Theme：Debt-Equity Conflict, Accounting Conservatism, and Executive Compensation
Speaker：Zhaoyang Gu（Professor of Accounting, The Chinese University of Hong Kong）
Address：Room 502, Mingde Business Building
Debtholders and equityholders have different preferences for risks. Equityholders have the incentive to take excessive risks at the expense of debtholders. We argue that executive compensation combined with accounting conservatism can serve as a low-cost alternative to mitigate the debt-equity conflict. For example, in the case of R&D, accounting is conservative in that all costs are immediately expensed when incurred, reducing the accounting earnings, while the stock price may react positively when the R&D project has positive NPV. By tying executive compensation more to accounting earnings than to stock returns, managers would be "punished" for taking R&D due to lower compensation in the early years. Thus, they would be incentivized to stay away from R&D, to the benefit of debtholders. Empirically we find evidence supporting the above argument. In particular, we find that the CEO pay sensitivity to accounting return on asset increases with financial leverage, a proxy of the equity-debt conflict. Such higher sensitivity is primarily driven by the bonus portion of CEO compensation. In addition, the results are mainly found among firms with higher accounting conservatism and higher uncertainty in operations, consistent with notion that protection of debtholders is most needed when the uncertainty level is high and most effective when accounting is conservative.
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