Executive Compensation and Earnings Persistence

Governing boards utilize executive compensation contracts in an attempt to align executive actions with corporate goals. The objective is to ensure that executive performance provides value to the organization in terms of successful outcomes. A key performance criteria typically specified in CEO compensation contracts is earnings targets. However, using earnings as a performance evaluation may be problematic because some firms exhibit robust and sustained earnings over time (high earnings persistence), and other firms, such as high growth oriented firms, exhibit weak or sometimes negative earnings over time (low earnings persistence). Our study reveals that the effect of high earnings persistence results in firms that focus more heavily on cash compensation (salary and bonus) rather than on equity compensation (stock options, etc.) to compensate executive performance. Additionally, for firms characterized by low earnings persistence, our study indicates that cash flows from operations act as a supplementary performance measure to accounting earnings, and become increasingly important as a means to justify executive cash compensation.