The Role of Losses and Profits in Cash Compensation

This paper provides evidence that certain value-relevance relations for earnings and book value hold in parallel for compensation-relevance. This is consistent with the hypothesis that accounting-driven components of CEO salary and bonus contracts align investor and manager objectives.

Using data from the Forbes, Inc. annual surveys of CEO compensation over the 18-year period 1979 to1996, we find first that firms with current losses (profits) exhibit a weak (strong) relation be-tween earnings and compensation and a strong positive (weak negative) relation between compensation and book value of equity. Second for firms with current profits but with previous consecutive losses, the compensation-relevance of book value is significantly positive and the relevance of earnings is diminished. Similarly, in industries where the proportion of industry members reporting current losses is relatively high, compensation paid by profit firms exhibits a significantly weaker relation to earnings and a significantly stronger relation to book value compared to profit firms in industries with relatively fewer members reporting current losses. We interpret the reliance on book value by loss firms and by profit firms that are unlikely to earn a “normal profit” as consistent with the agency theory prediction that firms will design executive compensation in a way that ensures a reservation wage for executives.

In a finding that is unique to compensation-relevance and unanticipated by our hypotheses, the sign of book value of equity is significantly negative for profit firms that do not have a history of previous consecutive losses or do not operate in an industry with a preponderance of losses. We tentatively interpret this as consistent with compensation contracts that impose a “lower bound” on earnings, i.e., with compensation formulas that specify a minimum or target earnings level that must be obtained for firms that operate in an environment where normal profits are likely. To illustrate, consider the following compensation formula, COMP = S + b(I – rV), where S is some fixed salary, I is some measure of accounting income, r is the target profit rate on shareholders’ equity V, and b is the bonus rate on “abnormal” profits. In simplified form, we run the following estimation equation, COMP = B0 + B1I + B2V + e. Given the compensation formula, E(B2) = –rb for firms without previous consecutive losses. In other words, a negative coefficient on book value for profit firms is consistent with a lower bound on earnings as documented by Healy (1985).