The role of accounting conservatism in executive compensation contracts

• Author: Takuya Iwasaki,Shota Otomasa,Akinobu Shuto,Atsushi Shiiba
• DOI: http://doi.org/10.1111/jbfa.12350
• Date: 01 October 2018
• Published date: 01 October 2018

DOI: 10.1111/jbfa.12350

The role of accounting conservatism in executive

compensation contracts

Takuya Iwasaki1Shota Otomasa1Atsushi Shiiba2Akinobu Shuto3

1Facultyof Business and Commerce, Kansai

University,Osaka, Japan

2GraduateSchool of Economics, Osaka Univer-

sity,Osaka, Japan

3GraduateSchool of Economics, The University

ofTokyo, Tokyo,Japan

Correspondence

AkinobuShuto, Graduate School of Economics,

TheUniversity of Tokyo,7-3-1, Hongo, Bunkyo-

ku,Tokyo 113-0033, Japan.

Email:shuto@e.u-tokyo.ac.jp

Fundinginformation

KAKENHI(Grants-in-Aid for Scientific Research

(C)),Grant/Award Numbers: 16K03979,

17K04086;the Support Project for Strategic

Collaborationbetween Private Universities,

Grant/AwardNumber: S1411034

JELClassification: M41

Abstract

To test the implication of Watts’ (2003) argument that account-

ing conservatism increases the efficiency of executive compensa-

tion contracts, we investigate the relation between accounting con-

servatism and earnings-based executive compensation contracts in

Japanese firms. We focuson Japanese executivecompensation prac-

tices because the demand for accounting conservatism is likely to

be greater for Japanese than for US firms given the predominance

of earnings-based executive compensation contracts and relatively

weak corporate governanceof compensation contracts in Japan. We

also investigate how the quality of the ex-ante information envi-

ronment affects the relation between accounting conservatism and

earnings-based executive compensation contracts. Consistent with

our expectations, we find a positive relation between accounting

conservatism and the compensation earnings coefficient. We also

show that this positive relation is greater for firms with poor ex-ante

information environment. These results suggest that the demand for

accounting conservatism is greater for firms that use more earnings-

based executive compensation contracts and havemore serious ex -

post settling-up problems.

KEYWORDS

accounting conservatism, compensation contract, compensation

earnings coefficient, ex-post settling-up problem, information

environment

1INTRODUCTION

Watts(2003) argues that accounting conservatism mitigates the agency problem between managers and stakeholders

and reduces firms’ agency costs. This study investigates the role of accounting conservatism in earnings-based execu-

tive compensation contracts among Japanese firms. FollowingWatts’ (2003) argument, we first examine whether the

demand for accounting conservatism is greater among firms that depend heavily on earnings-based executive com-

pensation contracts. We then investigate how the quality of the ex-ante information environment affects the relation

between accounting conservatism and earnings-based executivecompensation contracts.

J Bus Fin Acc. 2018;45:1139–1163. wileyonlinelibrary.com/journal/jbfa c

2018 John Wiley & Sons Ltd 1139

1140 IWASAKIET AL.

Managers usually have better information about their firm's prospects than other stakeholders do. In the absence

of accounting conservatism, they may bias their estimates of future cash flows upwards using their superior informa-

tion and inflate their net assets and earnings to receive greater payments under earnings-based compensation plans

(Ball, 2001; Watts,2003). Such opportunistic managerial behavior can create deadweight losses and reduce firm value.

Agency theory suggests that attempts to recover any excess compensation ex-post can be costly, as managers have

limited liability and tenure. This is usually referred to as the “ex-post settling-up problem” (Leone, Wu, & Zimmerman,

2006).

Furthermore, we infer that the ex-post settling-up problem is more likely to occur in firms with a low-quality ex-an te

information environment. Assuming that a poor ex-ante information environment implies severe information asymme-

try between managers and external stakeholders, managers in a low-quality information environmentare more likely

to bias their future cash flow estimates upward to receive larger current bonuses. Managers also have incentives to

manipulate earnings downwards to maximize multi-period compensation (e.g., Healy,1985). However, this incentive is

mitigated in Japan due to the absence of caps in bonus plans. The ex-post settling-up problem will thus be more serious

for firms with a poor information environment.

Watts (2003) argues that accounting conservatism is a means of reducing the probability that managers will dis-

tribute their firms’ net assets to themselves instead of investingin positive net present value projects. We hypothesize

that (1) accounting conservatism is positively related to the use of earnings-based executivecompensation contracts

and that (2) this positive relation is greater for firms with poor ex-ante information environments.

Although Watts (2003) contends that executivecompensation contracts are one of the factors behind the demand

for accounting conservatism, few studies have examined the role of accounting conservatism in compensation con-

tracts. One exceptionis O'Connell (2006). Assuming that accounting conservatism implies that earnings have a lower

correlation with returns in good-news firm-years, O'Connell (2006) revealsthat UK CEO cash compensation exhibits a

stronger (weaker) sensitivity to accounting earnings in good- (bad-) news firm-years. He thus concludes that compen-

sation committees are aware of the impact of conservatism when awarding earnings-based compensation (O'Connell,

2006, p. 643). However,this study does not measure accounting conservatism or examine the direct relation between

executivecompensation and accounting conservatism. Accordingly, it is unclear whether there is demand for account-

ingconservatism in earnings-based compensation contracts since his conclusion is drawn from composite assumptions.

Our study addresses this gap in the literature.

We focus on Japanese executive compensation because its features are more likely to increase the demand for

accounting conservatism. Studies have described two distinctive features of managerial compensation in Japan. First,

Japanese managers receive compensation more on earnings-based performance than on stock-based performance

(Kaplan, 1994; Kato & Kubo, 2006), which might increase the managerial incentive to engage in earnings manage-

ment to obtain cash bonuses. Second, corporate governance over executive compensation is weaker in Japanese

firms than in US firms. Specifically, the Japanese governance system features (1) fewer compensation committees

and less efficient board monitoring (i.e., an inefficient monitoring system); (2) no systematic disclosure concerning

individual compensation (i.e., an inefficient disclosure system); and (3) less explicit bonus plans and no clawback pro-

visions for preventing managerial moral hazard (i.e., a less explicit compensation system). We conjecture that these

features of corporate governance over executivecompensation in Japan increase managers’ opportunities to engage

in opportunistic behavior designed to increase their bonuses. Consequently, we expect to see demand for account-

ing conservatism in Japanese firms as it can prevent managers from inflating their earnings and obtaining excess

compensation.

We first examine the relation between accounting conservatism and the degree of dependence on earnings-based

compensation plans. Following Basu's (1997) specification, we define accounting conservatism as an asymmetric veri-

fication requirement for gains and losses. We derive a proxyfor the degree of dependence on earnings-based compen-

sation plans byestimating the compensation earnings coefficient (CEC), reflecting pay-for-performance sensitivity, fol-

lowing Bushman, Engel, and Smith (2006), who use the coefficient of earnings estimated from a model that regresses

executive compensation on earnings and returns. Firms with a relatively high CEC could havea more serious ex -post

settling-upproblem because their managers have a stronger incentive to manage their earnings and because the excess