Say-On-Pay Laws and Financial Reporting Quality around the World

The exponentially increasing yet unjustified executive pay around the world has prompted much debate over how to improve extant corporate governance systems to better align executive pay with shareholders’ interests. One of the most influential proposals to address this issue is to further empower shareholders to voice on executive pay or say-on-pay (SOP). Such proposals have gained widespread support from lawmakers, which have finally been translated to SOP laws in 11 countries as of 2014. Nevertheless, opponents of the law are rather pessimistic for several reasons. To date, studies show mixed results on whether SOP laws could curb executive overpay, enhance pay-for-performance sensitivity and therefore increase firm value. As such, the effectiveness of SOP laws remains controversial and needs further study. In addition, prior studies have not examined how SOP laws affect firms’ financial reporting quality (FRQ), an important factor that is related to several economic consequences and that affects the inferences drawn from pay-for-performance relations in prior studies.

The proposed research will aim to contribute to this debate and examine the causal effect of SOP laws on FRQ by taking advantage of the staggered initiation of SOP laws worldwide. Drawing on the existing literature, we propose three possible FRQ consequences following the adoption of SOP laws. We plan to capture FRQ using three proxies that reflect a firm’s involvement in accrual management, income smoothing and real earnings management. To further shed light on how SOP laws affect FRQ, we will further examine the moderating effect of country-level investor protection regimes and firms’ internal/external monitoring mechanisms. To supplement prior studies on the effectiveness of SOP laws, we will examine whether executives are more accountable for their performance after the passage of SOP laws by using a modified pay-for- performance sensitivity model that accounts for earnings quality (Cornett et al. 2008).

We expect the proposed research to make the following contributions. First, it could contribute to the debate on the monitoring role of SOP laws from the financial reporting perspective. Second, the proposed research could deepen our understanding of the causal relationship between shareholder protection and FRQ. Finally, it could extend the compensation contracting literature in which shareholders can intervene in the decision- making process concerning executive pay. We believe that our study will be timely as it will provide policy implications to securities regulators, especially those from jurisdictions which plan to adopt SOP laws in the future