Rationality of executive compensation schemes and real accounting changes

Managerial preference for accounting methods is examined with respect to the effects of the chosen methods on executives' annual compensation (salary and bonus). Two propositions are considered: (a) the bonus‐hypothesis, and (b) the rationality of compensation schemes. While the former asserts a tie between compensation and accounting income, the latter stipulates a connection between the real (cash flow) consequences of the choice of accounting methods and executives' compensation.

Two accounting method changes were used: (a) the change in pension costing and funding (which increases both income and operating cash flows), and (b) the change in inventory valuation method to LIFO (which decreases income and increases cash flows). Unexpected compensations in the switch‐year were correlated with the effects of each accounting change on income. The results suggest that top executives' salary and bonus payments increased in the switch‐year beyond levels predicted by the pre‐switch compensation parameters. Several validation checks were also performed using comparison samples. Furthermore, the effects of these two accounting changes on income were found to correlate with unexpected compensation in the directions predicted by the hypothesis of rationality of compensation schemes.