“Direct Evidence on Earnings Used in Executive Compensation Performance Measurement” by Dr. Yong Zhang
Dr. Yong Zhang
Associate Professor of Accounting
School of Accounting & Finance
Hong Kong Polytechnic University
This paper provides direct evidence on the properties of actual accounting earnings that are used in determining compensation payouts (Compensation Earnings). Using a large sample of manually collected Compensation Earnings for U.S. firms, we show that firms make economically significant adjustments to GAAP Earnings in arriving at Compensation Earnings. While we show that GAAP Earnings exhibit conditional conservatism (asymmetric timeliness in loss recognition), we fail to detect conditional conservatism in Compensation Earnings using the same sample and the same research design. Further analyses indicate that the adjustment from GAAP Earnings to Compensation Earnings involves the removal of less persistent components of GAAP Earnings, which results in Compensation Earnings that are more persistent than GAAP Earnings. Last, we show that Compensation Earnings also differ significantly from an alternative version of earnings that result from a mechanical removal of transitory earnings omponents.
This study adds to the literature of executive compensation by providing direct empirical evidence on the trade-off of two important features of accounting performance measures, namely conditional conservatism and persistence. We also contribute to the ongoing discussion on the explanations and implications of the widely documented conditional conservatism in GAAP Earnings. Last, this study is relevant to standard setting. The actions of the IASB and FASB in revising their respective concept statements suggest that there is a lack of consensus regarding whether or not the two financial reporting objectives, namely decision making and stewardship, require different financial reporting practices. The evidence of this study, combined with the evidence in the existing literature, suggest that the properties of earnings that are required by stewardship (compensation contracting) may be similar to those required for decision making, thereby providing support for the 2010 decision of the IASB and FASB in their conceptual framework joint project.
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