An International Meeting of the American Accounting Association American Accounting Association 2006 Annual Meeting August 6–9, 2006 Washington, D.C.

Claudine Mangen
Concordia University

Abstract: This study documents that the sensitivity of CEO cash pay to earnings increases with leverage. It is argued that this result obtains for two reasons. First, a higher weight on earnings provides CEOs with tighter incentives to prevent a debt covenant violation. Earnings include a charge for the interest cost of debt, which increases following a debt covenant violation that leads to technical default. The closeness to covenant violation itself is positively related to leverage. Second, a larger pay-performance sensitivity to earnings provides CEOs with incentives to mitigate the over-investment problem, which is likely more important when leverage is higher. Earnings are conservative, implying that CEO wealth is affected to a larger extent by the downside than by the upside consequences of risky projects. CEOs thus are likely to avoid negative NPV projects that increase firm risk.

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