Compensation Committees’ Treatment of Earnings Components in CEOs’ Terminal Years

Abstract

Compensation committees face special difficulties when setting pay in the last years of a CEO’s tenure. For example, incentives to manipulate earnings for the purpose of enhancing earnings-based compensation are greater in CEOs’ terminal years. We predict that compensation committees are aware of these incentives and adjust the relative weights placed on earnings components in the cash compensation function to mitigate the problem. Consistent with our prediction, we find that, in CEOs’ terminal years, positive changes in discretionary accruals receive significantly less weight than other income components in determining cash compensation. This provides new evidence that not all gains flow through to compensation. We also find that, in non-terminal years, managers’ compensation is partially shielded from the negative effects of SG&A expenditures, but this effect reverses in the terminal period, consistent with the compensation committee discouraging investment in legacy assets by outgoing CEOs. Overall, our findings suggest that compensation committees treat components of earnings differently when setting pay in the terminal period.

Keywords: horizon problem, compensation committee, discretionary accruals, real activity management

JEL Classification: M41, J33