Earnings-based bonus plans and the agency costs of debt

Compensation research commonly advocates using stock-based incentives to align managerial and shareholder interests. However, there is little in the literature to explain the widespread use of accounting-based compensation except as a complement to market-based measures of firm performance. This paper uses a simple model to show that earnings-based cash bonus compensation has an explicit role in reducing agency conflicts with debt holders. Specifically, we posit that one role of the accounting-based cash bonus is to provide an incentive for managers to seek stable and positive cash flows to meet debt obligations. To test this hypothesis, we use a sample of 5510 firm-year observations and find that earnings-based bonus compensation is positively associated with both firm leverage and pay-performance sensitivity. We also find that cash bonus compensation is negatively associated with corporate bond yields. Overall, our analysis suggests that earnings-based bonus plans are an important mechanism for reducing the agency costs of debt.