| Equity compensation, mainly including stock options and restricted stock, is an essential part of executive compensation. With respect to the concern on the eroding earnings quality with the increasing use of equity compensation, this study empirically examines the effect of CEO equity compensation on earnings quality. I measure earnings quality as the extent to which current period earnings or accruals are realized as future cash flows. I find that earnings quality is positively associated with CEO equity compensation. That is, CEO equity compensation enhances earnings quality. Moreover, this study further examines whether the positive effect is contingent on the quality of external monitoring, such as auditors and institutional shareholders. My results indicate that the positive role of equity compensation only persists when external monitoring by auditor and (or) institutional investors is weak. When external monitoring is strong, the effect of CEO compensation on earnings quality fades. It implies that the incentive from CEO equity compensation is more like a substitute governance mechanism for external monitoring by auditor or/and institutional investors. Overall, the findings of this study support that equity compensation is efficient in alleviating the agency conflicts between shareholders and managers. The findings also provide some empirical evidence supporting the substitute effect between incentive mechanism and external monitoring. |
