The Accountability System for Material Misstatements and Executive Pay Performance Sensitivity: A Quasi‐natural Experiment

Abstract

This study examines the impact of the accountability system for material misstatements (ASMM) on the sensitivity of executive compensation to accounting earnings in China. Using a difference‐in‐differences model, we find that the ASMM significantly decreases the sensitivity of executive compensation to accounting earnings, which we attribute to the monitoring and unintended effects of the ASMM. As executives’ cost to manage reported earnings for more bonuses is significantly heightened by the ASMM, their high compensation sensitivity to reported earnings, which contain earnings management, reduces. The unintended consequence is that executives’ risk aversion is also incentivized to preserve performance pay while the ASMM restricts earnings management, and boards reduce executives’ compensation sensitivity to accounting earnings to encourage their risk taking. These phenomena are more pronounced in companies with high agency conflict, audited by non‐Big 4 auditors, and less followed by analysts. The results indicate that corporate governance reforms that introduce personal responsibilities in China can improve the accuracy of accounting earnings but decrease the efficiency of assessing executive hard work. The board reacts to this change by increasing the role of stock returns in executive compensation contracts. This is consistent with the view that the principal dynamically adjusts executive compensation contracts to make them incentive compatible (Tirole and Laffont, 1988; Hall and Knox, 2004; He, 2011). Our study provides critical implications for the importance of institutional environments to impact governance reforms in emerging markets and beyond.