Accounting earnings and executive compensation:

Journal of Accounting and Economics 25 (1998) 169—193

Accounting earnings and executive compensation: The role of earnings persistence William R. Baber *, Sok-Hyon Kang
, Krishna R. Kumar School of Business and Public Management, The George Washington University, NW, Washington, DC 20052, USA
School of Management, Yale University, New Haven, CT 06520, USA Received 1 June 1997; received in revised form 1 July 1998

Abstract A cross-sectional analysis of cash compensation paid to CEOs of 713 US firms reveals that the sensitivity of compensation to earnings varies directly with earnings persistence. Additional analysis indicates that this sensitivity is greater for cases where executives are approaching retirement. Such evidence suggests the use of earnings persistence to counterbalance adverse consequences of earnings-based contracting with managers who face finite decision horizons.  1998 Elsevier Science B.V. All rights reserved. JEL classification: J33; L2; M4 Keywords: Earnings persistence; Executive compensation; Horizon problem

1. Introduction Contemporary economic theory, which portrays the firm as a series of contractual relations among stakeholders, establishes a significant role for accounting performance measures when such measures are incrementally informative with respect to management’s actions or when their use encourages efficient risk-sharing between contracting parties (Gjesdal, 1981; Holmstrom, 1979; Lambert and Larcker, 1987; Banker and Datar, 1989; Sloan, 1993).

* Corresponding author. Tel.: 202/994 5089; fax: 202/994 5164; e-mail: [email protected]. 0165-4101/98/$ — see front matter  1998 Elsevier Science B.V. All rights reserved. PII: S 0 1 6 5 - 4 1 0 1 ( 9 8 ) 0 0 0 2 1 - 4

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This role for accounting is supported by evidence of strong contemporaneous correlations between accounting earnings and executive compensation (e.g., Lambert and Larcker, 1987; Jensen and Murphy, 1990; Baber et al., 1996). Despite this considerable theoretical and empirical justification, performance evaluations based on accounting earnings continue to be criticized for encouraging actions that sacrifice long-term profitability for short-term profit gains (Smith and Watts, 1982; Dechow and Sloan, 1991; Kaplan and Atkinson, 1998). This drawback, designated the ‘horizon problem’, occurs when the decisionmaker’s anticipated tenure with the firm is shorter than the firm’s optimal investment horizon (Smith and Watts, 1982; Johnson, 1987; Dechow and Sloan, 1991; Ittner et al., 1997). Prior studies advocate reliance on long-term performance measures, deferred or stock-based compensation, or intra-firm monitoring to extend management’s decision horizon (Lewellen et al., 1987; Tehranian et al., 1987; Dechow and Sloan, 1991). Such mechanisms can temper the horizon problem, yet current earnings cannot easily be dismissed as a less preferred basis for contracting. In particular, both theory and empirical evidence support the premise that earnings are incrementally useful over stock returns and other measures for contracting purposes (Holmstrom, 1979; Lambert and Larcker, 1987; Jensen and Murphy, 1990; Sloan, 1993; Baber et al., 1996). Thus, deemphasizing current earnings can compromise efficient contracting. Recent studies suggest that compensation committees adjust earnings-based performance measures when doing so improves incentive arrangements (Clinch and Magliolo, 1993; Dechow et al., 1994; Gaver and Gaver, 1998). In this study, we present evidence that compensation committees consider not only the current-period earnings innovations but also their persistence into the future when rewarding managers based on earnings. Using a cross-section of 1992 and 1993 compensation paid to CEOs of 713 US corporations, we find that the strength of pay-for-performance relations between CEO salary and bonuses and accounting performance increases with measures of earnings persistence. The notion that more persistent earnings innovations are assigned greater value in securities markets is now well documented (Kormendi and Lipe, 1987; Collins and Kothari, 1989; Ali and Zarowin, 1992a); however, whether and why compensation committees adjust for earnings persistence in executive compensation contracts are heretofore uninvestigated. The finding that greater weight is assigned to persistent earnings innovations appears to be consistent with compensation committees’ efforts to mitigate the

 Other studies that examine whether compensation committees make informed adjustments on reported earnings include Abdel-Khalik (1985), Healy et al. (1987), Holthausen et al. (1995) and Natarajan (1996).

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horizon problem. Recall that the horizon problem derives from managers’ preferences for lower-NPV projects yielding higher current-period accounting earnings over higher-NPV projects yielding lower current earnings. Arrangements that reward earnings persistence encourage managers to look beyond the current-period earnings and thus extend managers’ decision horizons, without sacrificing the use of earnings as a contracting vehicle. Additional analysis indicates that relative weights assigned to persistence are greater for CEOs who are approaching retirement. Such individuals face relatively short decision horizons, and therefore, this evidence supports an interpretation that persistent earnings innovations are assigned greater weight to attenuate the horizon problem. The executive compensation literature also suggests different roles for current cash salary and bonus compensation components than for deferred, typically equity-based, components (Bizjak et al., 1993; Yermack, 1995). Thus, although our primary focus is to ascertain the extent that earnings persistence is related to executive compensation, an ancillary issue is whether persistence manifests differentially for alternative compensation vehicles. Deferred performance-based components, such as stock options and restricted stock which address long-term consequences of managers’ actions, are based primarily on security returns. Equity values impound the consequences of earnings persistence, and therefore, conditioning equity-based components on earnings persistence can be redundant. Our evidence is consistent with this reasoning. In particular, we find positive associations between earnings persistence and weights assigned to current-period earnings innovations for cash salary and bonus components, but not for deferred equity-based compensation components such as stock options or restricted stock. Finally, prior studies report statistically significant correlations between the properties of earnings time series and firm-specific characteristics, including firm size, risk, competition, product types, and earnings response coefficients (Lev, 1983; Collins and Kothari, 1989; Easton and Zmijewski, 1989). Other studies indicate that weights assigned to accounting earnings in determining the size and the change of executive compensation also depend on firm-specific factors such as investment opportunities and the cashflows-versus-accruals composition of reported earnings (Gaver and Gaver, 1993; Baber et al., 1996; Natarajan, 1996). Thus, we investigate whether the primary results can be attributed to these firm-specific characteristics that can be correlated with measures of earnings persistence. We find that the primary results are robust after considering these characteristics. The next section outlines the arguments that guide our expectations about the role of earnings persistence. The data are described in Section 3. The primary empirical tests are presented and discussed in Section 4. Additional analyses that support the primary results are reported and discussed in Section 5. Section 6 summarizes the implications of the study.

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2. Unexpected accounting earnings and executive compensation 2.1. Earnings innovations and earnings persistence We adopt an IMA(1,1) time-series characterization of earnings, which facilitates parsimonious empirical specifications of both earnings innovations and earnings persistence (Beaver, 1970; Beaver et al., 1980; Ali and Zarowin, 1992b). In particular, X !X "ºE(X )!H ºE(X ), (1) R R\ R R\ where period t earnings innovation ºE(X ) is i.i.d., and H is assumed to be R firm-specific. If H"0, then earnings follow a random walk process, and all earnings innovations are expected to be permanent (persistent). In contrast, when H"1, earnings follow a mean reverting process, and all earnings innovations are expected to be transitory. Thus, the parameter (1!H), which measures the extent that earnings innovations are permanent versus transitory, quantifies the notion of earnings persistence. 2.2. The compensation function Existing studies indicate contemporaneous correlations between stock returns and executive compensation (Murphy, 1985; Coughlan and Schmidt, 1985; Jensen and Murphy, 1990), and between accounting earnings and executive compensation (Lambert and Larcker, 1987; Dechow et al., 1994). Rosen (1992) and Holmstrom (1992), in particular, note the need for considering both accounting and security performance indicators when analyzing executive compensation arrangements. Thus, meaningful specifications of relations between compensation and firm performance include both accounting earnings and common stock returns as explanatory variables. Following Lambert and Larcker (1987), Jensen and Murphy (1990), and Baber et al., (1996), we consider a CEO compensation function *COMP "C #C ºE(R )#C ºE(X )#e , (2) GR   GR  GR GR where for firm i and period t, *COMP is the change in executive compensaGR tion, ºE(R ) is the unexpected common stock return, and ºE(X ) is the GR GR earnings innovation. The intuition behind expression (2) is that changes in compensation respond to unexpected performance in accounting earnings and security returns — in particular, we expect C '0 and C '0.    Results using (1!H) to measure earnings persistence are reported as primary results. We also report results for alternative measures of earnings persistence that are suggested in the extant literature.

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The principal focus is on the parameter C , which indicates the sensitivity of  compensation to earnings innovations. In particular, we are interested in how C varies with earnings persistence. For the IMA(1,1) characterization of earn ings time series, it can be shown that the expected present value of earnings innovations is [1#(1!H )/r]ºE(X ), where H is the IMA parameter for firm G GR G i and r is the equity discount rate. The unity in the brackets reflects the value of current-period earnings innovations, while the quantity (1!H )/r indicates the G present value of ‘persistent’ effects of the earnings innovation. Note that [1#(1!H )/r] increases in persistence. If earnings equal cashflows, if earnings G time series follow the IMA(1,1) process, and if compensation committees assign equal weights on current earnings innovations and discounted values of expected earnings in each future period (dollar-for-dollar), then the coefficient on ºE(X ) equals [1#(1!H )/r] times a certain (positive) proportionality conGR G stant — that is, C "d[1#(1!H )/r], d'0. All three conditions may not hold  G in practice, but in general, we expect C to be increasing in persistence (1!H ).  G More formally, we specify C "a #a (1!H ), where a '0. Thus (expres   G  sion) (2) becomes *COMP "C #C ºE(R )#[a #a (1!H)]ºE(X )#e , R   R   R R where firm subscripts i are suppressed to ease the exposition. The following hypothesis, stated in the alternative form, applies.

(3)

H : The sensitivity of CEO compensation to unexpected earnings increases with  the extent that earnings innovations are persistent (a '0).  A related issue is how associations between compensation changes and accounting earnings depend on whether compensation takes the form of cash or stock. Note that security prices incorporate both the short-run and the long-run consequences of managers’ actions. Thus, conditioning security returns on earnings persistence can be redundant. To the extent that equity-based compensation, such as stock options and restricted stock, is determined by security returns, we expect accounting earnings — and earnings persistence, in particular — to play a more dominant role in the determination of cash, than stock-based, compensation components. Two streams of the literature support this characterization. First, a number of studies indicate that the permanent versus transitory distinction is impounded in security prices (Kormendi and Lipe, 1987; Collins and Kothari,

 Formal analysis indicates that, if earnings persistence is rewarded, then the sensitivity of compensation to earnings innovations can vary with the discount rate (r). We demonstrate later that empirical results are robust to a consideration of the discount rate.

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1989). Second, results in Baber et al. (1996) indicate that relations between accounting earnings and cash compensation are more substantial (that is, relations are greater both in magnitude and statistical significance) than relations between accounting earnings and stock-based compensation. 3. Data and sample selection CEO compensation data are from 1992 and 1993 proxy statements for 2009 publicly traded US firms that responded to a mail request to provide statements for both years. We address compensation changes, and therefore, we omit 172 firms where the CEO does not serve at least two consecutive full years during the 1991—93 period. Financial data are from the 1993 COMPUSTAT primary, secondary, or tertiary data files. Eliminating firms that lack the data required to compute variables — primarily H — or where estimates of H do not converge, leaves 713 firms. In some cases, we have useable data for only one year. Excluding outliers using procedures described in Belsley et al. (1980) yields a maximum of 1268 firm-year observations for the primary analysis. Disclosures required since 1992 by the US Securities and Exchange Commission permit meaningful valuations of both cash and equity compensation and also permit decompositions of total compensation into cash versus non-cash and salary versus bonus components. Table 1 summarizes selected characteristics of the sample firms. Industry distributions are in panel A, and descriptive statistics are in panels B,C, and D. Profiles for 1992 and 1993 are comparable, and therefore, we report only the 1993 summary. Statistics displayed in panel B for CEO compensation indicate that the distribution of deferred compensation (primarily the value of stock options and restricted stock awards) is highly skewed and also has a relatively  If security prices are a sufficient statistic for the agent’s actions, then not only earnings persistence, but also earnings itself, is redundant. We observe, however, that accounting earnings is used in executive compensation contracts, which suggests that earnings offer incremental informational and/or risk-sharing benefits (Sloan, 1993).  If reported salaries are pro-rated for CEOs who serve less than a full year, then compensation changes are over- or under-stated. Note that 1992 is the first year that firms disclose executive compensation details. Thus, we obtain 1991 and 1992 data from 1992 proxy statements and 1993 data from 1993 statements.  Stock option values are computed using the Black and Scholes (1973) approach, adjusted to consider the possibility of early exercise (Hemmer et al., 1994). For relatively few cases where details required to apply the methodology are omitted, we assume that vesting occurs two years after the grant and that the exercise period is identical to the period for the most recent option where the exercise period is provided. Items designated as ‘other’ compensation — for example, the use of an automobile — are excluded from computations of total compensation and compensation components. Alternative values, computed using the Black—Scholes approach without adjusting for early exercise, do not materially affect the results.

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Table 1 Characteristics of sample firms Panel A: Distributions of sample firms across industries Industry

Number of firms

Basic industries Capital goods Construction Consumer goods Energy Financial services Transportation Utilities

50 168 28 245 38 78 25 81

Total

713

Descriptive statistics (1993)
n

Mean

Median

Std. dev.

688 689 688 689

997 642 355 218

627 495 59 110

1,126 524 795 339

Panel B. CEO compensation ($ thousands) Total compensation Cash salary plus bonus Stock-based compensation Cash bonus

Panel C: Dependent variables: percent change in compensation Total compensation Cash salary plus bonus Stock-based compensation Cash bonus

635 649 368 467

0.218 0.085 0.477 0.159

0.035 0.025 !0.029 0.011

1.047 0.374 4.573 1.210

649 649 649

0.169 0.041 0.857

0.092 0.018 0.854

0.498 0.394 0.300

Panel D: Independent variables: Stocks returns [RE¹] Earnings innovations [ºE(X)] Earnings persistence [PERSIS¹]

Total firms with usable data for 1992 or 1993 or both years. Industry classifications are from Ali and Kumar (1994).
Descriptive statistics for 1992 are comparable. Earnings persistence (1!H) is computed from *X "ºE(X !HºE(X ), where X is year R R R\ R t"1974 through 1993 earnings per share before extraordinary items (COMPUSTAT data item C58).

high variance. Moreover, although most firms have stock option plans (or similar deferred compensation plans), less than one-half awarded such compensation in 1993. Note that dependent variables, displayed in panel C, are computed as percent changes. Finally, the mean (median) value of the IMA

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parameter (1!H) is 0.857 (0.854) using 1974—1993 earnings per share data. This estimate is comparable to the median point estimate of 0.85 reported in Ali and Zarowin (1992a) using a different sample and time period (1970—1988). Finally, the requirement that firms have earnings time-series sufficient to compete H potentially restricts our ability to generalize results. To investigate this issue, we compare the sample observations with approximately 1400 observations that are excluded owing to data availability. We find that the excluded firms are smaller than the sample firms, but they perform comparably. In particular, both book values of total assets and market values of equity for excluded firms are substantially less (statistical comparisons are significant for a(0.01), but both accounting performance (accounting earnings deflated by the book value of stockholders’ equity) and security returns realized during 1992 and 1993 are comparable (two-tailed a'0.10). Our specific concern then, is whether these size differences indicate structural differences in relations between compensation and performance, and in particular, whether they undermine the use of accounting earnings to set executive compensation. Regressions of changes in executive compensation on security returns and changes in accounting performance indicate that compensation-accounting performance relations are positive and statistically significant for the excluded firms (t"4.65), although a Chow test indicates that these relations are less substantial than those for the larger firms that comprise the sample (t"2.09). These analyses suggest a cautious interpretation of the results with respect to the smaller, omitted firms to the extent that accounting performance is less important as a determinant of executive compensation.

4. Primary analysis 4.1. The regression specification We estimate the following specification of expression (3): *COMP "b #b RE¹ # b RE¹ *PERSIS¹ GR GR GR  GR   \ > #b ºE(X )#b ºE(X )*PERSIS¹  GR  GR GR b > #b PERSIS¹ #e ,  GR GR b

(4)

 We require a minimum of 12 annual earnings observations during the period 1974—1993 to estimate H. Firms are omitted when they do not satisfy this criterion.  Similar results obtain when earnings levels are included in the specification.

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where *COMP "year t!1 to year t percent change in firm i CEO compensation GR specified as either (i) cash compensation defined as cash salary plus cash bonus, (ii) total compensation defined as the sum of cash plus stock-based compensation, (iii) stock-based compensation defined as the value of stock options, stock appreciation rights, phantom stock, or restricted stock, or (iv) cash bonuses; RE¹ " firm i, year t (raw) common stock return; GR ºE(X )" firm i, year t unexpected earnings per share before extraordinary GR items (computed using COMPUSTAT data item C58 in expression 1), deflated by the beginning of the year book value per share of stockholders’ equity (COMPUSTAT data item C60 divided by COMPUSTAT data item C25); PERSIS¹ " firm i, year t earnings persistence estimated as (1!H ) from GR G expression (1) using 1974—1993 annual earnings per share before extraordinary items (COMPUSTAT item C58); b (k"0,2,5)" regression parameters; I e "error term; GR and where predicted signs for the estimates are displayed parenthetically. Five features of the model require elaboration. First, we address four specifications of the dependent variable *COMP. The motive for doing so is to evaluate whether various compensation components are structured differently, and in particular, to ascertain whether and how earnings persistence interacts with relations between the accounting earnings measures and changes for each compensation metric. Second, following Lambert and Larcker (1987), we use raw common stock returns RET as a proxy for unexpected security returns ºE(R). This procedure assumes that expected security returns are both cross-sectionally and intertemporally constant. Other studies that make this assumption include Jensen and Murphy (1990) and Baber et al. (1996). Results (not reported) are comparable for risk-adjusted, market-adjusted, and industry-adjusted common stock return specifications of ºE(R). Third, computations of the measure PERSIS¹, which indicate the extent that earnings are persistent, involve straightforward applications of expression (1) to

 Prior studies (e.g. Dechow et al., 1994; Gaver and Gaver, 1998) address compensation levels, rather than changes. We use compensation changes to control for a large number of factors that vary cross-sectionally across the sample firms, and that are shown in prior studies to influence compensation levels. Such factors include firm size, the CEO’s age, tenure and stock holdings, the composition of the board of directors, and other corporate governance-related factors (Core et al., 1998; Cyert et al., 1998). Also, results are comparable when dependent variables are computed, as in Baber et al. (1996), as the change deflated by the base salary in the prior year.  Note that (0) indicates that we do not expect the estimate to be statistically significant and (?) indicates that we make no prediction about the direction of the effect.

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obtain firm-specific maximum likelihood estimates of the parameter H (Ali and Zarowin, 1992b). Estimates of H, which in theory are 1 for a mean-reverting process and 0 for a random walk process, vary inversely with earnings persistence, and therefore, we use (1!H) as a measure of PERSIS¹ to obtain empirical measures that vary directly. Alternative measures of earnings persistence are considered later as refinements to the primary analysis. Fourth, the variables RE¹ *PERSIS¹ and PERSIS¹, which are not implied by the formal analysis (Eq. (3)), are included in the empirical specification to examine whether earnings persistence interacts with security returns or has explanatory power as a main effect. We expect the estimate b on  RE¹ *PERSIS¹ to be non-positive for two reasons. First, the existing evidence is that earnings persistence is properly impounded in security prices (Kormendi and Lipe, 1987; Collins and Kothari, 1989). If so, then conditioning relations between compensation and security returns on earnings persistence is redundant. This reasoning implies b "0. On the other hand, if earnings persistence  increases reliance on accounting earnings, then compensation committees may substitute accounting earnings for security returns. If so, then we expect b (0.  We note at this point that results are robust with respect to the inclusion or exclusion of these two variables from the specification. Fifth, since we use cross-sectional data, both the dependent and independent variables are scaled by appropriate deflators. Consistent with the use of security returns as an explanatory variable, and to preserve the use of a pure accounting-based performance measure, we scale unexpected earnings by beginning of the year book value of owners’ equity such that unexpected accounting earnings can be interpreted as unexpected ROE. Security return and accounting return computations are deflated to control for size-related factors, and thus, we specify dependent variables as percent changes. The parameter estimate b on ºE(X)*PERSIS¹ addresses the hypothesis,  and thus, is the principal focus of the study. Under the (null) hypothesis that the sensitivity of CEO compensation to earnings innovations is unaffected by earnings persistence, the parameter b is zero. Under the alternative hypothesis,  the weight assigned to earnings innovations increases as earnings persistence (PERSIS¹) increases, and thus, the estimate b for the interaction  ºE(X)*PERSIS¹ is positive. Expectations for other parameters are as follows. Given the well-documented role of stock returns in rewarding managers, we predict positive relations between compensation and security returns RE¹(b '0). Finally, if accounting  income plays a role in executive compensation, then we expect positive relations between compensation changes and unexpected earnings. In particular, if ºE(X)*PERSIS¹ is not in the specification, or if earnings persistence is irrelevant to executive compensation, then we expect positive signs for the estimate b . If earnings persistence is relevant, however, then both estimates  b and b indicate the overall relation between compensation and earnings  

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innovations. That is, predictions about the sign of b on the main effect need to  be interpreted in conjunction with the estimate b on the interaction. Thus, we  are uncertain about the sign on the estimate b .  4.2. Results Results for regression model (4), displayed in Table 2, support the hypothesis specifically, and more generally, the discussion in Section 2. When compensation is specified as the cash salary and bonus component and earnings persistence is not considered (column C1), relations between compensation changes and unexpected earnings are positive and statistically significant. Notice that, in the context of expression (3), b in column C1 is an estimate of the average of  [a #a (PERSIS¹ )] for all firms, which is positive. This estimate can be   G biased, however, since the specification does not permit PERSIS¹ to vary G across firms. Results when earnings persistence is considered (column C2) indicate a positive, statistically significant estimate b on the interaction ºE(X)*PERSIS¹,  which implies that the role of unexpected earnings varies directly with earnings persistence. The estimates b and b , evaluated for an average firm with   a persistence parameter (PERSIS¹) of 0.857, indicate that, if current period unexpected earnings are 10% of equity, then salary and bonuses increase by approximately 2.2%, which substantially exceeds the 0.6% increase indicated by the restricted specification in column C1. Relations are similar when compensation is specified as changes in cash bonus (column C3) but, not when specified as changes in stock-based compensation components (column C4). Results for total compensation are weak (column C5), as one would expect given the results for compensation components. Finally, for specifications of cash salary and bonus and of total compensation, estimates b on the interaction between  security returns and earnings persistence are negative and marginally significant (a(0.11). This relation provides some evidence of the substitution of accounting returns for security returns as accounting earnings become more persistent.

 More specifically, [a #a (PERSIS¹ )]ºE(X ) can be expressed as [d #d ]ºE(X )"   G G + G G d ºE(X )#d ºE(X ), where d is the mean [a #a (PERSIS¹ )] and d is the firm-specific + G G G +   G G deviation from the mean. The term d ºE(X ), which is an omitted variable in the restricted G G specification displayed in column C1, is negatively correlated with ºE(X ). This implies that the G estimate b is biased downward.   In particular, b #b PERSIS¹"!0.1487#(0.4292;0.857)"0.219. Thus, compensation   increase by 0.219;10%"2.19%.

? 0.102 1,261

n.a.

;

C1 0.0373 (4.89) 0.2072 (11.10) n.a.

C2 0.0300 (1.30) 0.2698 (5.07) !0.0953 (!1.62) !0.1487 (!2.93) 0.4292 (4.75) 0.0096 (0.38) 0.116 1,261

Cash salary and bonus Restricted Full model model

0.0602 (2.35) n.a.

?

0/!

;

Pred. sign

C3 0.0766 (0.50) 0.7932 (2.32) !0.0494 (!0.13) !0.7352 (!2.11) 2.1202 (2.68) !0.0212 (!0.13) 0.062 897

Cash bonus only

C4 0.0387 (0.15) 1.1265 (1.57) !0.3913 (!0.49) !0.2375 (!0.55) 0.7618 (0.91) 0.2639 (0.95) 0.015 712

Stock-based compensation only

C5 0.0341 (0.49) 0.7407 (4.66) !0.3397 (!1.90) !0.0809 (!0.53) 0.2981 (1.11) 0.0992 (1.30) 0.059 1,251

Total compensation

*COMP "b #b RE¹ #b ºE(X )#e GR   GR  GR GR

Entries are parameter estimates and t-statistics (in parentheses). Note that (0) indicates that we do not expect the estimate to be statistically different from zero; (?) indicates that we make no prediction about the direction of the effect; n.a. indicates that the variable is not included in the model. Observations are omitted as outliers when ‘dffits’ exceeds 2((p/n), where p is the number of parameters in the model and n is the number of observations (Belsley et al., 1980). Specification for column C1

b /security return  RE¹ b /security return * persistence  RE¹*PERSIS¹ b /earnings innovations  ºE(X) b /earn. innovations * persist  ºE(X)*PERSIS¹ b /earnings persistence  PERSIS¹ adjusted R number of observations

Column C b /intercept 

Coefficient/variable

Dependent variable — percent changes in:

Table 2 OLS specifications of percent changes in compensation on security returns and earnings innovations

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b (k"0,2,5)" regressions parameters. )

PERSIS¹ "firm i, year t earnings persistence — in particular, (1!H) estimated from expression (1) — defined in terms of the extent that 1974—1993 GH annual earings per share before extraordinary items (COMPUSTAT item C 58) follow a random walk process;

RE¹ "firm i, year t (raw) common stock return; GR ºE(X )" firm i, year t unexpected earnings per share before extraordinary items (COMPUSTAT data item C 58), computed using expression (1), GH deflated by the beginning of the year book value per share of stockholders’ equity (COMPUSTAT data item C 60/COMPUSTAT data item C 25);

*COMP "b #b RE¹ #b RE¹ PERSIS¹ #b ºE(X )#b ºE(X )PERSIS¹ #b PERSIS¹ #e GR   GR  GR GR  GR  GR GR  GR GR *COMP "year t!1 to year t percent change to firm i CEO compensation specified as either cash compensation defined as cash salary plus cash GR bonus (column C1 and C2), cash bonus only (column C3), stock compensation defined as the value of stock options, stock appreciation rights, phantom stock, or restricted stock (column C4), or total compensation defined as the sum of cash plus stock compensation (column C5);

Specification for columns C2—5

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5. Refinements Additional procedures are designed to investigate the plausibility of the assumptions that underlie our interpretations of the primary results in Table 2. 5.1. Alternative measures of earnings persistence The variable PERSIS¹ is central to the study, and thus, we examine whether the primary results hold for alternative measures of earnings persistence. We consider three measures. The first is the variance ratio (»R), described in Cochrane (1988) and adapted to the analysis of earnings time series by Lipe and Kormendi (1994) and Kang et al. (1995). The use of H presumes that earnings follow an IMA(1,1) process, whereas »R imposes no such restriction on the time-series process. Although this feature favours the use of »R, it is unclear whether the »R measure dominates H for short time series. The second measure is the firm’s earnings response coefficient (ERC), use of which is motivated by the well-documented positive association between ERC and earnings persistence (Kormendi and Lipe, 1987; Easton and Zmijewski, 1989; Collins and Kothari, 1989; Ali and Zarowin, 1992a). ERCs are estimated for each firm, using data for up to 20 preceding quarters, by regressing both levels (NI) and changes (*NI) in quarterly earnings before extraordinary items deflated by beginning of period market value of equity on security returns. Finally, the third measure presumes relations between earnings-price ratios (E/P) and the extent that earnings are persistent. This measure is motivated by Beaver’s (1998) suggestion that extreme E/P are, to an extent, attributable to investor perceptions that reported earnings contain sizable transitory components. Thus, following procedures proposed and described in Ou and Penman (1989), we use E/P to consider earnings persistence, and then employ a dummy variable to distinguish 1163 observations where earnings are presumed to be persistent (i.e., those with moderate E/P) from 931 observations where earnings are presumed transitory (extreme E/P observations). Although E/P is a noisy

 ERCs are affected by factors other than earnings persistence. For example, evidence in Collins and Kothari (1989) indicates that ERCs are determined in part by firm risk, prevailing interest rates, and earnings growth rates.  The regression model is R "c #c *NI #c NI #e , where *NI "NI !NI and R   R  R R R R R\ ERC"c #c . Results are comparable when R is specified as either raw returns or market-adjusted   returns (computed using either value-weighted or equally-weighted market returns). R are cumulated over the three-month period moved ahead 30 days to accommodate delay in the disclosure of quarterly earnings.  As with ERC, E/P is affected by factors other than earnings persistence. Beaver (1998) describes how E/P varies with expected earnings growth and discount rate.  A more detailed explanation of this procedure is in the notes to Table 3.

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measure of earnings persistence, its advantage is that the measure does not require time-series estimation, and therefore, potentially offers a more timely indication of earnings persistence. Results for these alternative measures of earnings persistence are presented in Table 3. Relations between compensation changes and accounting performance (b and b ) for the »R measure are similar to the primary results in Table 2.   Relations for the E/P and ERC measures also are similar, except that the main effect on unexpected earnings, which is negative and statistically significant for the other measures, is positive but not significant at usual confidence levels (a'0.10). 5.2. Competing explanations and potentially omitted variables A related issue is that earnings persistence may be correlated with other factors that can also influence weights assigned to accounting earnings in compensation. If so, the documented relations in Table 2 for earnings persistence can be spurious. The literature suggests at least four issues that need to be considered. First, evidence in Lev (1983) indicates that the statistical properties of earnings time series are related to several economic factors. In particular, Lev reports statistically significant relations between measures of serial correlation (a proxy for earnings persistence) and other factors such as capital intensity, industry concentration, firm size, and product type (durable versus non-durable goods). Second, our estimation model (Eq. (4)) does not consider the cost of capital, and therefore, we examine whether the primary results are attributed to crosssectional differences in the cost of capital. Third, Kumar et al. (1993) and Natarajan (1996) examine the role of operating cash flows versus accounting accruals in the context of executive compensation. Evidence reported in these studies suggests that the importance of accounting earnings varies directly with the extent that cashflows determine reported earnings. Finally, recent studies of the determinants of CEO compensation indicate that the relative weights assigned to accounting earnings versus security returns depend on the extent that investment opportunities comprise firm value (Smith and Watts, 1992; Gaver and Gaver, 1993; Baber et al., 1996). We consider the following nine variables to address concerns implied by these studies. To consider Lev’s (1983) results, we use (i) Herfindahl—Hirschman index (a proxy for industry concentration) based on four-digit standard industrial code (SIC) classifications, (ii) log book value of total assets, (iii) capital intensity, and (iv) durable—nondurable industry classification. To consider cost

 Detailed computations of these variables are described in the notes to Table 4.

?

;

?

0

;

Pred. Sign

C1 0.0325 (3.58) 0.2435 (9.80) !0.0520 (!1.81) !0.0702 (!2.60) 0.2317 (4.05) !0.0077 (!0.89) 0.127 1,733

»R Variance ratio

C2 0.0200 (2.64) 0.1832 (10.01) !0.0015 (!0.06) 0.0185 (1.42) 0.1755 (2.94) 0.0066 (0.62) 0.124 2,094

E/P Earnings price ratio

Persistence measure (PERSIS¹)

C3 0.0288 (4.14) 0.2005 (12.58) !0.0007 (!0.47) 0.0175 (1.27) 0.0163 (2.05) !0.0006 (!0.95) 0.126 1,632

ERC Earnings response coefficient

»ariance ratio (»R), computed as (1/k) times the variance of k-differences deflated by the variance of first differences, varies directly with the extent the earnings time series are permanent versus transitory. See Cochrane (1988), Lipe and Kormendi (1994) and Kang et al. (1995) for details.

Entries are parameter estimates and t-statistics (in parentheses). Observations are omitted as outliers when ‘dffits’ exceeds 2((p/n), where p is the number of parameters in the model and n is the number of observations (Belsley et al., 1980). Differences in sample size are attributable to data availability.

b /security return  RE¹ b /security return * persistence  RE¹*PERSIS¹ b /earnings innovations  ºE(X) b /earnings innovations * persist.  ºE(X)*PERSIS¹ b /earnings persistence  PERSIS¹ adjusted R number of observations

Column C b /intercept 

Parameter/variable

Table 3 OLS specifications of percent changes in CEO salary and cash bonuses on security returns and unexpected earnings for alternative measures of earnings persistence

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See notes to Table 2 for the specification, variable definitions, and explanations for predicted signs.

Earnings response coefficients (ERC) are estimated for each firm by regressing both levels (NI) and changes (*NI) in quarterly earnings before extraordinary items deflated by beginning of period market value of equity on security returns (R) cumulated over the three-month period moved ahead one month to accommodate delay in disclosures of quarterly earnings. The regression model is R "c #c *NI #c NI #e , and R   R  R R ERC"c #c . The model is estimated over a maximum of 20 quarters during the period 1989—1993.  

Earnings price ratio (E/P) is a dummy variable specified as follows. E/P are computed as the net income before extraordinary items (COMPUSTAT data item C18) deflated by the number of common shares (COMPUSTAT item C25) times the year-end price per share (COMPUSTAT item C199). Observations are classified into ten portfolios using procedures in Ou and Penman (1989, p. 131). Observations with negative E/P are assigned to portfolio 1. The remaining observations are distributed equally according to ranked E/P with portfolio 2 the lowest, and portfolio 10 the highest ranked observations. The dummy variable is set equal to 1 for 1163 observations in portfolios 3—8 (high persistence), and set equal to 0 for 931 observations from portfolios 1, 2, 9, and 10 (low persistence).

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of capital, we use both traditional CAPM-based measures that determine the relative cost of equity financing — (i) firm BETA and a (ii) year dummy variable to consider prevailing risk-free rate of return — and (iii) the ratio of market to book value of equity, as suggested by Fama and French (1993, 1995). To distinguish observations according to the extent that cashflows versus accruals determine reported earnings, we use dummy variables based on the ratio of absolute accruals over absolute value of cashflows (Natarajan, 1996). Finally, investment opportunities are considered using a measure advanced in Baber et al. (1996). We execute two procedures to examine the effects of these potentially correlated factors. First, we construct regression specifications that include the independent variables from expression (4), along with main effects and two interactions (one with earnings innovations and another with stock returns) for each of these nine variables. The results support the primary findings displayed in Table 2, but owing to the presence of 20 interaction variables (10 each on RE¹ and ºE(X)), there is evidence of severe multicollinearity. As a result, we consider a second, more parsimonious two-step procedure. In the first step, we regress PERSIS¹ on the nine variables discussed above. Residuals from this first-step specification, designated R—PERSIS¹, can be interpreted as the variation in PERSIS¹ that is not explained by cross-sectional differences in the nine firm-specific variables described above. In the second stage, we estimate Eq. (4) using R—PERSIS¹ as the measure of earnings persistence. Results for the second stage of the procedure, displayed in Table 4 for changes in CEO cash compensation, are comparable to the primary results reported in Table 2. An exception is that the estimate b for earnings innovations is positive  and statistically significant. Overall, this evidence indicates that the primary findings are robust when the effects of the correlated variables are considered and eliminated from the earnings persistence measure. 5.3. CEO age Theory and evidence in Gibbons and Murphy (1992) suggest that the horizon problem becomes more consequential as managers move closer to retirement. Moreover, in the particular context of earnings-based compensation, the effectiveness of alternative mechanisms such as long-term performance plans (Tehranian et al., 1987) diminishes as executives approach retirement, since these

 Note that this procedure differs from the procedure considered in Christie et al. (1984), which addresses the case where regressors used in the first-stage specification are included in the secondstage specification. Explanatory variables used in the first stage are not included in the specification displayed in Table 4.

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Table 4 OLS specification of percent changes in CEO salary and cash bonuses on security returns and earnings innovations for persistence measure computed as the component (1!H) unexplained by firm-specific characteristics Entries are parameter estimates and (t-statistics); n"1093; adjusted R"0.116 *COMP " b #b RE¹ #b RE¹ *R—PERSIS¹ #b ºE(X ) GR   GR  GR GR  GR     \        \    #b ºE(X )*R—PERSIS¹ #b R—PERSIS¹  GR GR  GR         R—PERSIS¹ is specified as the residual (e ) from the following specification: GR PERSIS¹ " a #a DºRAB¸E #a HH¸ #a CAPIN¹ #a MK¹2BK  GR  GR GR   GR  GR \  \        \  \        #a ¸N¹A #a ½EAR #a BE¹A #a ACC2CFO #a IOS #e , GR  GR  GR  GR  GR  GR   \    \      \    \    where DºRAB¸E is a dummy variable that distinguishes firms that produce durable goods (coded 0) from firms that either provide services or produce non-durable goods (coded 1) based on Survey of Current Business (1993); HHI is the mean annual 1974—1993 Herfindahl—Hirschman index, an indicator of industry concentration computed as the sum of squared market shares for COMPUSTAT firms in the same four-digit standard industrial code classification; CAPIN¹ is firm capital intensity computed as the mean annual 1974—1993 ratio of net property, plant, and equipment to total assets; MK¹2BK is the ratio of market value to the book value of equity at the end of year t; ¸N¹A is the natural log of the book value of assets at the end of year t; ½EAR is a dummy variable that distinguishes 1992 from 1993 observations; BE¹A is computed by regressing monthly returns on a value weighted market return index over the 60 month period from 1990 to 1994; ACC2CFO is a dummy variable that distinguishes observations where the year t ratio of absolute accruals to absolute operating cashflows exceeds the median from observations where the ratio is less than the median; IOS is the year t measure of the investment opportunity set computed as in Baber et al. (1996); a (j"0,2,9) are regression parameters. H

arrangements typically rely on the executive continuing in the labor market. To investigate whether attention to earnings persistence increases to counterbalance this problem, we expand expression (4) to consider the CEO’s age. Results for salary and bonus are presented in Table 5. The first five variables in the regression specification (parameters b —b ) are   identical to those considered in Table 2. The last three variables (parameters

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Table 5 OLS specification of percent changes in CEO salary and cash bonuses distinguishing observations where the CEO is sixty years of age or older Entries are parameter estimates (t-statistics) and [variance inflation factors] n"1242; adjusted R"0.133 *COMP " b #b RE¹ #b RE¹ *PERSIS¹ #b ºE(X ) #b ºE(X *PERSIS¹ GR   GR  GR GR  GR  GR GR     \  \        \  \     

 

 

 

#b PERSIS¹ #b ºE(X *AGE60 #b ºE(X )*PERSIS¹ *AGE60  GR GR  GR GR GR  GR   \      \     

 

 

#b AGE60  GR \  \   

*COMP "year i, t!1 to year t percent change in firm i CEO compensation specified as cash GR salary plus cash bonus; RE¹ "firm i, year t (raw) common stock return; GR ºE(X )"firm i, year t unexpected earnings per share before extraordinary items (COMPUSTAT GR data item C58), computed using expression (1), deflated by the beginning of the year book value per share of stockholders’ equity (COMPUSTAT data item C60/COMPUSTAT data item C25); PERSIS¹ "firm i, year t earnings persistence — in particular, (1!H) estimated from expression GR (1) — defined in terms of the extent that annual earnings per share before extraordinary items (COMPUSTAT item C58) follow a random walk process; AGE60 "a dummy variable set equal to 1 for 538 (43.3%) observations where the CEO is 60 years GR of age or older; set equal to 0, otherwise; b (k"0,2,8)"regression parameters. I

b —b ) delineate incremental relations for CEOs who are likely approaching   retirement. In particular, a dummy variable AGE60, set equal to 1 for 538 observations (43.3% of the sample) where the CEO is 60 or more years of age, and set equal to 0 otherwise, is used to construct these variables. The potential for multicollinearity is high in this specification, and therefore, we report the

 The use of 60 years is arbitrary. Results are comparable for other cut-off points (63 and 65) for distinguishing executives that anticipate retirement, and when specifying age as a Dechow and Sloan (1991), Gibbons and Murphy (1992), and Yermack (1996) use similar approaches to distinguish executives with short horizons. Comparisons of the subsample where the CEO is 60 years of age or older, with the subsample where the CEO is younger, indicate that means of the independent variables are not statistically significant. The mean percent change in salary and bonus compensation (the dependent variable) is statistically significant with younger CEOs experiencing mean increases of 10.2% and older CEOs increases of 3.3% (t"4.73).

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variance inflation factors, which indicate the extent that collinearity compromises statistical tests of parameter estimates. The statistically significant (a(0.05), positive estimate b for the interaction  ºE(X)*PERSIS¹*AGE60 indicates the relative importance of earnings persistence in determining accounting-based compensation to CEOs aged 60 and older. The positive and statistically significant estimate suggests that compensation committees assign greater weight to earnings persistence for CEOs that anticipate retirement. Finally, consistent with results in Gibbons and Murphy (1992), the statistically significant, negative estimate for b suggests that base  compensation increases to senior CEOs are less than increases paid to younger CEOs. In sum, evidence in Table 5 indicates a characterization where compensation committees rely more heavily on earnings persistence when earnings are used as a basis for contracting. 5.4. Other procedures Economic theory suggests the use of relative, rather than absolute, performance measures (Holmstrom, 1982). Prior empirical studies offer mixed evidence with respect to the superiority of relative performance measures when accounting measures determine executive compensation, however (Antle and Smith, 1986; Gibbons and Murphy, 1990; Janakiraman et al., 1992). Even so, we confirm that primary results reported in Table 2 are comparable for regression specifications that include security return and accounting return metrics that are adjusted for market and industry performance (results not reported). Finally, we partition the observations into two equal subsamples according to firm size (measured as revenue or total assets), according to investment opportunities (Baber et al., 1996), and then according to whether the ratio of cashbased compensation is high or low. Results for subsamples delineated according to size and investment opportunities are comparable to those for model 2 in Table 2. Earnings-compensation relations are stronger for the subsample where cash compensation is high. This finding is consistent with results in Table 2 which imply that earnings persistence plays a greater role in the determination of cash-based, rather than stock-based, compensation.  Variance inflation factors in excess of 10 indicate multocollinearity. Note that the presence of multicollinearity undermines the ability to achieve statistical significance.  Gibbons and Murphy (1992) also report that the sensitivity of compensation to security returns is greater for executives approaching retirement. We find that relations between compensation changes and variables that include ºE(X) are comparable to those in Table 5 for a specification that includes RE¹*AGE60 and RE¹*PERSIS¹*AGE60 along with the other independent variables displayed in the table. Thus, the evidence in Table 5 is not attributable to correlations between accounting earnings and security returns.

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6. Concluding remarks Our investigation of compensation paid to US CEOs suggests that the persistence of accounting earnings is relevant for setting executive compensation. In particular, we find that pecuniary rewards for a specified level of current-period earnings innovations vary directly with the extent that reported earnings are expected to persist. Further investigation suggests that the role of earnings persistence is greater for CEOs that are approaching retirement, and that the focus on earnings persistence is robust to a variety of competing explanations suggested by the extant literature. Finally, the analysis suggests that earnings persistence is relevant to cash salary and bonuses, but not to stock-based, compensation components. Overall, the evidence is consistent with a characterization where compensation committees assign higher weights to persistent earnings in order to mitigate the ‘horizon problem’ and induce managers toward value-maximizing actions. At the same time, we recognize that there may be competing explanations and that conditioning compensation on earnings persistence is only one way to abate horizon problems that result from the use of accounting performance measures. Other mechanisms include the use of stock-based compensation, labor market discipline which discourages management behavior that contradicts shareholder preferences (Fama, 1980), and the use of long-term compensation plans (Lewellen et al., 1987; Tehranian et al., 1987; Dechow and Sloan, 1991). Our interpretation then is that focusing on earning persistence complements other mechanisms advanced and investigated by prior studies. In sum, the analysis indicates that executive compensation is influenced by the economic substance of reported earnings, and therefore, implies an informed use of accounting earnings in executive contracting arrangements. Thus, the analysis contributes to the growing body of literature that addresses issues of how compensation committees interpret reported earnings (Abdel-Khalik, 1985; Healy et al., 1987; Dechow et al., 1994; Holthausen et al., 1995; Natarajan, 1996; Gaver and Gaver, 1998).

Acknowledgements Comments and suggestions by Anwar Ahmed (the referee), Scott Boylan, Jennifer Gaver, Robert Lipe, Toni Nelson, Eric Press, Renee Price, Heibatollah Sami, Nathan Stuart, Jerry Zimmerman (the editor), and workshop participants at Boston College, CUNY-Baruch College, the University at Buffalo, the College of William and Mary, Carnegie Mellon University, Georgetown University, Temple University, Wake Forest University, the University of WisconsinMadison, the 1997 National Conference of the British Accounting Association, the 1997 Annual Congress of the European Accounting Association, the 1997

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