Executive pay disparity and internal control material weaknesses

Abstract

Prior literature on executive pay disparity provides two perspectives. The tournament perspective considers the large pay gap between the CEO and other senior executives as an effective tournament incentive that can reduce the entrenchment of the CEO (Kale, Reis, and Venkateswaran (2009)). The other perspective named as the managerial power perspective suggests that large pay gap can make the CEO more entrenched by increasing the bargaining power of the CEO (Bebchuk, Cremers and Peyer (2011)). Therefore, this line of research provides inconclusive evidence. In this study, I try to extend and complement previous studies by investigating the role of executive pay disparity in affecting firms' internal control quality. Using 8,547 U.S. firm-year observations over 2004-2012, I document that firms with large executive pay disparity tend to be associated with a lower likelihood of having internal control material weaknesses. This relation is insensitive to different categories of internal control material weaknesses based on two classification schemes. In addition, I also find that a larger pay disparity between the CEO and non-CEO executives will lead to a higher degree of accounting conservatism and a lower probability of having financial restatements. Taken together, the evidence is supportive of the tournament incentive perspective. I further examine factors that may affect the extent of the association between CEO pay disparity and internal control material weaknesses. Based on the results of the baseline model, I find that the negative relation between CEO pay disparity and internal control material weaknesses is more stronger for firms with the most severe agency problems. This suggests that a large CEO pay disparity can be substitutive of other corporate governance mechanisms. Consistent with the tournament incentives perspective, I also find evidence showing that the negative relation between executive pay disparity and the probability of having internal control material weaknesses is less pronounced when the probability of promotion perceived by other senior executives is high. Specifically, I find that the relationship between executive pay disparity and material weaknesses is weakened when the CEO is new, and weakened further if the new CEO is an outsider. Finally, I perform several partitioning analyses. In particular, the evidence show that the pay disparity between the CEO and lower-level executives has a stronger impact on internal control weaknesses for firms with lower CEO ownership, a younger CEO, lower institutional ownership, less analyst coverage, lower degree of board independence, and no female board presence. As a whole, the results provided by partitioning analyses are supportive of the tournament incentives perspective as well. Most importantly, the evidence also suggests that executive pay disparity seem to serve as a substitute, as far as accounting practice is concerned, of other mechanisms for corporate governance that would otherwise be weak.