Pay Convexity, Earnings Manipulation, and Project Continuation
University of Texas at Austin - Department of Accounting
December 11, 2013
This paper studies the optimal design of long-term executive pay plans when boards of directors use accounting information for investment decision-making and executives can take costly actions to manipulate this information. The model predicts that a shift to more convex executive pay plans (e.g., equity plans that are more option and less stock heavy) is associated with higher levels of manipulation, lower reporting quality, and less efficient investment. When designing the optimal contract, the board trades off these effects with the cost of inducing effort.
In addition, the paper analyzes how the optimal pay convexity and the equilibrium level of manipulation change when the financial reporting environment changes. The model shows that the magnitude of manipulation is an inverted U-shaped function of the CEO's opportunistic reporting discretion. Thus, a move to better governance (which increases the CEO's marginal cost of misreporting) first increases and then decreases the level of manipulation. With respect to CEO compensation, the model predicts greater emphasis on stock options relative to stock in firms with stronger governance.
Number of Pages in PDF File: 68
Keywords: Equity pay mix, Project termination, Manipulationworking papers series
Date posted: May 10, 2012 ; Last revised: December 12, 2013
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