CEO Cash Compensation and Earnings Quality

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Authors Chen, Zhimin

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CEO Cash Compensation and Earnings Quality

Abstract

I examine the uses of accounting performance measures by testing the association

between CEO cash pay sensitivity and earnings quality. I assume that the valuation

and evaluation uses of accounting information are linked through the information risk.

I expect to find that the sensitivities of CEO cash compensation to accruals and cash

flows are associated with accrual quality and cash flow persistence. I find that there is

a significant positive relation between accrual quality and CEO cash pay sensitivity to

earnings. I find no association between the asymmetric pay-sensitivity to stock returns

and earnings quality, and no relation between persistence to pay sensitivity to

earnings. This research extends the accounting literature on earnings quality. This

research also leads to the discussion of one of the problems of CEO compensation

contracting since there appears to be no evidence showing that CEO receives

incentives for reporting high quality earnings information and penalties for reporting

low quality earnings information.

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I Introduction

A number of prior studies have examined how certain attributes of earnings

and stock returns are used in CEO compensation contracts. For instance, Leone, Wu

and Zimmerman [2006] test how the information of unrealized gains and losses

reflected in stock returns affect CEO cash compensation. Stock returns, therefore, serve

both the performance measuring and incentive contracting purposes for firms.

Nonetheless, limited literature focuses on the association between CEO compensation

and the quality of accounting information. The compensation committee uses earnings

and stock returns for incentive contracting; their consideration of the quality of

accounting information is unclear. On the one hand, the compensation committee

should concern about the quality when they use the information for decision-making;

on the other hand, it is uncertain whether the compensation committee gives CEO the

incentive for reporting information with good quality. If CEOs are paid based on

unreliable and irrelevant accounting information, both CEOs and firms would

experience the miscalculation of payment. In an effective compensation contract,

CEO pay would be related to the quality of accounting information used.

Banker, Huang and Natarajan [2009] provide evidence that value relevance

of earnings plays a significant role in its use for incentive contracting. In the study,

value relevance is the ability of earnings to explain variation in returns; it presents to

what extent shareholders can perceive the uncertainty in earnings. They examine the

association between value relevance of earnings and cash flows and pay-sensitivity.

Along with relevance, reliability is considered to be one of the two primary qualities

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(Richardson et al [2005]). To expand Banker’s result, I examine the association

between CEO cash pay-sensitivity and earnings quality focusing on reliability.

This paper builds on the work of Banker et al [2009]. I test whether earnings

quality (accrual quality and persistence of cash flow) are associated with CEO cash

compensation sensitivity of earnings, earnings components, and stock returns. Accrual

quality and persistence reflect earnings reliance. The valuation role of earnings is that

earnings are used for valuing firms together with other performance measures.

Therefore, earnings quality can proxy to which extent the earnings information is useful

for valuing firm performance. This study is aimed at further exploring whether the

valuation role of earnings is associated with the contracting role of earnings.

I consider earnings and earnings components (accruals and cash flows) as

accounting performance measures with contracting purpose, for the purpose of this

study. A possible reason why the contracting purpose and the valuation role should be

associated with each other is that earnings quality is a signal of information risk that

has impact on CEO compensation contracts. I conjecture that information risk links the

valuation and contracting uses of earnings. Information risk derives from imprecision

(i.e., dispersion) in estimates of the pay-off structure to investors based on available

information (Easley and O’Hara [2004]). High uncertainty in earnings gives rise to high

information risk while low uncertainty in earnings reduces information risk. To

guarantee investor’s interest, one can assume the compensation committee is interested

in long-term value. CEOs receive the incentives for keeping information risk low and

for keeping information useful for decision-making, if the compensation sensitivity is

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related to the earnings quality. I follow Francis et al [2004]’s measures of earnings

quality. They use earnings attributes to proxy for information risk in the examination of

seven earnings attributes and the cost of equity capital. The seven earnings attributes

captures earnings characteristics and reflects the quality of earnings. They provide

evidence that earnings quality reflects the uncertainty in earnings; for this reason,

earnings quality can be a signal for information risk. For example, high earnings quality

provides the board of directors with low information risk. Among the seven attributes,

accrual quality and persistence of cash flow are more sensitive signals for information

risk. As a result, I examine the impact of information risk on effective CEO

compensation contracts.

My measures of earnings quality follow Francis et al [2004]. They measure

accrual quality using the mapping of current accruals into cash flows1:

Accruals = φ0 + φ1CFOt−1 + φ2CFOt + φ3CFOt+1 + τ (1)

AccrualQualityt equals to the standard deviation of firm’s estimated residuals. Large

(small) values of AccrualQuality correspond to poor (good) accrual quality. The

measure of persistence is the slope coefficient of current cash flow and future cash

flow.

I distinguish accruals and cash flows as two separate accounting performance

measures as they have different implications for the assessment of future earnings

(Sloan [1996]). Sloan finds that some accruals are less likely to persist in future

1 CFO= the difference between Earnings and Accruals

Accruals= the change in non-cash current assets, less the change in current liabilities ,less depreciation

expense, all divided by average total assets

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periods’ earnings; however, cash flow persistence into earnings is greater than

accruals. Consequently, persistence is used as signal of cash flows information and

accrual quality as signal of accruals information when testing CEO cash

compensation sensitivity to accounting performance measures.

In summary, this research contributes in three ways to accounting literature.

First, it confirms the use of accounting information’s quality in CEO compensation.

Second, it contributes to the impact of information risk on CEO cash compensation to

stock returns and earnings. Third, it adds evidence to the asymmetric level of the

sensitivity of CEO cash compensation to stock returns.

Section II discusses the background of CEO compensation and earnings

quality. Section III develops the predictions. Section IV presents research design.

Section V and VI are results and conclusions.

II Background

In United States, the CEO pay packages are set by the compensation

committee with board members. Cash compensation components are salary, bonus

and deferred compensation; stock-based compensation components are option and

restricted stock grants. The results of Leone’s article show that 62% of the

performance measures used in bonus contracts are accounting based, while the other

measures include individual performance measures, stock price, and non-financial

measures (Leone et al [2006]).

III Hypothesis Development

This paper builds on the empirical research investigating the relationship

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between CEO cash compensation and earnings equity. From previous studies, CEO

cash compensation (salary, bonus and deferred compensation) is determined by both

earnings and stock returns (e.g. Bushman and Smith [2001]). This suggests that

accounting information plays a role in contracting. Banker, Huang and Natarajan

[2009] find that value relevance of performance measure plays an important role in

the choice of accounting performance measures for incentive contracting purposes,

following that the incentive contracts are written with consideration of the quality of

accounting information. How accounting information is reliable impacts to which

degree it is used in contracting as performance measurements. I use earnings quality

as a signal for information risk measuring how accounting information’s used for

valuing firm performance. Earnings quality has an effect on how accounting

information is processed. For example, high earnings quality leads to low information

risk and low cost of equity (Francis, LaFond, Olsson, and Schipper [2004]).

I test whether earnings quality influences the sensitivity of stock returns and

earnings on CEO cash compensation. Earnings quality is defined by earnings

attributes that capture the characteristics of earnings (Francis et al. [2004]).

Accounting-based attributes, including accruals quality, persistence, predictability and

smoothness, are measured using accounting information only. Market-based attributes,

value relevance, timeliness, and conservatism, take stock returns as a reference

construct. First, I test the relation between CEO compensation sensitivity to earnings

and earnings quality. Second, I test the relation between the asymmetric level of CEO

compensation sensitivity to stock returns and earnings quality. Prior researches find

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that accrual quality and persistence have the largest cost of equity effects among

accounting-based attributes (e.g. Francis, LaFond, Olsson, and Schipper [2004]).

Therefore, I use these two earnings attributes for earnings quality.

3.1. Pay sensitivity to earnings and earnings quality

Sloan [1996] provides evidence that accrual and cash flow of current

earnings contain information about future earnings for investors. He argues that the

extent to which current earnings performance persists into the future is dependent on

the relative magnitudes of the cash flows and accruals components of earnings. It

follows that both components of earnings have valuation purposes. For this reason, I

decompose earnings into accruals and cash flows to test the separate sensitivity of

each to CEO compensation.

Accrual quality and persistence are associated with the valuation use of

earnings (Francis [2006]). They determine how useful earnings are for

decision-making. Accrual quality tells the board of directors about the mapping of

current accruals into last-period, current-period, and next-period cash flows; good

accrual quality decreases information risk and the cost of equity. Persistent earnings

are linked to low information risk (Francis et al. [2005]). In other words, high accrual

quality and persistence send a signal indicating low information risk to the board of

directors. The compensation committee interprets this signal, and thus can increase

their reliance on the earnings when contracting CEO incentives or awarding pay. I

address whether firms with high accrual quality and persistence have a higher

sensitivity between earnings components and cash compensation, than firms with low

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earnings quality. When earnings quality is high, does the compensation committee

rely on earnings more and feel more certain rewarding the CEO with greater pay?

Therefore, accrual quality and persistence may be associated with the pay sensitivity

of earnings components. Using accrual quality together with persistence as a signal

for information risk, H1 in null form follows:

H1: Accrual quality and persistence are not associated with the sensitivity

of CEO cash compensation to earnings and earnings components.

3.2. Asymmetric pay sensitivity to stock returns and earnings quality

Leone, Wu and Zimmerman [2006] document that CEO cash compensation

is twice as sensitive to negative stock returns as it is to positive stock returns, to

reduce costly ex post settling up in cash compensation paid to CEOs. This suggests

that the compensation committee immediately penalizes CEOs for unrealized losses

and fails to reward CEOs for unrealized gains due to conservatism2. I conjecture that

earnings quality influences the asymmetric level of pay sensitivity to stock returns.

For instance, the board of directors may be more likely to reward CEOs for good

news reflecting unrealized gains with high earnings quality than good news with low

earnings quality. It follows that high earnings quality tells board of directors that the

gains have a higher probability to be realized, considering the low information risk.

The relatively low information risk allows board of directors to increase the

sensitivity of unrealized gains to CEO cash compensation. H2 follows:

H2: When the earnings quality is high, the sensitivity of CEO cash

2 Conservatism is the differential verifiability required for the recognition of accounting gains versus losses that

generates an understatement of net assets (Basu [1997]). (S.Basu, 1997)

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compensation to positive stock returns is greater than when the earnings

quality is low.

H2 assumes that the quality of accounting information provides a signal about the

extent of accounting information weighting in contracting.

Conversely, I make no specific predictions on earnings quality and

pay-sensitivity to negative stock returns. There are two possible situations. First,

conservatism suggests that the compensation committee will penalize CEOs for the

unrealized losses reflected by bad news immediately regardless of the earnings quality

signal. They would not allow any avoidable unrealized losses. CEOs would endeavor

to eliminate high uncertain unrealized losses as well as low uncertain unrealized

losses to evade penalization. Therefore, the contract protects shareholders from

unrealized losses effectively. Second, instead of ignoring information risk, the

compensation committee may penalize CEO more for bad news with high earnings

quality, but CEOs will not be penalized less for low earnings quality. High earnings

quality and low information risk tell the compensation committee that the losses have

a great probability to be realized. CEOs would avoid the lowest uncertain unrealized

losses first to mitigate penalization. Suppose that there are two investment decisions

leading to unrealized losses and only one of them can be avoided. In the first situation,

CEOs would remain either one; in the second situation, CEOs would remain the one

with high information risk. As a result, the second method of compensation contract

controls the unrealized losses with good possibility to be realized more that the first

one.

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IV Research Design

All the equations are based on the equations used by Leone et al [2006].

Linear regression models are used.

I test H1 with the following models:

In(COMP) = β0 + β1 Earnings + β2AccrualQuality + β3Earnings *

AccrualQuality + δControl*Size + α (2)

In COMP = β0 + β1Eanings + β2Persistance + β3Earnings ∗ Persistance +

δControl ∗ Size + α (3)

In COMP = β0 + β1CFO + β2Accruals + β3Accrualss ∗ AccrualQuality +

δControl ∗ Size + α (4)

In COMP = β0 + β1CFO + β2Accruals + β3CFO ∗ Persistance + δControl ∗

Size + α (5)

Where:

COMP= CEO cash compensation (salary+bonus)

Eanings= income from continuing operations/average total assets

Persistence= CFOt+1/CFOt

The β3 coefficient measures the sensitivity of CEO cash compensation to earnings,

accruals or cash flows when considering accrual quality or persistence. A significant

positive value for β3 is expected to provide support for the argument that the

association between pay-sensitivity and earnings quality is positive. Following Leone

et al [2006], sales and sales2

are included to control for potential (non-linear) size

effects.

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I test H2 with the following models:

∆In COMP = β0 + β1R + β2∆CFO + β3∆Accruals + β4AccrualQuality +

β5R ∗ AccrualQuality + δControl ∗ Size + α (6)

∆In COMP = β0 + β1R + β2∆CFO + β3∆Accruals + β4Persistance + β5R ∗

Persistance + δControl ∗ Size + α (7)

Where:

R= compounded monthly returns for fiscal year

Years of firms when the market-adjusted stock returns is negative are in negative

sample set and years of firms when the market-adjusted stock returns is positive are in

positive sample set. The β5 coefficient measures the sensitivity of CEO cash

compensation to negative or positive stock returns when considering accrual quality

or persistence. For positive sample set, a significant positive value for β5 is expected

to provide support for H2. I make no prediction for β5 for negative sample set.

Following Leone et al [2006], sales and sales2

are included to control for potential

(non-linear) size effects.

V Sample and data

CEO compensation data are obtained from Execucomp, earnings from

Compustat, and stock returns from CRSP. CEO-year observations from 1998-2008 are

selected. The restrictions on the sample are the followings: (1) CEO did not change

during the year, (2) positive total assets, (3) sufficient data to calculate changes in can

compensation and earnings components. The number of firms observed is 651, 7 out

of which are with missing values. Therefore, the useable observations are from 644

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firms.

VI Results

6.1. Descriptive Statistics

Table 1 presents the descriptive statistics of samples, including the entire

sample, the sample of good news firms and the sample of bad news firms. 306 firms

report bad news and 338 firms report good news. The mean of stock returns is -26%

for bad news firms, 39% for good news firms and 8% for the entire sample. The

average of CEO salary is $688.48 in thousands and the average bonus is $647.61 in

thousands. Both salary and bonus for CEOs of good news firms are higher than those

for CEOs of bad news firms. For the full sample as well as the other two samples, the

accruals are negative whereas the cash flows are positive. The mean of accruals for all

firms is -278.8 while the mean of cash flow is 565.32, resulting in the positive average

earnings. Good news firms have the smallest AccrualQuality and the largest

Persistence among the three samples. The accrual quality and persistence is higher in

good news firms than bad news firms.

Table 2 demonstrates Pearson and Spearman correlations among the

variables and CEO cash compensation. The coefficients correspond to 1%

significance levels. Accrual quality, persistence, stock returns, accruals and cash flows

are all significantly correlated to △ ln(cash comp). The coefficients are 0.08, 0.13,

0.26, 0.63, and 0.29 respectively. The correlation between accruals and △ ln(cash

comp) is larger in magnitude than that between cash flows and △ ln(cash comp). The

correlation between persistence and △ ln(cash comp) is larger in magnitude than that

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between accrual quality and △ ln(cash comp).

Table1- descriptive statistics

All firms Bad news firms Good news firms

Mean STD Median Mean STD Median Mean STD Median

R 0.08 0.48 0.02 -0.26 0.18 -0.23 0.39 0.45 0.24

Accruals -278.86 803.89 -74.97 -216.79 848.84 -52.28 -335.06 757.80 -97.90

CFO 565.23 1327.20 178.58 468.03 1449.46 139.96 653.22 1201.31 229.92

Earnings 0.05 0.08 0.04 0.04 0.09 0.04 0.06 0.05 0.05

△ Accruals -24.03 5 99.71

-4.70 -20.53 712.11 -5.40 -27.20 476.71 -3.61

△ CFO 61.93 787.34 9.16 46.79 934.97 3.22 75.64 625.48 18.36

AccrualQuality

yyyy

122.37 162.38 62.83 112.25 156.92 56.42 131.54 166.87 67.75

Persistence -0.50 32.12 1.00 -1.35 40.60 0.94 0.26 21.82 1.03

Sales 5446.14 8670.48 1902.92 5224.64 8934.43 1835.40 5647.21 8432.05 1959.18

Salary 688.48 298.77 657.67 685.84 297.83 651.94 690.87 300.05 659.38

Bonus 647.61 739.93 414.61 486.03 612.42 300.00 793.90 812.40 566.97

Table2- correlations

△ ln(cash comp)

accrual quality 0.08

persistence 0.13

R 0.26

Accruals 0.63

CFO 0.29

6.2. Empirical tests results

Table 3 presents the primary test results of equation 2,3,4 and 5 for H1.

Adjusted R2 are 0.09, 0.03, 0.08 and 0.05 respectively for equation 2,3,4 and 5.

Focusing first on the earnings and accrual quality regression, the coefficient of

Equation2 on Earnings is 1.1096, positive as predicted and statistically significant.

The coefficient on Earnings interacted with AccrualQuality is positive and statistically

insignificant. This result shows that the accrual quality is not related to the

pay-sensitivity to earnings. With high accrual quality, the sensitivity of CEO cash

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Table3-equation 2,3,4,5

Variables ln(cash comp)

Predict.sign Coef. (t statistic)

Equation 2

Earnings + 1.0196(2.19)

AccrualQuality

0.0016(4.85)

Earnings*AccrualQuality + 0.0046(1.27)

Sales

0.0000(1.09)

Equation 3

Earnings + 1.3406(3.13)

Persistence

-0.0012(-0.88)

Earnings*Persistence + -0.0001(0.00)

Sales

0.0000(3.75)

Equation4

CFO

0.0003(4.48)

Accruals + -0.000003(-0.02)

Accruals*AccrualQuality + 0.0000006(2.13)

Sales

0.0000(-0.01)

Equation5 CFO + 0.0001(2.36)

Accruals

-0.0012(-0.09)

CFO*Persistence + 0.0001(1.20)

Sales

0.0000(-0.27)

compensation to earnings bumps up. Also, the coefficient on AccrualQuality is

statistically significant, meaning that CEO cash compensation is related to the accrual

quality. The regression result of Equation 3 shows persistence of cash flow is not

associated with pay-sensitivity to earnings. The coefficient on Earnings is positive and

statistically significant. Against the prediction, the coefficient on Earnings interacted

with Persistence is negative and statistically insignificant. This follows that the

persistence of cash flow has limited influence on the pay sensitivity to earnings. The

coefficient on Sales is statistically significant.

In Equation 4 and 5, Earnings are decomposed into CFO and Accruals.

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Equation 4 tests the effect of AccrualQuality while Equation5 tests the effect of

Persistence. Focusing on Equation 4, I find that the coefficient on CFO is 0.0003 and

statistically significant while the coefficient on Accruals is not the same as my

prediction. The result illustrates that the coefficient on Accruals is negative; in

addition, it is not statistically significant. This shows that Accruals are not the major

component of Earnings to be considered by the board of directors when deciding CEO

cash compensation. Meanwhile, when interacted with AccrualQuality, the coefficient

becomes statistically significant and positive as predicted, showing that when accrual

quality is high, the pay sensitivity to accrual slightly changes. Only with high accrual

quality will accrual be considered by the board of directors. It shows that CEOs

receive incentives for keeping a high accrual quality; otherwise, their cash

compensation is barely related to accruals. The coefficient on the control variable is

statistically significant. The results of Equation 5 report that the coefficient on CFO is

0.0001, positive and statistically significant as predicted. The coefficient on Accruals

supports the previous result that Accruals are not related to CEO cash compensation

sensitivity. Interacted with Persistence, the coefficient is positive but statistically

insignificant. Consistent with the results of Equation 3, persistence has no relation

with the pay sensitivity to cash flow.

Table 4 reports the test results of equation 6 and 7 for H2. Adjusted R2 are

-0.0034, 0.0015, 0.0012 and -0.0145 respectively for Equation 6 for bad news firms,

Equations 6 for good news firms, Equation 7 for bad news firms and Equation 7 for

Table4-equation 6,7

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Bad news Good news

Variable △ ln(cash comp) △ ln(cash comp)

Predict.sign Coef. (t statistic) Predict.sign Coef. (t statistic)

Equation 6 R + 0.5345(1.12) + 0.0823(0.54)

△ CFO

-0.0001(-0.62)

0.0001(0.38)

△ Accruals

0.00001(0.06)

0.0001(0.37)

AccrualQuality

0.0004(0.50)

0.0012(2.38)

R*AccrualQuality 0.0015(0.56) + -0.0010(-1.28)

Sales

0.0000(0.79)

0.0000(-0.27)

Equation 7

R + 0.6965(1.79) + -0.0047(-0.04)

△ CFO

-0.0001(-0.40)

-0.0001(-0.32)

△ Accruals

0.0001(0.33)

-0.0001(-0.30)

Persistence

0.0047(0.20)

0.0269(0.72)

R*Persistence

0.0158(0.30) + -0.0277(-0.73)

Sales

0.0000(0.74)

0.0000(0.80)

good news firms. For good news firms sample, the coefficients on R interacted with

AccrualQuality and CFO are not positive or statistically significant as I predicted in

H2. Earnings quality is not realated to pay sensitivity to stock returns for good news

firms. This follows that the information risk of unrealized gains is not considered as

an incentive when the board of directors contract CEO cash compensation. For bad

news sample, the results of Equation 6 and 7 prove that the coefficients on R are

positive and statistically significant, adding evidence that CEOs receive immediate

penalty for unrealized losses. The coefficients on R interacted with AccrualQuality

and CFO are positive and statistically insignificant. Earnings quality is not related to

the pay sensitivity to stock returns for bad news firms. This follows that the

information risk of unrealized losses does not relate to cash compensation penalty for

unrealized losses. In summary, earnings quality is not related to the asymmetric level

of pay sensitivity to stock returns.

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H1 suggests that earnings quality is not associated with pay sensitivity to

earnings and earnings components. The regression analysis confirms H1 to the extent

that accrual quality is not associated with pay sensitivity to accruals and cash flows,

and persistence is not associated with pay sensitivity to earnings, accruals and cash

flows. Inconsistent with H1, accrual quality is associated with the sensitivity of CEO

cash compensation to earnings. When earnings have higher accrual quality, the

sensitivity of CEO cash compensation to earnings is higher; when earnings have

lower accrual quality, the sensitivity of CEO cash compensation to earnings is lower.

H2 suggests that earnings quality is associated with the asymmetric level of

pay sensitivity to stock returns. The regression analysis disproves H2. Neither accrual

quality nor persistence is associated with the sensitivity of CEO cash compensation to

stock returns for good news and bad news companies. CEOs are receiving no penalty

for low earnings quality and high accounting information risk, and no incentives for

high earnings quality and low accounting information risk.

VII Conclusion

This paper tests the relation between earnings quality and CEO cash

compensation. They represent the valuation and evaluation uses of earnings

information. First, I analyzed that earnings quality can signal information risk while

information risk links the uses of accounting information. Second, I examine the

impact of earnings quality on pay sensitivity. I use accrual quality and persistence to

present earnings quality and I decompose earnings into accruals and cash flows.

Based on this research, it is clear that accrual quality is associated with CEO cash

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compensation and impacts pay sensitivity to earnings. Earnings with high accrual

quality would be considered more useful than earnings with low accrual quality when

CEO incentives are contracted. One of the reasons could be that earnings with high

accrual quality signals low information risk and the board of directors face little

uncertainty in earnings information. I find no relation between accrual quality and pay

sensitivity to accruals, cash flows and stock returns and no relation between

persistence of cash flows and pay sensitivity to earnings, accruals, cash flows and

stock returns. With the research, I failed to see the compensation contracts that

include adequate consideration of earnings quality. Since CEOs are responsible to

report earnings information and unrealized gains and losses, the incentives for high

earnings quality may mitigate information risk and uncertainty in the reported

information. To upgrade the effectiveness of compensation contracts, the board of

directors and the compensation committee may consider the quality of received

accounting information rather than the mere information.

Future research may examine the role of earnings quality in determining

CEO cash compensation with “Say-on-Pay” policy starting at the financial crisis

period and whether the policy brings effective compensation method with respect of

earnings quality and information risk.

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