An empirical study of the relationship between accounting conservatism and executive compensation-performance sensitivity

Abstract

Purpose The purpose of this paper is to study the relationship between accounting conservatism and executive compensation-performance sensitivity with a view to identify the influence of accounting conservatism on the efficiency of executive compensation contracts. Design/methodology/approach This study uses multiple regression models based on the approach of Iyengar and Zampelli (2010), Clarkson et al. (2011) and Huang and Kisgen (2013) with the data from all of China’s listed non-financial firms over the period of 10 years to test the relationship between accounting conservatism and the sensitivity of executive compensation-performance. Findings This study finds a positive association between executive compensation and accounting-based measure of performance. More importantly, it reveals that conservatism has a positive relation with the executive compensation-performance sensitivity after controlling for a number of firm-specific factors and control variables. This study shows that the sensitivity of executive compensation to firm performance is higher for firms with higher accounting conservatism. Originality/value This is one of the few studies to examine the relationship between accounting conservatism and executive compensation-performance sensitivity. It provides supportive evidence to the argument that accounting conservatism, being an efficient governance mechanism, can help mitigate information risk and moral risk for agency problems.

The effects of accounting conservatism on executive compensation

“…Several papers have also investigated the relationship between accounting conservatism and executive compensation. Our study is closest in spirit to Zhang et al (2019) who found a significantly positive relationship between accounting conservatism and the executive compensation-performance sensitivity of Chinese listed companies. However, we delineate our study from their study in three ways.…”

“…Iwasaki et al (2012) find that the asymmetric timeliness of earnings is negatively related to the magnitude of excess compensation. Zhang et al (2019) found a significantly positive relationship between accounting conservatism and the executive compensation-performance sensitivity of Chinese listed companies, particularly for executive compensation contracts where accounting-based performance measure is used. Jeong and Kim (2013) found a positive relationship between equity-based compensation to outside directors and accounting conservatism using the US data between 2006 and 2008.…”

“…Previous research has found evidence that accounting conservatism can reduce information asymmetry and lower agency cost, and therefore, increase shareholder's value. Zhang et al (2019) argue that adoption of accounting conservatism enables firms to tie executive compensation more closely to firm performance because accounting conservatism can restrict earnings management activities and reduce the noise of accounting performance data. Hence, a higher level of accounting conservatism should be associated with a higher sensitivity of pay-for-performance.…”

“…However, we delineate our study from their study in three ways. First, Zhang et al (2019) focus on the total level of compensation but not on the structure of the compensation. There is a significant difference in the compensation structure between Chinese listed firms and the US firms, cash-based payments are the main form of executive compensation, whereas equity-based payments are seldom used by Chinese listed companies (Li et al, 2013).…”

How can Female Executives Shape the Effectiveness of Executive Compensation?- A Multi-Dimensional Approach

“…Female executives can enhance executive pay-performance sensitivities via positively determining accounting conservatism and social responsibility performance. Accounting conservatism has a positive relation with the executives' compensation-performance sensitivity after controlling for critical firmspecific factors and control variables (Zhang et al, 2019) while female executives show higher accounting conservatism than male peers due to their gender nature. Therefore, TMTs with higher ratio of female executives would intend to choose higher executives' compensation-performance sensitivity.…”