Corporate Transparency and CEO Compensation Contracts: Evidence from SFAS No. 131

Given the inability of shareholders to observe hidden managerial actions, agency theory suggests that tying CEO pay to firm performance mitigates agency problems. SFAS 131 requires firms to define segments as internally viewed by managers, rendering managerial hidden actions in internal capital allocation more observable to external shareholders. Using the adoption of SFAS 131 as improvement in corporate transparency, we examine how a change in corporate transparency affects a pay-performance relation in CEO compensation designs. We find that the sensitivity of CEO pay to stock performance is significantly reduced after the adoption of SFAS 131 for firms affected by the standard. Also, we find that such a reduction is more pronounced for (1) firms with lower CEO ownership where inherent agency problems due to the separation of ownership and control are higher and (2) firms with higher operating uncertainties where CEOs bear greater risks by linking pay to stock performance. Overall, findings in our study suggest that corporate transparency substitutes for incentive contracts as an alternative monitoring mechanism.