The Impact of Accounting Conservatism on the Compensation Relevance of UK Earnings

Vincent O'connell

European Accounting Review, 2006, vol. 15, issue 4, 627-649

Abstract: It has long been established that because of accounting conservatism, the contemporaneous correlation between returns and earnings is lower (higher) for good (bad) news firm-years. Meanwhile, prior analytical agency work suggests that the compensation role of accounting earnings is potentially greater (for tasks such as noise filtering and incentive balancing) when the contemporaneous correlation between earnings and returns is lower. Hence, since accounting conservatism implies that earnings have a lower correlation with returns in good news firm-years, the present paper hypothesises that UK CEO cash compensation exhibits a stronger (weaker) sensitivity to accounting earnings in good (bad) news firm-years. The empirical findings offer substantial support for this hypothesis and are robust to alternative estimation methodologies. In addition, the results appear not to be attributable to the well-established impact of earnings persistence on the compensation-earnings association. Overall, the findings are consistent with the notion that UK compensation committees appear to take cognisance of the impact of accounting conservatism when awarding earnings-based compensation. In addition, the present work offers additional insights into the nature of the interaction between the contracting and valuation roles of accounting numbers.

Date: 2006
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DOI: 10.1080/09638180601102222

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