Does the use of non‐GAAP earnings in compensation contracts lead to excessive CEO compensation? Efficient contracting versus managerial power

Abstract

AbstractWe examine whether the recent trend of firms’ using non‐GAAP earnings metrics in compensation contracts is consistent with the efficient contracting hypothesis or the managerial power hypothesis. We extract non‐GAAP performance metrics from compensation contracts in proxy statements of S&P 500 firms from 2006 to 2013. We find that the adoption of non‐GAAP earnings in CEOs’ compensation contracts is positively associated with CEOs’ cash compensation. However, the increase in CEOs’ compensation is primarily evident among firms with superior CEO talent. In addition, we find that the cash pay‐performance sensitivity (PPS) increases after the adoption of non‐GAAP performance measures, suggesting that boards use non‐GAAP performance measures to enhance CEOs’ performance‐improving incentives, rather than granting excessive compensation. Overall, our evidence suggests that, on average, the use of non‐GAAP performance metrics in executive compensation contracts reflects boards’ efforts to retain talented CEOs and mitigate agency problems, which is consistent with the efficient contracting hypothesis.