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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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