Institutional Change, Accounting Conservatism And Executive Compensation Contracts

Based on New Institutional Economics (NIE) and extensive literature review, this study discusses the influence of institutional change of China’s capital market, especially the influence of accounting system and legal environment on the firms’ accounting policy choice about accounting conservatism. Furthermore, based on verifying the effective of executive compensation contracts, it analysis whether accounting conservatism have an effect on the efficiency of executive compensation contracts.According to the basic idea of NIE, institutional structure has a very significant impact on individuals’ and organizations’ economic bahaviors, thus it plays an important role in the economic performance. Because of China’s unique system background, institutional change of market capital still principally relys on government macro-regulation. Being one kind of the rules and regulations that is about listed companies, the change of accounting system has the most direct and special influence on corporations’ accounting decision making, the quality of accounting information and then impacts stakeholders’ behaviors. Accounting conservatism which is one of the basic characteristics of accounting information has a profound influence on accounting theory and practice. Through two big accounting reformations which is in2001and2006, China’s accounting system forms its own change method that is in accordance with international practice (egIASB). The practice of accounting conservatism has had far-reaching historical and current significance although it has been canceled by the FASB and IASB or relaxed by China’s Ministry of Finance. Especially when there is great information asymmetry and imperfect corporate governance, accounting conservatism has significant on reducing information asymmetry, constraining managers’ opportunistic behaviors and lowering transaction cost of various stakeholders. In addition, relative laws and regulations that match with the capital market’s institutional change provide the extrinsic coercion form the third part. Watts (2003) suggests that under effective leagal mechanism, firms refer to accoungting conservatism in order to avoid lawsuit cost. So that, firms’ accounting behaviors are not only influenced by accounting standards directly, but also constrained by the legal environment. Accounting numbers are widely used in executive compensation contracts, assuming positive information costs and transaction costs (Smith and Watts,1992). Because of the information asymmetry, revenue function asymmetry and tenure asymmetry, managers have incentives and channels to pursue the maximum personal benefit, even at the cost of shareholders’ value. So it’s particularly important to design an incentive compatible constraint contract by which on the one hand, it have motivation, and on the other hand it can restrain managers’ opportunistic behaviors. And the common practice is to pay for performance (Jensen and Murphy,1990). As a result, accounting conservatism may:(1) limit the managers’earing manipulation due to delay income recognition and recognize loss more timely;(2) send the signals to shareholders and other contract parties timely when managers have underlying radical behaviors.By employing normative and empirical study, this study mainly investigates the link between institutional change and accounting conservatism, as well as the link between accounting conservatism and executive compensation contracts. First, according to the time, emphasis and implementation of relevant laws and regulations (mainly about small and mediun investor protection acts and accounting standards) as well as the market’s reaction, this paper divides China’s capital market institutional change into five stages together. Then constraited by data avilable, it tests accounting conservatism of A share listed firms in last four stages during1994-2012, and verifys whether there is noticeable difference about accounting conservatism in different regions and stages where the legal environment is different. Second, this study investigates whether executive compensation contracts are useful of China’s listed firms during2003-2012. Especially it pays attention to the pay performance sensitivity, meanwhile it includes other possible internal and external influencing factors, such as firm’s specific characteristics, ownership structure, governance structure, executive personal traits as well as industry and region features. Finally, based on the theory and model analyses, this paper studies the accounting conservatism’s effect on the executive compensation contracts.The following conclusions are reached. First, the results suggest that the existence of accounting conservatism in China’s listed companies during1994to2012and mainly due to accounting system change, the degree of accounting conservatism fluctuates in different stages. After saperating the net income and total accruals, it indicates that China’s listed firms’accounting conservatism mostly comes form net cash flow form operating activities and non-oprational accruals, but discretionary accruals during2001-2005. In addition, the capital market institution change may result in the legal environment improvement and the better legal environment, so accounting conservatism is higher where the legal environment is better. Then, there is a closely connection between executive compensation and accounting performance, but not market based performance, either tested as a whole or tested by stages. And the executive compensation is also effected by the scale of company, the debt burden, ownership concentration, the separation of ownership and controlling right of controlling shareholders, whether the CEO is also the chairman, the scale of board, executive’s age, executive’s education level and characters of industries and regions. Finally, consistent with optimal contract theory, the study finds that the sensitivity of executive compensation to accounting performance is higher for firms that accounting conservatism is higher, especially after2006. It’s known that China’s accounting standard reduces request about accounting conservatism after2006, so the results form another angle indicate that accounting behaviors is not only regulated by standards but also influenced by internal demand from firms’ contracts and external law and regulation environment improvement. Besides, the relationship between accounting conservatism and executive compensation is more pronounced when the firm’s performance is worse, information asymmetry is higher, the firm lists on the mainboard, and where the marketization process is better.This study contributes to the extant literature in several ways. First, from a longer period it organizes and summaries China’s capital market institutional changes, so longthening the current research observation period. Meanwhile this study considers both two big accounting system changes in China so extending current research about accounting standard changes’ influence on firms’accounting conservatism. And then, from the legal environment perspective, this study investigates the relationship between legal environment and accounting conservatism, to some extent confirming there is demand from legal lawsuit for accounting conservatism (Watts,2003). Second, considering internal and external possible factors may impact executive compensation, this study investigates whether the executive compensation contract is effective of China’s listed firms, so providing a more distinct insight into the executive compensation contracts. Third, by revealing the impacts of accounting conservatism on executive compensation contracts, this research supplements a flourishing stream of empirical research on accounting conservatism associated with positive outcomes. These conclusions explain that accounting change can influence accounting behaviors (accounting consetvatism), and further accounring behaviors can influence firms’ internal governace (executive compensation contracts). Specifically, it suggests that accounting conservatism can help improve the efficiency of executive compensation contracts. Finally, this study provides standard setters with a clear sense of the role of accounting conservatism in reducing the information asymmetry and improving the quality of accounting information. Especially after enforcing2007new accounting standards, these results suggest that the adoption of accounting conservatism is necessary and important for China where the investors need reliable accounting information much more and the information asymmetry is still high.