An Empirical Investigation of Trends in the Absolute and Relative Use of Earnings in Determining Cash Compensation of CEOs
Robert M. Bushman
University of North Carolina Kenan-Flagler Business School
University of Chicago Booth School of Business
Chicago Partners, LLC
Abbie J. Smith
University of Chicago - Booth School of Business
The purpose of this paper is to provide evidence on whether there have been changes over time in the compensation-earnings relation. We investigate whether there is a trend during the period 1971-95 in the sensitivity of executive pay to reported earnings and in the importance of earnings relative to other information in explaining executive pay. As addressed in Gjesdal  and in the model we develop, the relevance of a performance measure for valuing the firm may not be the same as its relevance for the purpose of inferring managers' contributions to firm value. Whether the decline in the value-relevance of earnings documented in recent research is accompanied by a decline in the stewardship relevance of earnings is an empirical issue that is the focus of this paper.
We estimate pooled regressions of the pay-earnings relation allowing intercepts and slopes to vary by year and industry. While we find significant positive correlation between the sensitivities of firm value and executive pay to earnings, our results fail to detect a general trend in the sensitivity of executive pay to reported earnings. We also conduct similar pooled estimations of the pay-performance relation incorporating non-earnings information reflected in stock prices to assess the importance of earnings relative to other information. Our results suggest that there has been a general decline during the last 25 years in the importance of earnings in explaining cash compensation relative to other information reflected in stock returns.
We further analyze our results indicating a decline in pay-earnings sensitivity relative to information in stock returns in the context of insights gained from existing studies of trends in the value relevance of earnings. We analyze changes in the sensitivity of earnings relative to accounting performance measures that explicitly incorporate balance sheet information. We find that, in contrast to price-earnings studies, the documented decline in relative pay-earnings sensitivity is not attributable to a shift from earnings to balance sheet-based measures. Finally, we examine whether factors capturing aspects of the quality of earnings and firm size that explain the shift in the value relevance from earnings to book values also explain shifts in the relative stewardship relevance of earnings. We find that changes over time in the proportion of intangible-intensive firms, the average magnitude of special items included in earnings and the frequency of negative earnings appear to explain much of the trend in relative pay-earnings sensitivity over the sample period.
Number of Pages in PDF File: 41
JEL Classification: C23, J33, M41working papers series
Date posted: October 7, 1998
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