CEO Compensation Structure and Asymmetric Timely Loss Recognition - An Empirical Analysis from Debt Contracting Perspective

Abstract

This paper examines the relation between CEO compensation structure and the demand for asymmetric timely loss recognition (AT) from debt contracting perspective. Prior studies demonstrate that high CEO compensation risk encourages managers to engage in risk-seeking behavior, thus intensifying agency conflicts between creditors and borrowers. By constraining managers to recognize economic losses in a timely fashion, AT is arguably to reduce managers’ incentive to undertake risky projects, and therefore creditors have greater demand for accounting conservatism when CEO compensation risk is high. We empirically test this prediction and find a positive relation between accounting conservatism and CEO compensation risk, and this positive relation is stronger for firms with high leverage. Further evidence shows that the negative relation between accounting conservatism and cost of debt increases in CEO compensation risk, suggesting that creditors value AT more in the presence of greater asset substitution problem. Last, we find that the positive relation between AT and CEO compensation vega is weakened for firms with high proportional use of short-term debt and for debt contracts containing covenants or collateral restrictions. Hence, the results indicate that accounting conservatism and other contracting mechanisms serve as substitutes in mitigating agency costs of debt arising from CEO compensation incentives.