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We investigate whether relative performance evaluation (RPE) in compensation contracts affects firms¡¯ conservative financial reporting. Using the propensity score matching approach, we show that accounting-based RPE firms exhibit less timely loss recognition than non-RPE and equity based RPE firms. Both agency and tournament theories provide plausible explanations for this finding. We find that firms facing greater common risks reduce accounting conservatism after RPE adoption. This is consistent with agency explanation that RPE, as an efficient incentive scheme, removes common shocks from managerial performance. Such risk-sharing benefits decrease agency costs and the demand for conservatism as a substitutive governance mechanism. In support of tournament incentives, we find that firms which perform poorly in the earlier years of performance measurement period will delay loss recognition in the last year to exceed their peers¡¯ performance. Moreover, less conservative reporting enables firms to meet or barely beat peer performance to win the tournament. We also find that the negative association between RPE usage and accounting conservatism is more pronounced when less capable CEOs¡¯ external job opportunities decrease after the adoption of Inevitable Disclosure Doctrine. Lastly, we find that RPE firms with less conservative reporting have higher firm valuation, implying that pay contracting efficiency resulting from reduced agency costs dominates managerial opportunism due to tournament incentives. Overall, our findings offer new insights into the consequences of RPE usage and provide further evidence on compensation contracting as a determinant of accounting conservatism.

zcarol2@ceibs.edu