Operating Cash Flows and Earnings Target Revision

Abstract

We examine the extent to which current operating cash flows are incorporated in future earnings targets in executive compensation. Using target and actual compensation earnings per share (EPS) disclosed in proxy statements for large U.S. public companies, we find that revision of the following year’s EPS target is unrelated to current operating cash flows. Because of the positive association of operating cash flows with future earnings incremental to current earnings, failing to incorporate operating cash flows in target revision results in more achievable earnings targets for firms with higher operating cash flows. Interestingly, we find that the positive relationship between target achievability and operating cash flows is attributable to both expectation bias related to operating cash flows and contractual considerations designed to reward CEOs who deliver greater cash flows and to limit activities that sacrifice cash flows.

Keywords: target setting; target revision; target achievability; operating cash flows

JEL Classification: M41; J33