Abstract
This paper investigates whether CEO pay disparity reflects efficient contracting or CEO entrenchment by exploiting an exogenous event which mandated option expensing, namely, the introduction of FAS 123R. Using a difference-in-difference approach, we find supportive evidence for the entrenchment hypothesis. Firms characterised by high pay disparity exhibit a significantly larger decline in options pre-versus post-FAS 123R than those characterised by low pay disparity. At the same time, firms with high pay disparity switch to salary more so than firms characterised by low pay disparity, consistent with entrenched CEOs preferring non-performance-based pay. Our findings suggest CEOs in high pay disparity firms exploited the free accounting cost advantage of options to inflate their pay rather than for their convexity property. These results are robust to alternative functional forms and measures of CEO pay disparity.
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