The Essential Role of Accounting Earnings in Return-Maximizing CEO Compensation Contracts
37 Pages Posted: 1 May 2015
Date Written: April 29, 2015
The agency literature on CEO compensation acknowledges the usefulness of both equity and accounting-based earnings incentives. We contend that since total shareholder returns depend directly on firm profitability and changes in its equity value, both these firm performance measures and their risks – ‘business risk’ and equity risk – are relevant to the design of efficient CEO contracts. Accordingly, we consider an agency framework in which shareholders maximize total firm returns (inclusive of both period profits and changes in firm equity value) through the provision of equity and profit incentives. Results from the model and numerical study provide a comprehensive set of insights on how return-maximizing CEO effort and equity/cash incentives depend on various firm-CEO characteristics (including firm growth prospects, firm scale, business risk and equity risk). Overall, our analysis shows that an appropriate mix of CEO equity and cash incentives linked to accounting-earnings measures are necessary to generate proper agency alignment for maximizing total shareholder returns.
Keywords: CEO pay, shareholder returns, earnings incentives, equity incentives, firm growth prospects, business risk, equity return risk, firm size
JEL Classification: G30, J33, M40, M41, M52
Suggested Citation: Suggested Citation