Economic Consequences of Equity Compensation Disclosure

The following paper comes to us from Jeremy Bertomeu of the Accounting Information and Management Department at Northwestern University.

In the paper Economic Consequences of Equity Compensation Disclosure, forthcoming in the Journal of Accounting, Auditing, and Finance, we develop a novel mechanism through which a principal may signal a firm’s type to outside investors. In our model, the principal does not need to retain any of the firm’s equity (unlike standard signaling models) but may competitively contract with a manager who is informed and may or may not provide effort.

We show that the choice of effort is affected by both the level of performance-pay chosen by the principal and the quality of the firm. If contracts convey information on the firm, then our analysis shows how and why a firm’s stock price and future operating performance should be associated to the choice of a particular pay package. In this respect, the model offers a framework to tie firm performance and contracting choices, in an optimal contract setting.

We further develop several predictions for future empirical applications. Even if information about a firm’s type is known to market participants, we show that pay-for-performance will be positively associated to the firm’s type and thus, also, to the agent’s effort and future earnings. In the model, the observed level of pay-for-performance is endogenous and the positive association of performance with incentive pay does not imply that greater firm value could be achieved by further increasing pay-for-performance. Examining reporting motives, we show that concerns for higher market prices can distort the optimal contract: namely, we show that when markets are more (less) responsive to information, such reporting motives lead to pronounced (muted) equity ownership, and higher (lower) pay and managerial effort. From a policy perspective, in these cases, mandated changes to compensation arrangements or their disclosure may potentially increase the efficiency of contracts.

The full paper is available for download here.

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