Executive Compensation Performance Sensitivity: A Further Evidence of the Role of Conservatism in Financial Reporting in the Iranian Capital Market

Separating ownership and management creates the problem of agency. Consequently, this information asymmetry between managers and shareholders brings the need for a conservative approach in financial reporting. In this way, shareholders use this approach to mitigate the effects of this information asymmetry. Hence, this study aims to investigate the relationship between conservatism in financial reporting and the sensitivity of compensation performance of managers. Also, this study identifies and examine the effect of conservatism in financial reporting on the effectiveness of the executive manager's compensation contracts in the Iran setting.

The research population selected through the systematic elimination method. The study population consists of 104 Iranian companies listed on the Tehran Stock Exchange (TSE) during the years 2011 to 2019. Research hypotheses and links between variables tested using the panel data. Also, the multivariate regression model is used for hypothesis testing.

The results indicate that there is a negative and significant relationship between conservatism in financial reporting and the level and sensitivity of executive manager's compensation. Also, results show no significant relationship between the interactive effect of the true performance of accounting and conservatism in financial reporting with the compensation-performance level of executive's managers. Findings show there is a positive and significant relationship between the interactive effect of conservatism and the sensitivity of the true performance of accounting based on book value with the sensitivity of executive manager's compensation. The results indicate that there is a positive and significant relationship between the interaction effect of stock returns and conservatism with the level of managers' compensation. There is also a positive and significant relationship between the interaction effect of conservatism and changes in stock returns with the sensitivity of managers' compensation-performance based on market value. Information asymmetry leads to conservatism in financial reporting as a solution to reduce the cost of agency. Hence, corporate financial reporting stakeholders demand conservatism to reduce agency costs by reducing information asymmetry and facilitate corporate governance.

The results of the current study extend the knowledge of previous studies. The results of this study indicate that conservatism in financial reporting can be effective in reducing information risks and the problems of agency.  Therefore, conservatism in financial reporting can be considered an effective contractual mechanism. Accordingly, conservatism can limit the opportunistic behaviors of executive managers. Conservatism in financial reporting allows firms to CEO compensation more closely to corporate performance. Also, shareholders consider conservatism as a governance mechanism. They should increase the level of conservatism to increase the performance-compensation sensitivity of executives. Hence, conservatism in financial reporting is a tool that a board of directors can use to monitor and control CEOs' investment decisions; therefore, high-quality accounting information leads to increased investment efficiency by eliminating information asymmetry between managers and investors.Based on the results of this study, we propose to use a conservative mechanism in financial reporting to protect the interests of shareholders against the opportunism of managers in an economic environment such as Iran, in which the state affects the economy. This paper is the first study of its type in Iran.