The Relationship between the Use of Accounting Measures in Debt and Incentive Contracts

• In Event: Lending and Performance

Abstract

The likelihood that tripping a debt covenant would precipitate the dismissal of top
management provides an implicit incentive for managers to perform that is incremental to the
explicit incentives in compensation contracts. I assess the sensitivity of the CEO’s cash
compensation to earnings and earnings-based covenants in the firm’s debt contracts. When the
debt contract contains an earnings-based covenant, the sensitivity of the CEO’s pay to earnings is
muted. This reflects the influence of earning-based debt contract terms on the CEO’s incentives
to focus on earnings. Additionally, I predict and find that the annual rebalancing of the CEO’s
incentives in the compensation contract varies with the intensity of the firm’s pre-existing
earnings-based debt covenants. For all firms, a one-percentage point increase in ROA increases
the CEO’s cash compensation by an average of 3.6 percent. In contrast, in firms with earnings-based
covenants, a one-percentage point increase in ROA is associated with an increase in cash
compensation of only 1.9 percent.

Author

• Adrienne Cheri Rhodes, The Pennsylvania State University