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

• Pages: 130-150
• Published date: 04 March 2019
• DOI: https://doi.org/10.1108/IJAIM-01-2018-0002
• Date: 04 March 2019
• Author: Xi Zhang,Simon Gao,Yi Zeng
• Subject Matter: Accounting & Finance,Accounting/accountancy,Accounting methods/systems

An empirical study of the

relationship between accounting

conservatism and executive

compensation-performance

sensitivity

Xi Zhang

The School of Accounting, Hubei University of Economics, Wuhan, China

Simon Gao

The Business School, Edinburgh Napier University, Scotland, UK, and

Yi Zeng

The School of Accounting, Hubei University of Economics, Wuhan, China

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

conservatismon the efficiency of executive compensation contracts.

Design/methodology/approach –This study usesmultiple 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

conservatismand the sensitivity of executive compensation-performance.

Findings –This study finds a positive associationbetween 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 firmswith 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

informationrisk and moral risk for agency problems.

Keywords Accounting conservatism, Firm performance, Corporate governance,

Executive compensation, Agency problem, Executive compensation-performance sensitivity

Paper type Research paper

1. Introduction

A separation of ownership and control gives rise to agency problems and results in information

asymmetry between managers and shareholders. Shareholders demand conservative accounting

to mitigate the effects of information asymmetry (LaFond and Watts, 2008). Accounting

The author would like to thank the funding support from the Humanities and Social Science, Hubei

Province Education Department, China (Grant No: 16Q213).

IJAIM

27,1

130

Received3 January 2018

Revised11 March 2018

26April 2018

Accepted16 May 2018

InternationalJournal of

Accounting& Information

Management

Vol.27 No. 1, 2019

pp. 130-150

© Emerald Publishing Limited

1834-7649

DOI 10.1108/IJAIM-01-2018-0002

The current issue and full text archive of this journal is available on Emerald Insight at:

www.emeraldinsight.com/1834-7649.htm

conservatism, defined as financial reporting policies or tendencies that results in the downward

bias of accounting net asset value relative to economic net asset value (Ruch and Taylor, 2015)is

a potential mechanism to address the agency problem (Basu, 1997;Watts, 2003;LaFond and

Roychowdhury, 2008;García Lara et al., 2016). This is because accounting itself has a primary

function to provide information that allows contracting parties to evaluate the efficiency and

effectiveness of performed obligations in contracting settings. Accounting conservatism

alleviates information asymmetry and improves information quality (Kim et al., 2013).

Corporate governance is a mechanism that shareholders use to monitor firm executives

to minimize agency costs (Caskey and Laux, 2017). One primary way of monitoring firm

executives is to align executive incentives with shareholder values by offering executive

compensation contracts including stock options (Jensen and Murphy, 1990;Mohan and

Ainina, 2012;Bennett et al., 2017). The novel intention of such contracts is to motivate

executives to work hard and to restrict their opportunism (Raffiet al.,2014). The

relationship between executive remuneration and corporate governance has been well-

documented in the literature (Core et al., 1999;Firth et al.,2007;Baixauli-Soler and Sanchez-

Marin, 2015;Descheneset al.,2015;Ntimet al., 2017).

Accounting performance has been used as the main yardstick for executive

compensation contracts in many countries. Prior studies have recognized that while

accounting performance reflects the state of a firm’s operations, it also gives executives

incentive to overstate the firm’s net asset value and earnings with a view to maximizing

their personal welfares (Sun, 2014).However, the loss of investor confidence in the integrity

of the accounting profession following several major financial reporting scandals has

resulted in a growing concern in the literatureabout the quality of accounting measure used

for executive compensatingcontracts (AL-Dhamari and Ismail, 2014;Li and Wang, 2016).

Conservatism resultsin an understatement of accountingvalue and performance relative

to the market value due to an understatement of assets and revenues and/or an

overstatement of liabilities and expenses (Zhong and Li, 2016). The literature has generally

shown that accounting performance information under the conservatism principle reflects

the value of assets more creditable (Iatridis, 2011). Also, conservatism reduces the room of

earnings manipulation and signals the potentialself-interest behavior of executives timelier

(Bertomeu et al.,2017). Overall, it has been argued that conservatism could improve the

effectiveness of executivecompensation contracts.

Various stakeholders of corporate reporting demand conservatism to reduce agency

costs by mitigating information asymmetry and facilitate corporate governance. Several

studies have examined the relationship between corporate governance quality and

accounting conservatism, portraying a positive relation between the two (Ramalingegowda

and Yu, 2012;García Lara et al., 2009). It hasbeen argued that conservatism as a tool that a

board of directors can use to monitor and control managers’investment decisions (Ball,

2001), therefore to improve a firm’s investment efficiencies (Ahmed and Duellman, 2011;

García Lara et al.,2016) and reduce investment risk (Kim and Zhang, 2016).

There is considerable debate on whether executive compensation contracts are designed to

align executive incentives with shareholder values. Several studies attempt to use executive

compensation-performance sensitivity as a magnitude of the alignment of shareholders’

interests with those of executive management (Lippert and Porter, 1997;Iyengar and Zampelli,

2010). Executive compensation-performance sensitivity is commonly defined as the change in

executives’compensation that is associated with a given performance of an organization that

they manage (Jensen and Murphy, 1990), reflecting the absolute increment to the executives’

compensation associated with a given amount of firm performance increased. Jensen and

Murphy (1990) argue that higher the sensitivity, as indicating a closer alignment of interests

A study of

accounting

conservatism

131