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

Abstract

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