The role of accounting conservatism in executive compensation contracts

Abstract To test the implication of Watts’ (2003) argument that accounting conservatism increases the efficiency of executive compensation contracts, we investigate the relation between accounting conservatism and earnings‐based executive compensation contracts in Japanese firms. We focus on Japanese executive compensation practices because the demand for accounting conservatism is likely to be greater for Japanese than for US firms given the predominance of earnings‐based executive compensation contracts and relatively weak corporate governance of compensation contracts in Japan. We also investigate how the quality of the ex‐ante information environment affects the relation between accounting conservatism and earnings‐based executive compensation contracts. Consistent with our expectations, we find a positive relation between accounting conservatism and the compensation earnings coefficient. We also show that this positive relation is greater for firms with poor ex‐ante information environment. These results suggest that the demand for accounting conservatism is greater for firms that use more earnings‐based executive compensation contracts and have more serious ex‐post settling‐up problems.