BUSHMAN Et Al-2006-Journal of Accounting Research PDF

DOI: 10.1111/j.1475-679X.2006.00192.
x
Journal of Accounting Research
Vol. 44 No. 1 March 2006
Printed in U.S.A.
An Analysis of the Relation between

the Stewardship and Valuation Roles
of Earnings
ROBERT BUSHMAN, ELLEN ENGEL, AND ABBIE SMITH
Received 14 May 2003; accepted 19 September 2005
ABSTRACT
In this paper, we seek a deeper understanding of how accounting infor-

mation is used for valuation and incentive contracting purposes. We explore
linkages between weights on earnings in compensation contracts and in stock
price formation. A distinction between the valuation and incentive contracting
roles of earnings in Paul [1992] produces the null hypothesis that valuation
earnings coefficients (VECs) and compensation earnings coefficients (CECs)
are unrelated. Our empirical analyses of the relations between earnings and
both stock prices and executive compensation data at the firm and industry lev-
els over the period 19712000 rejects Pauls [1992] hypothesis of no relation.
We also document an increasing weight over time on other public perfor-
mance information captured by stock returns in the determination of cash
compensation. Specifically, we find that the incentive coefficient on returns is
significantly higher in the second of two equal sample subperiods relative to
the incentive coefficient on earnings.
University of North CarolinaChapel Hill; University of Chicago. The authors thank Jeff
Abarbanell, Qi Chen, Thomas Hemmer, Raffi Indjejikian, Eddie Lazear, Richard Leftwich (the
editor), Kevin J. Murphy, Jim Ohlson, Mark Ubelhart, and seminar participants at the Univer-
sity of Chicago, Duke/UNC Fall Camp, Harvard Business School, Indiana University, London
School of Economics, University of Michigan, AAA Annual Meetings, and WorldatWork Aca-
demic Research Conference for useful comments. We are particularly grateful to three anony-
mous referees for their useful comments. We appreciate the research assistance of Xia Chen
and Jennifer Milliron, and thank Kevin J. Murphy for providing data from Forbes Compensa-
tion Surveys. We also thank the Graduate School of Business at the University of Chicago and
UNC Kenan-Flagler Business School for financial support. Engel also acknowledges research
support from the FMC Faculty Research Fund at the University of Chicago Graduate School of
Business.
53
Copyright
C , University of Chicago on behalf of the Institute of Professional Accounting, 2006
54 R. BUSHMAN, E. ENGEL, AND A. SMITH
1. Introduction
Ball [2001] and Holthausen and Watts [2001], among others, argue
that observed accounting practices are shaped by heterogeneous demands
placed on general purpose financial statements to support a wide range of
decisions and contractual arrangements. This suggests that insight into the
nature of observed accounting practices can be gained by investigating re-
lations across key roles played by accounting information. In fact, agency
theorists going back to at least Gjesdal [1981] have recognized the value of
such an approach, focusing attention on the use of accounting information
in valuation relative to its use in incentive contracting.1 However, the relation
between valuation and stewardship uses of earnings is still not well under-
stood. In this paper, we seek a deeper understanding of this relation. To this
end, we explore economic connections between the incentive weight placed
on earnings in compensation contracts and the valuation weight placed on
earnings in stock price formation.
There exists a large literature examining the determinants of the incen-
tive weights placed on performance measures in incentive compensation
contracts,2 and a vast literature concerning the determinants of the weight
placed on earnings in valuation.3 However, research directly examining rela-
tions between incentive contracting and valuation uses of earnings is more
limited. In an important paper, Gjesdal [1981] simultaneously considers
differential uses of accounting information, and illustrates that the rank-
ing of information systems for valuation purposes need not coincide with
the ranking of information systems for control purposes. In a similar spirit,
Paul [1992] demonstrates, in a plausible agency setting, that valuing firms
and evaluating managers are separate and distinct activities, suggesting fun-
damental differences in the valuation and incentive contracting roles of
earnings. Lambert [2001, section 3.35] provides an insightful discussion
and synthesis of the agency literature investigating how information is used
for managerial incentive purposes relative to how it is used for valuation
purposes and its implication for future research. It is this literature that mo-
tivates our empirical exploration of relations between valuation earnings
coefficients (VECs) and compensation earnings coefficients (CECs).
1 This latter role is often termed the stewardship role. Gjesdal [1981, p. 208] defines the
stewardship role as the demand for information about managers actions for the purposes
of controlling them. In what follows, we use the terms stewardship and incentive contracting
interchangeably.
2 Contributions include Lambert and Larcker [1987], Banker and Datar [1989], Holmstrom
and Milgrom [1991], Bushman and Indjejikian [1993], Sloan [1993], Feltham and Xie [1994],
Bushman, Indjejikian, and Smith [1996], Ittner, Larcker, and Rajan [1997], Datar, Kulp,
and Lambert [2001], and Murphy and Oyer [2002]. For recent reviews of this literature see
Bushman and Smith [2001] and Lambert [2001].
3 Contributions include Kormendi and Lipe [1987], Collins and Kothari [1989], Easton
and Zmijewski [1989], Freeman and Tse [1992], and Ohlson [1995]. See Kothari [2001] for a
recent review of this literature.
STEWARDSHIP AND VALUATION ROLES OF EARNINGS 55
In particular, the clean distinction between the valuation and incentive

contracting roles of earnings isolated in Paul [1992] and Lambert [2001]
provides a powerful point of departure for our analysis. The basic idea is
that, for valuation purposes, the role of earnings is to facilitate investors
inferences about stochastic elements of firm value that are independent
of managerial actions. Investors do not use earnings to infer managerial
effort. This result occurs because the agents effort is selected based on
the same information that investors have (i.e., common knowledge), and so
investors are able to perfectly conjecture what actions will be selected. Thus,
in equilibrium, the VEC is independent of both the sensitivity of earnings
to managerial effort and the marginal product of effort. In contrast, the
contracting role of earnings is to provide incentives for the manager to
supply effort. This role exploits the sensitivity of earnings to managerial
effort and knowledge of the marginal product of effort. In equilibrium,
the CEC depends explicitly on both the sensitivity of earnings to managerial
effort and the marginal product of effort. Based on Pauls [1992] result, we
empirically examine the null hypothesis that VECs and CECs are unrelated.
We investigate links between CECs and VECs using CEO annual cash com-
pensation from Forbes compensation surveys over the period 1971 to 2000.4
We examine the cross-sectional relation between CECs and VECs estimated
both at the firm-specific and industry levels. At both the firm and industry lev-
els, we find that CECs and VECs are positively and significantly related, after
controlling for earnings persistence, growth opportunities, noise in earnings
and returns, and regulation. We also examine the cross-sectional relation
between changes in industry-specific CECs from the first half (19711985)
to the second half (19862000) of our sample period with corresponding
changes in industry-specific VECs.5 We document a positive relation between
changes in CECs and changes in VECs. Thus, our analysis rejects the Paul
[1992] hypothesis of no relation between CECs and VECs.
While we are able to reject the hypothesis of no relation, our empirical
analysis does not provide an explanation for why the relation exists. It is, of
course, possible to analytically generate connections between contracting
and valuation roles of earnings by altering assumptions of the Paul [1992]
model. To see this, we offer two parsimonious alternative models. In the
first model, the CEC embeds the VEC to incorporate dynamic aspects of
the marginal product of current period action not captured by current
period earnings. The second model allows the marginal product of effort
and the sensitivity of earnings to effort to be correlated random variables. In
this setting, both the contracting and valuation role of earnings exploits the
4 We discuss the rationale of our focus on cash compensation in section 2.

5 We also document that across the two equal subperiods of the sample there is an increasing
weight on other (i.e., nonearnings) public performance information in the determination of
cash compensation. That is, the incentive coefficient on stock returns, our proxy for other
publicly available performance information, relative to the incentive coefficient on accounting
earnings is higher in the later subperiod.
correlation between earnings and the marginal product of effort, suggesting

a relation between CECs and VECs.
However, while alternatives can be analytically generated, we do not em-
pirically attempt to distinguish between these, or other potential alternative
theoretical motivations of an association between CECs and VECs. Further
theoretical and empirical investigation of the specific nature of the associ-
ation we document remains an interesting challenge for future research.
In addition, we note that constructing a convincing economic model that
links CECs and VECs is conceptually difficult, as both constructs are endoge-
nously determined in equilibrium. Inferring directional hypotheses about
the relation between two endogenous variables is challenging as they both
depend on underlying exogenous variables in a complex way. Statistical re-
lations will thus be a function of the exogenous variables that explain each
endogenous variable.
In related research, several earlier papers examine whether incentive
weights placed on earnings in compensation contracts increase with the cor-
relation between earnings and stock returns, with mixed results (Lambert
and Larcker [1987], Sloan [1993], and Bushman, Indjejikian, and Smith
[1996]). Biddle, Bowen, and Wallace [1997] examine the valuation proper-
ties of EVA , a measure widely studied for its incentive contracting proper-
ties (e.g., Rogerson [1997] and Reichelstein [1997]). Finally, Baber, Kang,
and Kumar [1998] document that the incentive weight on earnings in deter-
mining CEO cash compensation increases with earnings persistence. They
conjecture that this compensation feature is designed to mitigate myopic
decision making by managers. We revisit this conjecture in our discussion
and empirical analyses, extending and reinterpreting it in light of our formal
analysis.
The remainder of the paper is organized as follows. Section 2 presents our
models of relations between CECs and VECs. Section 3 describes the sample
and data. Section 4 presents the research design and empirical analyses and
Section 5 concludes.
2. Theoretical Development
In this section, we develop the hypothesis of no relation between contract-
ing and valuation uses of earnings and offer two parsimonious alternatives.
For simplicity, we focus on single action settings with contracts written only
on earnings. Analyzing contracts that do not include stock price is consis-
tent with our empirical focus on CEO cash compensation, which gener-
ally does not include stock price as an explicit performance measure (e.g.,
Ittner, Larcker, and Rajan [1997] and Murphy [1998]).6 While a focus on
cash compensation alone is not satisfactory from the viewpoint of general
agency theory, there is empirical justification for focusing our investigation
6 Although, as discussed in more detail below, we do include stock returns in addition to
earnings when estimating CECs to avoid any mechanistic relations between CECs and VECs.
of the use of earnings in contracting on the cash component of executive

compensation.
Recent findings by Core, Guay, and Verrecchia [2003] document that pre-
dictions from standard agency models find support when CEO cash compen-
sation is used, but not when compensation is expanded to include equity
grants and portfolio value changes.7 While a convincing explanation for
this result awaits further research, there are several potential explanations
pertinent to our analyses. Incentive packages may represent portfolios of
mechanisms whose components are individually designed to achieve dif-
ferent objectives, with cash compensation, for example, motivating effort
choice, and equity instruments promoting retention, risk taking, long-term
thinking, etc. A focus on cash compensation may also be justified by political
considerations that lie outside agency theory. For example, CEOs are likely
constrained in their personal portfolio decisions relative to firm-specific
option and stock holdings by pressure from outside investors. Or, as conjec-
tured by Core and Guay [2002], CEO bonus plans may not be designed to
create incentives for the CEO, but rather to create a political environment
in which similar plans can be pushed down to employees lower in the orga-
nization who do not face the same outside pressures and who hold much
less in company stock and options. This allows for the possibility that agency
theory can be studied by looking at cash compensation of CEOs, where this
plan is a sufficient statistic for incentive contracts lower in the hierarchy.
While we are agnostic on these explanations, we note their plausibility and
point to them as partial justification for our focus on cash compensation.
2.1 THE NULL HYPOTHESIS

In this section, we present models of the valuation and compensation
weights on earnings based on those in Paul [1992] as the basis for our
null hypothesis of no relation between the contracting and valuation uses
of earnings. Consider a principal-agent setting with a risk-neutral principal
and a single risk-averse agent who chooses unobservable effort, e. The op-
portunity cost of managerial effort is given by 0.5e 2 , and firm value, which is
assumed unobservable and thus noncontractible, is given by V = v e + V .8
Earnings are given by EARN = ae +V + E with i N(0, i2 ), i = V , E and
Cov(V , E ) = 0.9 Note that v, the marginal product of effort in the value
function, and a, the sensitivity of earnings to effort, are deterministic. The
wage contract is linear in EARN , given by w = 0 + CEC EARN , where CEC
7 See also Baber, Kang, and Kumar [1996], Core and Guay [1999], and Bryan, Hwang, and
Lilien [2000].
8 The assumption that value is unobservable is common in the recent agency literature (e.g.,
Holmstrom and Milgrom [1991], Baker [1992], Bushman and Indjejikian [1993], Feltham and
Xie [1994], and Datar, Kulp, and Lambert [2001]).
9 All that is required here is that the stochastic element of earnings be correlated with the
stochastic element of value. We use two independent stochastic terms in earnings solely to
facilitate exposition.
is the weight on earnings in contracting. Finally, the agents preferences

are represented by U = exp[r {w .5e 2 }], where r is the risk aversion
parameter.
The principal chooses CEC to maximize E [V w]]
subject to

Individual Rationality (IR) : 10
EU 0 + CEC EARN 1/.2e 2 = U ,
and

Incentive Compatibility(IC): e maximizes EU 0 + CEC EARN 1/.2e 2 .
To complete the specification, let equilibrium price be given as E[V | EARN ,

e], where e is the markets conjecture about the managers action, captur-
ing the fact that action is not observable. Given common knowledge about
all model parameters, preferences, and distributions, market participants
correctly conjecture the managers equilibrium action choice. The market
makes no statistical inferences about effort, and in equilibrium, the agents
action will equal the action conjectured by the market.
Given normal distributions, price is linear in EARN and is computed as
E[V | EARN , e] = E [V | e] + VEC (EARN E [EARN | e]) = v e + VEC
(EARN a e). Standard solution techniques lead to the following weights
on earnings in contracting and in valuation, respectively:
va Cov(V , EARN ) 2
CEC = 2 and VEC = = 2 V 2 . (1)
a + r E + V2
2 Var(EARN ) E + V
The optimal weights on earnings in the compensation and value func-
tion reflected in equation (1) are the basis for the hypothesis of no relation
between the weights. To see this, note that CEC depends on the marginal
product of effort, , and the sensitivity of EARN to effort, a, while VEC is
independent of these parameters. This occurs because the model assumes
that the valuation role of earnings is to infer stochastic elements of firm
value that are independent of managerial actions. That is, valuation exploits
Cov(V , EARN )as the market uses EARN to learn about the stochastic compo-
nent of value, V . In contrast, for contracting, the principal exploits the sen-
sitivity of EARN to managerial effort, a, to create incentives. Cov(V , EARN )
plays no role in contracting, and stochastic elements of earnings are viewed
as costly noise from a contracting perspective. This forms the basis for Pauls
[1992] conclusion that valuing firms and evaluating managers are separate
and distinct activities, suggesting fundamental differences in the valuation
and incentive contracting roles of earnings.
However, as discussed earlier, CEC and VEC in equation (1) are en-
dogenous variables. Although the analysis clearly isolates differences in the
10 We write the IR constraint as an equality as it is well known that this constraint is binding
in this setting.
valuation and incentive contracting roles of earnings and CEC depends on

the exogenous variables a and , while VEC does not, both endogenous vari-
ables depend on the variance terms, E2 and V2 . Thus, the hypothesis of
no relation between CECs and VECs is conditional on controlling for cross-
sectional differences in E2 and V2 . We discuss this issue further below in the
context of our empirical design.
2.2CONJECTURES CONCERNING POSSIBLE SOURCES OF RELATION
BETWEEN CEC S AND VEC S
While Pauls [1992] model yields a conclusion of no relation between
CECs and VECs, we acknowledge that alternative modeling assumptions
could produce sources of correlation between these two key uses of earn-
ings. We briefly present two alternative models in this section to illustrate
plausible sources of a connection between CECs and VECs. These are clearly
not the only possible scenarios of correlation but are, in our view, intuitive
and economically motivated bases for a link. Our tests explore the overall
correlation between CECs and VECs but do not attempt to isolate the spe-
cific underlying source of the correlation. We leave this analysis to future
analytical and empirical research.
The first source of possible connection we discuss posits that managerial
actions have multiperiod effects that are not fully captured in the current
earnings number, and so VEC is included in the incentive coefficient to moti-
vate the manager to internalize the discounted all-in value impact of current
period action. To see this simply in the Paul [1992] framework, adapt the
above model to assume a value function V = v EARN . In this case, CEC
is still given by equation (1), but VEC = v Cov(EARN , EARN )
Var(EARN )
= v.11 Note that
CEC in equation (1) depends directly on = VEC. This simple model ex-
tends and allows a reinterpretation of the empirical analysis in Baber, Kang,
and Kumar [1998]. They conjecture that boards consider the persistence
of earnings to mitigate a myopic decision focus by managers. Their analysis
assumes that earnings equal cash flows, and assumes an incentive weight
on earnings rather than deriving it within a contracting framework. While
multiperiod effects can be framed as myopia, it seems more natural to view
them as an issue of properly measuring the marginal product of current
period actions that impact current and future earnings. The multiperiod
impact of actions is incorporated through the valuation weight on earnings.
In the appendix, we present and analyze a second plausible alternative
model that characterizes the marginal product of effort and the sensitivity
of earnings to the managers actions as correlated random variables whose
distributions are common knowledge. In this setting, the contracting role
of earnings is to motivate actions consistent with the true marginal product
11 For example, if one were to adopt the linear dynamic of Ohlson [1995], VEC = /(R ),
where is the persistence parameter on abnormal earnings in the linear dynamic and R is the
discount rate. Thus VEC captures the discounted implications of current earnings on all future
periods. See also Govindaraj and Ramakrishnan [2000] and Ohlson [1999a, b].
of effort, which exploits the correlation between earnings and the marginal
product of effort. For valuation, earnings is used to infer true marginal
product, which similarly exploits the correlation between earnings and the
marginal product of effort. Thus, incentive contracting and valuation both
exploit the correlation between earnings and the marginal product of effort.
3. Sample and Data

The sample is drawn from firm-years with CEO cash compensation data
available from annual Forbes surveys during the 30-year period from 1970
to 2000. As discussed in some detail in the introduction to section 2, the
CEO compensation measure used is annual cash compensation, defined as
annual salary plus bonus. We exclude firm-years in which a CEO change
occurs. Firm-years are also excluded if earnings and stock return data are
not available on the Compustat and Center for Research in Security Prices
(CRSP) databases, respectively. As discussed below, we conduct analyses of
CECs and VECs using both firm-specific and industry frameworks and using
both levels (over the full sample period) and changes (across two equal
subperiods of the sample period) settings. Our primary sample includes
firm-years for industries, defined on the basis of two-digit Standard Indus-
trial Classification (SIC) codes, that have at least 50 observations in each
of the first and second halves of the period 19712000. We impose this
restriction to ensure a reasonable number of degrees of freedom in our
industry changes analyses. The primary sample includes 16,780 firm-years,
representing 1,380 different firms, with an average of 12 observations per
firm. Table 1 describes the industry membership of the sample firms. The
sample includes 28 different industries, ranging from 141 to 3,134 firm-years
per industry. For the firm-specific estimations of CECs and VECs, we further
require our primary sample firms to have more than 20 annual observations
over the sample period. This sample consists of 379 firms with an average
of 26 observations per firm.
Our decision to consider both industry and firm-specific analyses as well
as both levels and changes frameworks reflects trade-offs relative to the
alternative designs. Firm-specific analyses provide a natural control for inter-
firm differences in production functions and risk aversion of executives that
may impact the weight placed on earnings by the market and compensation
committees. Some prior studies of the relation between compensation and
performance have adopted a firm-specific research design (e.g., Lambert
and Larcker [1987]). A concern with any firm-specific analysis, however,
is the relatively small number of observations available for each estimation.
Industry analyses, in contrast, reduce concerns related to degrees of freedom
in estimations of CECs and VECs. We aggregate firms by industry to enhance
the power of coefficient estimates. This allows us to estimate coefficients
with a large number of observations relative to a firm-specific design, and
we expect more homogeneity within industries than across industries in the
TABLE 1
Industry Membership of Sample Firms over the Period 19712000
No. of No. of
Firm-Years Firm-Years
Two-Digit in Period 1 in Period 2
SIC Code Short Name Description of Industry Code (19711985) (19862000)
13 Oil & Gas Oil and gas extraction 236 177
20 Food Food and kindred products 455 358
26 Paper Paper and allied products 248 267
27 Printing Printing, publishing and allied 128 192
industries
28 Chemical Chemicals and allied products 678 631
29 Petroleum Petroleum refining and related 262 209
industries
30 Rubber Rubber and miscellaneous plastic 120 104
products
32 Concrete Stone, clay, glass and concrete 88 59
products
33 Metal Primary metal industries 213 202
34 Heavy Equip. Fabricated metal, ex machinery, 161 124
transportation equipment
35 Computer Industrial, commercial machinery, 391 465
computers
36 Elec. Equip. Electric, other electrical 305 345
equipment
37 Trans. Equip. Transportation equipment 339 315
38 Instruments Measurement instruments, photo 190 258
goods, watches
40 Railroad Railroad transportation 52 89
45 Airlines Transportation by air 100 94
48 Telecom. Communications 186 360
49 Utilities Electric, gas, sanitary services 1,034 1,039
50 Durables Durable goods, wholesale 62 139
51 Nondur. Nondurable goods, wholesale 175 181
53 Merch. General merchandise stores 166 191
54 Food Food stores 185 178
59 Retail Miscellaneous retail stores 82 125
60 Comm. Bank Depository institutions 1,505 1,629
61 Other Bank Nondepository institution 79 139
62 Securities Securities Brokers and Dealers 61 144
63 Insurance Insurance carriers 307 563
73 Business Business services 68 327
Totals 7,876 8,904
determinants of CECs and VECs.12 Industry analyses, however, may suffer

from correlated omitted variables as CECs and VECs may be impacted by
12 Prior research suggests that earnings coefficients are unlikely to be a cross-sectional con-
stant in either stewardship or valuation settings. Relative to valuation, see for example, Collins
and Kothari [1989], Easton and Zmijewski [1989], and Ahmed [1994]. Ely [1991] documents
significant inter-industry differences in the weights placed on performance measures in com-
pensation contracts.
items that vary cross-sectionally. As a result, we incorporate various control

variables in our multivariate analyses to capture firm- and CEO-level factors
that may impact CECs and VECs.
Levels analyses employing the entire sample period for both firm and
industry estimations allow for greater degrees of freedom while changes
over subperiod analyses allow for nonconstant CECs and VECs over the
30-year sample period. The changes analyses, particularly at the industry
level, also provide an approach to address correlated omitted variables. As
is clear from section 2, CECs are in general a function of unobservable
parameters such as managerial risk aversion (r ) and effort aversion (C).
Some studies address this issue by using ratios of incentive coefficients on two
performance measures, where under certain assumptions the unobservables
cancel out (e.g., Lambert and Larcker [1987]). However, our predictions
relate to absolute coefficients, and so the changes design attempts to control
for unobservable characteristics that are stable within an industry over time.
4. Test of the Association between Pay-Earnings

and Price-Earnings Sensitivities
In section 4.1, we estimate CECs and VECs and examine univariate rela-
tions between both levels of and changes in CECs and VECs. We conduct
multivariate analyses in section 4.2 that also control for other agency theo-
retic determinants of CECs.
4.1 UNIVARIATE ANALYSES OF CECs AND VECs
We begin by estimating CECs and VECs. We estimate VEC using a measure
of the sensitivity of stock returns to earnings changes. Similarly, we estimate
CEC using a measure of the sensitivity of annual cash compensation to earn-
ings changes, controlling for other public performance information. We
use stock returns to proxy for other public performance information that
is used by Boards of Directors in developing compensation contracts.13 As
discussed in section 3, we conduct our estimations using multiple empiri-
cal designswe aggregate observations by firm and by industry and employ
both levels of and changes in variables in our design. We discuss the details
of estimation of each design below.
13 In our model, we do not assume that stock prices are directly used in the compensation
contract, but rather that contracts reflect other available performance information. We proxy
for other available information using stock market returns that capture the value impact of
publicly available information. It is also important to include stock returns in our empirical
model because if the true compensation model involves stock returns, omission of stock returns
in the regression would result in a mechanistic relation between CECs and VECs (we thank Raffi
Indjejikian and an anonymous referee for bringing this to our attention). Also, as formally
demonstrated in Demski and Sappington [1999], omitted performance measures can cause
significant inference problems due to interactions between measures in the optimal contracts.
We replicate all empirical tests estimating a model of changes in compensation on changes in
earnings alone and find similar qualitative results.
We estimate firm-specific VECs from the following valuation model for

each firm:
XRET t = + VEC EARN t + t (2)
where: XRET t = the cumulative, market-adjusted return over the

12-month period of the firms fiscal year t and
EARN t = the change in earnings before extraordinary items and
discontinued operations between year t and year t1,
deflated by the market value of equity at the begin-
ning of year t.
Likewise, we estimate firm-specific CECs in a regression of changes in

compensation on changes in earnings and stock returns:
COMP t = + CEC EARN t + CRC RET t + t (3)
where: COMP t = the percentage change in the firms CEOs cash com-
pensation in year t;
RET t = the cumulative stock market return i over the 12-
month period of the firms fiscal year t;
EARN t is as defined in equation (2);14 and
CRC = the estimated coefficient on RET in the compensation
equation (i.e., compensation returns coefficient).
We also estimate the level of industry VECs and CECs using models similar
to those of equations (2) and (3). We estimate these models separately for the
28 sample industries after also including fixed year effects in both models.
We next estimate a changes design that allows the slope on earnings in
both valuation and compensation settings to vary over the 30-year sample
period by allowing a different slope for two equal subperiods of the sample
period: 1971 to 1985 and 1986 to 2000. We conduct the following estimation
for each firm15 :
14 We use change in earnings deflated by beginning market value of equity for consistency
with the traditional market returns model in equation (2). Percentage change in compensation
(or log of the change) is often used in estimations of the compensation/performance relation
(e.g., Sloan [1993], Baber, Kang, and Kumar [1998], Core, Guay, and Verrecchia [2003]). We
also conduct estimations with the change in compensation deflated by beginning market value
of equity. Results with the alternative compensation measure produce similar inferences as
those presented in section 4.
15 We divide our sample period into two equal subperiods for each firm for these analyses
(19711985 and 19862000). We do not hypothesize that a shock occurred at the midpoint of
the sample period (or any other point). We test the sensitivity of all reported results to alterna-
tive cutoff points ranging from 1982 to 1988 (i.e., three years on either side of the midpoint).
The results of these analyses are statistically similar to those reported in the accompanying
tables.
XRET t = + VEC 1 EARN t + VEC EARN 2t + t (4)

and
COMP t = + CEC 1 EARN t + CEC EARN 2t + CRC 1 RET t
+ CRC RET 2t + t (5)

EARN t if t 1986
where: EARN 2t = ;
0 otherwise

RET t if t 1986
RET 2t = ;
0 otherwise
CRC = the estimated coefficient on RET in the compensa-
tion equation (compensation returns coefficient);
CRC = the estimate of the change in the compensation re-
turns coefficient between subperiods; and
XRET t , EARN t , COMP t , and RET t are as defined above.
We also estimate equations (4) and (5) separately for the 28 sample in-
dustries. As before, the industry models also include fixed-year effects. For
each firm/industry, VEC 1 and CEC 1 reflect earnings coefficients in the first
subperiod, VEC 1 + VEC and CEC 1 + CEC capture the estimated earnings
coefficients in the second subperiod, and VEC and CEC are estimates of
the change in coefficients on earnings between subperiods.
Using the results of equations (2) and (3), we compute the correlation
between the level of VEC and CEC across firms and across industries. We
also compute correlations between changes in VECs and CECs from equa-
tions (4) and (5) over the two subperiods on a firm and industry basis. Table
2 reports the univariate correlation for each framework with correlations
significant at the 5% level or less shown in bold. Table 2 shows significantly
positive Pearson correlations in three of the four empirical designs. Specif-
ically, the firm-specific Pearson correlation between the level of CEC and
VEC is 0.34 with a p-value less than 0.0001. Likewise the Pearson correlation
between the level of industry CECs and VECs is also highly significant at 0.60
(p-value = 0.001). The correlation between industry shifts in CECs and VECs
is 0.48, which is significant at the .01 level. The correlation between shifts in
firm-specific CECs and VECs is not significant. It is possible that the relatively
smaller number of degrees of freedom in the firm-specific changes analyses
contribute to the insignificant correlation relative to the other three frame-
works. Table 2 reports that, despite the insignificant correlation between
firm-specific changes in CECs and VECs, the correlation between the level
of CECs and VECs within each of the two subperiods is significantly positive
across firms (0.12 and 0.21 in the first and second subperiods, respectively).
We similarly document significant positive subperiod correlations in the in-
dustry analyses. With the exception of the correlation between shifts across
industries, Spearman rank correlations are similar in significance to those
of the Pearson correlations. Overall, our univariate analysis of correlations
TABLE 2
Correlations between Levels of and Changes in Valuation Earnings Coefficients (VECs) and
Compensation Earnings Coefficients (CECs)
Firm Analyses (N = 379) Industry Analyses (N = 28)

Pearson Spearman Rank Pearson Spearman Rank
Levels analyses 0.34 0.27 0.60 0.72
(<0.0001) (<0.0001) (0.001) (<0.0001)
Changes analyses:
Change across subperiods 0.07 0.01 0.48 0.30
(0.183) (0.788) (0.010) (0.116)
First period 0.12 0.12 0.54 0.42
(0.017) (0.026) (0.003) (0.027)
Second period 0.21 0.20 0.39 0.57
(<0.0001) (<0.0001) (0.039) (0.002)
The table reflects correlations, with p-values in parentheses. Correlation values significant at less than
the 5% level are bolded.
Levels analyses:
VEC = valuation earnings coefficient estimated by firm or by industry from the equation (year fixed-
effects added for industry estimations) ->
XRET t = + VEC E ARNt + t (2)
CEC = compensation earnings coefficient estimated by firm or by industry from the equation (year
fixed-effects added for industry estimations) ->
COMP t = + CEC EARN t + C RC RET t + t (3)
Changes analyses:
VEC = change in valuation earnings coefficient estimated by firm or by industry from the equation
(year fixed-effects added for industry estimations) ->
XRET t = + VEC EARN t + VEC EARN 2t + t (4)
CEC = change in compensation earnings coefficient estimated by firm or by industry from the
equation (year fixed-effects added for industry estimations) ->
COMP t = + CEC 1 EARN t + CEC EARN 2t + CRC 1 RET t
+ CRC RE T2t + t (5)
where:
XRET t = the cumulative, market-adjusted return over the 12-month period of the firms fiscal
year t;
EARN t = the change in earnings before extraordinary items and discontinued operations
between year t and year t1, deflated by the market value of equity at the beginning
of year t;
COMP t = the percentage change in the CEOs cash compensation between year t and t 1;
RET t = the cumulative stock market return over the 12-month period of the firms fiscal year
t;
CRC = compensation returns coefficient estimated by firm or industry from equation (3) (i.e.,
coefficient on RET ;
EARN 2t = EARN t if year 1986, and = 0 otherwise;
RET 2t = RET t if year 1986, and = 0 otherwise;
CRC = change in the compensation returns coefficient estimated by firm or industry from
equation (5) (i.e., coefficient on RET 2).
between CECs and VECs indicates the existence of a positive association

between valuation and stewardship weights placed on earnings.
Table 3 reports further details from the by-firm and by-industry models
of changes in CECs and VECs. Specifically, we report descriptive statistics
of the coefficient estimates from models (4) and (5). While the magnitude
and direction of changes in CECs and VECs over the sample period is not
the primary motivation of our analyses, we present information about the
TABLE 3
Estimation of Valuation Earnings Coefficients (VECs) and Compensation Earnings Coefficients (CECs)
over the Period 19712000
XRET t = VEC 1 EARN 2t + VEC EARN 2t + t (4)

COMP t = CEC 1 EARN t + CEC EARN 2t + CRC 1 RET t + CRC RET2 t + t (5)
Market-Adjusted Returns (XRET ) % Change in Compensation (COMP )

Dependent
Variable VEC 1 VEC Adj. R 2 CEC 1 CEC CRC 1 CRC Adj. R 2
Firm-specific estimations (N = 379):
Mean 3.08 0.50 0.13 2.62 0.08 0.04 0.11 0.17
Median 2.51 0.86 0.10 1.54 0.18 0.03 0.06 0.14
Std. Dev. 3.77 4.95 0.16 4.46 5.55 0.26 0.44 0.23
Z -stat. 21.6 4.85 15.73 1.42 3.70 4.72
(p-value) (<0.001) (<0.001) (<0.001) (0.16) (<0.001) (<0.001)
# positive 334 145 304 200 218 224
(p-value
binomial test) (<0.001) (<0.001) (<0.001) (0.28) (0.004) (<0.001)
Industry estimations (N = 28):
Mean 1.46 0.81 0.34 0.82 0.19 0.10 0.10 0.11
Median 1.40 0.70 0.33 0.38 0.10 0.09 0.08 0.10
Std. Dev. 1.06 1.19 0.15 1.25 1.56 0.13 0.17 0.09
Z -stat. 7.44 3.66 6.00 0.31 4.51 3.52
(p-value) (<0.001) (<0.001) (<0.001) (0.76) (<0.001) (<0.001)
# positive 27 5 26 12 23 20
(p-value
binomial test) (<0.001) (<0.001) (<0.001) (0.035) (0.001) (0.038)
XRET t = the cumulative, market-adjusted return over the 12-month period of the firms
fiscal year.
COMP t = the percentage change in annual cash compensation between year t and year
t1.
EARN t = the change in earnings before extraordinary items between year t and year t1,
deflated by the market value of equity at the beginning of year t.
EARN2 t = EARN t if year 1986, and = 0 otherwise.
RET t = the cumulative stock market return i over the 12-month period of the firms fiscal year t;
RET2 t = RET t if year 1986, and = 0 otherwise.
VEC 1 = estimate of VEC for the first subperiod computed as the coefficient on EARN t from the
estimation of equation (4).
CEC 1 = estimate of CEC for the first subperiod determined by the coefficient on EARN t from the
estimation of equation (5).
CRC 1 = estimate of the compensation returns coefficient (CRC) for the first subperiod determined
by the coefficient on RET t from the estimation of equation (5).
VEC = estimate of the change in VEC between the two subperiods determined by the coefficient
on EARN 2t from the estimation of equation (4).
CEC = estimate of the change in CEC between the two subperiods determined by the coefficient on
EARN 2t from the estimation of equation (5).
CRC = estimate of the change in the compensation returns coefficient (CRC) between the two
subperiods determined by the coefficient on RET 2t from the estimation of equation (5).
Z -stat. = test of whether the average coefficient from the 28 industry regressions is different from
zero, adjusting for cross-sectional dependency between the 28 observations, calculated as:

Z = (N 1)1/2 ([ ti /N]/stddev(t )) where N = 28, the number of t-statistics to be aggre-
gated; t i = t-statistic from regression of industry i; and stddev(t) = standard deviation of the
t-statistics.
coefficient estimates underlying equations (4) and (5), as these estimates are
used in both our univariate and multivariate tests. Further, the nature of the
changes in CECs and VECs over the sample period may provide interesting
insights about extent of correlation between these coefficients.
Table 3 reports that the mean firm-specific VEC in the first subperiod
is 3.08 and drops by an average of 0.50 in the second subperiod, a 16%
decline, on average. This average decline in VECs from the first to the second
subperiod (i.e., VEC) across firms is negative and significantly different
from zero (Z -statistic = 4.85, p-value < 0.001). The industry analyses of
VECs document a mean first subperiod VEC of 1.46 followed by an average
decline of 0.81 in the second subperiod, an average 55% decline. The
average decline in VECs across industries is significant with a Z -statistic of
3.66 (p-value < 0.001).
In contrast, we find slightly smaller average estimates of first period CECs
followed by average changes in CECs across firms and industries that are not
significantly different from zero. Firm-specific CECs average 2.62 in the first
subperiod with an average shift of 0.08 from the first to the second subpe-
riod (an average 3% decline). The shift across subperiods is not significantly
different from zero (Z -statistic = 1.42, p-value = 0.16). The industry analy-
ses produce similar inferences with a mean first period CEC of 0.82 followed
by an insignificant average decline of 0.19.16 , 17
For completeness, we also report the weights placed on market returns in
the compensation equation (CRC). We compute CRCs from estimations of
equation (5) for both firm and industry analyses. The average CRC across
firms in the first period (CRC 1 ) is 0.04, which is significantly greater than
zero (Z -statistic = 3.70). In contrast to the CEC estimates, the average firm-
specific change in the coefficient on stock returns (CRC) across subperi-
ods is positive (0.11) and is significantly different from zero (Z -statistic =
4.72). Likewise, the average first-period estimate of industry CRCs is
0.10 (Z -statistic = 4.51) and roughly doubles in the second period, with an
average shift of 0.10 (Z -statistic = 3.52). These results document an increas-
ing weight on other public performance information in the determination
of cash compensation across the two subperiods.
4.2 MULTIVARIATE ANALYSIS OF RELATIONS BETWEEN CECS AND VECS

While we focus on links between CECs and VECs, prior literature posits
other factors as determinants of CECs. We consider the importance of
16 We also conduct nonparametric binomial tests of the direction (ignoring magnitude) of
the change in VECs (CECs). The binomial tests suggest a significant negative shift in firm-
specific VECs, with 234 of 379 firms (p-value < 0.001) experiencing a negative change in VECs,
and a statistically insignificant change in CECs between the two subperiods, with 179 of 379
firms experiencing a negative change in CEC (p-value = 0.28). Qualitatively similar results are
found for binomial tests of the direction of changes in industry VECs and CECs.
17 While predictions of industry-specific changes in VECs and CECs are beyond the scope of
the paper, we observe that the VEC in the first subperiod is positive for 27 of the 28 industries
(and significantly greater than zero at the 5% level in 25 of these cases). The VEC decreased
significantly for 13 industries and increased significantly for two industries from period 1 to
period 2. The CEC in the first subperiod is positive for 26 of the 28 industries (and significantly
greater than zero at the 5% level) for 11 industries. The CEC decreased significantly for three
industries and increased significantly for four industries from period 1 to period 2.
growth opportunities, noise in earnings and in other public performance

information, and regulation. Controlling for cross-sectional differences in
performance measure noise is especially important, as discussed in section
2, since the Paul [1992] framework that yields the null hypotheses of no
relation suggests the importance of holding variation in noise constant. In
this section, we continue to document a positive relation between CECs and
VECs using firm and industry specifications after controlling for these other
determinants.
To explore a systematic link between CECs and VECs, we estimate the
following multivariate regression (the predicted sign of the relation with
CECs is noted below each variable):
CEC j = 0 + 1 VEC j + 2 GRO OP j

+
+ 3 NOISE EARN j + 4 NOISE RET j + 5 REG j + j (6)

+ +
where: CEC j = estimated compensation earnings coefficient for firm

j or industry j based on equation (3);
VEC j = estimated valuation earnings coefficient for firm j or
industry j based on equation (2);18
GRO OP j = proxy for the importance of growth opportunities for
firm or industry j;
NOISE EARN j = proxy for the performance measure noise in earnings
for firm or industry j;
NOISE RET j = proxy for the performance measure noise in returns
for firm or industry j; and
REGj = 1 if the firm/industry is airlines, banking, telecommu-
nications, or utility and 0 otherwise.
Similar models are estimated for the changes specifications across both
firms and industries with signaling that the variable reflects the change in
the variable for the firm or industry from subperiod 1 to subperiod 2. For
the changes models, VEC and CEC are estimated for firms and industries
using equations (4) and (5), respectively as described above.
We next describe our proxies for importance of growth opportuni-
ties, noise in earnings and other public performance information, and
regulation.
18 Murphy and Topel [1985] propose an adjustment to standard error estimates to eliminate
potential bias in settings in which regressors are estimated in a first-stage estimation, as is the
VEC in equations (2) and (4). Pagan [1984], however, illustrates that standard error estimates
are consistent in settings with a null hypothesis of a zero coefficient. We conduct Whites tests for
heteroskedasticity (White [1980]), which do not reject the null hypothesis of homoskedasticity
for each model.
Importance of Growth Opportunities Relative to Assets in Place. Prior research

documents that the weight on earnings in cash compensation declines as the
importance of growth opportunities increases (e.g., Lambert and Larcker
[1987], Bushman, Indjejikian, and Smith [1996], Ittner, Larcker, and Rajan
[1997], and Smith and Watts [1992]). The idea is that with significant growth
opportunities, expansive investment opportunity sets, and long-term invest-
ment strategies, earnings exhibit low sensitivity relative to current manage-
rial actions. We use two proxies to capture the importance of growth oppor-
tunities. We compute median firm and industry market-to-book values of eq-
uity (MTB), and the median firm and industry sales growth (SALES GROW )
over the sample period. Median firm market-to-book values are computed
using all years available for the firm over the sample period, while median
industry market-to-book values are based on all firm-years in the industry
in the sample period. We compute the annual sales growth for each firm
as one plus the percentage change in sales level from year t1 to year t. As
with MTB, the median firm sales growth is based on all years available for
the firm, while median industry sales growth is based on all firm-years in the
industry. Likewise, we compute the changes between subperiods in these
measures as the change between subperiods in median firm and industry
market-to-book values of equity (MTB), and the change in median firm
and industry sales growth between subperiods (SALES GROW ).
We employ a principal components analysis for both the levels and
changes in variables to address multicollinearity between these proxies and
measurement error. The principal components analyses using the firm and
industry data produce first principal components that explain between 57%
and 70% of the variation in the level of and changes in the variables. All
analyses produce first principal components with an eigenvalue greater than
one. We use the first principal component to measure the level of (change
in) growth opportunities, GRO OP (GRO OP ) at both the firm and indus-
try level.19
Performance Measure Noise. Agency theory suggests that noise in perfor-

mance measures disguises managerial actions and imposes a cost on the
agency as managers must be compensated for bearing risk (e.g., Lambert
[2001]). Empirically, there is not universal agreement on how to proxy for
such noise (e.g., see discussions in Bushman and Smith [2001] and Core
and Guay [2002]). We use three proxies to measure the change in the noise
in earnings with respect to managers actions.
The first, 2 EARN , is based on the time-series variance of annual changes
in earnings before extraordinary items and discontinued operations. We
compute the firm-specific 2 EARN for each firm with at least 10 observations
19 We adopt the latent root criterion method that selects principal components with eigen-
values greater than one (see Johnson and Wichern [1992]). In this study, the first principal
component for each construct explains a large proportion of the variance and is the sole
component with an eigenvalue great than one.
over the sample period. Likewise, we compute the firm-specific 2 EARN

as the change in time-series variance between subperiods based on all firms
for which 10 observations are available in each subperiod. Industry 2 EARN
is the median industry time-series variance over the sample period based on
all firms in the industry and industry 2 EARN is computed as the change
in the median industry time-series variance between subperiods based on
all firms in the industry within the subperiod.
The second proxy, 2 SYS EARN , captures the variance of the system-
atic component of earnings changes. Specifically, we decompose earnings
changes using firm-specific time-series regressions over the sample period
of changes in earnings before extraordinary items and discontinued items
on annual market valueweighted averages of earnings changes of Compu-
stat firms. Firm-specific 2 SYS EARN is computed over the full sample pe-
riod, while 2 SYS EARN captures the change in subperiod 2 SYS EARN.
Industry 2 SYS EARN reflects the median industry variance of the sys-
tematic component of earnings changes over the sample period while
2 SYS EARN is the change between subperiods in the median industry
subperiod 2 SYS EARN.
Finally, our third proxy, 2 ABS ONETIME, is computed as variance of the
absolute value of the annual ratio of changes in one-time items (i.e., ex-
traordinary items, discontinued operations, and special items, net of tax)
to changes in earnings before one-time items. As with the variance of earn-
ings proxies above, firm-specific 2 ABS ONETIME is computed from annual
values over the full sample period, while 2 ABS ONETIME captures the
change in subperiod 2 ABS ONETIME. Industry 2 ABS ONETIME reflects
the median industry variance in the absolute value of the ratio for each firm
in the industry while 2 ABS ONETIME captures the change between sub-
periods in the median industry subperiod 2 ABS ONETIME. These three
proxies are condensed using principal component analysis. The principal
components analyses using the firm and industry data produce first prin-
cipal components that explain between 62% and 67% of the variation in
the level of and changes in the variables. All analyses produce first principal
components with an eigenvalue greater than one. We use the first principal
component for both the firm and industry analyses to measure the level of
(change in) the noise in earnings, NOISE EARN (NOISE EARN ).
We also use two proxies for noise in other public performance infor-
mation to control for the fact that the noise in alternative performance
measures may impact the incentive weight placed on earnings. The first
proxy, 2 RET , is based on the time-series variance of raw stock returns. We
compute firm-specific 2 RET for each firm with at least 10 observations
over the sample period and 2 RET for all firms for which 10 observations
are available in each subperiod. Industry 2 RET is the median industry
time-series variance over the sample period based on all firms in the in-
dustry and industry 2 RET is computed as the change in the median
industry time-series variance between subperiods based on all firms in the
industry in each subperiod.
The second proxy, 2 SYS RET , captures changes in the variance of the
systematic component of returns on the basis of firm-specific time-series re-
gressions of returns on annual market valueweighted averages of returns
of CRSP firms. Firm-specific 2 SYS RET is computed over the full sample
period, while 2 SYS RET captures the change in subperiod 2 SYS RET.
Industry 2 SYS RET reflects the median industry variance of the systematic
component of the returns over the sample period, while 2 SYS RET is the
change between subperiods in the median industry subperiod 2 SYS RET.
The principal components analyses using the firm and industry data pro-
duce first principal components that explain between 72% and 89% of the
variation in the level and changes in the variables. All analyses produce first
principal components with an eigenvalue greater than one. We use the first
principal component for both the firm and industry analyses to measure
the level of (change in) the noise in other public performance information,
NOISE RET (NOISE RET ).
Regulatory Environment. Executives in highly regulated industries arguably

have less influence over shareholder value, leading to the prediction that
the impact of earnings on executive pay is lower in heavily regulated in-
dustries.20 We use a dummy variable to capture changes in regulation (i.e.,
deregulation) of the banking, telecommunication, airline, and utility indus-
tries over the sample period (REG). We expect a positive relation between
changes in the compensation weight on earnings and our dummy variable
proxying for deregulation.
Descriptive Statistics. Table 4 presents descriptive statistics for all model vari-
ables for both the firm and industry analyses. Panel A captures the levels of
the variables over the full sample period and panel B captures the changes in
the variables between the two subperiods of the sample. Not surprisingly, we
observe generally higher standard deviations in both levels of and changes
in the variables when measured on a by-firm basis, as a result of the relatively
lower number of observations per firm used to compute mean values com-
pared with the industry values. While we make no specific predictions about
shifts in the variables across subperiods, we note that a number of variables
experience a significant shift in mean (median) values based on a paired
t-test (the Wilcoxon signed rank test). Consistent with table 3, VECs and
CECs are negative, on average, but only VECs are significantly different
from zero. The two growth proxies, MTB and SALES GROW , experi-
ence a significant shift in both the firm and industry analyses, but in oppo-
site directions, with MTB experiencing an increase and SALES GROW
20 Joskow, Rose, and Shepard [1993] document lower levels of pay and less incentive pay in
regulated firms than in unregulated firms, with more dramatic differences when regulations
are tighter. Hubbard and Palia [1995] provide evidence that deregulation activities in the
banking industry positively impact the extent of use of incentive pay.
72
TABLE 4
Descriptive Statistics for Models Variables
Panel A: Levels of regression variables over the period 19712000. Descriptive statistics are computed on both a by-firm and by-industry basis.
Mean Median Std. Dev. 25th percentile 75th percentile
Variable Firm Industry Firm Industry Firm Industry Firm Industry Firm Industry
Dependent variables
VEC 2.27 0.72 1.67 0.78 3.19 0.53 0.75 0.33 3.51 0.96
CEC 2.12 0.59 1.37 0.41 3.27 0.63 0.39 0.07 3.17 0.85
Independent variables
GRO OP
MTB 1.740 1.731 1.396 1.502 0.997 0.677 1.127 1.293 1.929 2.03
SALES GROW 1.094 1.109 1.089 1.093 0.041 0.045 1.071 1.080 1.114 1.133
R. BUSHMAN, E. ENGEL, AND A. SMITH
NOISE EARN
2 EARN 0.0301 0.004 0.002 0.0002 0.263 0.006 0.0002 0.001 0.007 0.004
2 SYS EARN 0.002 0.0004 0.0001 0.0001 0.012 0.001 0.0000 0.00003 0.0004 0.0004
2 ABS ONETIME 0.172 0.067 0.067 0.042 0.251 0.064 0.009 0.020 0.208 0.104
NOISE RET
2 RET 0.104 0.112 0.081 0.105 0.090 0.045 0.060 0.078 0.117 0.130
2 SYS RET 0.024 0.026 0.018 0.022 0.024 0.018 0.009 0.017 0.032 0.032
PERSIST
PERS TS1 0.108 0.140 0.168 0.133 0.345 0.060 0.274 0.189 0.032 0.098
PERS TS2 0.696 0.795 0.741 0.840 0.461 0.162 0.356 0.701 1.029 0.914
LW SW 3.085 0.248 1.692 0.291 6.412 0.391 0.378 0.53 4.689 0.049
Panel B: Changes in regression variables for the subperiods 19711985 and 19862000. Descriptive statistics are computed on both a by-firm and by-industry basis.
Mean Median Std. Dev. 25% percentile 75% percentile
Variable Firm Industry Firm Industry Firm Industry Firm Industry Firm Industry
Dependent variables
VEC 0.50 0.81 0.86 0.70 4.95 1.19 3.10 1.46 1.36 0.14
VEC1 3.08 1.46 2.51 1.40 3.77 1.06 0.92 0.47 4.69 2.19
VEC2 2.58 0.65 1.38 0.57 4.77 0.65 0.30 0.25 3.47 0.89
CEC 0.08 0.19 0.18 0.10 5.55 1.56 2.49 0.31 2.51 0.53
CEC1 2.62 0.82 1.54 0.38 4.46 1.25 0.25 0.12 3.85 1.05
CEC2 2.53 0.63 1.81 0.26 4.97 0.83 0.20 0.12 4.25 1.13
Independent variables
GRO OP
MTB 0.962 0.985 0.697 0.797 1.272 0.535 0.371 0.626 1.104 1.191
SALES GROW 0.058 0.028 0.059 0.028 0.066 0.045 0.096 0.051 0.023 0.005
NOISE EARN
2 EARN 0.007 0.004 0.0002 0.0001 0.119 0.032 0.001 0.0016 0.003 0.0012
2 SYS EARN 0.001 0.0001 0.0000 0.0001 0.022 0.002 0.002 0.0003 0.0001 0.0000
2 ABS ONETIME 0.267 0.144 0.077 0.089 0.447 0.132 0.007 0.041 0.304 0.233
NOISE RET
2 RET 0.012 0.014 0.009 0.018 0.129 0.047 0.053 0.045 0.040 0.006
2 SYS RET 0.011 0.021 0.008 0.017 0.046 0.022 0.028 0.035 0.009 0.006
PERSIST
PERS TS1 0.189 0.091 0.121 0.049 0.877 0.197 0.356 0.174 0.087 0.074
PERS TS2 0.339 0.245 0.249 0.244 0.735 0.506 0.930 0.494 0.122 0.015
LW SW 0.640 0.618 0.142 0.061 11.425 1.581 4.173 0.862 3.105 0.264

, indicates paired t-test (mean) or Wilcoxon signed rank test (median) that the change is equal to zero is rejected at the 1% and 5% probability levels, respectively.
MTB = the median annual market-to-book ratio over the sample period across sample firms or industries;
SALES GROW = the median sales growth rate over the sample period across sample firms or industries;
2
EARN = the variance of earnings changes over the sample period for all sample firms or industries;
2 SYS EARN = the variance of the systematic component of earnings changes over the sample period for all sample firms or industries;
2
ABS ONETIME = the variance of the ratio of one time items to core earnings over the sample period for all sample firms or industries;
2 RET = the variance of total stock market returns over the sample period for all sample firms or industries;
2 SYS RET = the variance of the systematic component of total stock market returns from period 1 to period 2 for all sample firms or industries.
STEWARDSHIP AND VALUATION ROLES OF EARNINGS
PERS TS1 = the median annual persistence in earnings estimated from an ARIMA (2,1,0) model over the sample period for all sample firms or industries;
PERS TS2 = the median annual persistence in earnings estimated from an IMA(1,1,0) model over the sample period for all sample firms or industries;
LW SW = the difference between the long-window (3 years) and short window (1 year) earnings response coefficient over the sample period for all sample firms or
industries;
73
denotes the change in the dependent variable from subperiod 1 to subperiod 2 for sample firms or industries.
displaying a decrease across the subperiods. Despite these differences in

the average values of the direction of the shift, the shifts in the two growth
variables are significantly positive correlated ( = 0.59 and 0.69 for the firm
and industry analyses, respectively). Panel B also documents significant neg-
ative shifts in the variance of the systematic component of stock returns and
in the time series persistence measures (discussed in the next section) and
significant positive increases in the variance of the ratio of one-time items
to core earnings.
Regression Results. Estimations of equation (6) are reported in

table 5 for both firm and industry models. Levels (changes) estimation
results are presented in panel A (panel B). In both panels, columns
(1) through (3) reflect the by-firm estimations and columns (4) through
(6) capture the by-industry estimations. Column (1) of panel A docu-
ments a positive and significant relation between firm-specific VEC and
CEC(t-statistic = 3.60), after controlling for other determinants of CECs.
Thus, as in the univariate tests, the multivariate tests do not support the
null hypothesis of no relation between coefficients on earnings in in-
centive and valuation settings and, instead, document a significant pos-
itive relation between the weights on earnings in these two settings. In
TABLE 5
Cross-sectional regression results for determinants of Compensation Earnings Coefficients (CECs) as a

function of Valuation Earnings Coefficients (VECs) and control variables
Panel A: Results for levels analyses over the period 19712000.
CEC j = 0 + 1 VEC j + 2 GRO OP j + 3 NOISE EARN j
+ 4 NOISE RET j + 5 REG j + j (6)
Level of CEC
Firm Industry
Variable Pred. (1) (2) (3) (4) (5) (6)
INTERCEPT 1.81 2.37 1.77 0.17 0.64 0.04
(7.01) (11.00) (6.40) (0.93) (5.07) (0.25)
VEC (+) 0.21 0.22 0.63 0.78
(3.60) (3.37) (3.28) (4.20)
PERSIST (+) 0.05 0.14 0.07 0.17
(0.33) (0.91) (0.81) (2.39)
GRO OP () 0.80 1.05 0.84 0.04 0.07 0.04
(4.74) (6.11) (4.60) (0.37) (0.54) (0.36)
NOISE EARN () 0.19 0.24 0.20 0.03 0.04 0.01
(1.38) (1.70) (1.42) (0.31) (0.45) (0.08)
NOISE RET (+) 0.14 0.18 0.16 0.10 0.11 0.15
(0.93) (1.14) (1.05) (1.13) (1.01) (1.91)
REG (+) 0.93 1.10 1.04 0.27 0.37 0.15
(2.66) (2.91) (2.81) (0.98) (1.10) (0.56)
Adjusted R 2 0.17 0.15 0.17 0.33 0.03 0.45
N 377 348 348 28 28 28
T A B L E 5 Continued
Panel B: Results for changes analyses from subperiod 1 (19711985) to subperiod 2
(19862000).
CEC j = 0 + 1 VEC j + 2 GRO OP j + 3 NOISE EARN j
+4 NOISE RET j + 5 REG j + j
Change in CEC
Firm Industry
Variable Pred. (1) (2) (3) (4) (5) (6)
INTERCEPT 0.37 0.32 0.32 0.56 0.12 0.65
(0.92) (0.77) (0.76) (2.13) (0.47) (2.05)
VEC (+) 0.01 0.01 0.68 0.81
(0.17) (0.07) (3.29) (2.48)
PERSIST (+) 0.66 0.66 0.34 0.13
(2.45) (2.40) (1.93) (0.51)
GRO OP () 0.75 0.80 0.81 0.61 0.60 0.60
(2.38) (2.61) (2.45) (3.10) (2.70) (3.04)
NOISE EARN () 0.18 0.17 0.16 0.10 0.02 0.09
(0.71) (0.66) (0.65) (0.60) (0.13) (0.51)
NOISE RET (+) 0.33 0.25 0.25 0.16 0.03 0.19
(1.17) (0.87) (0.87) (0.72) (0.12) (0.81)
REG (+) 0.26 0.16 0.16 1.42 2.18 1.30
(0.35) (0.21) (0.20) (1.94) (2.80) (1.66)
Adjusted R 2 0.01 0.03 0.03 0.49 0.34 0.47
N 300 273 273 28 28 28

, Significant at the 5% and 1% levels, respectively, for a one-tailed test where sign is predicted,
two-tailed test otherwise.
CEC = estimated compensation earnings coefficient for firm or industry j from equation (3).
CEC = estimate of the change in CEC between the two subperiods determined by the coefficient
VEC = estimated earnings coefficient for firm or industry j from equation (2).
VEC = estimate of the change in VEC between the two subperiods determined by the coefficient
PERSIST = principal component for persistence construct formed from PERS TS1, PERS TS2, and
LW SW (see table 4);
GRO OP = principal component for growth opportunities not reflected in current earnings formed
from MTB and SALES GROW (see table 4);
NOISE EARN = principal component for noise in earnings construct formed from 2 EARN ,
2 SYS EARN , and 2 ABS ONE (see table 4);
NOISE RET = principal component for noise in other public performance information construct
formed from 2 RET and 2 SYS RET (see table 4);
REG = 1 if two-digit SIC code is 45 (airlines), 48 (communications), 49 (utilities), or 60
(banking)industries that underwent major deregulation from subperiod 1 to sub-
period 2.
for all variables other than CEC and EC denotes the change in the dependent
variable from subperiod 1 to subperiod 2 for firm or industry j.
addition, the coefficient on growth opportunities (GRO OP ) is positive and

significant, which is opposite from our expectation. The coefficients on
noise in earnings (NOISE EARN ) and noise in other public performance
information (NOISE RET ) are negative and positive, respectively, as pre-
dicted, but are not significantly different from zero. Finally, the coefficient
on deregulation is negative, which is opposite of our expectation from prior
research.
We also consider the nature of the documented relation between CECs

and VECs by expanding the regression model to include a proxy for the
persistence of earnings. Our interest in probing the impact of persistence
is partially related to the Baber, Kang, and Kumar [1998] result that the in-
centive weight on earnings increases with earnings persistence, which they
attribute to the Board of Directors interest in countering myopic decision
making by managers. We posit an alternative potential role for persistence
in contracting that arises from managers actions possessing multiperiod ef-
fects that are not fully captured in current earnings. This multiperiod effect
is captured through the valuation role of earningsearnings persistence
thus plays a possible role in contracting via its impact on VECs. We, there-
fore, include a proxy for persistence along with VEC in our cross-sectional
model of determinants of CECs to gauge the incremental explanatory power
of persistence beyond its role in VECs.
We compute three proxies of earnings persistence. First, we measure
persistence in the time series of changes in earnings before extraordinary
items and discontinued operations using an Autoregressive Moving-Average
(2,1,0) model. We estimate rolling annual firm-specific regressions from
1971 to 2000 for all firms for which 10 consecutive years of data are avail-
able for each estimation.21 We aggregate across annual firm and industry
values over the sample period to compute median firm and industry persis-
tence measures, PERS TS1. Likewise, we compute subperiod median firm
and industry persistence values to allow a computation of the change in
persistence as the change in median persistence for each firm (or industry)
from period 1 to period 2 (PERS TS1).
Second, we follow Baber, Kang, and Kumar [1998] by estimating rolling
annual firm-specific Integrated Moving-Average(1,1) models for all firms
for which 10 consecutive years of data are available for each estimation.22
As with PERS TS1, we compute median persistence by firm and industry
over the sample period to create the second time-series persistence mea-
sure, PERS TS2. We use median subperiod persistence values to compute
the median shift in firm and industry values, PERS TS2, as the change in
median persistence for each firm and industry from period 1 to period 2.
Third, we use differences between long and short window earnings re-
sponse coefficients.23 We estimate short window earnings response coeffi-
cients from firm- and industry-specific regressions of annual market-adjusted
21 Specifically, we estimate EARN = a + b EARN
t 0 1 t 1 + b 2 EARN t 2 + t annually for
each firm with 10 years of complete data. An annual persistence proxy is then computed for
each firm using Kormendi and Lipes [1987] PVR measure capturing the sum of the present
value of expected future earnings assuming a 10% discount rate.
22 See Baber, Kang, and Kumar [1998] for further discussion of the IMA(1,1) model. As in
Baber, Kang, and Kumar [1998], our measure of persistence is computed as 1 , where is
the IMA(1,1) parameter.
23 Beaver, Lambert, and Morse [1980] and Beaver, Lambert, and Ryan [1987], among others,
find that stock prices lead accounting earnings. Kothari and Sloan [1992] document that
returns measured over three leading years contain information about an annual earnings
change, and conjecture that this effect relates to the persistence, or permanence, of earnings.
returns on contemporaneous annual earnings before extraordinary items

and discontinued items over the sample period. We estimate long window
earnings response coefficients analogously, using three-year return windows
(current and two lagged years) regressed against annual earnings. Our
proxy, LW SW , is the difference between long and short window VECs. We
also develop a similar proxy for the shift in this measure, using a similar
regression model that also allows the slope on earnings to differ across sub-
periods. LW SW is then computed as the change across subperiods in the
difference between long and short window VECs.
These three measures are grouped to allow determination of principal
components. The principal components analyses using the firm and indus-
try data produce first principal components that explain between 50% and
74% of the variation in the level of and changes in the variables. All analyses
produce first principal components with an eigenvalue greater than one.
We use the first principal component to measure the level of (change in)
persistence of earnings, PERSIST (PERSIST ), at both the firm and industry
level.
The results of the regression estimations that incorporate the persistence
measures are reported in columns (2) and (3) of table 5 for the firm-specific
analyses. Column (2) reflects equation (6) in which VEC is replaced with
PERSIST , to gauge the importance of persistence as a driver in the rela-
tion between CECs and VECs, while column (3) includes both VEC and
PERSIST to assess any incremental contribution of the two measures rela-
tive to each other. The results in columns (2) and (3) indicate that PERSIST
is not significant in either firm-specific specification, suggesting that the
persistence of earnings is not a factor in determining CECs either on its own
or through its role in VECs in the by-firm analyses. We note in column (3)
that the coefficient on VEC remains positive and significant in the presence
of PERSIST .
Columns (4) through (6) present similar analyses for the industry-level
models. As with the firm-level models, the coefficient on VEC in the VEC
only model (column [4]) is positive and significant (t-statistic = 3.28). In
contrast to the firm analyses, the coefficients on both VEC and PERSIST
are positive and significant in the model that includes both proxies (col-
umn [6]). Interestingly, the significance of PERSIST is conditional on the
inclusion of VECPERSIST is not significant in the column (5) PERSIST
only model. The significance of both VEC and PERSIST in the column (6)
model suggests that, while persistence is associated with CECs through its
role in determining VECs, other factors captured by VECs are also linked
with CECs.24 This offers an interesting contrast to Baber, Kang, and Kumar
[1998], who focus on the persistence of earnings as the primitive construct.
Our result suggests that the VEC may be the primitive construct, while per-
sistence works through the VEC.
24 We also included an estimate of beta in the regression. The coefficient on beta was not
significantly different from zero.

Panel B of table 5 presents the results of equation (6) for the analyses of
changes in CECs and VECs for both firm-specific and industry models. The
firm-specific changes results contrast with the firm-specific levels analyses in
that it is the coefficient on PERSIST that is significant in the model, while
the coefficient on VEC is not significant. Recall that, in the univariate anal-
yses in section 4.1, the firm-specific changes model was the only specification
that did not produce significant correlation between CECs and VECs. These
results suggest that changes in firm-specific CECs are impacted by the per-
sistence of earnings, independent of any role that earnings persistence may
have in the valuation process. The results of the industry shifts model, how-
ever, are more consistent with the panel A levels analysesthe coefficient
on VEC is positive and significant both on its own (column [4]) and in
the presence of the earnings persistence variable (column [6]). PERSIST
is marginally significant (t-statistic = 1.93) in the model without VEC, but
its significance declines when VEC is included, suggesting that while per-
sistence may impact CECs, it appears to do so through its role in VECs. We
observe that the coefficient on GRO OP is negative and significant in both
the by-firm and by-industry changes analyses, consistent with expectations
from prior research discussed in section 4.1, while other control variables
are not significant in the changes models.
Collectively, the results of the multivariate analyses validate the univari-
ate results by documenting a strong relation between CECs and VECsthe
estimated coefficient on the VEC measures is positive and significant in all
but the by-firm changes model. The estimations produce somewhat less
consistent evidence on the impact of earnings persistence measures, linked
with VECs in our theoretical modelPERSIST is significantly associated with
CECs in three of the four specifications but its significance varies within two
of the specifications depending on whether VEC is included in the model.
Nonetheless, VEC coefficients remain significant in the presence of PERSIST
(and other control variables) suggesting that while PERSIST may be linked
with CECs (as documented by Baber, Kang, and Kumar [1998]), the impact
of the overall valuation role of earnings appears to have a more dominant
relation with CECs.
5. Summary and Conclusions

It is widely accepted that published financial accounting reports seek to
serve multiple purposes. The nature of these competing purposes impacts
existing accounting regimes in subtle and important ways. Thus, under-
standing relations among the multiple roles of accounting information is
important to a complete understanding of the forces shaping accounting
and reporting practices. In this paper, we contribute to this undertaking by
investigating the link between the weight placed on earnings in compen-
sation contracts (CEC) and the weight placed on earnings in stock price
formation (VEC).
Following the economic logic underlying Paul [1992], we examine the
null hypothesis that VECs and CECs are unrelated. We investigate links
between CECs and VECs using CEO annual cash compensation from Forbes
compensation surveys over the 30-year period from 1971 to 2000. We con-
duct empirical analyses of the association between the levels of both firm and
industry CECs and VECs. We document a strong positive relation between
CECs and VECs in both univariate and multivariate analyses. We also employ
a specification that probes changes from the first half to the second half of
the 19712000 sample period for both firm and industry specifications. We
document a strong positive association between average industry changes in
CECs and VECs across the two subperiods. The association between average
firm-specific changes in CECs and VECs, however, is not statistically signifi-
cant. Taken together, the strong positive association between CECs and VECs
in three of our four specifications leads us to reject the null hypothesis of no
relation in favor of the alternative hypotheses of a link between the two key
uses of earnings.We also find that the positive association between CECs and
VECs is robust to the inclusion of persistence in multivariate regressions.
Our analyses add to the small body of evidence in support of agency the-
orys predictions concerning pay-performance sensitivities. In addition, our
analyses extend existing research by suggesting a more direct link between
pay-earnings and price-earnings sensitivities as a means of connecting the lit-
erature addressing the stewardship and valuation roles of reported earnings.
APPENDIX
Implications for VEC and CEC of stochastic marginal product and sensitivity
of earnings to effort
This appendix presents an alternative model to Paul [1992] that adapts
the Paul [1992] framework to allow for a possible association between the op-
timal weights on earnings in valuation and contracting settings. This formu-
lation models the marginal product of effort and the sensitivity of earnings
to the managers actions as correlated random variables whose distributions
are common knowledge. In the Paul [1992] framework these are determin-
istic parameters. A risk-neutral owner hires a risk-neutral agent who receives
private information after signing the contract but prior to taking actions.25
Let unobservable firm value be given by V = V e and earnings by
EARN = E e . The marginal product of effort is given by v N(, V2 ), the
sensitivity of earnings to effort by E N(, E2 ), and Cov(V , E ) > 0.26
The managers cost of effort is again given by 0.5e 2 , and the principal offers
a linear contract w = 0 + CEC EARN . To complete the specification, we as-
sume that the manager observes the realization of E after signing the wage
25 The assumption that the manager is risk neutral greatly simplifies the analysis. This as-
sumption is also used in Baker [1992] and Bushman, Indjejikian, and Penno [2000] who also
analyze the risk-averse case. The unobservability of V implies that the firm cannot be sold to
the manager. With risk aversion, the agents risk aversion parameter would impact the CEC.
26 The fact that the means are assumed equal is without loss of generality and is done primarily
for notational simplicity. If they we not equal, a simple rescaling could make them equal. See
Baker [1992] for more on this.
contract, but before choosing effort, while no one observes the realization
of V .27 The principal thus chooses CEC to maximize:
E [V w] = E [V e 0 CEC EARN ]
subject to:

IR: E 0 + CEC EARN 1/.2(e )2 = U and

IC: for all E , e maximizes E [0 + CEC EARN | E ] 1/.2e 2 .
A few comments on this formulation are in order here. First the incentive
compatibility constraint, IC, must be met for each realization of E , as the
manager observes this realization before choosing effort. Solving IC yields
effort selection e = CEC E , implying that from the principals perspec-
tive, effort is a random variable depending on unobservable realizations of
E . Secondly, when contracts are signed, the principal and manager have
common priors about the state of the world, implying that the agents partic-
ipation constraint, IR, must be met in expectation, and not state by state for
each realization of E . Following Bushman, Indjejikian, and Penno [2000],
the compensation weight on earnings is given by:
2 + Cov(V , E )
CEC = . (A1)
2 + E2
The intuition behind equation (A1) is that the principal increases incen-
tive weight on earnings as the correlation between the managers private
information, E , and the true marginal product of effort, V , increases. Be-
cause firm value is driven by the true marginal product of effort, not E ,
and the agent only cares about earnings, the principal increases incentive
power as the statistical linkage between E and V increases.
Turning to valuation, we again assume risk neutral pricing with price
given by E [V | EARN ; e ( E )]. This notation captures the idea that, in this
setting, market participants correctly conjecture the effort function, e ( E ) =
CEC E , rather than effort level as in the Paul [1992] framework. Given
this conjecture, the market knows that the functional form of earnings is
EARN = E e = CEC 2E . Because CEC is commonly known to all market
participants, the real information set contained in the realization of earnings
is given by 2E . Thus, substituting e = CEC E , price is given by E [V =
V e | EARN ; e ( E )] = CEC E [V E | 2E ].
In general, this expectation is difficult to assess as it involves inferring the
product of random variables conditioned on a random variable squared.
One approach to finessing this difficulty is to assume that all variables are
distributed lognormally rather than normally, producing tractability at the
27 The model could allow the manager to observe a signal y that is imperfectly correlated
with E and V , but at the cost of mathematical complexity that is beyond the scope of this
paper.
cost of additional complexity. However, even without adding significant al-

gebraic complexity, it is obvious that E [V E | 2E ] will, in general, depend
on the Cov(V , E ), creating a link with the CEC in equation (A1). To il-
lustrate this as simply as possible, assume that the mean of the distribution
over E is positive and large enough to make the probability of a nega-
tive realization of E arbitrarily small. Given the markets conjecture about
the managers effort function, then additionally knowing E >0 renders
observation of EARN informationally equivalent to observing 2E = E .
Under normal distribution theory, price is then given by E [V e | E ] =
E [V | E ]e = e (1 VEC) + VEC EARN ,
where
Cov(V , E )
VEC = . (A2)
E2
A comparison of equations (A1) and (A2) completes the analysis. Both the
CEC and VEC increase in Cov(V , E ), as the correlation between earnings
and the marginal product of effort are key to both incentive contracting and
valuation. Cov(V , E )impacts incentive power by capturing the relationship
between the managers objective and marginal product of effort, while for
valuation the market uses EARN to make inferences about marginal product,
V .
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DOI: 10.1111/j.1475-679X.2006.00192.

An Analysis of the Relation between

Received 14 May 2003; accepted 19 September 2005

In this paper, we seek a deeper understanding of how accounting infor-

In particular, the clean distinction between the valuation and incentive

4 We discuss the rationale of our focus on cash compensation in section 2.

correlation between earnings and the marginal product of effort, suggesting

6 Although, as discussed in more detail below, we do include stock returns in addition to

of the use of earnings in contracting on the cash component of executive

2.1 THE NULL HYPOTHESIS

is the weight on earnings in contracting. Finally, the agents preferences

To complete the specification, let equilibrium price be given as E[V | EARN ,

valuation and incentive contracting roles of earnings and CEC depends on

3. Sample and Data

determinants of CECs and VECs.12 Industry analyses, however, may suffer

items that vary cross-sectionally. As a result, we incorporate various control

4. Test of the Association between Pay-Earnings

We estimate firm-specific VECs from the following valuation model for

XRET t = + VEC EARN t + t (2)

where: XRET t = the cumulative, market-adjusted return over the

Likewise, we estimate firm-specific CECs in a regression of changes in

COMP t = + CEC EARN t + CRC RET t + t (3)

XRET t = + VEC 1 EARN t + VEC EARN 2t + t (4)

Firm Analyses (N = 379) Industry Analyses (N = 28)

between CECs and VECs indicates the existence of a positive association

XRET t = VEC 1 EARN 2t + VEC EARN 2t + t (4)

Market-Adjusted Returns (XRET ) % Change in Compensation (COMP )

4.2 MULTIVARIATE ANALYSIS OF RELATIONS BETWEEN CECS AND VECS

16 We also conduct nonparametric binomial tests of the direction (ignoring magnitude) of

growth opportunities, noise in earnings and in other public performance

CEC j = 0 + 1 VEC j + 2 GRO OP j

+ 3 NOISE EARN j + 4 NOISE RET j + 5 REG j + j (6)

where: CEC j = estimated compensation earnings coefficient for firm

Importance of Growth Opportunities Relative to Assets in Place. Prior research

Performance Measure Noise. Agency theory suggests that noise in perfor-

over the sample period. Likewise, we compute the firm-specific  2 EARN

Regulatory Environment. Executives in highly regulated industries arguably

displaying a decrease across the subperiods. Despite these differences in

Regression Results. Estimations of equation (6) are reported in

Cross-sectional regression results for determinants of Compensation Earnings Coefficients (CECs) as a

addition, the coefficient on growth opportunities (GRO OP ) is positive and

We also consider the nature of the documented relation between CECs

returns on contemporaneous annual earnings before extraordinary items

significantly different from zero.

5. Summary and Conclusions

cost of additional complexity. However, even without adding significant al-

BUSHMAN, R.; R. INDJEJIKIAN; AND M. PENNO. Private Predecision Information, Performance

MURPHY, K. J. Executive Compensation, in Handbook of Labor Economics, Volume 3, edited by

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XRET t = + VEC EARN t + t (2)

COMP t = + CEC EARN t + CRC RET t + t (3)

XRET t = + VEC 1 EARN t + VEC EARN 2t + t (4)

XRET t = VEC 1 EARN 2t + VEC EARN 2t + t (4)

over the sample period. Likewise, we compute the firm-specific 2 EARN