To test the implication of Watts’ (2003) argument that accounting conservatism increases the efficiency of executive compensation contracts, we investigate the relation between accounting conservatism and earnings‐based executive compensation contracts in Japanese firms. We focus on Japanese executive compensation practices because the demand for accounting conservatism is likely to be greater for Japanese than for US firms given the predominance of earnings‐based executive compensation contracts and relatively weak corporate governance of compensation contracts in Japan. We also investigate how the quality of the ex‐ante information environment affects the relation between accounting conservatism and earnings‐based executive compensation contracts. Consistent with our expectations, we find a positive relation between accounting conservatism and the compensation earnings coefficient. We also show that this positive relation is greater for firms with poor ex‐ante information environment. These results suggest that the demand for accounting conservatism is greater for firms that use more earnings‐based executive compensation contracts and have more serious ex‐post settling‐up problems.

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This article investigates whether and how Japanese firms use management earnings forecasts as a performance target for determining executive cash compensation. Consistent with the implications of the agency theory, we find that the sensitivity of executive cash compensation varies with the extent to which realized earnings exceed initial management forecasts. In particular, we find that the executive cash compensation is positively related to management forecast error ( MFE) for a sample of Japanese firms comprising 15,941 firm-year observations from 2005 to 2013. Moreover, we show that the relationship between executive cash compensation and MFE strengthens (weakens) when current realized earnings exceed (fall short of) aggressive initial forecasts. In additional analysis, we find that pay-for-performance sensitivity is weaker for extremely positive MFEs due to the ceiling on total cash compensation. Overall, we find that initial management forecasts can be used as a performance target in executive compensation contracts. These findings also suggest that management earnings forecasts are important for improving contract efficiency as well as for providing useful information to investors in the capital market.

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This paper investigates the relative importance of parent-only and subsidiary earnings in Japanese firms using a variance decomposition methodology. The findings generally indicate that subsidiary return on equity (ROE) news has a greater effect in driving current stock returns than parent-only ROE news. In addition, we show that as subsidiary companies’ performance becomes relatively important as an indicator of consolidated performance, the market pays greater attention to subsidiary ROE news. Finally, we show that the market does not pay greater attention to subsidiary earnings when consolidated earnings are negative. In that case, parent-only earnings become a good indicator of consolidated performance.