The Association between Stock/Compensation Mix and Earnings Usefulness

Abstract

Management incentives have been suggested as a factor affecting the usefulness of reported earnings for readers of financial statements. Prior research has demonstrated that the quality of earnings has been associated with levels of managerial ownership (Warfield, Wild and Wild (1995)), audit quality using Australian data (Gul, Lynn, and Tsui (2002), and compensation mix in 0%-5% manager owned firms (Behn, Nagy, and Riley (2000). We extend this line of research by theoretically demonstrating and empirically examining whether companies, with any level of stock ownership, can use higher levels of stock remuneration relative to annual salary and bonus compensation to enhance the informativeness of accounting information. We proxy for earnings informativeness by using the earnings-returns relationship and three different earnings management techniques: discretionary accruals, R&D investments and advertising expenditures. By using a more precise and theoretically derived stock compensation ratio on a sample of all publicly traded firms and using different measures of earnings management techniques, we provide additional, more robust, empirical evidence that the stock compensation ratio (SCR), not just ownership levels, can improve the informativeness of earnings. Our findings suggest that higher levels of the SCR are associated with improvements in the usefulness of earnings and with reductions in the magnitude of discretionary accrual adjustments, advertising expenditures, and to a lesser extent, research and development investments. This study contributes to the extant managerial compensation and earnings quality literature by enhancing our understanding of the financial disclosure environment by providing empirical evidence for specific factors that improve the usefulness of earnings disclosures.