The Relationship between the Use of Accounting Measures in Debt and Incentive Contracts
46 Pages Posted: 14 Sep 2012 Last revised: 15 Nov 2012
Date Written: November 13, 2012
The likelihood that tripping a debt covenant would precipitate the dismissal of top management provides an implicit incentive for managers to perform that is incremental to the explicit incentives in compensation contracts. I assess the sensitivity of the CEO’s cash compensation to earnings and earnings-based covenants in the firm’s debt contracts. When the debt contract contains an earnings-based covenant, the sensitivity of the CEO’s pay to earnings is muted. This reflects the influence of earning-based debt contract terms on the CEO’s incentives to focus on earnings. Additionally, I predict and find that the annual rebalancing the CEO’s incentives in the compensation contract varies with the intensity of the firm’s pre-existing earnings-based debt covenants. For all firms, on average a one-percentage point increase in ROA increases the CEO’s cash compensation by 3.6 percent. In contrast, in firms with earnings-based covenants, a one-percentage point increase in ROA is associated with an increase in cash compensation of only 1.9 percent.
Keywords: Executive compensation, Pay for performance, Earnings-based covenants
JEL Classification: G32, J31, J33, M12, M41
Suggested Citation: Suggested Citation