EFFECT OF DISCRETIONARY ACCRUALS ON EXECUTIVE COMPENSATION

Abstract

This paper investigates whether compensation committees understand earnings management when they decide CEO cash compensation through analysing the role of discretionary accruals in the CEO cash compensation function. Based on financial and compensation data for firm-years from 1997 to 2010, I find that CEO cash compensation is significantly and positively related to different earnings components (cash flow from operations, non-discretionary and discretionary accruals), controlling for firm performance, research and development, and advertising expenditures. Tests indicate that the regression coefficients on these three components of earnings (cash flow from operations, nondiscretionary and discretionary accruals) are significantly different from each other. The coefficient on cash flow from operations is significantly larger than that on nondiscretionary accruals, which is significantly larger than that on discretionary accruals. This pecking order is consistent with the decreasing earnings persistence of the three components. In addition, the differential treatment between nondiscretionary and discretionary accruals on CEO compensation only exists in low growth firms but not in high growth firms. The data tells a consistent story: compensation committees do not react naively or apply a functional fixation on CEO compensation. Rather, they understand the meaning of discretionary accruals and can be quite demanding and sophisticated when setting cash compensation. Not only do they take earnings persistence into consideration, but they also award CEOs based on the firms’ status.