| This study examines how shareholders compensate managers using accounting performance measures. While these measures are informative about the manager's production and investment decisions and hence are useful as performance measures in evaluation and motivation, their usefulness is limited by the discretion the manager exercises in the reporting process. The trade-off between the informativeness and discretion associated with these performance measures plays a crucial role in determining the weights assigned to them in the compensation contract. This study first examines the usefulness of discretionary reports in an agency-theoretic setting and develops sufficient conditions for the reports to be useful in contracting. The intuition derived from the theoretical discussion is then used to develop testable empirical hypotheses. The hypotheses are tested using CEO compensation, accrual and cash flow data from a large sample of US firms. It is found that accruals and cash flows are, on average, assigned different weights in CEO compensation contracts and that the weight given to the accrual portion of the earnings is, on average, less than the weight assigned to the cash flow component. This is consistent with the hypothesis that the informativeness of accruals, after adjusting for managerial discretion, is less than that of cash flows. Cross-sectional analysis of the weights on the accrual measure indicates that the perceived discretion is negatively correlated with the weight. It is also found that further decomposition of accruals into discretionary and non-discretionary components improves the explanatory power of the compensation-earnings relationship. It is concluded that, on average, components of earnings, rather than earnings itself, are used as performance measures in US corporations to reward CEOs. |
