The real effects of financial reporting on pay and incentives

This paper looks at the real effects of financial reporting and accounting quality on pay and incentives.

Author:

• John E. Core, MIT Sloan School of Management

Abstract

This paper discusses two real effects of real effects of financial reporting on pay and incentives: (1) Better earnings leads to better incentives, and (2) If pay is mis-measured, pay can be mis-used. The first real effect follows from the fact that incentives are often based on earnings, and the effectiveness of earnings-based incentives is positively related to the quality of earnings. Greater use of earnings in incentives provides better incentives at a lower cost. The second real effect has to do with how well the accounting system measures the expense of various pay components. Complex calculations are required to value complex pay components such as options, post-employment benefits, and performance-vested equity, and these calculations have historically not been done correctly. The incorrect accounting leads to these pay components being mis-used. I conclude by discussing how accounting and disclosure of pay and incentives may be improved in the future.

The full paper will be published in the annual International Accounting Policy Forum special issue of Accounting and Business Research. The paper will be available on the Taylor and Francis website later in 2020.