The Explanatory Power of Earnings Levels vs. Earnings Changes in the Context of Executive Compensation

Abstract

Studies in the capital market context indicate that earnings changes and earnings levels considered jointly provide a more comprehensive representation of unexpected earnings than either earnings changes or earnings levels considered alone. Recent studies of executive compensation demonstrate that executive compensation revisions are greater when earnings innovations are permanent, than when innovations are transitory. Together, these literatures imply that both earnings changes and earnings levels explain revisions to CEO compensation. Specifically, formal analysis implies that weights on earnings changes vary directly with the persistence of earnings innovations and that weights on earnings levels vary directly with persistence for low persistence observations and inversely with persistence for high persistence observations. Evidence for compensation to 712 executives of U.S. corporations is consistent with these expectations. Such results suggest that earnings levels, earnings changes, and earnings persistence need to be considered when investigating relations between accounting earnings and executive compensation.

An Empirical Investigation of the Relationship between Executive Risk Sharing and Stock Performance in New and Old Economy Firms

“…A common proposition underlying this line of research is that in order to motivate executives to work for the best interest of the shareholders, compensation contracts should include some form of incentive component (Hayes & Schaefer, 2000;Indjejikian, 1999;Baber et al, 1999;Sloan, 1993). Despite the differences in compensation contracts used in different firms, they embody both the incentive and risk sharing components.…”

“…Much of that research employs the agency theory to explain incentives in compensation contracts and performance (e.g., Indjejikian, 1999;Bushman &Indjejikian, 1993;Lambert &Larcker, 1987). The common proposition underlying this line of research is that in order to motivate executives to spend effort and work for the best interest of the shareholders, compensation contracts should include some form of incentive component (Hayes & Schaefer, 2000;Indjejikian, 1999;Baber et al, 1999;Sloan, 1993). Such an incentive component should establish a link between executive compensation and the performance of the firm they manage.…”

The impact of customer satisfaction on CEO bonuses

“…Subsequent studies (e.g., Baber et al 1998Baber et al , 1999Core et al 2003;Lambert and Larcker 1987) have extended this idea so that, today, compensation studies frequently utilize a conceptual framework whereby the unexpected component of CEO incentives are modeled as a function of the unexpected component of the performance measures under consideration. This basic framework may be expressed mathematically as follows:…”

“…CEO bonuses are also linked to stock returns (Leone et al 2006). As stock returns are serially uncorrelated, unexpected returns are normally proxied by "raw" returns (e.g., Baber et al 1999;Lambert and Larcker 1987). Thus, we define unexpected RET as the actual stock return for the period (i.e., U(RET)=RET).…”

Are CEOs compensated for value destroying growth in earnings?

“…Second, it is unclear how many firms use relative performance evaluation for compensation. In addition,Baber et al (1999) recommend adding the level of net income in addition to the change in net income to compensation regressions. When we add the level of net income to our regressions, the coefficient on net income is insignificant and all other inferences unaltered.…”