Accounting Conservatism and Executive Compensation

Abstract

Using a firm-year measurement of accounting conservatism developed by Khan and Watts (2009), I find that accounting conservatism is positively related to the pay-for-performance sensitivity of executive compensation, negatively related to the level of executive compensation. These empirical findings are robust after controlling, size, performance, risk, growth opportunities, firm age, capital expenditure institutional ownership and corporate governance. The results suggest that accounting conservatism can facilitate linking shareholders’ wealth to managers’ wealth and are consistent with the view that accounting conservatism reduces information asymmetry and enhance corporate governance. I also find significant differences in firms’ stock returns across the portfolios formed on the level of conservatism and the pay-for performance sensitivity of executive compensation. This finding indicates that accounting conservatism may play a role in stock valuation.