Reclassification of income statement items and weight adjustment of compensation performance indicators

Abstract

The selection and weighting of performance indicators are of vital importance for an effective compensation contract. We examine the effect of the reclassification of income statement items, caused by China’s new Accounting Standards for Business Enterprises (ASBE) in 2007 on the weight adjustment of compensation performance indicators. The results show that the sensitivity of executive pay and investment income increases significantly after ASBE moves investment income in the income statement from below-the-line of operating income to above-the-line, which indicates that the disclosure position of income statement items is directly related to the weight of compensation performance indicators. We also find that the earnings persistence of investment income increases significantly after ASBE, which implies that the reclassification of investment income conforms to business practice and also performs well. However, the increased sensitivity of executive pay and investment income may induce management’s opportunistic investment in financial assets.