The differential asset substitution effects of accounting-based and market-based long-range executive compensation plans

This study empirically examines the moderating influences of different forms of long-range executive compensation on an incentive effect of debt known as the asset substitution problem. Analytical studies of other researchers hypothesize that increasing the proportion of debt in a firm's capital structure will induce substitutions of low risk assets with high risk assets by an owner-manager such that wealth is expropriated from bondholders. However, the introduction of a separation of ownership from control introduces an additional agency consideration. A nonowner-manager's natural tendency toward risk aversion will lead to a form of shirking in which the risk-increasing asset substitutions desired by the owner are not made. However, the nonowner-manager's attitude toward making these asset substitutions may be influenced by the design of the long-range executive compensation package. Previous studies indicate that both accounting-based and market-based long-range executive compensation plans have the potential to reduce a nonowner-manager's risk aversion tendencies. This study assesses and compares the moderating influences of these two types of long-range executive compensation on asset substitutions.;The empirical study focuses on petroleum companies and their propensity to engage in the inherently risky activity of oil and gas exploration as a measure of asset substitution effects. Through a set of time series regression analyses the moderating influences of accounting-based and market-based long-range executive compensation measures on the relationship between leverage and exploration activity measures are examined. The results indicate that accounting-based long-range executive compensation is neutral with respect to both interactive and direct asset substitution effects. However, the results also indicate that significant interaction exists between market-based long-range executive compensation and leverage related to risk-increasing asset substitutions. The observed differential asset substitution effects of accounting-based and market-based long-range executive compensation plans point to a rational explanation of long-range executive compensation plan choice.