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The Essential Role of Accounting Earnings in Return-Maximizing CEO Compensation Contracts

37 Pages Posted: 1 May 2015  

Gurupdesh S. Pandher

University of Windsor, Odette School of Business

Jagdish Pathak

University of Windsor - Odette School of Business

Date Written: April 29, 2015

Abstract

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.
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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

Pandher, Gurupdesh S. and Pathak, Jagdish, The Essential Role of Accounting Earnings in Return-Maximizing CEO Compensation Contracts (April 29, 2015). Available at SSRN: https://ssrn.com/abstract=2600765 or http://dx.doi.org/10.2139/ssrn.2600765

Gurupdesh S. Pandher

University of Windsor, Odette School of Business ( email )

401 Sunset Avenue
Windsor, Ontario N9B 3P4
Canada
519-253-3000 ext 3091 (Phone)

HOME PAGE: http://www1.uwindsor.ca/odette/gurupdesh-pandher

Jagdish Pathak (Contact Author)

University of Windsor - Odette School of Business ( email )

401 Sunset
Windsor N9B 3P4, Ontario
Canada
519-253-3000 ext. 3131 (Phone)
519-973-7073 (Fax)

HOME PAGE: http://www.jagdishpathak.com

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