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Imran S. Currim, Jooseop Lim, Joung W. Kim

You Get What You Pay For:The Effect of Top Executives'

Compensation on Advertising andR D Spending Decisions and Stock

Market ReturnAlthough there is literature on how top executives' compensation influences general management decisions,relatively little is known about whether and how compensation influences advertising and research-and-development(R D) spen ding decision s. This study address es two question s. First, is there an incentive effect of  long-  versusshort-term co mpensation on advertising and R D spending? Se cond, is there a mediation effect of advertising andR D spending on the relationship between  long-  versus short-term compensation and stock market return? Theauthors address these questions using a combination of ExecuComp, Compustat, and Center for Research in

Security Prices data on 842 firms during the 19 93-200 5 period. They find that an increase in the equity to bonuscom pens ation ratio is positively associated with an increase in advertising and R D spending as a share of sales.Adv ertising and R D spending as a share of sales also mediates the effect of equity to bonus ratio on stock m arketreturn. The authors discuss implications for top m anagement seeking to mitigate myopic m anagement of resourcesby employing compe nsation to incentivize a longer-term orientation for advertising and R D spending to improvestock return.

  eywords top executives' compensation, advertising and R D spending, stock m arket return

If you pick the right people and give them the opportunityto spread their wings and put compensation as a carrier

behind it you almost don't have to manage them.

—Jack Welch (www.brainyquote.com/quotes/quotes/j/jackwelchl30691.html)

AS a result of declining co rporate profitab ility, stag-

nant share prices in the 1970s, and the emergence of

agency theory , there has been a rapid movement in

the redesign of top executives ' compensation to al ign i t

Imran S. Currim is Chanceilor's Professor, Paui Merage Schooi of Business,

University of California, Irvine (e-mail: iscurrim§uci.edu ). Jooseop Lim is

Associate Professor of IVIarketing, John Molson School of Business, Con-

cordia University, Montreal (e-mail: jlimQjmsb.concordia.ca). Joung W.

Kim is Associate Professor of Accounting, H

Wayne Huizenga School ofBusiness and Entrepreneurship, Nova Southeastern University, Fort

Lauderdale (e-mail: joung@huizenga.nova.edu). The authors thank Pro-

fessors Gary Erickson of the University of Washington; Connie Pech-

mann, Morton P incus, and Yu Zhang of the University of California, Irvine;

and the UCI/UCLA/UCR/USC marketing colloquium participants for their

comments. This article is supported by the dean's office of the University

of California, Irvine, Paul Merage School of Business; FQRSC (Fonds de

recherche sur la société et la culture); SSHRC (Social Science and

Humanities Research Council of Canada); and the Bell Research Center

for Business Process Innovations. The first two authors contributed

equally to the manuscript and are listed in alphabetical order. Leigh McAl-

ister served as area editor for this article.

more closely with sh areholders' interests. By 1998, the esti-

mated present value of stock options, which incentivize

long-term performance, represented 45 of the median paypackage for chief executive officers (CEOs) of public cor-

porations (Copeland, Koller, and Murrin 2000). A new

trend, however, emerged in the early 2000s—a shift away

from stock options and toward short-term performance-

based bon uses and restricted stock, so that the proportion of

compensation delivered through stock options in 2004

reached its lowest level in the previous seven years   Th e

Economist  2004). Because top executives' compensation

has changed substantially over time, it is important to ask

whether such changes have influenced advertising and

research-and-development (R&D) decisions.

Value creation, through investments in R&D for new

product and process development, in combination with

value appropriation, through investments in advertising for

building brands and product sales, are two m ain elements of

a firm's strategy that have been found to be important deter-

minants of firm growth, risk, performance, and value (e.g.,

Krasnikov and Jayachandran 2008; McAlister, Srinivasan,

and Kim 2007 ; Mizik 20 10; for a review, see Srinivasan and

Hanssens 2009). However, there has been little study in the

marketing literature of financial drivers of advertising and

R&D spending decisions. Two studies have considered

financial pressures on managers from investors—specifi-

© 201 2, American Marketing AssociationISSN: 0022-2429 (print), 1547-7185 (electronic) 33

  ournal of MarketingVolume 76 (September 2012), 33-48

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cally, how a seasonal equity offering can affect marketing

spending (Mizik and Jacobson 2007) and how investor

expectations of stock returns can affect advertising and

R&D spending (Chakravarty and Grewal 2011). Joseph and

Richardson (2002) consider the influence of free cash flow

and agency costs on advertising spending. We study a dif-

ferent financial variable that potentially drives advertising

and R&D spending—namely, top executive compensation.

Although there are studies on the relationship between

compensation and general management decisions—such asinvestment in property, plant, and equipment; corporate

focus versus diversification; and the use of financial lever-

age in investment, debt, and firm risk policies (e.g.. Coles,

Daniel, and Naveen 2006; for a review, see Devers et al.

2007)—relatively little is known about the impact of com-

pensation on advertising and R&D spending decisions.

Top executives are ultimately responsible for firm strat-

egy, growth, risk, budgets, and firm performance in the

product and capital markets. They hold final responsibility

for budgets that affect the firm's investments in value crea-

tion (R&D) and value appropriation (marketing) strategies.

Although top executives are not directly involved in the

day-to-day operational decisions of the firm (e.g., theadvertising spending decision), their motivations strongly

influence the behavior of lower-level managers (Joseph and

Richardson 200 2). Such a view is consistent with Fama and

Jensen's (1983) observation that lower-level managers initi-

ate and implement spending plans and top executives

approve and monitor such plans. In other words, managers

who initiate and implement spending plans learn to submit

plans and budgets that have a convergence of interest

with top executives so that these plans and budgets are

likely to be approved (Joseph and Richardson 2002). In this

way, top executives influence a variety of operational deci-

sions taken by lower-level managers, including the setting

of advertising and R&D budgets.

Managers generally expect long-term benefits of R&D

spending on new product and process development and

long-term benefits of advertising spending on building

brands and product sales. However, the Financial Account-

ing Standards Board's (FASB) policies in the United States

based on Generally Accepted Accounting Principles

(GAAP) require marketing and R&D spending to be, in

most cases, completely expensed in the period incurred,

which offers tax advantages but makes the important

assumption that there are no future benefits, resulting in

current-period expenses that are larger than the tax savings.

In addition, managers are often faced with short-term earn-

ings pressures, declining demand, less than desirable eco-

nomic conditions, and the prospect of limited tenure in the

firm. Furthermore, there may be uncertainty regarding the

long-term benefits of R&D in particular, and advertising as

well. Such factors can create powerful short-term disincen-

tives for managers to spend on advertising and R&D, if

they believe that the full benefit from current spending will

not be observed immediately but rather at some point in the

future, while the costs are realized immediately (Mizik

2010).  We are interested in exploring whether top execu-

tives'  compensation, if designed to incentivize long- versus

short-term performance, will motivate advertising and R &D

spending, despite these powerful disincentives.

The marketing literature has focused on marketing-

based drivers of product development and advertising deci-

sions,  such as a firm's marketing goals, outcomes, and the

marketing efforts and outcomes of its competitors (e.g.,

Danaher 2008; Kotier and Keller 2008; Leeflang et al.

2000; Lilien, Kotler, and Moorthy 1992). There may be

nonmarketing drivers of product development and advertis-

ing decisions as well. If a nonmarketing driver such as top

executives' compensation influences R&D and advertising

spending and stock market return and this driver is not con-

sidered, the resultant understanding of managerial product

development and advertising decisions could be myopic.

Consequently, our first research question is whether top

executives' long- versus short-term compensation incen-

tivizes advertising and R&D spending. Second, we are

interested in whether advertising and R&D spending medi-

ates the effect of long- versus short-term compensation on

stock market return. We find that long- versus short-term

compensation is associated with advertising and R&D

spending and that advertising and R&D spending mediate

the effect of long- versus short-term compensation on stockmarket return. The contributions of our results are twofold.

First, if value creation and appropriation are important for

the firm, compensation committees can employ long- ver-

sus short-term compensation to incentivize advertising and

R&D spending despite the powerful disincentives noted

previously. This is particularly important because the cur-

rent trend toward short-term performance-based bonuses

can hurt long-term value creation and appropriation invest-

ments, goals, and activities of firms. The decision to

employ long- versus short-term compensation to incentivize

long-term investments and goals is facilitated if such com-

pensation is found to incentivize long-term investments in

value creation and appropriation and if such investmentsare found to improve stock market returns. Second, the

potential mediation of R&D and advertising also provides

an explanation for the relationship between compensation

and stock market return observed in the compensation lit-

erature (Devers et al. 2007), which we review in greater

detail in the next section. The results of agency theory-

based studies on the role of incentive pay in aligning goals

and risk preferences have been mixed (for a review, see

Devers et al. 2007), so whether goals will be aligned in the

advertising and R&D spending decision remains unclear.

As Devers et al. (2007, p. 1039) state, It is clear that there

is still much to be learned about executive compensation;

thus we believe that cross-discipline integration holds thepotential to significantly advance compensation research

and practice. Consequently, by testing whether compensa-

tion incentivizes advertising and R&D spending and

whether advertising and R&D spending mediates the rela-

tionship between compensation and stock m arket return, we

attempt to provide such cross-discipline integration. To the

best of our knowledge, establishing the  incentive  effect of

compensation on advertising and R&D spending and the

medi tion  effect of advertising and R&D spending on the

relationship between compensation and stock market return

is new in both marketing and compensation literatures.

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The findings have potential to benefit top executives,

marketing managers, firms, employees, shareholders, and

consumers. By understanding the disincentives to invest in

advertising and R&D and the relationship between compen-

sation and spending on advertising and R&D, as well as

stock market return, corporate compensation committees

will be better able to design the compensation packages of

top executives so that correct incentives are created   {The

Economist  2004). In turn, top executives could design bet-

ter compensation packages for senior managers, including

senior marketing managers, so that they will be less pres-

sured to employ marketing resources in ways that might be

counterproductive to the firm's long-term performance

(e.g., Lodish and M ela 2007). Firms with growth o pportuni-

ties related to value creation and value appropriation would

stand to gain if risk-averse managers could be motivated to

invest in long-term performance (e.g., Guay 1999). As a

result, firms would be financially better off or more stable

in the long run, employees would benefit from company

stability, shareholders would receive m ore long-term value,

and consumers would be better off living in an economy

enabled by higher long-term firm performance.

ExpectationsIn this section, we briefiy review background literature in

marketing, accounting, finance, and management to for-

mally develop our expectations. Specifically, we do this in

three steps. First, we identify components of top manage-

ment compensation to identify those that incentivize long-

versus short-term performance. Second, we review studies

on how compensation affects general managerial decisions

to develop an expectation on the relationship between long-

versus short-term compensation and advertising and R&D

spending decisions. Third, we review studies on (1) the

relationship between compensation and stock market return

and (2) the relationship between advertising and R&D

spending and stock market return to develop an expectation

regarding advertising and R&D spending mediating the

relationship between compensation and stock market return.

  omponents of Top Executive ompensation

The literature on incentive contracting identifies seven

components of total compensation reported for an execu-

tive: cash salary, cash bonus, the   ex ante  value of options

awarded, restricted stock awards, incentive plan payouts,

other annual compensation, and all other compensation

(Anderson, Banker, and Ravindran 2000). Salary is a fixed

portion of compensation and is not dependent on the perfor-mance of executives. Cash bonuses are designed to moti-

vate executives to perform to the best of their abilities and

achieve the firms' financial and other performance objec-

tives in the current year, or on a short-term basis.

Restricted common stock, while also performance

based, is designed to provide a longer-term incentive to

executives. The stock option component is a contract

between a firm and employees obligating the company to

sell stock to the employee at a predetermined price.

Employee stock options are typically designed to be exer-

cised in the long run, so that this component of compensa-

tion can encourage operating the business in a way that is

aligned with the maximization of long-term performance.

Stock options are a riskier compensation contract than

restricted common stock because stock options pay out only

if the share price rises above a certain point, whereas

restricted stock is worth something at any level. This is par-

ticularly relevant when the market falls because options

could be valueless, while restricted stock can be sold even

at a lower price  {The Economist  2004).

Incentive plan payouts are amounts paid to the execu-tives during a current year and consequently do not rely on

firm value in the future. Of the seven components of com-

pensation identified, the value of restricted stock and stock

options are based on stock market return in the future and

consequently can motivate top executives to exercise strate-

gies that enhance a firm's long-term performance. In con-

trast, cash bonuses incentivize executives to meet the firm's

short-term objectives. Consequently, we employ the ratio of

restricted stock and stock options (long-term-based com-

pensation) and cash bonus (short-term-based compensa-

tion), or equity to bonus ratio, as our measure of long- ver-

sus short-term compensation.'

Incentive Effect of ompensation on ManagerialDecision Making

In this section, we develop hypotheses on the effect of com-

pensation on advertising and R&D spending. We do this in

two steps. First, we briefiy review theory on myopic man-

agement of resources—in other words, what causes man-

agers to cut advertising and R&D spending in the short run

even though such cuts are not in the long-term interest of

the firm. Second, we briefiy review theory on equity-based

compensation, which is designed to incentivize a longer-

term orientation and curb myopic management of resources,

so that managers make advertising and R&D spending deci-

sions that are in the best long-term interest of the firm.

Myopic management of resources Under perfect infor-

mation and effective compensation-based incentive con-

tracts, managers will make spending and investment deci-

sions based on net present value, in accordance with the

best interests of shareholders (e.g., lensen 1986). In reality,

however, managers are often better informed than share-

holders about the true state of a firm's current earnings and

future prospects, are often faced with earnings pressures

based on analysts' expectations, and have compensation-

based incentives that are not always well aligned with the

long-term interests of shareholders, all of which lead to an

overemphasis of short-term goals and the myopic manage-

ment of resources (Mizik 2 010). For example, in a theoreti-

cal model. Stein (1989) shows that introducing asymmetric

information in place of perfect information—that is, when

the manager has an advantage over the shareholder in

assessing the true state of a firm's current earnings and

future prospects—creates an incentive for the manager to

engage in intertemporal borrowing of earnings by cutting

intangible assets that are not on the balance sheet (e.g.,

advertising, R&D) to innate current earnings and mislead

'We thank a reviewer for suggesting this measure.

YouGetWhatYouPayFor 5

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investors to expect higher future earnings, thus temporarily

increasing stock price. Although the temporary increase in

stock price may be (negatively) corrected in the long-term,

managers who take the market reaction as fixed continue to

behave myopically. Myopic management of resources, or a

short-term opportunistic orientation, has been documented

in the marketing literature. Managers are found to cut

expenditures on marketing and R&D to improve bottom-

line earnings in the short-term, even if such cuts are found

to reduce stock market return in the long-term (e.g., Mizikand Jacobson 2007). Managers also have a tendency to be

risk averse (e.g., Guay 1999). Marketing and R&D spend-

ing can have uncertain future payoffs, and as we mentioned

previously, the FASB's GAAP-based policies require most

such spending to be expensed immediately, which exacer-

bates myopic management of resources. Myopic manage-

ment of resources is related to earnings management, and

several studies in the accounting and finance literatures

demonstrate that managers engage in earnings management

to affect stock price (e.g.. Baker, Stein, and Wurgler  2003;

Coles,  Hertzel, and Kalpathy 2005; Gong, Louis, and Sun

2008; McAnally, Srivastava, and Weaver 2008).

Equity based compensation.  Equity-based compensa-

tion is a motivational tool that can encourage longer-term

orientation, discourage m yopic management of resources or

short-term opportunism, and encourage risk seeking,

because it aligns the interests of managers with the longer-

term interests of shareholders. The majority of compensa-

tion research and practice is based on agency theory (e.g..

Fama 1980), which focuses on a central question: How does

one ensure that shareholders' interests are foremost in the

minds of managers when they make spending decisions?

Principals (shareholders) delegate duties to an agent

(manager), who is expected to act in the best interest of the

principal. Agents are self-interested and may extract bene-

fits or perquisites that sacrifice the principal's wealth. Thus,

agency theory raises the possibility of manag erial oppor-

tunistic behavior —for exam ple, myopic management—

which is referred to as an agency cost. Agency scholars

have suggested that equity-based compensation reduces

agency cost and myopic management because it aligns the

interest or goals of managers and shareholders by curbing

executive opportunism and discouraging risk aversion. For

example. Fama and Jensen  (1983,  p. 329) indicate that

 common stock that represents proportionate claims on the

payoffs of all future states eliminates these agency prob-

lems (costs).... Common stock and other forms of residual

income also avoid most of the costs of defining and verify-

ing states of the world. This quotation addresses the role of

equity-based compensation in curbing myopic management

of resources so that managerial decisions are made in the

best long-term interest of the firm.

While a considerable body of theory has been devel-

oped over the past three decades positing that equity-based

compensation that includes stock options and restricted

stock affects managerial decision making (e.g., Defusco,

Zorn, and Johnson 1991; Hemm er, Kim, and Verrecchia

  ;  Jensen and Mec kling 1 976), two studies in the

accounting and finance literatures—namely, Rajgopal and

Shevlin (2002) and Coles, Daniel, and Naveen  2006) —

provide empirical evidence that equity-based compensation

reduces agency cost and increases firm value for sharehold-

ers in the equity market.^ Optimal equity-based compensa-

tion contracts provide managers with adequate incentives to

maximize shareholder value. The use of equity-based com-

pensation increases the sensitivity of managers' wealth to

stock price or stock return volatility. The higher the sensi-

tivity of managers to stock options or restricted stock, the

harder managers work to increase the long-term value offirms because they share the same gains and losses that

shareholders take in the market. Rajgopal and Shevlin

(2002) show that managers who receive more stock option

compensation in the oil and gas industry invest more in

risky projects such as R&D. Coles, Daniel, and Naveen

(2006) confirm Rajgopal and Shevlin's result on risk taking

using a larger sample of Standard & Poor's firms and report

that managers with higher sensitivity to stock price spend

more on risky projects to increase the long-term value of

the firm, such as the usage of higher leverage in policies

related to investment, debt, and firm risk. These managers

spend less on less risky investments such as property, plant,

and equipment and engage in less diversification or focuson fewer lines of business.

There are other studies as well that use limited subsam-

ples or focus on special cases or specific conditions. For

example, Cheng (2004) shows a positive association

between CEO option-based compensation and R&D spend-

ing in R&D intensive industries (1) when the CEO

approaches retirement and (2) when the firm experiences an

earnings decline or small loss. Wu and Tu (2007) find a

positive association between CEO options and R&D spend-

ing in four industries. A few other studies do not focus on

the effect of compensation but rather on the effects of man-

agement style, geographic diversification, and CEO

turnover and comment on compensation. Bertrand andSchoar (2003) focus on management style and track top

managers across different firms over time to show that they

are well compensated and that their style explains several

organizational practices of the firm, including advertising

and R&D spending investments as well as firm perfor-

mance. Kim and Mathur (2008) focus on the effect of geo-

graphical diversification on firm performance and find that

geographically diversified firms have higher advertising

and R&D expenditures and return on assets than industri-

ally diversified firms. Firms with high equity-based com-

pensation are found to be associated with higher firm value

than firms with low equity-based compensation. Du and Lin

(2011) focus on the effects of CEO turnover and show thatnew CEOs with high options-based compensation follow-

ing forced turnover and with shorter organizational turnover

2Very few studies in this literature focus on marketing or R&Ddecisions. In contrast, the studies focus on developing agencytheory-based arguments related to goal alignment and misalign-ment (e.g.. Lie 2005), informational disclosures by executives ontheir strategic choices (e.g., Nagar, Nanda, and Wysocki 2003),individual choices (e.g., Rynes, Gerhart, and Parks 2005), riskpreference alignment (e.g., Desai and Dharampala 2006), and con-textual influences (e.g.. Cadenillas, Cvitanic, and Zapatero 2004).

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are associated with higher R&D and advertising invest-

ments. Luo, Wieseke, and Homburg (2011) show that

change in the proportion of long-term equity-based CEO

compensation is associated with a change in action to build

firm-customer and firm-employee relationships and cus-

tomer satisfaction and that customer satisfaction partially

mediates the relationship between changes in actions to

build firm-customer and firm-employee relationships and

firm value.

In summary, a variety of drivers, including asymmetricinformation, earnings pressures, poor economic conditions

or firm performance, and the prospect of limited tenure in

the firm, can drive managers to be myopic and cut advertis-

ing and R&D spending to improve the firm's bottom-line

earnings and stock price in the short run even if such

actions are likely to negatively affect the bottom line and

stock price in the long run. Managers display risk aversion

in cutting advertising and R&D spending because future

benefits can be un certain w hile costs are realized imm ediately.

Equity-based compensation is a motivational tool designed to

discourage myopic cutting of advertising and R&D spend-

ing because it attempts to align the interests of managers

with the longer-term interests of shareholders. Managers areless likely to be risk averse and thus are more likely to

make investments that have uncertain future payoffs, even

though costs are realized immediately. Consequently,

H|: An increase in the equity to bonus compensation ratio isassociated with an increase in the allocation to advertising

as a percentage of sales.

H2: An increase in the equity to bonus compensation ratio is

associated with an increase in the allocation to R&D as apercentage of sales.

We view spending as a share of sales to enable compari-

son between firms of different sizes. In the Mo del sec-

tion, we describe additional controls employed to test Hj

and H2. The po ssibility that a change in the equity to bon us

ratio of compensation is not associated with a change in

advertising or R&D spending as a share of sales—in other

words, the possibility that H| and H2 are not supported—is

consistent with comments in the press and academic work

that equity-based compensation is a politically expedient

way for top executives to pay themselves with little or no

relationship between compensation and managerial deci-

sion making or  ex post  performance (Yermack 1995). In

addition, many scholarly studies on compensation in the

accounting, finance, and management literatures offer

empirical evidence that stock options do not lead to behav-

ior that consistently conforms to rational finance-economic

predictions based on agency theory but rather conforms to

the behavioral agency model (Wiseman and Gomez-Mejia

1998). However, few such studies have investigated adver-

tising and R&D spending decisions (Wu and Tu 2007). In

contrast, these studies have examined early exercising of

options and have shown that stock price movements result

in risk aversion (e.g., Bettis, Bizjak, and Lemmon 2005;

Heath, Huddart, and Lang 1999) and not risk seeking as

assumed in the agency theory model. In other words, the

results of agency theory-based studies on the role of incen-

tive pay in aligning goals and risk preferences have been

mixed (for a review, see Devers et al. 2007), so whether

goals will be aligned in the advertising and R&D spending

decision remains unclear. Devers et al. (2007) indicate that

there is still much to be learned about executive compensa-

tion and that cross-discipline integration holds the potential

to significantly advance compensation research and prac-

tice. Consequently, by testing H| and H2 in the context of

advertising and R&D spending decisions, we provide cross-

discipline integration to make a contribution to the market-

ing literature and the compensation literatures in account-ing, finance, and management.

Mediation Effect of Advertising and R DSpending on Reiationship BetweenComp ensation and Stock  aricet Return

To hypothesize a mediation effect of advertising and R&D

spending on the relationship between compensation and

stock market return, we briefly review the literature on two

effects: (1) the effect of compensation on performance and

(2) the effect of advertising and R&D spending on stock

market return. We reviewed the effect of compensation on

advertising and R&D spending in the preceding section.

Effect of compensation on performance Compensation

research in accounting, finance, and managem ent literatures

has evolved significantly over time. Earlier compensation

research focused on the direct but coarse and distal

pay-performance relationship by examining the influence

of total pay or aggregate pay measures on firm outcomes.

However, considerable literature suggests that firm perfor-

mance is a function of not just managerial decisions but

also factors ou tside manag ers' control (McGahan and Porter

1997; Yermack 1997). Consequently, it is not surprising that

results of early research examining the effect of aggregate

or total pay on performance were mixed (Tosi et al. 2000).

As a result, subsequent research examined the effect of pay

plan proposals, adoption, and individual pay elements (e.g.,

stock options) on performance. For example, Morgan and

Poulsen (2001) demonstrate that pay plan proposals are sig-

nificantly associated with shareholder wealth in the year

before and after proposals and that proposing firms increase

earnings and stock market performance over nonproposing

firms. Core and Larker (2002) show that following pay plan

adoption, executive equity ownership and stock returns

increase significantly relative to prior pay plan adoption.

Hogan and Lewis (2005) show that anticipated economic

profit plan (which reward managers when earnings exceed

the cost of capital) adopters managed assets more effi-

ciently and had higher profits and shareholder value than

comparable firms that were predicted to adopt economic

profit plans but did not. Certo et al. (2003) find support for

the relationship between stock options and equity owner-

ship on valuation for initial public offerings. Hanlon, Raj-

gopal, and Shevlin (2003) find that top management team

stock option grants positively influence firm performance.

Kato et al. (2005) demonstrate higher returns for Japanese

firms adopting stock option compensation following a regu-

lation change in 1997 that permitted its use. Bhagat and

Bolton (2008) focus on corporate governance and find cor-

relations between stock ownership and firm performance.

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In summ ary, there is a clear body of research dem onstrating a

positive relationship between compensation and stock return.

Effect of advertising and R D spending on stock market

return. The literature on the effect of advertising and R D

spending on stock return was recently reviewed in the mar-

keting literature (see Srinivasan and Hanssens 2009), so our

coverage is brief and focuses on theoretical linkages. In a

recent study, Joshi and Hanssens (2010) demonstrate a posi-

tive relationship between advertising and firm value for five

of nine firms in two product categories. They suggest twotheoretical effects, spillover and signaling, as potential links

between advertising and firm value. First, an increased

level of advertising will spill over to the demand for stocks

of companies due to a higher level of brand awareness and

perceived brand quality in a product market. Research in

finance and behavioral decision theory supports the

spillover effect (Frieder and Subrahmanyam 2005; Heath

and Tversky 1990; Huberman 2001). Second, an increased

level of advertising gives investors a signal of financial

well-being or competitive viability of a firm. Research in

accounting, finance, and marketing supports the signaling

effect (Cha uvin and Hirschey 1993; Gifford 1997; Mathur

and Mathur 2000; Mathur, Mathur, and Rangan 1997;Simpson 2008). Luo and De Jong (2010) use a large data

set of 1052 firms over 20 years to show that reduction in

advertising is associated with reduction of stock return and

that analysts' activities, which serve as external validation

of the logic underlying advertising spending, mediate the

impact of advertising on firm return and risk. In addition,

there are a few studies that suggest a relationship between

advertising and stock market return because, on the one

hand, they link brand values (Barth et al. 1998), brand strat-

egy (Rao, Agarwal and Dahloff 2004), customer satisfac-

tion (Fornell et al. 2006; Luo, Homburg, and Wieseke

2010),  and marketing communications productivity (Luo

and Donthu 2006) to financial market outcomes and, on theother hand, link advertising effort to systematic market risk

(McAlister, Srinivasan, and Kim 2007).3-4

Researchers have also found that R D expenditures

(e.g., Chan, Lakonishok, and Sougiannis 2001) and related

^There are also some early studies in the accounting literaturethat show a relationship between advertising and R D spendingon financial market outcomes (Hirschey 1982; Hirschey and Wey-gandt  1985). The main focus of these studies is capitalization andamortization of intangibles.

'•In addition, the marketing literature theorizes that advertisinghas the potential to develop a comparative advantage because it

can enhance brand name recognition and equity (Aaker 1996;Keller 1998), increase differentiation (Kirmani and Zeithaml1993), reduce product substitutability (Mela, Gupta, and Lehmann1997),  increase the price premium (Ailawadi, Neslin, andLehmann 2003), lower price sensitivity (Kaul and Wittink 1995;Sethuraman and Tellis 1991), and protect a brand from competi-tive sales promotions of lower-equity brands (Blattberg, Briesch,and Fox 1995). In addition, brand equity can improve loyalty andreceptiveness of consumers and distributors to new product intro-ductions in existing markets (Kaufman, Jayachandran, and Rose2006), help up-sell and cross-sell existing customers (Kamakura etal. 2003), and help the firm when it enters new markets (Srivas-tava, Shervani, and Fahey 1998). Advertising can also create barri-ers to entry and increase bargaining power over distributors.

constructs such as innovation (e.g., Pauwels et al. 2004;

Srinivasan et al. 2009), new product announcements (Chaney,

Devinney, and Winer 1991), brand extensions (Lane and

Jacobson 1995), and product quality (Aaker and Jacobson1994;  Mizik and Jacobson 2009b) are associated with stock

return. In summary, compensation research indicates a po si-

tive relationship between equity-based compensation and

stock market return. Hj and H2 predict that equity-based

compensation will encourage advertising and R D spending.

In addition, advertising and R D spending is positivelyassociated with stock market return .5 On the basis of these

expectations and findings, we hypothesize the following:

H3: Advertising and R D spending as a percentage of s les atleast partially mediates the effect of equity to bonus com-pensation on stock return.

Our perspective is that compensation affects advertising

and R D spending , which in turn affects stock return. An

alternative perspective is that advertising and R D spend-

ing affects firm performance, which in turn infiuences com-

pensation. The difference is that the alternative perspective

focuses on the actual amount of compensation (the number

of dollars) a manager receives at the end of the period,

while our perspective focuses on the compensation package

(equity to bonus ratio) that will motivate the manager's

behavior in the coming period . An example of a part of the

second perspective is O'Connell and O'Sullivan (2011),

who show a relationship between firm performance on a

customer satisfaction metric and the total cash the CEO

receives at the end of the period. However, the second per-

spective assumes that compensation is based on spending,

which could be viewed as counterintuitive.

H3 does not suggest full mediation for two reasons.

First, as we reviewed previously, considerable literature

suggests that firm performance is a function of not just

managerial decisions but also factors outside managers'

control (e.g., the economy and actions of compe titors). Sec-

ond, there could be long-term strategic managerial deci-

sions other than advertising and R D that managers with

higher equity to bonus compensation ratios could pursue

and that could also drive stock returns (e.g., mergers and

acquisitions). H3 is worthwhile to test because, on the one

hand, it could be argued that advertising and R D clearly

create value, and therefore, in line with the established

theory of capital markets, top executives will invest in

advertising and R D spending , which will increase stock

market return, in support of  H3.  On the other hand, as Kim-

brough and McA lister (2009, p. 313) state.

Although the well-established theory of capital marketspredicts that actions that create value will be appropriately

5An exception is Joshi and Hanssens (2009), who find thatmovies with above-average prelaunch advertising have lowerpostlaunch stock returns, possibly due to high performance expec-tations built up before launch. Another is Erickson and Jacobson(1992), who fin substantially lower (or no) accounting and stockmarket measure returns to advertising and R D for 99 firms dur-ing the 1972-1986 period than had been indicated in previousresearch (Connolly and Hirschey 1984; Salinger 1984).

^We  thank the area editor for suggesting this explanation for thedifferences in perspectives.

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reflected in observed market values on a timely basis, thedegree to which this prediction holds empirically is notobvious, given ample evidence of the existence of fric-tions that may delay investors' efficient processing ofvalue-relevant information. In the case of intangibleinvestments such as marketing, these frictions include thelong-time horizon for the benefits of value-creating activ-ities to be realized and the inherent riskiness of such activ-ities, both of which complicate the task of forecasting thefuture implications of current marketing actions.

If frictions prevent investors from incorporating this infor-mation in the s tock value, we would expect no mediation

effect, and H3 would not be supported. Consequently, it is

wor thwhile to tes t whether adver t is ing and R&D decis ions

mediate the relat ionship between equity-based compensa-

tion and stock return and the extent to which such mediation

occurs . To the best of our knowledge, such mediation has

not been tested in the marketing literature or the compensa-

t ion li terature in accounting , f inance, and m anagem ent.

Model

  dvertising Share of Sales

The advertising spending decision as a share of sales is

modeled as a function of the equity to bonus ratio of com-

pensation, control variables related to performance in the

previous period, and year and firm fixed effects. We use

two performance measures for controls, one from the prod-

uct market (return on investment [ROI]) and one from the

capital market (stock return), because firms could increase

spending due to the affordability effect from the product

market (higher RO I, more cash, fewer financial constraints)

and reinforcing effect from the capital market (higher stock

return, firm value). We employ a one-period lag for each

performance measure because those are the product- and

capital-market ou tcomes observed at the time spending deci-sions are made (e.g., Markovitch, Steckel, and Yeung 2005;

Rappaport 1987; Srinivasan and Hanssens 2 009). Firm fixed

effects control for firm-level changes that affect the adver-

tising spending decision, such as the marketing literature-

based variables that we noted in the beginning of this article

and that are unobserved in ExecuComp and Compustat

data. Firm fixed effects are also important because there

could be unobserved heterogeneity across firms that affects

the equity to bonus ratio and advertising spending as a share

of sales (Himm elberg, Hubbard, and Palia 1999). Time-

based (year) fixed effects control for dynamics during the

period studied, including effects of the economy.

The dependent variable is advertising spending as ashare of sales, the values of which range between 0 and 1;

as a result, we have a limited dependent variable. To avoid

problems associated with directly using a limited dependent

variable in a regression (e.g., there may be several propor-

tions of advertising spending as a share of sales that are

close to 0 or 1, so the variable may not be normally distrib-

uted and the regression equation might generate incorrect

predictions of advertising spending as a share of sales out-

side the 0-1 range), a traditional solution is to perform a

logit transformation on the limited dependent variable. The

logit transformation will (1) stretch out proportions close

to 0 and  1 and com press proportions close to .5 so that the

resulting dep endent variable is more likely normally distrib-

uted and (2) correctly restrict predictions of advertising

spending as a share of sales to the 0-1 range. Therefore, the

model that describes the advertising share of sales for firm i

at time t  ADVSHAREK)  is as follows:

(1) i = 1/(1 + e-^

where X is the matrix of independent variables, including

the equity to bonus ratio of compensation (EQTYj,/BONUSjt); control variables, such as ROI and the stock

holding return (HDR) from the previous period; and firm

and time-based dumm y variables. In add ition, B is the coef-

ficient matrix. After performing the logit transformation, we

can write Equation 1 as follows:

(2) InADVSHAREji

1 - ADVSHA REi,

1- 1

ßU^sarDummy, +  ßisFirmDummy; + en( = 1994

wh ere

AD VSH ARE j, = Adver t is ing Spending¡(/Revenuei(t  _ i) ,

E QT Yi , /BONUS¡ ,  = (Stock Opti ons¡ , + Res tr icted Stock

Grantedit)/BonuSj(,

= Return on invest men t of firm i at the

end of period t, and

jt = One -yea r stock holding return of firm i

at the end of period t.

Adver t is ing sales rat io (and R&D sales rat io , which we

descr ibe next) at t ime t is backward- looking , or based on

the previous per iod ROI and s tock return , which are

observed at the t ime spending (budgetary) decis ions are

made for the current period. We calculate stock return using

  - 1 ,

where it is the stock return for month t (t = 1 indicates the

beginning month of the period, and t = 12 indicates the last

month of the period). The level-based Equation 2 is trans-

formed into a change-based specification as follows:

 3) lnA D V S H A R E I ,

1 - A D V S H A R E I ,- I n

-ADVSHAR E¡( , _ | )

 = Y i o Y i i

t = l995

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Transforming the level-based Equation 2 into the change-

based specification in Equation 3 is an attempt to address

the correlated omitted variables problem in level-based

regressions under the assumption that correlated omitted

variables are stationary from period to period (Kimbrough

and McAlister 2009). A potential concern for taking first

differences is that the effects of measurement error may be

exacerbated (Griliches and Hausman 1986), and thus the

signal to noise ratio will be lower for the differenced data

than for the levels data. However, when the analysis isfocused on assessing the information content of a specific

metric (e.g., whether changes in the metric are reflected in

changes in an outcome variable), measurement error

becom es less of an issue (Mizik and Jacobson 200 9a). A

lower signal to noise ratio allows for a conservative test of

the relationship. Both Kimbrough and McAlister (2009)

and Mizik and Jacobson (2009a) advocate difference mod-

els over level models. The period in the difference model

begins with 1995 because the data set begins with 1993,

and two-period lags are included in the difference model

specification. The year dummy variables in the difference

Equation 3 have the superscript d for difference equation

because their specification is different from that of theircounterparts in Equation 2. Hi requires Yu to be positive

and significant. Note that if there is error in the compensa-

tion variable, we will not observe a significant effect of

compensation on advertising share of sales.

R D Share of Sales

The model specification for R&D spending as a share of

sales is similar to Equation 2, except that the dependent

variable is R&D share of sales. R&D share of sales is a

function of equity to bonus compensation ratio, control

variables related to previous period outcomes in the product

market (ROI) that make spending affordable and outcomes

in the capital market (Stock Return) that reinforce spendingdecisions, and time-based and firm fixed effects. Similar to

advertising share of sales, R&D share of sales ranges

between 0 and 1, and consequently, we perform a logit

transformation as in Equation 1. The level-based eq uation ,

like Equation 2, is transformed into a change-based specifi-

cation like Equation 3;

 4) InR&DSHARE;,

- InR&DSHAREi(t_,)

1-R&DSHARE¡( ,_ | )

t = l995

H2 requires Y2 to be positive and significant. Note that

as in the advertising share of sales model, if there is an error

in the compensation variable, we will not observe a signifi-

cant effect of compensation on R&D share of sales. We esti-

mate Equations 3 and 4 independently. Because the inde-

pendent variables are the same in both equations, the

parameter estimates from independent estimation will be

the same as those using joint estimation, as in seemingly

unrelated regressions (Wooldridge 2002). By using sales

ratios,  product- and capital-market outcome-based control

variables, and time-based fixed effects and by taking first

differences in Equations 3 and 4, we attempt to remove sys-

tematic sources of cross-sectional differences across firms

due to omitted variables (e.g., the marketing literature-

based variables we noted previously), financial variables(e.g., recorded net assets), and risk factors in the four-factor

Carhart model (Fama and French 1992, 1996) related to

size,  market to book value, the market, and momentum.

Taking first differences also enables us to investigate

whether investors are reacting to new inform ation, in

contrast to studies that have linked stock prices directly to

levels of marketing spending.

Mediation Effect of Advertising and R DSpending on the Relationship BetweenCom pensation and Stock Market Return

To test the mediation effect of advertising and R&D spending

on the relationship between compensation and stock marketreturn, we follow the convention in the marketing literatureand conduct the Sobel mediation test (Baron and Kenny1986). Following Baron and Kenny (1986), we estimate twoseparate regression analyses. First, the logit-transformedadvertising and R&D spending to sales ratio is the depen-dent variable, and the equity to bonus compensation ratio isan independent variable. Second, the one-year stock holdingretum is the dependent variable, and the advertising and R&Dspending to sales ratio and the equity to bonus compensa-tion ratio are independent variables. We use the z-statisticfrom the two regressions (for details, see Baron and Kenney1986) to test H3, the mediation of advertising and R &D

spending as a share of sales on the relationship betweenequity to bonus compensation ratio and stock market retum .For our setting, we chose the Sobel test over Preacher andHayes's (2004) test (described by Zhao, Lynch, and Chen2010) for two reasons. First, it allows for flexibility in spec-ifying the mediating variable in the regressions models; InModel 1, we logit-transform the mediating variable adver-tising and R&D spending as a share of sales to avoid theusual problems with limited dependent variables we notedpreviously, while in Model 2, we follow the convention inthe marketing literature by specifying it in its raw form.Second, the Sobel test is a more conservative test because  the 95 % confidence interval will often inc lude zer o

(Zhao, Lynch, and Chen 2010, p. 202), so if a Sobel testsupports mediation, the result is a conservative one.

Empirical Test

  t

To test the three hypotheses, we constructed a data set of 842

companies during the 1993-2005 period. We defined all

variables—equity to bonus compensation ratio, advertising

and R&D sales ratios, ROI, and stock retum—according to

the same time period (i.e., the fiscal year). We collected the

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executive compensation information from the ExecuComp

database. The ExecuComp database covers current, historic,

and total compensation data on the top five executives of

more than 2600 com panies in Standard & Poor's S&P 500,

S&P 400 MidCap, and S&P 600 SmallCap indexes in the

United States. ExecuComp provides yearly data on the

compensation of only the top five executives, the rationale

being that the top five executives are usually part of a senior

management team ultimately responsible for firm strategy,

spending and resource allocation decisions, and product-and capital-market outcomes. We employ a simple equal-

weighting model to aggregate the compensation data on top

five executives, which has been found to offer robust pre-

dictions, even when weights across variables vary, in both

marketing research (Srinivasan 1977) and other settings

(e.g., Dawes and Corrigan 1974). If there is an error in our

compensation variable, we will not observe an incentive

effect of compensation on advertising (Hj) and R&D (H2)

spending decisions or a mediation effect of advertising and

R&D spending decisions on the relationship between com-

pensation and stock market return (H3). The E xecuCom p

database only includes firms from the three major S&P

indexes, and ExecuComp firms comprise approximately25 %   of the domestic firms in the Compustat database. For

firms to be included in the S&P major indexes, firms must

meet several criteria, such as financial viability and stock

liquidity. Therefore, on average, the ExecuComp firms tend

to be those that are relatively large and profitable and have

stable cash flows and liquid shares (Cadman, Klasa, and

Matsunaga 2010). To allow for two-period lagged variables

in the analysis, the first period for analysis is 1995, though

our data set begins in 1993. We end w ith 2005 to avoid any

compounding effects due to change in accounting policy by

the FASB-revised Statement of Financial Accounting Stan-

dards No. 123 for the reporting of employee stock options

for the period ending after Ju ne 15, 200 5. According to thenew statement, all firms are required to expense employee

stock options on the financial statements. Before the state-

ment was issued, however, firms were not required to

expense stock options on the financial statements. They

only reported the information in footnotes, which did not

affect their earnings.

We collected data on sales, advertising and R&D spend-

ing, and ROI from the 22,198 firms included in the Compu-

stat database. According to the FASB's GAAP-based poli-

cies,  the advertising expense reporting is required when the

amount is material. Materiality is based on a manager's

subjective judgment. Thus, the firms included in our study

are those that have material or larger advertising expenses.

We employ yearly advertising and R& D data so that there is

a match in the unit of analysis between the ExecuComp and

Compustat data. While data at disaggregated units of analy-

ses are generally preferred over data at more aggregate lev-

els of analyses, the advantage of using ExecuComp and

Compustat databases is that we can study a large number of

firms over a significant period— in this ca se, 842 firms ov er

11 years. In addition, if we do not have the correct level of

disaggregation or measurement error in the advertising or

R&D spending variables, we are less likely to find support

for H i, H2, and H3. We collected data on stock return from

the Center for Research in Security Prices database.

The time-series panel data offer several benefits, such

as increased heterogeneity of observations, which alleviates

multicollinearity concerns and provides the ability to study

dynamic phenomena (Wooldridge 2002). Because this data-

base has a larger cross-section (842 companies) and fewer

time periods (maximum of nine), it is not the traditional set-

ting for the use of VARX models (see Table 1 in Srinivasan

and Hanssens [200 9], notes under Persistence Mo deling ).In Table 1, we present descriptive statistics for mean

sales, mean percentage of equity-based compensation,

mean percentage of bonus-based compensation, mean

advertising and R&D share of sales, the number of firms

reporting advertising and R&D spending, mean ROI and

one-year stock holding return, and the number of firms

reporting ROI and for which stockholder returns are avail-

able for each year between 1995 and 200 5. We observe that

the mean percentage of equity-based compensation increases

and then decreases during the time period; the mean per-

centage of bonus-based compensation decreases and then

increases during the time period; the mean advertising share

of sales spending is at a higher level during the first half of

the time period, after which it is at a lower level; and the

mean R&D share of sales spending increases and then

decreases during the period.

  sults

We present the correlation matrix in Table 2. Controls such

as ROI and stock return from the previous period are not

correlated with the equity to bonus compensation ratio in

the current period, so there are no concerns about multi-

collinearity between independent variables in the advertising

and R&D share of sales models. Note that the correlation

between advertising and R&D spending as a share of salesis highly positive (.98), indicating that as one type of spend -

ing increases, the other type of spending increases as well;

as a result, it is unlikely that there is a fixed budget for these

two types of spen ding. If there were a fixed budget for these

two types of spending, the correlation between advertising

and R&D spending as a share of sales would be negative.

We present the results of model estimations in Tables 3

and 4. We begin with the advertising share of sales model

(Table 3). Because year effects can soak up considerable

variation, we report two estimated versions of the model

with and without such effects. Our first main result is that

the effect of equity to bonus compensation ratio on advertis-

ing spending as a share of sales is positive   p <  .01) across

both estimated versions of the model. Consequently, Hj is

supported. This positive effect suggests that an increase in

the equity to bonus compensation ratio, which is designed

to incentivize longer-term decision making, results in an

increase in advertising spending as a share of sales. The

coefficients of the ROI and stock return control variables

from the previous period are positive and largely significant

 p < .05, in three of four ca ses) , indicating affordability and

reinforcing effects. Improvements in product-market out-

comes (ROI) make advertising spending more affordable.

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TABLE 2Correlation Matrix

Equity to Bonus

Compensation Ratio

Advertising

Share of Sales

R D

Share of Sales

Equity to bonus c ompensation ratioAdvertising share of salesR D share of sales

Stock return, _ i

00 600807 2005

—.986

- .220.004

—-.240

.005 .110

TABLE 3Results of Change in Compensation on

Advertising Share of Sales Spending

Model 1 Model 2

ConstantD(EQTY,/BONUS,)

D(HDR,_ i )Year dunnmiesR2Log-likelihood

AlCNumber of observationsNumber of firms included

-.0393 (.008)**.0002 (.000)**.1212 (.060)*.0453 (.008)**Not included

.0135-2045.047

1.2123382

745

-.0518 (.019)**.0002 (.000)**.078  .060)

.0451 (.009)**Included

.0353-2007.233

1.195338274 5

  p <  0501

Notes: Change in advertising share of sales is the change betweenthe current and previous period. D( ) is the difference betweenthe current period and the previous period. The greater thelog-iii<eiihood (iower negative values), the better is the fit; fitis not adjusted for the number of parameters. AlC = Akaikeinformation criterion, which is -2(log-l ikel ihood/number ofobservations)  2(number of parameters/number of observa-tions); this adjusts for the number of model parameters, sothat a lower vaiue denotes a better modei.

and improvements in capital-market outcomes (stock

return) reinforce such spending.

Next, we turn to the results of the R&D share of sales

model (Table 4). Our second main result is that the effect of

equity to bonus compensation ratio on R&D spending as a

share of sales is also positive  p <  .01) across both esti-

mated versions of the model. Consequently, H2 is sup-

ported. This positive effect suggests that an increase in the

equity to bonus compensation ratio, which is designed to

incentivize longer-term decision making, results in an

increase in R&D spending as a share of sales. The coeffi-

cient of the stock return control variable is positive and sig-

nificant  p <  .01), also indicating a reinforcement effect; as

stock market return in the previous period increases, invest-ments in R&D spending as share of sales increase. Return

on investment in the previous p eriod, which we use for con-

trol purposes, is occasionally significant (one of two cases,

p <  .05) in the advertising share of sales model but is not

significant in the R&D share of sales model. A potential

explanation is that R&D efforts are more long-term in

nature, and ROI from the previous period is a short-term

performance indicator.

We conducted analyses on potential outliers. Because

the measure of long- versus short-term compensation is

equity divided by the bonus amount, if the bonus is zero, or

TABLE 4Results of Change in Com pensation on R D

Share of Sales Spending

Model 1 Model 2

ConstantD(EQTY,/BONUS,)

D(HDR,_ i )Year dum miesR2Log-likelihoodAlCNumber of observationsNumber of firms included

.0207 (.007)*

.00007 (.000)*

.0383  .044)

.0237 (.006)*Not included

.008

-3249.6471.297

501784 2

-.0902 (.020)*.00007 (.000)*.0407 (.045).0221 (.006)*

Included.017

-3226.8371.292

501784 2

  p <  01

Notes: Change in R D share of saies is the change between thecurrent and previous period. D( ) is the difference betweenthe current period and the previous period. The greaterthe iog-iikeiihood (lower negative values), the better is thefit; fit is not adjusted for the number of parameters. AlC =the Akaii<e information criterion, which is -2(log-iikelihood/number of observations)  2(number of parameters/numberof observations); this adjusts for the number of modelparameters, so that a lower value denotes a better modei.

very small, this can lead to high values of equity to bonus

ratio, which could distort the results. We automatically

dropped bonus values of zero when combined with nonzerovalues of equity from the analyses. Bonus values of zero,

when present with equity values of zero, are indicative of

long- and short-term compensation, which is equal and thus

defined as one. To investigate whether very high values of

equity to bonus distort the results, we dropped the top 5

(approximately) of equity to bonus cases, similar to win-

sorizing, which equates to dropping cases in which the

equity to bonus ratio w as greater than 17.82. We found that

both the signs and significance levels of the results we

reported in testing H] and H2 remained the sam e.

Finally, we describe the results of whether advertising

and R&D spending as share of sales mediates the relation-ship between equity to bonus compensation ratio and stock

return. Following the convention in the marketing literature,

we conducted a Sobel mediation test, which resulted in a z-

statistic of 2.44   p <  .05), indicating that advertising and

R&D spending as share of sales partially mediates the rela-

tionship between equity to bonus compensation ratio and

stock market return. Consequently, H3 is supported. When

we dropped the top 5 of equity to bonus cases, as in the

outlier analysis, the results of the Sobel m ediation test were

even stronger, with a z-statistic of 4.09   p < .01). In addi-

tion, while the mediation tests we reported previously are

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for advertising and R&D spending considered in combina-tion as a share of sales, we conducted separate Sobel m edi-ation tests for advertising spending as a share of sales fol-lowed by R&D spending as a share of sales. The z-valueswere  1.96 p < .05) and 2.46 p < .05), respectively.

  dditionai naiyses

We conducted two additional types of analyses for eachdependent variable, change in advertising and R&D spend-

ing as a share of sales, to investigate whether the effects ofchange in compensation (equity to bonus) were nonlinear(Morck, Shleifer, and Vishny 1988). For the first analysis,we considered two main independent variables, change incompensation (equity to bonus) and change in compensa-tion squared, in addition to the usual controls. In the secondanalysis, we segmented the compensation region by themedian, 33rd percentiles, and quartiles, in addition to theusual controls. For advertising, the compensation term ispositive and statistically significant  p <  .01), as hypothe-sized; however, the compensation-squared term is not sig-nificant, indicating a lack of a turning point. When we seg-mented the compensation region by the median, 33rd

percentiles, and quartiles, we found that the effect of com-pensation on advertising comes from higher levels of com-pensation above the median  p <  .05), the top 33rd per-centiles (p < .01) and between the 34th and 66th percentiles{p <  .05), and the top quartile  p <  .05). For R&D, weobserve that the compensation-squared term is marginallysignificant  p <  .05), indicating a turning point, though at avery large equity to bonus compensation ratio. When wesegmented the compensation region by the median, 33rdpercentiles, and quartiles, we found that the effect of com-pensation on R&D comes from higher levels of compensa-tion above the median (p < .01), the top 33rd percentiles  p <

.01),  and the top quartile  p < .01).

Next, we investigated whether firm size moderated theeffect of equity to bonus compensation on advertising andR&D spending. For the effect of equity to bonus compensa-tion on advertising spending as a share of sales, we foundthat the effect is stronger  p <  .01) for smaller companies.Smaller firms that have sales lower than the median spendmuch less on advertising in absolute terms ( 16.7 millionfor small firms vs. 439.77 million for larger firms), are lesswell known, and consequently may expect that increases inadvertising spending will provide returns that are largerthan those of larger firms because smaller firms are morelikely to operate in the increasing returns portion of the s-shaped advertising-sales response function than large firms,

which are more likely to operate in the nonincreasingreturns portion of the response function.'' For the effect ofequity to bonus compensation on R&D spending as a shareof sales, we found that the effect is weaker   p <  .01) forlarger firms that are between the median and the 75th per-centile in  sales ^  The R&D spending of such firms is

^A two-segment model had an Akaike information criterionvalue that was better than that of one-  or three-segment models.

8A four-segment model had an Akaike information criterion valuethat was better than that of one-, two-, three-, and five-segmentmodels.

between two and four times (in absolute terms) that of firmsin the lower and lowest sales quartiles, respectively; conse-quently, such firms may perceive less potential for returnsfrom R&D spending. In other words, small firms (those inin the lowest and second-to-lowest sales quartiles) spendmuch less on R&D—between one-quarter and one-half thatof larger firms in the 50th-75th percentiles—and oftencompete on R&D, so they may expect larger returns fromR&D spending, which results in a stronger effect of com-

pensation on R&D spending.We also conducted an analysis to determine whether theeffect of the equity to bonus compensation ratio on bothadvertising and R&D spending varied across industries. Foradvertising spending as a share of sales, we found that theeffect of the equity to bonus compensation ratio has agreater effect in the automotive dealers industry   p < .01)and a marginally greater effect in the electronics industry   p <

.056). For R&D spending as a share of sales, we found thatthe effect of the equity to bonus compensation ratio has agreater effect in the instruments and related products indus-try and the engineering and management industry (both  ps <

.01) and a marginally lower effect in the security and com-

modity broker industry  p <  .05). Ove rall, the industry dif-ferences appear to be minimal, and the aggregate effect ofequity to bonus compensation ratio on advertising andR&D spending as a share of sales identified earlier (Hi andH2) is robust to industry variation.

We also assessed an alternative model on the percentagegrowth of spending and dropped ROI so that we have onlyone (and not two) performance measure in the model. Wedid this for both advertising and R&D spending using thelog-log specification of differenced variables. The effects ofequity to bonus on both advertising spending and R&Dspending were statistically significant  p < .01 a nd  p  < .01,respectively). Therefore, the results of the alternative model

are consistent with the results from the proposed models.

DiscussionOur compensation results have strategic implications forcompensation committees and top executives regardingmarketing and R&D investments and capital-marketreturns. If a firm has strategic interests in value creation,through continuous investments in R&D for new productand process development, and value appropriation, throughcontinuous investments in advertising for building brandsand sales, there should be a clear recognition among mem-bers of the compensation committee that top executives

have a powerful short-term disincentive to spend on adver-tising and R &D . The disincentive is because such spendingis expected to have longer-term benefits, while the FASB'sGAAP-based policies require costs associated with suchbenefits to be completely expensed in the current period, sothat such spending, though it has tax advantages, has anegative effect on current-year profit. The disincentives arefurther exacerbated when top executives are under earningspressure due to analysts' expectations of performance,declining sales, and less than desirable economic conditionsand when they face the prospect of limited tenure in thefirm. Such disincentives can result in myopic management

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of resources toward value creation and appropriation

through cuts in R D and advertising spending, which has

been documented in the marketing literature.

One way to deal with such a powerful disincentive is to

increase the equity to bonus compensation ratio by granting

more stock options and restricted stock. Our first and sec-

ond main results are that an increase in the equity to bonus

compensation ratio is associated with an increase in adver-

tising and R D spending as a share of sales (H | and H2).

The increase in equity to bonus compensation ratio incen-tivizes top executives to have a longer-term orientation

toward value creation and appropriation and increase adver-

tising and R D spending as a share of sales, even though

there may be uncertainty regarding the future benefits of

such spending and costs are realized immediately. In the

absence of such an incentive or when such incentives are

being reduced, as the current market trend suggests, it is

likely that top executives will engage in myopic manage-

ment of resources. Downstream m arketing and R D man-

agers who initiate and implement spending plans leam to do

so for plans that have a convergence of interest with top

executives because top executives approve and monitor

such plans (Fama and Jensen 1983; Joseph and Richardson2002).  As a result, the top executives' tendency to manage

resources myopically will result in downstream marketing

and R D managers being pressured to employ product and

process development and advertising resources in ways that

are productive to the short-term performance of the firm

(e.g., reducing advertising and R D spending to improve

current-year profits) but counterproductive to long-term

performance of the firm (e.g., Lodish and Mela 2007). In

other words, it is likely that firms with long-term growth

opportunities could fail to capitalize on their potential

because risk-averse managers are not motivated to invest in

long-term performance, such as developing new products

and processes and building brands and sales, because of theuncertainty of the future payoffs of these activities (e.g.,

Guay 1999).

The effect of the compensation incentives on advertis-

ing and R D spending is larger in smaller firms; as a result,

if a larger firm w ants to incentivize advertising and R D

spending, higher levels of equity to bonus compensation

ratio will be required relative to smaller firms. Larger firms

spend more on advertising and R D and thus may benefit

less; however, if the success of the firm is driven by R D,

innovation, new products, and using advertising to inform

its current and potential customers about these new prod-

ucts, such additional spending may be warranted, particu-

larly when the environment becomes more competitive. Insummary, the first and second main results of this study are

important because they build confidence among compensa-

tion committees and top executives that the equity to bonus

compensation ratio can be employed to ensure that correct

incentives are in place for managers to curb myopic man-

agement of resources and to encourage investments in long-

term goals related to value creation (e.g., R D to develop

products and processes) and value appropriation (e.g.,

advertising to build brands and sales).

Our third main result is that advertising and R D

spending as a share of sales mediates the relationship

between equity to bonus ratio and stock market retum (H3).

This result is important because it can build confidence

among compensation committee members and top execu-

tives that the equity-based incentives are to achieve not just

desired long-term goals for investments in advertising and

R D but stock market retum as well. In other words, the

decision to increase the equity to bonus compensation by

granting stock options and restricted stock will also be

facilitated by improvements in stock market retum. Corpo-

rate compensation committees and top executive commit-tees are accustomed to paying for performance. As a result,

when there is recognition that compensation-based incen-

tives not only curb myopic resource management and

incentivize long-term investing in R D for new product

and process development and advertising to build brands

and sales but also pay off in stock market retum, compensa-

tion committees and top management should have greater

willingness and confidence to employ compensation so that

the correct incentives are in place not just for long-term

investments but for stock retums as well. The greater will-

ingness and confidence should apply not just to designing

equity to bonus compensation ratios for top executives but

to downstream marketing and R D managers as well, sothat the correct incentives are in place throughout the deci-

sion-making ranks in the organization for long-term value

creation and appropriation as well as stock retum.

To the best of our knowledge, the findings on the incen-

tive effect of equity to bonus compensation on advertising

and R D spending as a share of sales (H] and H2) and the

mediation effect of advertising and R D spending as a

share of sales on the relationship between equity to bonus

compensation ratio and stock market retum (H3) are new in

the marketing literature and the compensation literature in

accounting, finance, and management. The results of

agency theory-based studies on the role of incentive pay in

aligning the goals and risk preferences of managers havebeen mixed (Devers et al. 2007), so whether the goals will

be aligned in managerial advertising and R D spending

decisions has been unclear. As a result, our findings make

an important contribution to the marketing literature and the

compensation literatures in management, accounting, and

finance.

This study is not without limitations. The maturing of

incentive compensation given to top executives in the past

can affect spending decisions. Change in the makeup or

tumover of top executives can also result in changes in

compensation and a change in strategic focus of the com-

pany. For example, a change in CEO, from one with a

finance orientation to one with a marketing orientation,could affect the firm's ad vertising and R D spendin g. Fur-

thermore, top executive compensation is not the only non-

marketing driver of advertising and R D spend ing. For

example, eamings pressures could also affect advertising

and R D spending. In addition, advertising and R D are

not the only managerial decisions that are potentially

affected by top executive compensation. It is also conceiv-

able that pricing, temporary price promotion, and distribu-

tion decisions could be affected as well because these deci-

sions involve trade-offs between the short and long mn

(Jedidi, Mela, and Gupta 1999). Furthermore, stock m arket

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return is not the only metric to justify advertising and R&D

spending, and not all advertising and R&D spending has

long-term orientation (Farris et al. 2010). Further research

can consider maturing of incentive compensation, other

nonmarketing drivers of marketing decisions, other market-

ing decisions, and other metrics to judge the efficacy of

marketing decisions. Moreover, further research could con-

sider antecedents of executive compensation, such as

changes in the makeup of the top executive team, which

may affect changes in compensation. For practicality rea-

sons, the effect of such an antecedent variable could be

investigated for a smaller sample of firms than that used in

this study.

Several questions remain. One is whether process mea-

sures such as attention, prioritization of goals, and so forth

can explain how top executive compensation results in

greater advertising and R&D spending to sales ratios. A sec-

ond question is whether the effects of top executive com-

pensation on the advertising and R&D spending to sales

ratios and the mediation of advertising and R&D spending

on the effect of equity to bonus compensation ratio on stock

market return is based on characteristics of the firm other

than size and characteristics of managers. Because this is

the first article on the effect of compensation on marketing

and R&D spending decisions, we focus on establishing the

main effects, leaving process measure-based studies and

interaction effects other than firm size and industry effects

for further research. Process measure-based studies could

provide useful insights into how top executive compensa-tion results in higher advertising and R&D spending to

sales ratios, and interaction effects could provide useful

insights into conditions under which top executive compen-

sation affects the advertising and R&D spending decisions

to a greater or lesser extent and the conditions under which

the mediation of advertising and R&D spending on the

effect of compensation on stock market return is stronger or

weaker. We hope our work will inspire the research efforts

identified.

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