pay Donghua Chen Nanjing University Oliver Zhen Li National University of Singapore Shangkun Liang Nanjing University

ABSTRACT: We examine how perk consumption is determined and whether it impacts firm value in China where executive pay is regulated. We find that perks are provided when the relative pay between top executives and average employees is low, in firms with high free cash flows, economic rent and growth. Perks are positively associated with firm value, but to a much lesser extent than monetary compensation, suggesting that if perks can be converted to cash compensation, shareholder wealth could be further enhanced. However, under China’s regulated compensation structure, this conversion may not be easily achieved and perks likely represent a second-best solution in motivating executives. We also find that the predicted component of perks motivates managers better than the unpredicted component, suggesting that there potentially exists a norm level of perks determined by firm characteristics. Finally, the effect of perks in enhancing firm value is more pronounced in firms with high economic rent, high growth and low relative pay between top executives and average employees. Keywords: Compensation; perk; agency conflict; China JEL Codes: G30; J33

______________ We thank workshop participants at the Arizona State University, University of Arizona, University of Missouri, the International Accounting and Finance Conference at Nanjing University in 2008, and the American Accounting Association International Accounting Section Mid-Year Meeting in 2010 for helpful comments. We also thank China Natural Science Foundation (Grant #: 70602011) and China Social Science Foundation (Grant #: 08CJY009) for financial support.

0

1. Introduction China’s economy realized phenomenal growth in the past thirty years. In 2010, it surpassed Japan to become the second largest economy in the world, just behind the U.S.. Economic growth often requires a sound motivation system. However, monetary pay to China’s executives has been kept at a very low level due to regulations. Can low monetary pay induce such growth through some so-called socialist ideals? Or, does there exist some less studied mechanisms that motivate managers? We provide evidence supporting the latter. Top level executives play an important role in shareholder wealth creation. However, due to the wide spread agency problem between them, the interests of executives and shareholders are not necessarily well aligned. Therefore, it is important to use various mechanisms to motivate managers to work for the best interest of the shareholders, and reduce the extent of the agency problem. Many researchers have examined firms’ pay-for-performance sensitivities (Murphy, 1985; Jensen and Murphy, 1990; Leone, Wu and Zimmerman, 2006). The intuition behind payfor-performance is the assumption that when executive pay is linked to firm performance, managers work hard to create shareholder wealth. There are many means, apart from salaries, bonuses, stocks and options, that firms can use to reward or motivate their top managers. Perks are one of those widely used forms of nonmonetary compensation. While perks can potentially motivate managers to work for shareholders’ interest, they are also associated with a high level of agency cost. Recent research has revealed to a certain extent these two opposing forces of perks. Yermack (2006) finds that when firms announce CEOs’ personal use of company planes, their market values go down. Therefore, perks indicate managerial excesses that are detrimental to shareholders. Rajan and Wulf (2006), on the other hand, provide evidence that perks are offered in situations where they enhance managerial productivity and therefore should increase firm value. These two opposing views suggest the need to further examine the role played by perks. However, because of the difficulty of obtaining comprehensive data on perks, this issue has not been explored thoroughly. The unique policy and economic environment as well as data availability in China offers an excellent opportunity to study this phenomenon. We first examine the determinants of perks. We find that firms with high free cash flows, high economic rent, high growth, high monetary compensation for top managers and low relative pay between top managers and average 1

employees provide more perks to their top managers. An important implication of this result is that perks are provided to circumvent government pay regulations. We then examine whether and how perks enhance firm value. Our results show that firms’ future performance is positively associated with top managers’ perk consumption, suggesting that perks play a positive role of motivating top managers. However, the association between firms’ future performance and top managers’ monetary compensation is larger and more persistent than that between future performance and perks, suggesting that monetary compensation motivates top managers better than perks. Further analysis suggests that the predicted portion or the norm of perks motivates managers better than the unpredicted portion of perks. Considering the fact that the cash equivalent amount of perks vastly exceeds monetary compensation for top managers in China, our results suggest that if perks can be converted to cash compensation, shareholder wealth can be further enhanced. Of course, there are situations where efficiency can only be achieved with perks. It can be argued that our perk-related accounting numbers are just management expenses. Of course they are. While managers cannot cash them out, they likely derive personal utilities out of consuming them, therefore the term “perks”. Further, perks and monetary compensation are not necessarily perfect substitutes. Managers’ utility derived from a unit of monetary compensation is likely higher than that from a unit of perks. However, certain types of managerial consumption can only exist in the form of perks. When perks are internalized, managers may drastically reduce perk consumption by sacrificing good work conditions for a potential increase in cash compensation. Therefore, while too many perks can be detrimental to shareholders, too few perks can also be inefficient for shareholder wealth creation. Maintaining a norm level of perks is potentially good for shareholders. We hope to make the following contributions. First, we contribute to the literature on managerial incentives. The role of perks as a motivation mechanism for top managers is an issue of universal interest and importance but it has not been thoroughly investigated. The unique policy and economic environment in China provides an excellent opportunity for studying this question. Monetary compensation is regulated and managers turn to non-monetary motivations. A poor legal system and an immature market economy also create high transaction costs in the managerial market. These features likely cause a high level of perk consumption in China. The above policy and economic environment, to a varying degree, exists not only in China, but also 2

in many other transitional economies, even in developed countries. We find that perks are determined by firms’ levels of agency cost, economic rent, growth and the relative pay between top managers and average employees, and that these factors influence the way perks affect firm value. We also contribute to a better understanding of China’s economy and managerial motivation system by showing that implicit contracts, such as perks, play an important role in human society. For several thousand years, China has emphasized individuals’ morality and has historically lacked a civil law tradition. The traditional and even the current Chinese society is not one regulated by law. The rapid economic, social and cultural transformations in China render it hard for an explicit system to take form. A vast array of implicit contracts exists in China’s economy and society. Implicit contracts lead to an implicit system and an implicit system forms the backbone of China’s social and economic system. Without studying this implicit system, it is difficult to see a full picture of China’s economy and therefore understand its economic development. Examining the role of perks in motivating top managers can open us to a world of implicit contracts and enables us to see other possibilities. Of course, we are not necessarily advocating the use of perks in China or other economies. Our results in fact show that perks are less efficient than monetary compensations in motivating managers. We merely argue that perks in China represent a second-best, albeit still effective, way of motivating managers under certain circumstances. The rest of the paper is organized as follows. Section 2 formulates our story and develops hypotheses. Section 3 presents and discusses main empirical results. Section 4 presents results for additional analyses. Section 5 summarizes and concludes.

2. Theory and hypothesis development Defining perks Defining perks is difficult, both theoretically and empirically. This difficulty to a large extent hinders an in-depth investigation of perks. Theoretically, perks have the following characteristics. 1) They are related to top managers’ jobs and positions. 2) They increase top managers’ personal utilities. 3) The relation between top managers’ personal utilities and firm value is not clear-cut. 4) The amount, purpose and timing of perks are often flexible and not governed by specific contracts. 5) Compared with monetary compensation, perks to a larger 3

extent reflect top managers’ decision rights or their degree of entrenchment. The first characteristic causes quantifying perks to be technically difficult. Perks are often grouped with management expenses and not disclosed separately. The second characteristic causes perks to be different from other expenses because perks also provide personal utilities. Because of the possibility of providing personal utilities, perks become a form of motivation device. The last three characteristics cause perks to deviate from their intended goal of motivating managers to create shareholder value due to their high information and monitoring cost. For example, top managers can turn personal expenses to company expenses or consume an excessive amount of perks than what is necessary to support their work. It is important to note that motivating top managers with perks does not necessarily come at the expense of shareholders. Managers can be motivated when perks are aligned with shareholder value maximization. Renting luxury office space, providing club memberships and paying for vacations for top managers can enhance shareholders’ interest as well as increase top managers’ personal utilities. We define total managerial monetary compensation as salaries and bonuses paid to members of the board of directors, CEOs and other top executives. Managerial perquisites in our analysis include office administrative expenses, business travel expenses, business entertainment expenses, communication expenses, training abroad expenses, board meeting expenses, company car and chauffer services, and conference expenses. Rajan and Wulf (2006) examine the following types of perks: company plane, chauffer services, company car, country club membership, lunch club membership, health club membership, financial counseling, tax preparation and estate planning. Yermack (2006) focuses on the personal use of company planes. While there is some overlap between our examples of perks and those of Rajan and Wulf’s (2006), the types of perks that we examine are somewhat different from those of Rajan and Wulf’s (2006) and of course Yermack’s (2006). 1 Perks in our analysis are broadly defined as company resources, other than salaries, bonuses, stocks and options, directly or indirectly 1

Following the classification of perquisites from prior studies and the SEC’s interpretive guidance, Andrews, Linn and Yi (2009) classify all individual perquisite items into 10 broad categories (1) air and long-distance travel expenses, (2) company car and local transportation, (3) entertainment and other extra-curricular activities, (4) personal and family related perquisites that enhance home/family situation of the executive, (5) severance package and/or special dividend distribution, (6) legal, financial, and tax services, (7) medical allowances and medical expenses paid by the corporation, (8) financial perquisites unrelated to savings or retirement, (9) administrative privileges, and (10) other. We have a partial overlap with Andrews, Linn and Yi (2009). 4

devoted to sustaining top executives’ effort in the management of the firm. As in Yermack (2006) and Rajan and Wulf (2006), we certainly can argue that many of the above expenses are legitimate and necessary for sustaining managerial performance and thus are not perks. However, unlike other firm expenses, top managers can potentially derive some personal utilities from these expenses and therefore we define them as perks. Further, while Yermack (2006) and Rajan and Wulf (2006) study incidences of various types of perks, we quantify them into accounting numbers. 2

Institutional background for monetary compensation and perks in China Regulated monetary compensation There is a great degree of variation in top manager cash compensation among countries in the world. In some cases, this variation is driven by labor market competitions while in other cases it is driven by cultures or regulations. According to Murphy and Zábojník (2004), the base salaries and bonuses of Forbes 800 CEOs increased from an average of $700,000 in 1970 (in 2002-constant dollars) to over $2.2 million in 2000. During the same period, the ratio of CEO cash compensation to the average pay for production workers increased from about 25 in 1970 to nearly 90 in 2000. In China however, this ratio is very low at around 2 to 3 times for all firms, 1.5 to 2.5 times for state owned firms and 2.5 to 3.5 times for non-state owned firms. Although this ratio has been rising in recent years, it is still at a relatively low level (see Figures 1 and 2). 3 While recognizing that managerial talent is essential for creating firm value and therefore requires motivation, in practice, the Chinese central government strictly regulates top manager pay. An important means of regulation is linking top managers’ pay to that of average employees (Chen, Chen and Wan, 2005, written in Chinese) in order to maintain a sense of equality between managers and employees. For example, the Chinese government often mandates a limit on the relative pay between top managers and average employees. Panel A, Table 1 presents the average number of top managers per firm from 1999 to 2007 in our sample. Panel B, Table 1 shows that the average top manager pay is RMB42,469 (median 2

Andrews, Linn and Yi (2009) and Grinstein, Weinbaum and Yehuda (2008) in their examinations of the consequence of the SEC’s enhanced disclosure rules for perks quantify perks but they cover only the year 2007. We hand-collect information on perks from Chinese publicly listed firms’ annual reports for a nine-year period from 1999 to 2007. 3 We do not include long term incentives in computing this ratio. However, this is unlikely to bias our analysis as long term incentives are rare among Chinese firms. 5

is RMB28,800) in 1999. This number increases steadily over time. The average pay is RMB174,602 (median is RMB138,288) in 2007. 4 These statistics suggest that monetary compensation for top managers in China is very low compared with that in developed countries. Restrictions on top management compensation imposed on state owned firms distort the relative compensation structure between top managers and average employees. Pay restrictions originate from the management system of state owned assets and the government’s administrative interventions of state owned firms. Facing the task of managing a huge number of state owned firms, the owner (the state asset management department or the government) is at an information disadvantage and often finds it difficult to observe the performance of state owned firms. Therefore, it is difficult for the government to sign effective contracts with managers of state owned firms to motivate them to work hard ex ante and it is equally difficult to monitor the performance of managers ex post. The presence of administrative interventions or regulations causes firms to shoulder policy burdens and of course to receive policy benefits as well (Lin, 1998; Lin and Tan, 1999). Firm objective shifts from shareholder value maximization to other multidimensional goals, such as full employment, social stability, maximizing tax revenue, etc. Therefore, the causal relation between firm financial performance and managerial effort is blurred, further aggravating the government’s information disadvantage in this transaction with a severe degree of information asymmetry. At the same time, due to the nature of state ownership, the government finds it difficult to withdraw from this exchange or to price-protect. Thus, a system of regulations on monetary compensation appears to be the government’s solution to this problem. Finally, regulating monetary compensation can also be ideologically motivated. Due to its visibility, a large ratio of relative pay between top executives and average employees can potentially cause social conflicts in an ostensibly socialist country. Regulating monetary compensation reduces this possibility. 5

Interaction between monetary compensation and perks

4

Consider using an exchange rate of 7 to 8 RMBs for a US dollar during the test period. Of course, pay regulation also exists in western economies, though to a much lesser extent. Cai and Walkling (2011) find that when the House passed the Say-on-Pay Bill in the U.S., which gives shareholders a say on executive compensation, the market reacted positively for firms with high abnormal chief executive officer (CEO) compensation, low pay-for-performance sensitivity, and responsive to shareholder pressure.

5

6

Regulations on monetary compensation reduce the negotiating power of managers of state owned firms, causing pay arrangement to be a pre-existing constraint on the hiring of managers. Rigid pay contracts cannot compete effectively with those based on market forces. The behaviors of managers under those rigid contracts are likely different from those under more flexible market oriented contracts. On one hand, even if the initial pay restriction is a result of correct judgment based on market forces, which is unlikely, the rapid changes that occur during the cause of economic development often exceed the cost-effective observation range of the regulators. Further, the high cost associated with modifying the compensation contracts of a large number of state owned firms often prevents these contracts from being quickly adjusted. Therefore, over time, regulated compensation contracts are often stale and rigid, causing managers’ compensation arrangements to move further away from the market based equilibrium, inducing a series of adverse selection or moral hazard problems. On the other hand, due to the fact that performance based compensation contracts cannot be effectively written, other substitute arrangements can be created. Firm objectives other than value maximization, such as reducing unemployment, increasing tax revenue, etc., can be observed within the cost range sustainable by the regulated party. Non-performance based objectives can be linked to non-performance based methods of motivations, such as political promotions, personal fames, etc. Therefore, outside the compensation arrangements that are regulated, multidimensional, non-cash based systems of compensation are created. Perks are one of them. The above discussion describes the basic characteristics of the compensation system of China’s state owned firms.

Why perks? From its origin, the issue of how to motivate top managers in China belongs to the realm of “the theory of pricing”, an old and now defunct academic discipline in China and other former socialist countries where prices of various goods and services are determined without references to market forces of supply and demand (due of course, to the lack of markets). The demand for firms’ top managerial talent mainly comes from the State Commission on Asset Control, state owned enterprise groups and other various levels of the government and control departments. These organizations not only demand superior managerial skills and output (similar to that of mature market economies), but also require managers to understand and realize various 7

multifaceted goals of the government. As discussed earlier, the market for managerial talent in China is regulated by the government and managers’ pay is often set low. If we only consider monetary compensation for top managers as their total compensation, we would find it hard to explain the frantic development of China’s economy in the last three decades. Managerial talent has to be expressed with a proper system of motivations and China certainly cannot be an exception. In China’s transitional economy, there are many forms of compensation other than monetary pay, for example, perquisites, political promotions, and other forms of implicit compensation. Simply put, “to ride a horse without feeding it” does not exist in economic realities. In fact, based on our descriptive statistics, perks vastly exceed monetary pay. From a certain angle, the price paid to motivate managers is not necessarily as low as policymakers, who regulate monetary compensation, have anticipated, and the cost saving through regulations is limited and the wastefulness is perhaps high. This being the case, why do policymakers allow the use of perks to motivate managers instead of using other more explicit forms of motivations, such as direct monetary compensation? This is because, compared with explicit contracts, implicit contracts can be more easily adjusted or changed. As discussed above, the government, as a party that demands top managerial talent, has multiple goals. The multiple goals of the government can change with changes in the economic environment. These changes are often frequent and unpredictable. If explicit contracts are signed, the government and the managers will have to be harassed with frequent violations and readjustments of contracts, causing high contracting costs. To the government, a more convenient option might be to lower monetary pay in explicit contracts while implicitly allowing the existence of perks. In other words, the government will choose a flexible implicit contract to induce managers to serve for the ever changing goals of the government.

Why perks also in non-state owned firms? It is important to note that though regulations on compensation contracts are intended for state owned firms, they have a spillover effect and can affect the whole market. State owned firms play an important role in China’s economy. Currently, many non-state owned firms were reformed from state owned firms. They naturally are affected by the system of the original state owned firms. Further, state owned firms are often non-state owned firms’ shareholders and 8

business partners who can exert a big influence on non-state owned firms. The business norms of state owned firms can bring a high level of perk consumption to non-state owned firms. Finally, as the personal income tax rate in China can reach above 40%, tax avoidance can also be a powerful reason for perks to exist in large amount in both state owned and non-state-owned firms.

Determinants of perks Relative pay between top managers and average employees Jensen and Meckling (1976) argue that with fractional ownership, managers have a tendency for perk consumption since they enjoy all the benefits of the perks but bear only a fraction of the cost. Therefore, the value of a firm when managers own just a fraction of it is lower than the value of a firm when managers own all of it. Jensen (1986) suggests that managers of firms with more severe free cash flow agency problem tend to consume more perks. Therefore, perk consumption is detrimental to shareholders. Indeed, Yermack (2006) finds that managers’ personal use of corporate planes is associated with a negative stock return of 4% annually and that around the disclosures of personal uses, firms’ stock prices fall by 1.1%. Of course, Yermack (2006) focuses on a more extreme form of perks, the personal use of company planes. Andrews, Linn and Yi (2009) and Grinstein, Weinbaum and Yehuda (2008) also find a negative market response to the announcements of perks after the SEC issued enhanced disclosure rules regarding perks in December 2006, suggesting perks as managerial excesses. However, an over-emphasis on the detrimental effect of perks is not well justified. Rajan and Wulf (2006) analyze situations where perks may actually enhance productivity. Perks can directly enhance managerial productivity (e.g. business travel in first class) or can be more cost effective when offered by the firms (executive dining facility). Rajan and Wulf (2006) find that company jets are provided when firms are not headquartered near commercial hubs and in counties with small populations. Chauffer-driven cars are provided to executives who work for firms headquartered in large counties and in counties with long commute time. The provision of these perks presumably enhances managers’ ability to better accomplish their tasks and is therefore good for shareholders. Perk consumption as a means to motivate managers exists all over the world. Compared with the monetary compensation of mature market economies such as the U.S., Japan and some 9

European Union countries, the role played by perks in substituting monetary compensation is likely more pronounced in China’s transitional economy, due to the fact that monetary compensation is heavily regulated by the government. Managers’ monetary compensation relative to that of averages employees is potentially a major determinant of perks. Managers in China’s state owned firms face low monetary compensation and high reliance on personal fame and political promotions as means of motivation. This divergence causes a spate of selfmotivation, an important form of which is an excessive consumption of perks. At least partially, temptations for a large amount of perks are perhaps behind political promotions. Of course, firms, in order to attract talented top managers, are also willing to supply more perks if they have difficulty paying high a level of monetary compensation. Therefore, perks are not necessarily a product of managerial opportunism. They can also substitute monetary compensation as a motivation device. When cash compensation cannot be fully determined by market forces but are influenced by other factors such as regulations, the substitution role played by perks is likely large. We propose our first hypothesis related to regulated managerial pay below. Hypothesis 1: Top managers consume more perks when their monetary compensation relative to that of average employees is low.

Free cash flows, economic rent, growth and absolute compensation Apart from relative monetary compensation, top managers’ perk consumption is also influenced by other factors. Boschen, Duru, Gordon and Smith (2003) divide factors influencing CEO’s cash compensation into three categories: economic factors, governance factors, and ownership factors. We follow them and roughly divide factors into these categories. Economic factors include free cash flows, economic rent, financial leverage, firm size, geographic characteristic and industry. Governance factors include the percentage of independent directors and incidence of dual position as a chairperson of the board of directors and a top manager. Ownership factors include the stock ownership of the largest shareholder and that of the top managers. When a firm’s level of free cash flow is high, its agency cost problem is more severe, and the extent of perk consumption by its managers is likely high. When the economic rent extracted by a firm is high, its financial condition is sound, the firm is likely able to afford a high level of 10

perks. Growth firms value managerial talent and likely use perks, apart from monetary compensation, to attract talented managers. Therefore, growth firms have a high level of perks. Top managers’ consumption of perks is likely related to their absolute level of monetary compensation. In fact, both perks and monetary compensation reflect their recipients’ relative positions within the management hierarchy. We expect perks to be positively related to the absolute level of top managers’ monetary compensation. We propose our second hypothesis below. Hypothesis 2: Top managers consume more perks when firms’ free cash flows, economic rent, growth potentials and top managers’ absolute monetary compensation are high.

We also consider the following control variables. Large firms demand a high level of managerial skills. The price is likely high for top managerial skills and therefore the level of perk consumption is high. The eastern region of China has a more developed market economy and more intense economic activities, which can induce perk consumption. However, it also has a more competitive market for managerial talent, which can reduce the level of perk consumption. Therefore, while geographic characteristic can influence perk consumption, its direction is not obvious. Based on Jensen and Meckling (1976), protected industries have a low level of perks. High percentage of independent directors, the separation of the chairman of the board of directors and the CEO, the percentage ownership of the largest shareholder, likely reduce top managers’ opportunistic behavior, reduce agency cost and minimize the consumption of perks. High percentage of top management stock ownership aligns the interest of the managers to that of the shareholders, reducing their opportunistic behavior and therefore perks (Jensen and Meckling, 1976).

Perks and firm performance For a long time, the mainstream academic view of perks is that they are means by which top managers expropriate firm resources and therefore they represent agency costs (Grossman and Hart, 1980; Jensen and Meckling, 1976; Jensen, 1986; Yermack, 2006). Jensen and Meckling (1976) start from the principle-agency relationship in a firm and argue that the agent (manager) will not always work towards the value-maximization goal of the principle (owner). The owner can set up incentives and monitoring mechanisms to limit the agent’s propensity to deviate from 11

value-maximization, even though this propensity cannot be completely eliminated. Without considering monitoring, if managers can freely choose their desired level of perks, they can maximize their personal utilities through perks since they are only responsible for part of the cost while reaping the full benefit. The lower the level of managers’ stock ownership, the lower the level of the cost they are responsible for, the more likely they are to consume perks. Jensen (1986) argues that top managers will consume more perks when a firm’s free cash flow problem is more severe. Empirically, Yermack (2006) shows that firm value decreases by 1.1% if a firm discloses managers’ personal uses of company planes and that disclosing firms underperform the market by 4.0% annually. On the other hand, the above analysis likely ignores another possibility. The existence of perks may well be rational. For example, Alchian and Demsetz (1972), from the angle of information cost, argue for the rationale of perks. The cost of eliminating managerial opportunistic behavior may well exceed the benefit of doing so. Therefore, firms allow managers to enjoy privileges, extra bonuses and benefits. Rajan and Wulf (2006) examine the same issue in Yermack (2006) and present evidence of a positive role of perks. They find that managers are more likely to have access to company planes when their firms are headquartered in cities far away from major public airports and they are more likely to have company cars when they live in counties with long commute time and large populations. Therefore, these forms of perks arise from work requirements. They improve the efficiency of top managers and therefore should have a positive impact on firm value. In fact, there are several ways that perks may help enhance firm value. First, providing more perks, for example, more entertainment expenses, can reduce personal expenses by top managers, which in turn motivates them to form more social networks that are good for businesses. Second, providing more perks, for example, reimbursing a faster and more comfortable mode of transportation, can help save time for top managers, enhance their efficiency, and therefore increase firm value. Third, perks can be a direct substitute for monetary compensation. Fourth, the use of perks can also be due to some other considerations. For example, perks are often not based on written contracts and are less likely to attract the attentions of regulatory authorities and mass media than monetary compensation and therefore are associated with a lower political

12

cost. 6 Fifth, the determination of perks is relatively flexible. Firms can easily modify the level of perks based on the diligence level of managers and other factors such as the shifting goals of the owners without feeling bounded by written contracts. Finally, perks are not subject to individual taxes. In sum, perks can motivate managers. As perks have these two opposing effects, we are interested in which one of the two forces dominates. We propose our third hypothesis below. Hypothesis 3: Top managers’ perk consumption affects firm values.

Though Rajan and Wulf (2006) and Yermack (2006) have provided some empirical evidence on the valuation implication of perks, their respective limitations and opposing conclusions render further research on this topic necessary. Rajan and Wulf (2006) find that top managers’ perks are provided based on needs and likely enhance their efficiency. They do not analyze the effect of perks on firm performance. Yermack (2006) examines the market reactions to disclosures of “abusive” perks, personal uses of company planes and finds that perks reduce firm values. However, personal uses of company planes in Yermack (2006) are just one form of perks and they are relatively extreme. We collect information on many forms of perks disclosed in firms’ financial statements and therefore more comprehensively examine how perks impact firm performance.

3. Empirical results Sample selection We hand-collect managerial perk data for the period from 1999 to 2007, from the annual reports of Chinese companies listed in the Shanghai and Shenzhen Stock Exchanges. Managerial perks in our paper include the following expenses: 1) office administrative expenses, 2) business travel expenses, 3) business entertainment expenses, 4) communication expenses, 5) training abroad expenses, 6) board meeting expenses, 7) company car and chauffer service, and 8) conference expenses. Chinese listed companies usually disclose the above information in the column of “other cash flows related to operating activities”. This information sometimes can also be found in the detailed “management expenses”. 6

Core, Guay and Larcker (2008) find that negative press coverage is strongly related to excess annual pay and that negative coverage is also greater for CEOs with more option exercises. 13

Other data are commercially available from Chinese research data suppliers. Ownership structure and industry classification data are from CCER (China Center for Economic Research at Peking University). Stock return and accounting data are from CSMAR (China Stock Market and Accounting Research) supplied by China Shenzhen GTA Information Technology Limited. We obtain perk information for around 40% of the publicly listed firms (Figure 3). We start with 4,869 firm-year observations. We delete 692 observations that have no more than one year of listing history, 33 observations that belong to the financial sector, and 483 observations with missing variables required by our regression models. We are left with 3,661 observations. We delete the upper and lower 1% of perks scaled by beginning of the year total asset. We obtain a final sample of 3,588 observations. See Table 2 for sample selection year by year.

Variable definitions Perk is defined as the total amount of managerial perquisites, the aggregate of the eight expenses that we list earlier. To facilitate regression analysis, the total amount of perks is scaled by beginning of the period total asset. Cp is defined as total managerial monetary compensation such as salaries and bonuses paid to members of the board of directors, CEOs and other top executives. Cp is scaled by the beginning of the period total asset. Oi is operating income scaled by the beginning of the period total asset. Stkre is the cumulative stock return. FCF is a firm’s free cash flow measured based on Richardson (2006). A firm’s economic rent, Rent, is its gross profit margin minus the median gross profit margin of the industry that the firm belongs to. TQ is a firm’s Tobin’s Q. Rp is an indicator variable for relative pay. If a firm’s ratio of per capita pay for top managers divided by per capita pay of average employees exceeds that of the median in the industry, Rp equals one, otherwise it equals zero. 7 Rinde is the ratio of the number of independent directors to the number of all directors. Dual is an indicator variable that equals one if the CEO also serves as the chairman of the board, and zero otherwise. Sh is the percentage stock ownership of the largest shareholder. Mshare is the percentage ownership of the firm by top managers. Lev is the ratio of year-end debt divided by total asset. Size is the natural logarithm of year-end total asset. East is an indicator variable that equals one if a firm is on the east coast

7

Relative pay, Rcp, is computed as (Total top manage monetary compensation / Number of top managers) divided by (Total employee monetary compensation / Number of employee). 14

of China, and zero otherwise. 8 Industryi (i = 1, 2, …, 20) is an indicator variable that equals one if a firm belongs to Industry i, and zero otherwise. 9 Protected is an indicator variable that equals to one if a firm belongs to a protected industry, and zero otherwise. 10

Descriptive statistics and correlations Figure 4 shows that consistent with China’s economic development, top managers’ monetary compensation and perks both increase over time. However, perks are always many times that of monetary compensation. Panel A, Table 3 shows descriptive statistics of the variables used in our analysis. Sample firms have an average total asset of RMB2,642 million. The average monetary pay to top managers is RMB1.42 million, or about 0.10% of a firm’s total assets, while the expense related to perks by an average firm is RMB16.98 million, or about 0.87% of a firm’s total assets. Considering an exchange rate between USD and RMB of 7 to 8 during our sample period, Chinese top managers’ monetary compensation is exceedingly low compared with their counterparts in the U.S.. This is partially due to the differences in the stages of economic development and firm sizes between these two countries. It is also important to note that small pay also motivates. For example, Adams and Ferreira (2008) provide evidence that USD1,000 can provide significant incentives for board members, many of whom are top executives and CEOs of US firms, to attend board meetings. The fact that the exchange rate of RMB is kept low against USD also contributes to the disparity in top managers’ pay between China and the U.S.. Panels B and C, Table 3 present correlation coefficients among major variables. The lower triangle contains Pearson correlations and the upper triangle contains Spearmen correlations. From the correlation matrix, we observe that Perk is not correlated with the current year stock

8

East coast of China includes Beijing, Tianjin, Hebei, Liaoning, Shanghai, Jiangsu, Zhejiang, Fujian, Shandong, Guangdong and Hainan. 9 Based on the classifications by the China Securities Regulatory Commission (CSRC), they are: 1) agriculture, forestry, livestock and fishery; 2) mining; 3) food and beverages; 4) textile, garment and fur; 5) timber and furniture; 6) paper and printing; 7) petroleum, chemical and plastics; 8) electronics; 9) metal and non-metal; 10) machinery, equipment and instrument; 11) pharmaceutical and biological products; 12) other manufacturing businesses; 13) electricity, gas and water production and supply; 14) construction; 15) transportation and warehousing; 16) information technology; 17) whole and retail sales; 18) finance and insurance; 19) real estate; 20) services; 21) media and cultural; 22) conglomerates. We do not include the financial and insurance industry in this paper. 10 Protected industries include 2) mining; 7) petroleum, chemical and plastics; 9) metal and non-metal; 13) electricity, gas and water production and supply; 15) transportation and warehousing; and 16) information technology. 15

return, Stkre0. However, there is a degree of positive correlation between perks and subsequent one-year stock return, Stkre1 (p = 0.1256) and subsequent two-year stock return, Stkre2 (p = 0.1468). 11 Monetary compensation, Cp, is positively correlated with subsequent one-year, twoyear and three-year stock returns (Stkre1, Stkre2, Stkre3), with the correlations with Stkre2 and Stkre3 significant. Therefore, both top management monetary compensation and perks positively affect firm values, but the effect of monetary compensation is stronger than that of perks.

Determinants of perks We use the following regression model to test Hypotheses 1 and 2 that the level of perks is negatively related to the relative pay between top managers and average employees and that the level of perks is high in firms with high free cash flow, high economic rent and high managers’ absolute monetary compensation: Perkit = a0 + a1FCFit, it - 1, it - 2, it - 3 + a2Rentit, it - 1, it - 2, it - 3 + a3TQit, it - 1, it - 2, it - 3 + a4Cpit, it - 1, it - 2, it - 3 + a5Rpit, it - 1, it - 2, it - 3 + a6Rindeit + a7Dualit + a8Shit + a9Mshareit + a10Levit + a11Protectedit + a12Sizeit + a13Eastit + ∑Yearit + εit,

(1)

where perk consumption, Perk, is the dependent variable. Free cash flow, FCF, economic rent, Rent, Tobin’s Q, TQ, monetary compensation, Cp, relative pay, Rp, are explanatory variables. The ratio of independent directors to all directors, Rinde, CEO on the board, Dual, shareholding of the largest shareholder, Sh, shareholding of the top management, Mshare, financial leverage, Lev, protected industries, Protected, firm size, Size, geographic location, East, and time period, Year, are control variables. Regression results are reported in Table 4. All regression t-statistics in this table and subsequent tables are based on Huber-White’s robust t-statistics. The coefficient on Rp is negative and significant (-0.0015, t = -4.00) for Year t, supporting Hypothesis 1 that in firms with low relative pay between top managers and average employees, top managers consume more perks. We further examine the effects of the determinants of perks by using their lagged values. Control variables are from the current period. The results are reported in columns Year t 11

Current year (Year t) cumulative stock return, Stkre0, is the cumulative stock return from the beginning of May of Year t to the end of April of Year t + 1. Cumulative stock return from Year t to Year t + 1, Stkre1, is the cumulative stock return from the beginning of May of Year t to the end of April of Year t + 2. Cumulative stock return from Year t to Year t + 2, Stkre2, is the cumulative stock return from the beginning of May of Year t to the end of April of Year t + 3. Cumulative stock return from Year t to Year t + 3, Stkre3, is the cumulative stock return from the beginning of May of Year t to the end of April of Year t + 4. 16

1, Year t - 2, and Year t - 3 of Table 4. The most important variable, the relative pay between top managers and average employees, Rp, is always significantly negatively related to perks, Perk. The coefficients are -0.0019, t = -5.10 (lagged for one year), -0.0020, t = -4.43 (lagged for two years), and -0.0023, t = -4.01 (lagged for three years). This further illustrates that when the relative pay is constrained to a low level, perks substitute for monetary compensation, as a device to motivate top managers, supporting Hypothesis 1. In the concurrent regression for Year t, the effects of FCF and TQ are not significant. However, for Year t - 1, Year t - 2 and Year t - 3, FCF and TQ are positively associated with Perk. The coefficients on FCF are 0.0045, t = 2.43 (lagged for one year), 0.0019, t = 0.75 (lagged for two years) and 0.0047, t = 1.70 (lagged for three years). To the extent that free cash flow represents agency cost, perks appear to be associated with agency cost. As discussed earlier, agency cost certainly cannot be avoided in perks. However, it is unrealistic if we completely view perks as a result of agency cost. If perks are entirely due to the agency cost, then the effect of TQ should be negative. However, the coefficients on TQ are 0.0021, t = 3.10 (lagged for one year), 0.0016, t = 2.18 (lagged for two years) and 0.0019, t = 2.35 (lagged for three years). Growth firms tend to value top managerial talent more and have a high level of risk. These two factors cause growth firms to use more perks to reward top managers, supporting perks as a means of motivation instead of as a consequence of the agency cost. The coefficients on Rent are all positive, 0.0020, t = 2.11 (current year), 0.0072, t = 3.68 (lagged for one year), 0.0061, t = 2.92 (lagged for two years), and 0.0031, t = 1.38 (lagged for three years). This suggests that, on the one hand, if a firm is in a competitive industry and has sound financial performance, it is capable of better compensating top managers through perks; on the other hand, top managers may have contributed to this competitive advantage and therefore deserve this reward. The coefficients on Cp are positive and significant, 2.6806, t = 4.99 (current year), 2.6299, t = 8.80 (lagged for one year), 2.7990, t = 6.91 (lagged for two years) and 2.8644, t = 5.84 (lagged for three years), suggesting that firms paying a high level of monetary compensation also provide more perks. These results generally support Hypothesis 2.

Perks and firm performance We use the following regression models to test Hypothesis 3 that perks affect firm performance and value: 17

Oiit, it + 1, it + 2, it + 3 = a0 + a1Cpit + a2Perkit + a3TQit + a4Levit + a5Sizeit + a6Eastit +∑Industryit + εit,

(2)

Stkreit, it + 1, it + 2, it + 3 = a0 + a1Cpit + a2Perkit + a3TQit + a4Levit + a5Sizeit + a6Eastit +∑Industryit + εit.

(3)

Panel A of Table 5 presents results for regression Model (2). When the dependent variable is the current year operating income, Oi, the coefficients on Perk (0.7431, t = 4.97) and Cp (14.6448, t = 6.62) are both significantly positive but the role of monetary compensation is more pronounced. When we use future operating income Oi in Years t + 1, t + 2 and t + 3, the coefficients on Perk are 0.5029 (t = 2.09), 0.7853 (t = 3.35) and 0.9427 (t = 2.71), respectively; the coefficients on Cp are 16.0737 (t = 6.45), 12.1100 (t = 3.27) and 17.3700 (t = 4.67), respectively. Again, these results suggest that both monetary compensation and perks positively influence future firm performance and that the effect of monetary compensation is more pronounced. Panel B in Table 5 presents regression results for Model (3). We obtain similar though slightly weaker results. Specifically, when we use stock returns Stkre in Years t, t + 1, t + 2 and t + 3, the coefficients on Perk are 0.7261 (t = 0.32), 9.5131 (t = 2.00), 10.6073 (t = 1.69) and 0.4290 (t = 0.08), respectively; and the coefficients on Cp are 36.8192 (t = 1.91), 189.3305 (t = 4.00), 316.7278 (t = 5.36) and 401.0332, (t = 6.49), respectively. The above results suggest that perks’ motivation role likely dominates that of agency cost. However, the effect of monetary compensation vastly exceeds that of perks and is more persistent. Therefore, converting perks to monetary compensation can potentially enhance shareholder value. Of course, we can imagine scenarios where converting perks to monetary compensation may not enhance efficiency. First, there potentially exists a norm level of perks depending on firm characteristics and only a deviation from that norm is sub-optimal. Second, the way perks are consumed limits their substitutability. For example, if the cost of a first class ticket is paid to a manager in the form of salary and the manager determines whether she flies first class or coach, she may not necessarily choose to fly first class. To the extent that a more comfortable travel mode enhances managerial efficiency, this arrangement actually reduces efficiency. Third, in 18

China’s regulated market for managerial talent, it may simply be difficult to substitute perks with monetary compensation.

4. Additional analyses Controlling for the disclosure of perks It is important to note that detailed information on perks is disclosed voluntarily. China Securities Regulatory Commission (CSRC) does not require mandatory disclosures of perks. Therefore, our conclusion on the effect of perks on firm performance potentially suffers from a self-selection problem. It is possible that firms with high earnings potential and good governance are more willing to disclose information on perks. Disclosing firms with poor earnings potential and governance may attract the attentions of the securities regulatory authority and the mass media. Therefore, firms for which the negative effect of perks dominates may choose not to disclose information on perks, potentially biasing our results. Of course, the disclosure of perks is affected by many factors. For example, a factor affecting the disclosure of perks may be the materiality principle. If we do not observe information on perks for a firm, it may not necessarily be due to its lack of earnings potentials or good governance. Instead, it can be due to the fact that the firm’s level of perks is immaterial. We also do not rule out the possibility that we fail to hand-collect information on perks for some firms when that information is actually available. From Figure 3 we learn that the proportion of disclosing firms increases over time. With 40% of firms disclosing this information, our conclusion should be meaningful. Nevertheless, we perform a probit analysis of perk disclosers versus non-disclosers. We consider the effects of lagged operating income (Oiit-1), Tobin’s Q (TQit-1), equity financing (SEOit-1), past enforcement actions by CSRC in the industry (Punishit-1), 12 industry competition (Compit-1) computed as the Herfindahl-Hirschman Index which is sum of the squared fractions of sales of the top 10% largest firms in an industry, leverage (Levit-1) and firm size (Sizeit-1) on the perk disclosure decision (Discloseit) in the following equation following Dhaliwal, Li, Tsang and Yong (2011):

12

These enforcement actions are related to 1) failures to provide financial statements in time; 2) inaccurate forecasts; 3) failures to disclosure material events; 4) false disclosures and misguidance; 5) stock price manipulations and insider trading; 6) failures to fulfill other obligations. 19

log[prob(Discloseit)/(1-prob(Discloseit))]= a0 + a1Oiit-1 + a2TQ it-1 + a3 SEOit-1 + a4Punishit-1 + a5 Compit-1+ a6 Levit-1 + a7 Sizeit-1 + ∑Industry + εit-1.

(4)

Results are reported in Panel A, Table 6. We find that the probability of disclosing information on perks is positively associated with operating performance, CSRC enforcement actions in the industry and industry competition, and negatively associated with firm size. When we incorporate the inverse Mills ratio (IMR) estimated from the probit model to regression Equations (2) and (3) analyzing the role of perks on firms’ future operating income and stock returns, inferences are qualitatively unchanged (See Panels B and C, Table 6).

Norm and the unpredicted component of perks and firm performance It is possible that for each firm there exists a “norm” level of perks depending on its characteristics. This level of perks is what is necessary to motivate managers and a deviation from this norm reflects agency cost and is therefore less likely to improve firm performance. We use the predicted value of perks, Perk_Pre, from estimating regression Model (1) to represent the norm and use the residual value of perks, Perk_Res, from estimating regression Model (1) to represent the deviation from this norm. We run the following two regressions: Oiit, it + 1, it + 2, it + 3 = a0 + a1Perk_Preit + a2Perk_Resit +∑Industryit + εit,

(5)

Stkreit, it + 1, it + 2, it + 3 = a0 + a1Perk_Preit + a2Perk_Resit +∑Industryit + εit.

(6)

Results are presented in Table 7. Panel A contains results for operating income, Oi. In Year t, the coefficient on Perk_Pre (3.2531, t = 7.87) is significantly higher than that on Perk_Res (0.5653, t = 3.73), suggesting that the predicted portion or the norm of perks enhances current period earnings more than the unpredicted portion of perks. In Years t + 1, t + 2 and t + 3, the coefficients on Perk_Pre (2.1598, t = 2.79; 3.4071, t = 3.12; and 3.7823, t = 3.10, respectively) are also significantly higher than those on Perk_Res (0.4358, t = 1.90; 0.5858, t = 2.41; and 0.9965, t = 2.52, respectively), suggesting that the predicted portion or the norm of perks enhances a firm’s operating income more than the unpredicted portion of perks. Panel B reports results for stock returns, Stkre. The coefficients on the predicted portion of perks, Perk_Pre, are positive and significant for Years t + 1, t + 2 and t + 3 (117.4185, t = 7.44; 137.3368, t = 6.80; and 44.0370, t = 2.62, respectively) while the coefficients on the unpredicted portion of perks, 20

Perk_Res, are all insignificant. Again, results based on stock returns suggest that the predicted portion or the norm of perks enhances firm value and operating performance and not the unpredicted portion of perks. This result enhances the notion that perks, used properly, can motivate managers to work hard for the shareholders.

Value enhancing role of perks under certain conditions Supporting Hypothesis 3, we find that perks generally have a positive effect on firm value. Therefore, the positive motivation role of perks likely exceeds the agency cost associated with them. Based on results related to the major determinants of perks, firms with higher economic rent, more growth and a lower level of relative pay provide more perks to top managers. Under these conditions, the positive effect of perks on firm value should also be higher. To test this possibility, we create indicator variables, Indicator_Rent, Indicator_TQ, and Indicator_Rp. If a firm’s economic rent, Rent, growth, TQ, or relative pay, Rp, is above the industry median, the corresponding indicator variable equals one, otherwise it equals zero. We add their interaction terms with Perk to Models (2) and (3) and obtain Models (7) and (8) below: Oiit, it + 1, it + 2, it + 3 = a0 + a1Cpit + a2Perkit + a3Perkit*Indicator_Xit + a4Levit + a5Sizeit + a6Eastit +∑Industryit + εit,

(7)

Stkreit, it + 1, it + 2, it + 3 = a0 + a1Cpit + a2Perkit + a3Perkit*Indicator_Xit + a4Levit + a5Sizeit + a6Eastit +∑Industryit + εit,

(8)

where Indicator_X represents Indicator_Rent, Indicator_TQ or Indicator_Rp. If our reasoning is valid, then the coefficients on Perk*Indicator_Rent and Perk*Indicator_TQ should be positive while the coefficient on Perk*Indicator_Rp should be negative. We first examine the effects of these interaction terms on current period firm performance. From Panel A, Table 8, when the dependent variable is the current year operating income, Oi, the coefficients on Perk*Indicator_Rent (1.8586, t = 9.92) and Perk*Indicator_TQ (1.5280, t = 7.88) are positive and significant. The coefficient on Perk*Indicator_Rp is negative but not significant (-0.2361, t = -1.14). From Panel B of Table 8, when the dependent variable is the current year stock return, Stkre, the coefficient on Perk*Indicator_Rent is positive but not significant (3.2218, t = 1.10). The coefficient on Perk*Indicator_TQ is significantly positive (8.1662, t = 2.68). The coefficient on Perk*Indicator_Rp is negative but not significant (-0.6011, t = -0.20). 21

Next, we examine the effects of these interaction terms on future firm performance. Panel A, Table 8 presents results for operating income Oi one year, two years, and three years in the future. The coefficients on Perk*Indicator_Rent are positive and significant: 1.3593 (t = 5.59) for one year, 1.0665 (t = 2.65) for two years, and 1.3041 (t = 2.01) for three years in the future. The coefficients on Perk*Indicator_TQ are positive but significant only for Oi one year in the future: 1.5833 (t = 6.59) for one year, 0.5369 (t = 1.32) for two years, and 0.4746 (t = 0.58) for three years in the future. The coefficients on Perk*Indicator_Rp are negative but significant only for Oi one year in the future: -0.5808 (t = -2.29) for one year, -0.2885 (t = -0.55) for two years, and -0.6836 (t = -0.79) for three years in the future. Panel B, Table 8 presents results for cumulative stock returns, Stkre, one year, two years and three years in the future. The coefficients on Perk*Indicator_Rent are always positive: 4.6349 (t = 0.75) for one year, 13.8519 (t = 1.77) for two years, and 19.8295 (t = 2.91) for three years in the future. The coefficients on Perk*Indicator_TQ are always positive but not significant. The coefficients on Perk*Indicator_Rp are always negative: -9.1405 (t = -1.42) for one year, -18.6605 (t = -2.21) for two years, and -32.1880 (t = -4.23) for three years in the future. Results above generally support our prediction that firms with high economic rent, high growth, and low relative pay tend to use perks to motivate top managers and enhance firm value. These results are consistent with the notion that perks, used properly, can motivate managers to work hard for the interest of the shareholders.

State owned versus non-state owned firms As discussed earlier, pay restrictions are usually imposed on state owned enterprises (SOEs). Of course, their spillover effect can impact non-state owned enterprises (non-SOEs), causing these firms to also have a relatively low level of monetary compensation. However, non-SOEs are more likely to have some freedom in choosing their levels of top management monetary compensation. We run regressions separately for SOEs and non-SOEs. Results using operating income are presented in Panel A, Table 9. Using the current period operating income, the coefficient on Perk is 0.7796 (t = 4.83) for SOEs while that for non-SOEs is 0.5397 (t = 1.88). Using operating income one year in the future, the coefficient on Perk is insignificant for SOEs while that for non-SOEs is positive and significant (0.9058, t = 2.44). Using operating income two years and 22

three years in the future, the coefficient on Perk is positive and significant, 0.8028 (t = 3.26) two years in the future, and 0.8058 (t = 1.97) three years in the future, for SOEs, while that for nonSOEs is insignificant for operating income two years in the future and positive significant, 1.9783 (t = 2.48) for operating income three years in the future. Therefore, when we focus on operating income, it is not obvious that the positive role of perks is more pronounced for SOEs than for non-SOEs. Results using future stock returns are presented in Panel B, Table 9 and the difference between SOEs and non-SOEs is not obvious either.

5. Summary and conclusion Using information on publicly listed Chinese firms, we empirically examine the determinants of top managers’ perk consumption and the effect of perks on firm performance. We find that top managers’ perk consumption is high in firms with high free cash flows, high economic rent and growth potentials and in firms with low relative pay between top managers and average employees. Our analysis of the effect of perks on firm performance reveals that both top management monetary compensation and perks positively affect firm performance. However, the effect of monetary compensation is more pronounced and persistent than that of perks. Further, we find that the predicted portion or the norm of perks enhances firm performance and not the unpredicted portion of perks. Finally, we find that for firms with high economic rent, high growth and low relative pay between top managers and average employees, the effect of perks on firm performance is stronger. By examining the determinants of perks and whether and how perks impact firm value, we make a contribution to the literature on managerial incentives and to a better understanding of China’s economic development. While we use data collected from Chinese firms, we believe that we have answered or have attempted an answer to a research question that is of universal importance and interest. It is important to note that we discuss advantages and disadvantages of perks based on certain assumptions. For example, perks are associated with a high level of monitoring cost; perks are less likely to attract the attentions of the regulatory authority and mass media than monetary compensation; perks are flexible and firms can easily modify perks without being constrained by the rigidity associated with monetary compensation. These assumptions are not 23

empirically tested in this paper and we leave them to future research.

24

References Adams, R. B., and D. Ferreira. 2008. Do directors perform for pay? Journal of Accounting and Economics 46, 154-171. Alchian A. A., and Harold Demsetz. 1972. Production, Information Costs, and Economic Organization. American Economic Review 65, 777-795. Andrews, A., S. C. Linn, and H. Yi. 2009. Corporate governance and executive perquisites: Evidence from the new SEC disclosure rules. Working paper. Berle, A. A., and G. C. Means. 1932. The modern corporation and private property. New York, Harcourt, Brace and World, 1968. Boschen, J. F., A. Duru, L.A. Gordon, K.J. Smith. 2003. Accounting and stock price performance in dynamic CEO compensation arrangements. The Accounting Review 78, 143168. Cai, J., and R. A. Walkling. 2011. Shareholders’ say on pay: Does it create value? Journal of Financial and Quantitative Analysis 46, 299-339. Chen, D., X. Chen and H. Wan. 2005. Regulations on compensation and perks in state owned enterprises. Economic Research (in Chinese) 442, 92-101. Coase, R. H. 1937. The nature of the firm. Economica 4, 386-405. Coase, R. H. 1960. The problem of social cost. Journal of Law and Economics 3, 1-44. Coase, R. H. 1972. Durability and monopoly. Journal of Law and Economics 15,143-149. Core, J., W. Guay, and D. F. Larcker. 2008. The power of the pen and executive compensation. Journal of Financial Economics 88, 1-25. Grinstein, Y., D. Weinbaum, N. Yehuda. 2008. Perks and excess: Evidence from the new executive compensation disclosure rules. Working paper. Grossman, S. and O. Hart. 1980. Takeover bids, the free-rider problem, and the theory of the corporation. Bell Journal of Economies 11, 42-64. Hart, O. D. 1988. Incomplete Contracts and the Theory of the Firm. Journal of Law, Economics, and Organization, 4, 119-140. Reprinted in Oliver E. Williamson and Sidney G. Winter, eds. 1991. The nature of the firm. Oxford University Press, New York. Hart, O. D. 1995. Firms, contracts, and financial structure. Clarendon Press, Oxford. Jensen, M. C. 1986. Agency costs of free cash flow, corporate finance, and takeovers. American Economic Review 76, 323-329. Jensen, M. C., and W. H. Meckling. 1976. Theory of the firm: Managerial behavior, agency cost and ownership structure. Journal of Financial Economics 3, 305-360. Jensen, M. C., and K. T. Murphy. 1990. Performance pay and top-management incentives. Journal of Political Economy 98, 225-264. Leone, A. J., J. S. Wu, and J. L. Zimmerman. 2006. Asymmetric sensitivity of CEO cash compensation to stock returns. Journal of Accounting and Economics 42, 167-192. Lin, J. Y. 1998. Competition, policy burdens, and state-owned enterprise reform. American Economic Review: Papers and Proceedings 88, 422-27. Lin, J. Y., and G. Tan. 1999. Policy burdens, accountability, and the soft budget constraint. American Economic Review: Papers and Proceedings 89, 426-31. Murphy, K. J. 1985. Corporate performance and managerial remuneration: An empirical analysis. Journal of Accounting and Economics 7, 11-42. 25

Murphy, K. J. and J. Zábojník. 2004. CEO pay and appointments: A market-based explanation for recent trends. American Economic Review 94, 192-196. Rajan, R. G., and J. Wulf. 2006. Are perks purely managerial excess? Journal of Financial Economics 79, 1-33. Richardson, S. 2006. Over-investment of free cash flow. Review of Accounting Studies 11, 159189. Williamson, O. E. 1988. Corporate finance and corporate governance. Journal of Finance 53, 567-591. Yermack, D. 2006. Flights of fancy: Corporate jets, CEO perquisites, and inferior shareholder returns. Journal of Financial Economics 80, 211-242.

26

Figure 1. Relative pay of sample firms during 1999-2007

Figure 2. Relative pay of SOEs and Non-SOEs during 1999-2007

27

Figure 3. Percentage of firms disclosing perk information

Percentage of disclosing perk information companies

Percent 60% 50% 40% 30% 20% 10% 0% 1999

2000

2001

2002

2003 Year

2004

2005

2006

2007

Figure 4. Sum of monetary compensation and perks (in millions) per year Cp

M illions

Perk

30 25 20 15 10 5 0 1999

2000

2001

2002

28

2003 Year

2004

2005

2006

2007

Table 1 Number of Top Managers and Average Compensation Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 Year 1999 2000 2001 2002 2003 2004 2005 2006 2007

Panel A. Number of Top Managers Mean Lower Quartile Median Upper Quartile 11.50 8 11 15 11.13 8 11 14 11.05 8 10 14 12.40 10 12 15 13.52 11 13 16 13.66 11 13 16 12.98 11 13 15 13.64 11 13 16 13.88 11 13 16 Panel B. Average Top Manager Monetary Compensation N Obs Mean Lower Quartile Median Upper Quartile 163 42,469.29 18,750.00 28,800.00 50,000.00 254 49,207.49 21,454.55 34,426.57 60,558.76 317 76,810.53 32,376.13 56,975.00 101.473.33 397 78,194.28 38,928.57 64,144.62 102,500.00 398 92,334.66 44,166.67 71,696.97 115,882.35 503 109,859.13 53,888.89 85,923.08 137,909.09 558 112,834.27 56,654.20 91,784.52 145,966.67 509 127,427.61 60,885.18 102,500.00 163,613.33 489 174,602.12 83,571.43 138,288.24 221,140.00 N Obs 163 254 317 397 398 503 558 509 489

29

Table 2 Sample Selection This table presents the sample selection procedure. We examine Chinese listed companies that disclose perk data from 1999 to 2007. We obtain 4,869 firm-year observations. We delete 692 firm-year observations that have no more than one year of listing history, 33 firm-year observations for financial companies, 483 firm-year observations with missing data required by our regression model and end up with 3,661 firm-year observations. In regression analysis, we use perk divided by year-start total asset. Since the data on perks are manually collected, we delete the upper and lower 1% of perk and obtain 3,588 firm-year observations.

Year 1999 2000 2001 2002 2003 2004 2005 2006 2007 Total Observations

923 1,060 1,136 1,200 1,263 1,353 1,358 1,411 1,574

Companies disclosing perk informatio n 256 395 467 531 540 646 688 604 742

11,278

4,869

A share Listed companie s

Age no more than 1

Financi al compan ies

Compani es with missing values

Observatio ns available

60 106 92 68 64 106 77 5 114

1 1 3 0 1 6 8 7 6

32 28 46 63 70 23 38 66 117

163 260 326 400 405 511 565 526 505

692

33

483

3,661

30

Table 3 Descriptive Statistics and Correlations Perk is defined as the total amount of managerial perquisites, the aggregate of the following eight expenses: 1) office expense, 2) business travel expense, 3) business entertainment expense, 4) communication expense, 5) training abroad expense, 6) board meeting expense, 7) company car and chauffer service, and 8) meeting expense. To facilitate regression analysis, the total amount of perks is scaled by beginning of the period total asset. Cp is defined as total managerial monetary compensation such as salaries and bonuses paid to members of the board of directors, CEOs and other top executives. Cp is scaled by the beginning of the period total asset. Oi is operating income scaled by the beginning of the period total asset. Stkre is cumulative stock return. FCF is a firm’s free cash flow measured based on Richardson (2006). A firm’s economic rent, Rent, is its gross profit margin minus the median gross profit margin of the industry that the firm belongs to. TQ is a firm’s Tobin’s Q. Rp is an indicator variable for relative pay. If a firm’s ratio of per capita pay for top managers divided by per capita pay of average employees exceeds that of the median in the industry, Rp equals one, otherwise it equals zero. Rinde is the ratio of the number of independent directors to the number of all directors. Dual is an indicator variable that equals one if the CEO also serves as the chairman of the board, and zero otherwise. Sh is the percentage stock ownership of the largest shareholder. Mshare is the percentage ownership of the firm by the top managers. Lev is the ratio of year-end debt divided by total asset. Size is the natural logarithm of year-end total asset. East is an indicator variable that equals one if a firm is on the east coast of China, and zero otherwise. Industryi (i = 1, 2, …, 20) is an indicator variable that equals one if a firm belongs to industry i, and zero otherwise. Protected is an indicator variable that equals to one if a firm belongs to a protected industry, and zero otherwise.

Variable Stkre Oi Perk Perk(abs) Cp Cp(abs) FCF Rent TQ Rp Rinde Dual Sh Mshare Lev Protected Size Size(abs) East # Obs.

Mean 0.3910 0.0402 0.0087 16.9794 0.0010 1.4189 -0.0134 0.0057 1.1964 0.5137 0.2636 0.1034 0.4075 0.0050 0.4856 0.3743 21.1831 2,642.2885 0.5362 3,588

Panel A : Descriptive Statistics Lower Quartile Median -0.2570 -0.0285 0.0086 0.0347 0.0029 0.0057 3.5801 7.6513 0.0004 0.0007 0.5024 0.9709 -0.0597 -0.0118 -0.0550 -0.0000 0.8355 1.0306 0.0000 1.0000 0.2222 0.3333 0.0000 0.0000 0.2758 0.3937 0.0000 0.0001 0.3617 0.4889 0.0000 0.0000 20.5957 21.1352 880.2217 1,509.7839 0.0000 1.0000 3,588 3,588

31

Upper Quartile 0.4527 0.0707 0.0108 16.4060 0.0013 1.8110 0.0355 0.0645 1.4149 1.0000 0.3333 0.0000 0.5396 0.0003 0.6121 1.0000 21.7259 2,725.5600 1.0000 3,588

Variable Perk FCF Rent TQ Cp Rp Rinde Dual Sh Mshare

Table 3 Descriptive Statistics and Correlations (continued) Perk 1.0000 0.0336 0.0442 0.0607 0.0003 -0.0154 0.3554 0.3065