Pay Convexity, Earnings Manipulation, and Project Continuation

49 Pages Posted: 9 Mar 2014 Last revised: 4 Jun 2014

Volker Laux

University of Texas at Austin - McCombs School of Business

Date Written: June 3, 2014

Abstract

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, such as equity plans that rely more on options and less on stock, 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 executive effort. The paper also analyzes how the optimal pay convexity and the equilibrium level of manipulation change when the CEO's opportunistic reporting discretion changes. The model predicts that an increase in the CEO's marginal cost of manipulation increases the optimal level of pay convexity and first increases and then decreases the magnitude of manipulation.

Keywords: pay convexity, accounting manipulation, project continuation, reporting discretion

JEL Classification: M12, M41, G31

Suggested Citation

Laux, Volker, Pay Convexity, Earnings Manipulation, and Project Continuation (June 3, 2014). Accounting Review, Forthcoming. Available at SSRN: https://ssrn.com/abstract=2406218

Volker Laux (Contact Author)

University of Texas at Austin - McCombs School of Business ( email )

2317 Speedway
Austin, TX 78712
United States

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