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Journal of Accounting and Economics 42 (2006) 167192


www.elsevier.com/locate/jae

Asymmetric sensitivity of CEO cash compensation


to stock returns$
Andrew J. Leonea, Joanna Shuang Wub,, Jerold L. Zimmermanb
a
Smeal College of Business, Pennsylvania State University, University Park, PA 16802-1912, USA
b
William E. Simon Graduate School of Business Administration, University of Rochester,
Rochester, NY 14627, USA
Received 1 March 2004; received in revised form 5 February 2005; accepted 6 April 2005
Available online 5 June 2006

Abstract

We document that CEO cash compensation is twice as sensitive to negative stock returns as it is to
positive stock returns. Since stock returns include both unrealized gains and unrealized losses,
we expect cash compensation to be less sensitive to stock returns when returns contain unrealized
gains (positive returns) than when returns contain unrealized losses (negative returns). This is
consistent with boards of directors exercising discretion to reduce costly ex post settling up in cash
compensation paid to CEOs.
r 2006 Published by Elsevier B.V.

JEL classification: D23; J33; M40; M46

Keywords: Management compensation; Contracting; Pay-performance sensitivity; Ex post settling up

$
We gratefully acknowledge the helpful comments from workshop participants at UC Berkeley, the University
of Chicago, University of Colorado, Cornell University, Georgia State University, Harvard University, Penn
State University, University of Rochester, and the Journal of Accounting and Economics 2004 conference, and
Ray Ball, Dan Bens, Jim Brickley, Patricia Dechow (the referee and discussant), Zhaoyang Gu, Philip Joos, DJ
Nanda, Shail Pandit, Doug Skinner (the editor), Charles Wasley, and Ross Watts. The John M.Olin Foundation
and the Bradley Policy Research Center at the University of Rochester provided support. This paper was
previously titled Conservatism in CEO Cash Compensation.
Corresponding author. Tel.: +1 585 275 5468; fax: +1 585 442 6323.
E-mail address: wujo@simon.rochester.edu (J.S. Wu).

0165-4101/$ - see front matter r 2006 Published by Elsevier B.V.


doi:10.1016/j.jacceco.2006.04.001
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1. Introduction

A number of studies in accounting develop and test theories about how certain
attributes of stock returns and earnings affect their relative use as performance measures in
executive compensation contracts. For example, Lambert and Larcker (1987) test whether
the weight placed on earnings versus returns is a function of their relative signal-to-noise
ratios. Our study extends this research by exploring how other features of stock returns
and earnings, namely the treatment of unrealized gains and losses, inuence the sensitivity
of cash compensation to stock returns and earnings. In particular, we consider how the
inclusion of unrealized gains in a performance measure, such as stock returns, can give rise
to costly ex post settling up. The ex post settling up problem arises when managers are paid
for expected future cash ows that do not materialize. For example, if the CEO receives a
bonus for signing a rm-value increasing long-term contract, but later the contract is
canceled, the stockholders incur costs recouping the bonus paid for expected cash ows
that vanish (Watts, 2003a; Barclay et al., 2005).1
We argue that efcient cash compensation contracts mitigate the ex post settling up
problem by limiting cash distributions to managers for unrealized gains that may later
disappear. We use the term realization to mean the process of converting changes in rm
value into cash or into what can later be converted into cash with a high degree of
certainty. Note that by our denition, realization does not require conversion into cash
itself. For example, accounting revenues are considered to be realized for compensation
purposes due to their high degree of veriability (Watts, 2003a). Another example is the
discovery of a gold deposit by a gold mine company. The CEO should be compensated for
the discovery if the value of the deposit is highly veriable.
If the rm pays the manager a cash bonus for an unrealized gain, but that gain does not
later materialize, the manager can quit the rm and the shareholders will have difculty
recovering the cash paid for that unrealized gain. Managers, like shareholders, have
limited liability, which creates costly ex post settling up when managers are paid for
unrealized gains that evaporate (Watts, 2003a). By not rewarding a CEO immediately with
cash for unrealized gains, the board also provides the CEO an incentive to take the
necessary actions to realize those gains. In contrast to unrealized gains, we expect cash
compensation to reect unrealized losses, to prevent managers from evading the cash
compensation consequences of these losses.
We emphasize that managers should be rewarded for generating unrealized gains but
compensating managers immediately with cash for unrealized gains likely increases the cost
of ex post settling up compared to other forms of compensation, such as equity-based
compensation with vesting constraints. Even though rewarding managers for unrealized
gains with equity rather than immediately with cash imposes compensation risk on a risk-
averse CEO, the costs of imposing the additional compensation risk can be offset by the
gains from mitigating ex post settling up in cash compensation.
Since stock returns incorporate both unrealized gains and unrealized losses, we predict
CEO cash pay to be asymmetrically related to stock returns in the sense that pay is less

1
Recent efforts by several companies, for example Fannie Mae, Freddie Mac, Conseco, and Computer
Associates, to recoup cash compensation paid to executives indicate just how costly ex post settling up can be.
Litigation and proxy ghts are often involved in order to force the executives to return the cash they received, and
such attempts are not always successful.
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sensitive to stock returns when returns contain unrealized gains than when returns contain
unrealized losses. Finding that CEO cash pay is more sensitive to negative than positive
stock returns is consistent with boards of directors seeking to mitigate ex post settling up
that would arise if CEO cash pay was equally sensitive to positive and negative stock
returns.
We make no predictions regarding the asymmetric relation between CEO cash
compensation and accounting earnings for two reasons. First, most bonus plans use
accounting earnings in a piece-wise linear fashion. This can contribute to an asymmetric
relation between cash compensation and accounting earnings. Murphy (1999) reports that
earnings-based bonus contracts often contain lower and upper bounds, suggesting reduced
sensitivity of cash pay to earnings when earnings are either very high or very low. Second,
since accounting earnings exclude unrealized gains and include unrealized losses, CEO pay
will react symmetrically to accounting earnings and losses. However, additional factors
affect the level of conservatism chosen by rms, such as other accounting-based contracts
(e.g., debt covenants), litigation, taxes, and regulation (Watts, 2003a). These other factors
can cause the rm to deviate from the optimum level of accounting conservatism chosen
solely for compensation contracts, potentially creating asymmetry in the relation between
cash compensation and earnings.
While the ex post settling up problem also exists in other types of management
compensation, it is likely more severe when payments are made in cash. The CEO is given
equity-based pay today for anticipated, but unrealized future gains. But these equity claims
generally restrict managers as to when they can convert the claims into cash. If the
unrealized gain evaporates before the claim vests, the equity claims price reects such
information and there is no ex post settling up problem for the shareholders. Hence, we
predict CEO equity-based compensation grants will react equally to stock returns containing
unrealized gains and stock returns containing unrealized losses.
Analyzing management compensation data from ExecuComp for 19932003, we nd
that CEO cash compensation (salary and bonus) is roughly twice as sensitive to negative
stock returns as it is to positive stock returns. This nding is consistent with boards of
directors structuring cash compensation so that CEOs are rewarded less for unrealized
gains than they are penalized for unrealized losses. We nd equity-based compensation
reacts symmetrically to positive and negative stock returns, consistent with our prediction
that ex post settling up is more costly for cash compensation than for stock-based
compensation. However, not nding an asymmetric response for equity-based compensa-
tion could be due to our tests lacking power. Our ndings that CEO cash compensation
reacts asymmetrically to stock returns whereas CEO equity-based compensation does not,
are robust to alternative measures of unrealized gains and unrealized losses, and to
alternative model specications where we control for various rm and CEO characteristics.
We also explore alternative explanations for our results, such as a possible mechanical
relation induced by the piece-wise linear shape of the bonus plan, different compensation
structures for rms with good and bad performance, differential noise in returns and
earnings, cash constraints facing poorly performing rms, and political costs. Our results
are robust to these alternative explanations.
While our ndings are consistent with ex post settling up playing a role in CEO
compensation contracts and we rule out a number of alternative explanations for our
results, we offer the following caveat. We are unable to document cross-sectional
differences in the asymmetric reaction of cash compensation to bad news and good news in
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stock returns where the ex post settling up problem is likely more severe. Until researchers
nd such evidence, the ex post settling up problem will remain a plausible but not a
compelling explanation for the asymmetry. Accordingly, this provides an avenue for future
research on compensation and the ex post settling up problem.
Our study makes several contributions. First, we add to the compensation literature by
documenting that positive and negative stock returns are treated asymmetrically in CEO
cash compensation. Our results also suggest that the low pay-performance sensitivity
documented in the previous literature (e.g. Rosen, 1992; Hall and Liebman, 1998) is
partially due to researchers adopting a linear specication to analyze a non-linear relation.
Second, we add to the existing studies that explain the use of accounting earnings in
management compensation. Sloan (1993) argues that earnings-based incentives shield
managers from market-wide risk that is out of managers control. It remains unclear,
however, why shareholders would not simply compensate managers based on market-
adjusted returns.2 Our study provides an additional explanation for the role of accounting-
based incentives. Following Holthausen and Watts (2001) and Watts (2003a), we argue
that management compensation contracts use accounting earnings not just to lter out
market risk, but also because conservative earnings (unlike returns) lter out unrealized
gains and (like returns) include unrealized losses. Our ndings help explain the widespread
use of earnings-based cash compensation plans documented in previous studies
(Murphy, 2001). Finally, little research exists on the hypothesized role conservatism plays
in management compensation contracts (Watts, 2003b). The theory predicting that
accounting earnings reacts asymmetrically to unrealized gains and losses also predicts that
CEO pay should react asymmetrically to stock returns. Hence, our ndings on the
asymmetric relation between cash compensation and positive and negative stock returns is
an indirect test of accounting conservatism.
Sections 2 and 3 develop our predictions and present the methodology, respectively.
Section 4 provides descriptive statistics of our sample. Results are in Section 5 and
Section 6 concludes.

2. Predictions

CEOs receive both cash (salary, bonus, and deferred compensation) and stock-based
compensation (typically option and restricted stock grants). An extensive literature
documents the relation between cash compensation and both stock returns and accounting
earnings (e.g., Bushman and Smith, 2001; Lambert and Larcker, 1987; Sloan, 1993; Jensen
and Murphy, 1990). Bonus contracts are usually written based on accounting earnings and
not explicitly on stock returns (Murphy, 1999). Several reasons exist for why stock returns
and CEO cash compensation are positively correlated, even though returns generally are
not contractually linked to either salary or bonus.
First, as long as both returns and earnings are informative about managers effort, each
will be used in setting the CEOs cash compensation (Holmstrom, 1979). Second, bonus
2
Sloan (1993) states (p. 57): The reasons for the use of earnings-based incentives, rather than schemes explicitly
rewarding market-relative stock-price performance, are not well understood. Potential reasons include the costs of
implementing such schemes and the costs associated with the adverse incentives they can create. It is also likely
that earnings-based incentives provide other benets besides the particular risk-sharing role documented in this
paper.
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payouts are typically indexed to base salary (Murphy, 1999). For example, if the CEO
meets the performance target (usually stated in terms of accounting ROA or EPS), he or
she receives a bonus of say 80% of his/her salary (Murphy, 1999). CEO salary levels, being
determined by a competitive market for CEOs, are likely related to rm performance as
measured by stock returns. Murphy (1999) points out that CEO salaries are strongly
correlated with rm size, which increases with strong stock price performance. Third,
although accounting earnings is the most prevalent performance measure used in bonus
contracts, it is not the only measure. Murphy (1999) reports that 62% of the performance
measures used in bonus contracts are accounting based, while the other measures include
individual performance measures, stock price, and various non-nancial measures. The use
of these non-accounting based performance measures likely creates a link either explicitly
or implicitly between cash compensation and stock returns (Bushman and Smith, 2001).
Fourth, board discretion is another mechanism linking cash compensation and stock
returns.3 Murphy and Oyer (2003) document frequent use of board discretion in setting
executive bonuses. In Section 5.8, we provide evidence that among rms with very good
accounting performance (top quintile of the change in ROA), there is still signicant
variation in bonus changes that is related to stock returns. For the preceding reasons we
expect a positive correlation between stock returns and cash compensation even though
they are not contractually linked in most formal bonus contracts.
Since unrealized gains and losses are not observable, we use positive stock returns
to proxy for unrealized gains (good news) and negative stock returns to proxy for
unrealized losses (bad news). Later in the paper we discuss alternative proxies. The
remainder of this section develops our predictions about the differential sensitivities of:
(i) cash compensation to stock returns, (ii) cash compensation to accounting earnings,
(iii) equity-based compensation to stock returns, and (iv) equity-based compensation to
accounting earnings.

2.1. Sensitivity of cash compensation to stock returns

Stock returns in efcient markets react equally to an unexpected risk-adjusted dollar of


unrealized gains and unrealized losses. Under the assumption that boards of directors
implement rm-value maximizing senior management compensation contracts, we
conjecture that boards will limit cash compensation to managers today for stock returns
that incorporate unveriable unrealized gains because it is costly to recover this pay in the
future if these unrealized gains vanish (Barclay et al., 2005). However, boards will want to
hold managers accountable today for unrealized losses.
Penalizing managers for unrealized losses but not rewarding them for unrealized gains in
cash compensation has two effects on managers incentives. First, shareholders avoid
having to recover cash compensation paid to managers for unrealized gains that evaporate
while at the same time give the CEO incentive to bring the unrealized gains to fruition.
Second, shareholders prevent managers from evading the compensation consequences of
the unrealized losses, which promotes managers incentives to make value-maximizing
investment decisions. Prompt incorporation of losses into cash compensation reduces
managers incentives to accept projects they know are unprotable because timely loss
recognition eliminates their ability to defer the losses until after they leave the rm (Ball
3
For example, AMR CEO Donald J. Cartys base salary fell 24% after AMR share price dropped 43% in 2001.
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et al., 2003). Incorporating unrealized losses immediately into compensation also gives
managers incentives to stem losses from unsuccessful past investments quickly because the
compensation consequences of the losses are no longer tied to the sale or abandonment
decisions. Therefore using positive stock returns as a proxy for unrealized gains and
negative stock returns as a proxy for unrealized losses, Hypothesis 1 predicts the sensitivity
of CEO cash compensation to stock returns is larger for negative stock returns than for
positive stock returns.

2.2. Sensitivity of cash compensation to earnings

We make no specic predictions on the potential asymmetric relation between CEO cash
pay and accounting earnings for two reasons. First, most bonus plans use accounting
earnings in a piece-wise linear fashion, thereby creating a mechanical asymmetric relation
between cash compensation and accounting earnings. Murphy (1999) reports that
earnings-based bonus contracts are often piece-wise linear plans containing lower and
upper bounds, suggesting reduced sensitivity of cash pay to earnings when earnings are
either very high or very low.
Second, an important feature of conservative accounting is that it generally excludes
unrealized gains from earnings and recognizes unrealized losses in a timely manner.
Therefore, in contrast to stock returns, the problem of ex post settling up is mitigated when
compensation contracts are based directly on earnings (since unrealized gains are
excluded). However, the extent to which unrealized gains are excluded from income
or the speed and extent to which unrealized losses are recognized, likely varies both
cross-sectionally and over time. The variation arises from accounting choices the rm
makes given its compensation contracts, debt contracts, litigation concerns, and tax
strategies; as well as from regulations by the FASB, the SEC, and other regulatory
agencies (Watts, 2003a). If the accounting system were designed solely for use in
compensation contracts (unrealized gains are excluded from income and unrealized losses
are recognized immediately), there would be no asymmetry in the relation between cash
compensation and accounting earnings as in the case of stock returns. However, this only
holds when rms have no other accounting-based contracts and litigation, taxes, and
accounting regulation do not affect the amount of accounting conservatism rms choose.
The existence of these other factors likely causes the rm-value maximizing level of
accounting conservatism to differ from that chosen solely for efcient compensation
contracting.

2.3. Sensitivity of stock-based compensation to stock returns

Maximizing rm value requires CEO to take actions today that increase the rms future
cash ows. Shareholders face a tradeoff. To avoid ex post settling up, these future cash
ows should be veriable before the CEO is rewarded. However, not rewarding CEOs for
efforts that increase future cash ows occurring after the CEOs horizon reduces their
incentives to undertake actions today that yield anticipated, but unrealized future gains.
Motivating managers to undertake these long-term value-maximizing decisions requires
long-term contracts (Fudenberg et al., 1990). Equity-based compensation such as stock
options, restricted stock, and performance shares provide such incentives (Smith and
Watts, 1982). Smith and Watts (1992) predict and nd that rms with more growth options
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employ more stock option-based compensation.4 Presumably, the long-term value


implications of current managerial actions are less veriable, and hence rms with
substantial growth options rely more on equity-based compensation. Kole (1997)
documents that high market-to-book value rms or research-intensive rms (which proxy
for low veriability of long-term managerial value creation) use more equity-based
compensation plans and have longer vesting periods in their stock option plans.
Executive stock options and restricted stock provide forfeitable rewards that raise the
cost to the manager of leaving the rm. Moreover, these equity-based forms of
compensation have lower ex post settling up costs than cash compensation. Prior to
vesting and sale of the equity grant, the executives wealth and rm value are directly
linked. Equity-based pay forces managers to bear the wealth consequences of unrealized
gains that disappear before the equity claim vests and is sold. If the unrealized gains
evaporate before the equity claim is sold, the value of the claim adjusts and ex post settling
up costs are reduced. Because equity claims (with vesting provisions) reduce ex post settling
up costs, boards of directors do not have to adjust the sensitivity of stock-based
compensation to performance like they do for cash compensation. Therefore using positive
stock returns as a proxy for unrealized gains and negative stock returns as a proxy for
unrealized losses, Hypothesis 2 predicts that CEO stock-based compensation grants are
equally sensitive to positive stock returns and negative stock returns.
Hypothesis 2 assumes that option and restricted stock grants reward CEOs for
past performance. Besides compensating CEOs for past performance (often in lieu of
cash compensation), equity-based grants also provide incentives to CEOs for future
performance, and have tax and nancial reporting motivations (Core et al., 2003a). Core
and Guay (1999) nd that CEOs receive equity grants for compensation reasons, to align
their incentives with those of the shareholders, and for other non-compensation reasons
such as liquidity constraints, and tax and nancial reporting motivations. However,
because of a potentially spurious relation between the value of current period equity grants
and current period returns, Core and Guay (1999) are cautious in interpreting the positive
association between grants and stock returns as evidence of pay for performance.

2.4. Sensitivity of stock-based compensation to earnings

Prior studies (Baber et al., 1996, 1998; Core et al., 2003b) report no statistically
signicant association between stock-based grants and accounting earnings. Since pay for
performance is but one of several reasons why equity grants are awarded, and since prior
research nds no association between equity grants and accounting earnings, we make no
prediction about the sensitivity of equity grants to good and bad news in earnings.

3. Data and Methodology

3.1. Sample selection

Compensation, accounting, and returns data are obtained from ExecuComp, Compu-
stat, and CRSP, respectively. Table 1 summarizes our sample selection procedures starting
with 20,981 CEO-year observations in ExecuComp from 19922003. We eliminate
4
Also see Gaver and Gaver (1993) and Bizjak et al. (1993), and Baber et al. (1996).
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Table 1
Summary of sample selection process

Total CEO-year observations in ExecuComp from 1992 to 2003. 20,981


Less:
CEO-year observations where the CEO was not in ofce for the entire current and previous year 2,458
Observations with insufcient data to calculate change in total cash compensation 4,754
Observations that could not be matched with CRSP 1,583
Observations with insufcient Compustat data 151
Observations where the absolute value of the change in log (salary+bonus) exceeds 2 127
Observations where the CEO is a founder, the family member of founder, or became CEO through 2,050
acquisition
Total usable observations (19932003) 9,858

observations if the CEO was not in ofce for the entire current and previous year, if there is
insufcient data to calculate changes in total cash compensation or with missing data on
CRSP or COMPUSTAT, if the absolute value of the change in the log of salary plus bonus
exceeds two (because changes this large are likely due to data errors),5 and if the CEO is a
founder or family member of a founder or became CEO through a corporate control
transaction (Joos et al., 2002). Our nal sample consists of 9,858 CEO-years for 2,751
CEOs.

3.2. Methodology and variable definitions

We test for asymmetric sensitivity of cash and equity-based compensation to stock


returns by introducing a bad news dummy variable to reect unrealized losses (Basu, 1997)
into the following model that relates CEO compensation to stock returns and accounting
earnings:
D1nCOMPit b0t b1t Dit b2t Rit b3t DROAit
b4t Dit Rit b5t Dit DROAit
b6t Salesit b6t Sales2it eit . 1
COMP is either CEO cash compensation or equity-based compensation, where cash
compensation is salary plus bonus and equity-based compensation is the value of stock
option grants plus restricted stock grants. Options grants are valued as reported by the
rm and restricted stock grants are valued using the market price of the stock at the grant
date. Using the BlackScholes model to value option grants does not alter our results.
Because the sum of annual option and restricted stock grants is often zero, we add $1 to
the sum to avoid losing data when calculating the change in logarithms. R is compounded
monthly returns for scal year t.6 Following Sloan (1993) we use the change in ROA from
5
The same lter is also applied to the change in the log of equity compensation.
6
Following Lambert and Larcker (1987), we use raw returns with the implicit assumption that the expected
value of stock returns is constant over time. Using continuously compounded returns leads to similar coefcient
estimates.
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year t1 to year t as the accounting performance measure, where ROA is dened as net
income scaled by beginning of the year total assets.7
D is a dummy variable that represents the existence of an unrealized loss (bad news) and
is interacted with R and DROA. D is equal to one when there is bad news and zero
otherwise. We use a variety of metrics to proxy for an unrealized loss (negative stock
returns, negative change in earnings, negative unusual earnings items, and negative
changes in expectations about future cash ows). For our primary analyses, we dene
D 1 when the market-adjusted stock return based on the CRSP value-weighted index is
negative, and zero otherwise. Following Ball et al. (2000), we remove market returns from
raw returns in computing D to control for changes in discount rates. Our results are robust
to using negative raw returns to measure bad news. One concern of using either negative
market-adjusted returns or negative raw returns to proxy for unrealized losses is that some
industries may perform better than others in a particular year; therefore, our dummy
variable may proxy for industry effects. To address this concern, we also use negative
industry-adjusted returns (industry classication based on two-digit SIC codes) to proxy
for unrealized losses and nd our results robust to this alternative denition.
The b2 and b3 coefcients reect the sensitivities of CEO compensation to stock returns
and accounting earnings, respectively, when there is good news. From previous studies,
both stock returns and accounting earnings should receive positive weights when the
dependent variable is cash compensation (b240 and b340). For the equity-based
regression, we only expect b240 based on previous research.
The b4 coefcient measures the incremental sensitivity of CEO compensation to stock
returns when there is bad news. Stock returns incorporate both unrealized gains and
unrealized losses symmetrically. However, given that it is costly to recover from CEOs cash
compensation paid for unrealized gains that are not realized, CEO cash pay will be less
sensitive to stock returns when returns contain unrealized gains (good news) than when
returns contain unrealized losses (bad news). Hence, we predict that b440 when the
dependent variable is cash compensation (Hypothesis 1). When the dependent variable is
equity-based compensation, we predict that b4 0 (Hypothesis 2). We make no prediction
for b5 in either the cash or equity-based compensation regressions.
We also include sales and sales2 to control for potential (non-linear) size effects. Using
total assets or market value of equity to proxy for size or the log of the size variables yields
similar results. To mitigate the inuence of extreme observations, we winsorize the
independent variables at 1% and 99%. Results are qualitatively the same without
winsorization.

3.3. Errors in variables

Since unrealized losses are not directly observable, our various proxies for the dummy
variable D (the existence of an unrealized loss) contain measurement error. Our primary
proxy for D is whether the rms stock return is negative. A rms current period stock
return reects both current period unexpected performance and changes in expectations
7
Bonuses are often based on exceeding a target ROA (Murphy, 2001). We assume that last years ROA proxies
for this years target. Using operating income (rather than net income) divided by total assets as an alternative
denition of DROA, or using DEPS instead of DROA as the accounting performance measure does not change
our inferences.
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about future performance (giving rise to either unrealized losses or gains). Hence, when
returns are used to proxy for unrealized losses, it contains measurement error (current
period unexpected performance).8 To the extent that current periods unexpected
performance is of a different sign and larger in absolute value than the change in
expectations about future performance, our dummy variable misclassies the nature of the
news, thereby introducing potential bias into our tests.
An alternative proxy for unrealized losses is whether accounting earnings are negative.
However, this proxy for D also contains measurement error. Accounting earnings do not
reect all unrealized economic losses. Unrealized losses are only recognized in accounting
earnings to the extent that net assets have been previously recorded. For example, suppose
the market learns that a positive net present value projects expected future cash ows are
lower than previously expected. The rms stock return will reect the loss. However, the
accounting system does not recognize this unrealized loss because the positive net present
value of the project was not previously recognized (e.g. Givoly et al., 2003).
We also proxy for unrealized losses by directly estimating changes in expectations about
the rms future performance. A rms current period stock return reects both current
period unexpected performance and changes in expectations about future performance. To
proxy for the second component, we subtract current period unexpected operating cash
ows, which we use to measure current period unexpected performance, from the change in
the market value of equity during the current period. This proxy for unrealized losses
overcomes some of the problems of the stock return-based proxy. However, the time-series
estimations required for calculating unexpected operating cash ows impose more
stringent data requirements and introduce measurement error into our analysis.
The previously described alternative proxies for unrealized losses do not alter our
inferences.

4. Descriptive Statistics

Table 2 reports descriptive statistics for the entire sample and for the sub-samples of
good news and bad news rms. CEO-years are included in the bad news sub-sample if
market-adjusted returns are negative; otherwise they are included in the good news sub-
sample. There are 5,749 bad news CEO-years and 4,109 good news CEO-years. Positive
skewness in the return distribution explains the larger number of bad news CEO-years
compared to good news CEO-years. All differences between the bad and good news sub-
samples in Table 2 are statistically signicant at po0.01 for both parametric (t-test) and
nonparametric (Wilcoxon) tests, with the exception of rm size, rm age, and salary, which
are not signicantly different between the two sub-samples.
Stock returns average -10% for the bad news sub-sample and 41% for the good news
sample.9 Mean (median) ROA based on net income (ROANI) is 0.02 (0.04) and 0.05 (0.05)
for the bad news and good news sub-samples, respectively. The mean of DROAOI and
8
Note that accounting earnings does not help disentangle the two effects. When there is an unrealized loss in a
particular period, this loss is also likely reected in accounting earnings due to conservatism, but is not specically
identied in the nancial reports.
9
The good news and bad news rms likely differ in magnitude (41% vs. 10%) because the good news/ bad
news partition is based on market-adjusted returns. Firms in the good news sample are not likely to have negative
raw returns, since market returns are generally positive during our sample period. But the bad news sample likely
contains a large number of rms with raw returns that are positive but less than the market return.
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Table 2
Descriptive statistics

All rms Bad news (RoRm) Good news (RXRm)


N 9,858 N 5,749 N 4,109

Description Mean STD Median Mean STD Median Mean STD Median

R 0.11 0.39 0.10 0.10 0.28 0.09 0.41 0.32 0.36


ROAOI 0.09 0.09 0.09 0.08 0.10 0.08 0.10 0.08 0.10
ROANI 0.04 0.09 0.04 0.02 0.10 0.04 0.05 0.08 0.05
DROAOI 0.01 0.05 0.00 0.01 0.06 0.00 0.01 0.05 0.00
DROANI 0.01 0.08 0.00 0.02 0.08 0.00 0.01 0.07 0.00
Unusual items dummy 0.48 0.50 0.00 0.53 0.50 1.00 0.42 0.49 0.00
Sales 4,228 11,358 1,135 4,210 11,678 1,123 4,253 10,897 1,147
Firm age 23 19 18 23 19 18 23 19 19
Leverage 0.24 0.18 0.23 0.25 0.18 0.25 0.23 0.17 0.22
Book-to-market 0.51 0.35 0.45 0.58 0.39 0.51 0.42 0.26 0.38
Salary 625 323 570 628 323 574 620 324 567
Bonus 661 1,672 334 544 987 250 825 2,301 445
Cash comp (salary plus bonus) 1,285 1,791 920 1,171 1,167 847 1,445 2,397 1,012
Change in cash comp 74 1,324 53 35 1,474 16 225 1,061 113
D1n(cash comp) 0.06 0.34 0.07 0.01 0.35 0.03 0.15 0.29 0.13
Value of stock options granted 2,033 3,884 655 1,957 3,776 601 2,139 4,028 736
Value of restricted stock granted 272 905 0 254 868 0 296 955 0
Equity comp 2,356 4,338 810 2,264 4,232 733 2,486 4,480 916
Change in equity comp 100 3,984 3 125 4,064 0 414 3,849 71
D1n(equity comp) 0.09 0.65 0.00 0.05 0.64 0.00 0.16 0.66 0.08

The sample includes 9,858 CEO-year observations from 19932003 (see Table 1 for sample selection procedure).
All differences between the bad news and good news sub-samples are statistically signicant at po.05 for both
parametric (t-test) and nonparametric (Wilcoxon) tests, with the exceptions of sales, rm age, and salary, which
are not signicantly different.
A rm year is classied as bad news if the market-adjusted return is negative (RoRm), and is classied as good
news otherwise, where market return is dened as the CRSP value-weighted index.
R cumulative monthly raw returns for the scal year from CRSP.
ROAOI operating income divided by beginning of the year total assets (compustat #178/ #6).
ROANI net income divided by beginning of the year total assets (compustat #172/ #6).
DROAOI change in ROAOI.
DROANI change in ROANI.
Unusual items dummy 1 if the rm reports negative unusual items, dened as the sum of special items
(compustat data item #17) adjusted for tax effect, and extraordinary items and discontinued operations
(compustat data item #48), 0 otherwise.
Sales compustat (#12), reported in millions of dollars.
Firm age the scal year of the observation minus the year the rm rst appeared on CRSP.
Leverage debt divided by total assets (compustat (#9+ #34)/#6).
Book-to-market common equity divided by market value of equity (available on ExecuComp).
Cash comp salary plus bonus, reported in thousands of dollars.
Value of stock options granted as reported by the company in thousands of dollars (observations with zero values
are included).
Value of restricted stock granted is market value of restricted stock at the date of grant in thousands of dollars
(observations with zero values are included).
Equity comp value of stock options granted plus the value of stock options granted.
Change in value of equity comp change in value of stock options and restricted stock granted in thousands of
dollars (observations with zero values are included).
D1n(equity comp) change in log of $1 plus stock options granted as valued by the rm plus market value of
restricted stock grants.
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DROANI are negative for the bad news sub-sample and positive for the good news sub-
sample. About 53% of the bad news rms report negative unusual items while only 42% of
the good news rms do.10 The mean (median) age of our sample rms is 23 (18) years and
mean (median) sales in millions is $4,228 ($1,135). Bad news rms have higher leverage,
with mean of 0.25 versus 0.23 for good-news rms; they also have higher book-to-market
ratios, with mean of 0.58 versus 0.42 for good news rms. Mean (median) total cash
compensation in thousands is $1,285 ($920), and is similar to statistics reported by Murphy
(2001). Cash compensation is higher for good news rms than for bad news rms. The data
in Table 2 regarding option (restricted stock) grants include zeros if the rm did not grant
any options (restricted stock). Most of the value of equity-based pay comes from stock
option grants. In the full sample, the median value of option grants in thousands is $655
whereas the median value of restricted stock grants is zero. For the full sample as well as
the two sub-samples, the mean of equity compensation is higher than the mean of cash
compensation, whereas the median is lower than that of cash compensation.
Table 3 reports correlations among the variables used in the multivariate tests.
Spearman (Pearson) correlations are reported above the (below) diagonal. Since Pearson
results are similar, we discuss only the Spearman correlations. All of the performance
metrics are signicantly correlated with Dln(Cash Comp), 0.33, 0.37, and 0.33 for R,
DROAOI, and DROANI, respectively. The correlations between Dln (Equity Comp)
and the performance metrics, while statistically signicant, are substantially smaller in
magnitude compared to the corresponding correlations of Dln (Cash Comp). These smaller
correlations are consistent with Core and Guays (1999) ndings that equity grants are
awarded for other reasons (such as incentives) in addition to rewarding managers for past
performance.

5. Empirical tests

In this section we test our main hypotheses. Section 5.1 presents the main results for
both cash and equity-based compensation. Sections 5.25.5 investigate several alternative
explanations. In Section 5.6 we replace the return-based proxy for unrealized losses with
ones that are based on accounting earnings or future unexpected cash ows. We discuss
how our results relate to CEO horizon in Section 5.7. We provide evidence on the boards
use of non-accounting information in setting CEO bonuses in Section 5.8.

5.1. Main results

Table 4 reports our primary results from estimating Eq. (1), rst for cash compensation
and second for equity-based compensation. To lessen the effect of outliers, we eliminate
inuential observations as per Belsley et al. (1980).11 We estimate separate annual
regressions following Fama and MacBeth (1973) to avoid understating standard errors due
to cross-sectional dependence. Reported coefcients, adjusted R2 s, and number of
observations are the means of eleven annual cross-sectional regressions from 1993 to 2003.
10
Unusual items dummy 1 if the sum of special items (Compustat data item #17) adjusted for taxes, and
extraordinary items and discontinued operations (Compustat data item #48) is negative, 0 otherwise.
11
We exclude observations with absolute studentized residuals that exceed 2 times log (number of independent
variables/N). Our results do not change qualitatively without this procedure.
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Table 3
Correlations coefcients

R DROAOI DROANI Sales Firm age Leverage Book-to- Dln(cash Dln(equity


market comp) comp)

R 0.29*** 0.26*** 0.05*** 0.04*** 0.04*** 0.32*** 0.33*** 0.09***


DROAOI 0.28*** 0.65*** 0.05*** 0.04*** 0.05*** 0.12*** 0.37*** 0.07***
DROANI 0.24*** 0.64*** 0.05*** 0.04*** 0.04*** 0.10*** 0.33*** 0.06***
Sales 0.01 0.03*** 0.03*** 0.49*** 0.27*** 0.03*** 0.04*** 0.06***
Firm age 0.02* 0.06*** 0.05*** 0.32*** 0.21*** 0.07*** 0.02 0.06***
Leverage 0.05*** 0.01 0.02** 0.10*** 0.18*** 0.14*** 0.00 0.01
Book-to- 0.34*** 0.08*** 0.06*** 0.08*** 0.01 0.08*** 0.09*** 0.07***
market
Dln(cash 0.30*** 0.31*** 0.24*** 0.01 0.02* 0.01 0.08*** 0.08***
comp)
Dln(equity 0.10*** 0.06*** 0.05*** 0.02* 0.04*** 0.00 0.05*** 0.08***
comp)

The sample includes 9,858 CEO-year observations from 19932003 (see Table 1 for sample selection procedure).
Spearman (Pearson) correlations are reported in the upper (lower) diagonal. *, **, and *** correspond to 10%,
5%, and 1% signicance levels, respectively.
R cumulative monthly raw returns for the scal year from CRSP.
ROAOI operating income divided by beginning of the year total assets (compustat #178/ #6).
ROANI net income divided by beginning of the year total assets (compustat #172/ #6).
DROAOI change in ROAOI.
DROANI change in ROANI.
Sales compustat #12, reported in millions of dollars.
Firm age the scal year of the observation minus the year the rm rst appeared on CRSP.
Leverage debt divided by total assets (compustat (#9+ #34)/ #6).
Book-to-market common equity divided by market value of equity (available on ExecuComp).
Dln (cash comp) change in log of salary plus bonus, reported in thousands of dollars.
Dln(equity comp) change in log of $1 plus stock options granted as valued by the rm plus market value of
restricted stock grants.

The standard errors are based on the time-series standard deviations of the coefcients
divided by the square root of eleven. T-statistics are reported in parentheses below the
regression coefcients in the table and signicance levels are based on one-tailed tests
where there is a prediction of the coefcients sign and based on two-tailed tests otherwise.
Results from estimating a single pooled time-series and cross-sectional regression are
qualitatively similar.
Focusing rst on the cash compensation regression without the various control
variables, the average number of observations in the eleven cross-sectional regressions is
833 and the average adjusted R2 is 0.18. As expected, the coefcients on R and DROA
(dened based on net income) are positive and statistically signicant (po0.01). Consistent
with Hypothesis 1, the coefcient on the return interacted with the bad news dummy
(DR) is positive (0.157) and statistically signicant (po0.01). Cash compensation is
more sensitive to returns in the bad news case presumably because CEOs are rewarded
less for unrealized gains than they are penalized for unrealized losses. Bad news more
than doubles the sensitivity of cash compensation to R than in the good news case
(0.137+0.157 0.294 versus 0.137). Out of the eleven annual regressions (untabulated),
the return interactive term is positive in all years and signicant (po0.10) in seven years.
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Table 4
Tests of asymmetry in CEO compensation relative to stock returns (FamaMacBeth regressions)

D1n COMPit b0t b1t Dit b2t Rit b3t DROAit b4t Dit Rit b5t Dit DROAit b6t Salesit b7t Sales2it eit
D1n COMPit b0t b1t Dit b2t Rit b3t DROAit b4t Dit Rit b5t Dit DROAit b6t Salesit b7t Sales2it
b8t firm ageit b9t firm ageit nRit b10t leverageit b11t leverageit nRit
b12t booktomarketit b13t booktomarketit nRit eit

Variable Dln(cash comp) Dln(equity comp)

Predict. sign Coef. (t statistic) Coef. (t statistic) Predict. sign Coef. (t statistic)

Intercept ? 0.108*** 0.071*** ? 0.135***


(7.27) (4.29) (3.87)
D ? 0.067*** 0.038*** ? 0.038
(4.65) (5.92) (1.61)
R + 0.137*** 0.112*** + 0.079*
(5.44) (5.00) (1.45)
DROANI + 0.795*** 0.908*** ? 0.180
(9.62) (8.69) (0.91)
DR + 0.157*** 0.123*** 0 0.107
(4.80) (3.68) (1.33)
DDROANI ? 0.122 0.010 ? 0.107
(0.91) (0.07) (0.53)
Sales ? 0.000 0.002 ? 0.073*
(0.03) (0.17) (2.25)
2
Sales ? 0.001 0.000 ? 0.016**
(0.40) (0.10) (2.77)
Firm age ? 0.000** ? 0.000
(2.32) (0.08)
Firm ageR ? 0.003*** ? 0.002*
(8.99) (1.89)
Leverage ? 0.037 ? 0.010
(1.56) (0.22)
LeverageR ? 0.021 ? 0.147
(0.55) (1.30)
Book-to-market ? 0.028*** ? 0.038
(3.80) (1.20)
Book-to-marketR ? 0.037 ? 0.002
(1.40) (0.02)
2
Adjusted R 0.18 0.18 0.01
No. of observations 833 832 621

Results are based on 11 annual FamaMacBeth regressions from 1993 to 2003. The number of observations is the
average over the 11 years. t-statistics are in parentheses. Signicance levels are based on one-tailed tests where
there is a prediction of the sign of the coefcient and based on two-tailed tests otherwise. *, **, and ***
correspond to 10%, 5%, and 1% signicance levels, respectively.
Cash comp salary plus bonus, reported in thousands of dollars.
Equity comp $1 plus stock options granted as valued by the rm plus market value of restricted stock grants.
D 1 if the market-adjusted return is negative, and 0 otherwise, where market return is dened as CRSP value-
weighted index.
R cumulative monthly raw returns for the scal year from CRSP.
ROANI net income divided by beginning of the year total assets (compustat #172/ #6); DROANI change in
ROANI.
Sales compustat #12.
Firm age the scal year of the observation minus the year the rm rst appeared on CRSP.
Leverage debt divided by total assets (compustat (#9+ #34)/ #6).
Book-to-market common equity divided by market value of equity (available on ExecuComp).
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Previous studies generally nd that the elasticity of CEO cash compensation with respect
to stock returns is in the range of 0.10 to 0.15 (Rosen, 1992).12 Our results suggest that the
compensation elasticity is substantially higher (0.29) when there is bad news. The
coefcient on the DROA interacted with the bad news dummy (0.122) is positive but not
signicantly different from zero. The coefcients on sales and sales2 are statistically
insignicant.
The second cash compensation regression in Table 4 includes control variables that are
potentially correlated with the pay-performance sensitivity. Firm age, leverage and book-
to-market ratio are likely related to the rms investment opportunity set, which in turn
can affect pay-performance sensitivity. We nd that after controlling for these variables,
the coefcient on DR remains signicantly positive as predicted by Hypothesis 1.
Therefore, our inferences are unlikely affected by good and bad news rms facing different
investment opportunity sets. Later we also conduct our analysis at the rm level as a
further control for differences in rm characteristics.
Hypothesis 2 predicts that equity-based compensation is equally sensitive to positive and
negative returns. Column (3) of Table 4 tests this conjecture. The average number of
observations in the eleven cross-sectional regressions falls to 621 because fewer rms report
option or restricted stock compensation. Consistent with Baber et al. (1996, 1998), the
average adjusted R2 is only 0.01. The coefcient on R is positive and statistically signicant
(po0.10). The coefcient on DROA is not statistically signicant at the 0.10 level.
Consistent with Hypothesis 2, the coefcient on returns interacted with the bad news
dummy (DR) is not statistically different from zero at the 0.10 level. We nd equity-based
compensation to be equally sensitive to positive and negative returns. However, this
nding must be interpreted cautiously. The equity-based compensation model estimated in
Table 4 does not include other factors shown by Core and Guay (1999) to affect equity
grants. Moreover, to the extent that the association between returns and grants is spurious
(Core and Guay, 1999), the coefcient on DR could be affected.
We test the robustness of the ndings in Table 4 regarding equity-based compensation to
alternative treatments of zero equity grants. About 59 observations per year out of 621
observations contain either zero equity grants or zero changes in equity grants. We re-
estimate Eq. (1) rst dropping observations that contain zero equity grants and second
dropping all observations with a zero change in equity grants. Both estimated models
(untabulated) using about 562 observations per year produce results very similar to those
reported in Table 4. Consistent with Hypothesis 2, in no case is the coefcient on returns
interacted with the bad news dummy (DR) signicantly different from zero.

5.2. Piece-wise linear bonus plans as an alternative explanation

In this subsection, we examine whether the form of earnings-based bonus plans induces
the asymmetric relation between cash compensation and stock returns in Table 4.
Earnings-based bonus contracts often contain lower and upper bounds, suggesting reduced
sensitivity of cash pay to either very good or very bad accounting earnings performance.
Since stock returns can affect cash compensation through non-accounting performance
measures and through board discretion, the shape of the formal bonus plan does not
12
Hall and Liebman (1998) nd that the elasticity of cash compensation with respect to current period stock
returns has increased to about 0.22 in more recent years.
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Table 5
Truncation of observations at the upper bound of the earnings threshold

D1n CASH COMPit b0t b1t Dit b2t Rit b3t DROAit b4t Dit Rit b5t Dit DROAit b6t Salesit b7t Sales2it
b8t firm ageit b9t firm ageit nRit b10t leverageit b11t leverageit nRit
b12t booktomarketit b13t booktomarketit nRit eit

Average N Coefcients on
per year
R RD DROA DROAD

No truncation 832 0.112*** 0.123*** 0.908*** 0.010


Truncate if DROA45% 756 0.119*** 0.108*** 1.136*** 0.196
Truncate if DROA44.5% 747 0.115*** 0.116*** 1.147*** 0.227
Truncate if DROA44.0% 739 0.118*** 0.113*** 1.117*** 0.216
Truncate if DROA43.5% 724 0.114*** 0.113*** 1.022*** 0.125
Truncate if DROA43.0% 712 0.113*** 0.118*** 0.991*** 0.112
Truncate if DROA42.5% 695 0.114*** 0.130*** 0.958*** 0.120
Truncate if DROA42.0% 671 0.119*** 0.125*** 0.862*** 0.091

Results are based on 11 annual FamaMacBeth regressions from 1993 to 2003. The number of observations is the
average over the 11 years. Signicance levels are based on one-tailed tests where there is a prediction of the sign of
the coefcient and based on two-tailed tests otherwise. Control variables are included in regressions but omitted
from the table for brevity. *, **, and *** correspond to 10%, 5%, and 1% signicance levels, respectively.
Cash comp salary plus bonus, reported in thousands of dollars.
D 1 if the market-adjusted return is negative, and 0 otherwise, where market return is dened as CRSP value-
weighted index.
R cumulative monthly raw returns for the scal year from CRSP.
ROANI net income divided by beginning of the year total assets (compustat #172/ #6); DROANI change in
ROANI.
Sales compustat #12.
Firm age the scal year of the observation minus the year the rm rst appeared on CRSP.
Leverage debt divided by total assets (compustat (#9+ #34)/ #6).
Book-to-market common equity divided by market value of equity (available on ExecuComp).

necessarily affect the relation between stock returns and cash pay. However, one potential
explanation for the reduced sensitivity of cash compensation to good stock return
performance can be that rms with high stock returns have reached the upper bounds of
their bonus plans.
In Table 5, we conduct a truncation analysis, where we exclude rm-year observations
with large DROA when estimating Eq. (1). The rst row summarizes the ndings
previously reported in Table 4. The second row truncates all observations with
DROA45%, whereas the last row truncates all observations with DROA42%. As more
large DROA observations are truncated, the coefcient on RD does not decline. This
suggests that our primary ndings in Table 4 are unlikely attributable to the piece-wise
linear structure of earnings-based bonus plans.

5.3. Firm level analysis

In Table 4, we control for various rm characteristics likely related to payperformance


sensitivity, such as rm age, leverage, and book-to-market ratio. To further alleviate the
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Table 6
Firm level analysis

D1n CASH COMPit b0t b1i Dit b2i Rit b3i Dit Rit eit

Variable Predict. Coef.


sign (t-statistic)

Intercept ? 0.121***
(5.82)
D ? 0.110***
(3.72)
R + 0.104**
(1.53)***,a
DR + 0.261
(3.65)
Adjusted R2 0.16
No. of observations 8 per rm for 324 rms

For the rm-specic regressions, we eliminate all rms where there are fewer than six observations. This reduces
the sample of 2,024 rms and 9,858 rm-year observations to 782 rms and 6,180 rm-year observations. Next, we
restrict the sample to rms where the proportion of bad news years to total number of years is 4060%. This
reduces the sample to 324 rms and an average of 8 years per rm. We omit DROA and sales from the regression
because of the limited number of observations we have for the rm-specic regressions. The average coefcients
across all rms are reported above. t-statistics are in parentheses. Signicance levels are based on one-tailed tests
where there is a prediction of the sign of the coefcient and based on two-tailed tests otherwise. *, **, and ***
correspond to 10%, 5%, and 1% signicance levels, respectively.
Cash comp salary plus bonus, reported in thousands of dollars.
D 1 if the market-adjusted return is negative, and 0 otherwise, where market return is dened as CRSP value-
weighted index.
R cumulative monthly raw returns for the scal year from CRSP.
a
A binomial test also rejects the null at po.01.

concern that our results may be driven by rms with different payperformance
sensitivities being systematically classied into good and bad news sub-samples, we
estimate rm-specic compensation regressions. We require at least six observations for
each rm, and in order to assure that there is sufcient variation in good and bad news for
each rm, we limit our rm-specic regressions to rms with bad-news proportions
between 40% and 60% of their total observations. This reduces the sample to 324 rms
and an average of 8 years/rm.
Table 6 reports the mean coefcients and t-statistics from the rm-specic analysis. To
conserve degrees of freedom, we include only those variables related to Hypothesis 1, D, R
and DR. The mean coefcient on R (0.104) is signicant at 0.05 level for a one-tailed test.
Consistent with Hypothesis 1, the mean coefcient on DR (0.261) is signicant at 0.01
level using a t-test as well as a binomial test. The results suggest that cross-sectional
differences in the structure of compensation plans are not responsible for the asymmetric
sensitivity of cash compensation to stock returns.

5.4. Noise in performance measures as an alternative explanation

Principal-agent theory suggests that the weights two performance measures receive in
optimal compensation contracts are related to the relative signal-to-noise ratios in the
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measures (Lambert and Larcker, 1987; Bushman and Smith, 2001). Accounting losses
tend to be more volatile than accounting prots due to conservatism. Thus, one
possible alternative explanation for our nding, that more weight is placed on stock
returns when there is bad news, is that accounting earnings are noisier in bad news
cases than in good news cases. One potential problem with this argument is that if
earnings are indeed noisier in the bad news case, it would only imply that the weight on
stock returns relative to earnings would increase when there is bad news. It does not
necessarily suggest that the absolute weight on stock returns would increase, which is our
nding.
Nonetheless, to investigate the effect of the noise components in stock returns and
accounting earnings on our results, we use the variances of the market-related components
in stock returns and accounting earnings as noise measures (Sloan, 1993). We estimate
these measures for each rm over the period of 19631992, requiring a minimum of 20
annual observations. The additional data requirement reduces our sample to 3,097
observations. The market noise in stock returns over that in accounting earnings, var(ei)/
var(ei), and the correlation of the two noise measures, r(ei,ei), are interacted with both
DROA and R in our cash compensation regression, and following Sloan, we estimate
pooled regressions.13 The results are reported in Table 7. The coefcients on the control
variables related to sales, rm age, leverage, and book-to-market ratio are suppressed in
the table, though these variables are included in the estimations.
Column (1) replicates our main results without the Sloan market noise variables for the
smaller sample. The results are similar to those reported in Table 4. When the market noise
variables are included, consistent with Sloan, we nd that higher var(ei)/var(ei) is
associated with higher weight on accounting performance, while higher r(ei,ei) is
associated with lower weight on accounting earnings. The interactions of these variables
with stock returns are not signicant. After controlling for the Sloan noise measures, we
continue to nd a signicant positive coefcient (po0.01) on DR.

5.5. Alternative explanations based on cash constraints and political costs

In this subsection we investigate two other alternative explanations, cash constraints


facing poorly performing rms and political costs, along with a summary of additional
robustness tests. Core and Guay (1999) nd that cash constrained rms tend to use more
equity-based compensation, presumably as a substitute for cash.14 Cash constraints are
likely associated with poor stock performance (our proxy for unrealized losses). If boards
replace cash with equity pay in such circumstances, the heightened sensitivity of cash
compensation to poor stock performance that we predict under ex post settling up could be
13
We follow Sloans denitions of the market noise in stock returns and in accounting earnings. Specically,
Sloan denes noise in stock returns, eit, as movements in stock returns that are related to market-wide variation in
equity values, eit b1iRmt, where Rit b0i+b1iRmt+Sit. Noise in accounting earnings, eit, is dened as
movements in earnings performance that are unrelated to rm-specic value changes, scaled by the sensitivity of
earnings performance to rm-specic value changes, eit Eit/f1i, where Ait f0i+f1i Sit+Eit, Ait being earnings
performance.
14
While a variety of mechanisms exist to motivate CEOs, limited research has been conducted on the tradeoffs
among the different compensation components. Stock options have been shown to be more prevalent in larger
rms and in rms with growth options because monitoring in these rms is more difcult (Demsetz and Lehn,
1985; Smith and Watts, 1992). But most studies focus more narrowly on examining one type of pay (cash, equity,
or total) and typically ignore the tradeoffs among various pay components.
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Table 7
Controlling for the Sloan (1993) market noise variables (pooled regressions)

D1n CASH COMPit b0 b1 Dit b2 Rit b3 ROAit b4 Dit Rit b5 Dit DROAit
b6 DROAit nvarei =varei  b7 DROAit nrei ; ei b8 Rit nvarei =varei 
b9 Rit nrei ; ei b10 salesit b11 sales2it b12 firm ageit b13 firm ageit nRit
b14 leverageit b15 leverageit nRit b16 booktomarketit b17 booktomarketit nRit ei

Variable Predicted sign (1) (2)

Intercept ? 0.089*** 0.091***


(5.20) (5.26)
D ? 0.079*** 0.081***
(6.67) (6.81)
R + 0.078** 0.064*
(1.87) (1.48)
DROANI + 1.365*** 1.376***
(8.86) (8.60)
DR + 0.214*** 0.226***
(5.38) (5.66)
DDROANI ? 0.460** 0.243
(2.35) (1.24)
DROANI[var(ei)/var(ei)] + 6.055**
(2.16)
DROANIr(ei,ei)  1.648***
(3.58)
R[var(ei)/var(ei)]  0.055
(0.19)
Rr(ei,ei) + 0.009
(0.14)
Adjusted R2 0.21 0.22
Number of observations 3,097 3,102

Results are based on pooled regressions from 1993 to 2003. T-statistics are in parentheses. Regressions include
control variables (shown in the model, above) but are excluded from the table for brevity. Signicance levels are
based on one-tailed tests where there is a prediction of the sign of the coefcient and based on two-tailed tests
otherwise. *, **, and *** correspond to 10%, 5%, and 1% signicance levels, respectively. The market noise
variables are estimated according to Sloan (1993) for each rm over the period of 19631992, requiring a
minimum of 20 observations.
Cash comp salary plus bonus, reported in thousands of dollars.
D 1 if the market-adjusted return is negative, and 0 otherwise, where market return is dened as CRSP value-
weighted index.
R cumulative monthly raw returns for the scal year from CRSP.
ROANI net income divided by beginning of the year total assets (compustat #172/ #6); DROANI change in
ROANI.
var(ei)/var(ei) variance of market related noise in stock returns over that in DROA.
r(ei,ei) the correlation of the two noise measures.
Sales compustat #12.
Firm age the scal year of the observation minus the year the rm rst appeared on CRSP.
Leverage debt divided by total assets (compustat (#9+ #34)/ #6).
Book-to-market common equity divided by market value of equity (available on ExecuComp).
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due to tradeoffs among different compensation components under the cash constraint
hypothesis rather than ex post settling up.
To investigate whether our results are driven by bad news rms reducing cash
compensation due to cash constraints, we include cash shortfall in the cash compensation
regressions and nd our main result (untabulated), that DR is positive and signicant, is
unaffected. Further, controlling for CEO compensation mix by including CEO stock
holdings in the cash compensation regressions does not change our inferences.15
The heightened pay-performance sensitivity that we document for bad news rms could
be due to political costs, where CEOs face pressure to reduce their own pay when their rm
experiences very poor economic performance, which is reected in stock returns. Large
rms and rms with large employee layoffs face more scrutiny on CEO pay. We use 20%
or larger reductions in employee headcount and rm size as proxies for political costs.
After including the political cost measures and their interactive terms with R, the
coefcient on DR remains signicantly positive. The coefcients on the political cost
proxies are insignicant, inconsistent with a political costbased explanation for our
results.
Prior literature also suggests that CEO pay-performance sensitivity systematically varies
with stock return volatility (Aggarwal and Samwick, 1999). We measure return volatility
over the 60 months before the current period and include return volatility and an
interactive term with R in our cash compensation regressions. In untabulated results, we
continue to nd a signicant positive coefcient on DR. We also replicate our models by
excluding rms in the nancial and utilities industries, as the regulated environments in
these industries likely impact the payperformance sensitivity in CEO compensation. Also,
we estimate the two compensation regressions using just stock returns. In both cases, our
results remain unchanged.
Finally, Garvey and Milbourn (2004) nd that CEOs are rewarded for good luck, but
not penalized for bad luck, where luck is dened as the component of rm stock return
that is associated with market or industry returns. In untabulated analysis, we conrm
their nding that CEO cash compensation is less sensitive to bad luck than to good luck.
However, we also nd that CEO cash compensation is more sensitive to bad news in the
firm-specific return component than to good news in the rm-specic component.16 Since
market or industry returns explain less than 20% of the stock return variation for our
sample rms, the higher cash compensation sensitivity to negative firm-specific returns
dominates the nature of the asymmetric relation between cash compensation and stock
returns in general.

5.6. Alternative proxies for unrealized losses

Our previous tests use market-adjusted stock returns as a proxy for unrealized losses. In
this subsection, we use alternative measures based on accounting earnings and future
unexpected cash ows as proxies for unrealized losses and results are reported in Table 8.
15
We follow Core and Guays (1999) denition of cash shortfall, i.e., three-year average of [(common and
preferred dividends + cash ow from investing cash ow from operations)/total assets]. The CEO stock
holdings variable is dened according to Sloan (1993) [value of CEO stock holdings]/[CEO salary and bonus
compensation].
16
Interestingly, Garvey and Milbourn (2004) also report that cash compensation is more sensitive to firm-specific
bad news (their Table 5 results on bonus), though they offer no explanation for this nding.
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Table 8
Alternative proxies for unrealized losses (Fama-MacBeth regressions)

D1n CASH COMPit b0t b1t Dit b2t Rit b3t DROAit b4t Dit Rit b5t Dit DROAit
b6t salesit b7t sales2it b8t firm ageit b9t firm ageit nRit b10t leverageit b11t leverageit nRit
b12t booktomarketit b13t booktomarketit nRit eit

Variable Predict. (1)a (2)b (3)c (4)d


sign Coef. Coef. Coef. Coef.
(t-statistic) (t-statistic) (t-statistic) (t-statistic)

Intercept ? 0.090*** 0.088*** 0.040** 0.070**


(7.21) (9.34) (2.98) (2.94)
D ? 0.119*** 0.100*** 0.014 0.057***
(10.61) (9.81) (1.68) (4.64)
R + 0.117*** 0.093*** 0.131*** 0.107***
(5.56) (3.05) (7.45) (3.56)
DROANI + 0.429*** 1.292*** 1.198*** 0.934***
(4.58) (9.70) (16.48) (12.00)
DR + 0.091*** 0.088*** 0.066*** 0.142***
(3.99) (3.42) (6.04) (3.82)
DDROANI ? 0.135 0.264 0.453*** 0.087
(1.25) (1.75) (5.46) (0.76)
Adjusted R2 0.20 0.23 018 021
No. of observations 834 831 832 578

Results are based on 11 annual FamaMacBeth regressions from 1993 to 2003. Regressions include control
variables (shown in the model, above) but are excluded from the table for brevity. The number of observations is
the average over the 10 years. t-statistics are in parentheses. Signicance levels are based on one-tailed tests where
there is a prediction of the sign of the coefcient and based on two-tailed tests otherwise. *, **, and ***
correspond to 10%, 5%, and 1% signicance levels, respectively.
Cash comp salary plus bonus, reported in thousands of dollars.
R cumulative monthly raw returns for the scal year from CRSP.
D and DROA are dened differently in columns 13, as follows:
Sales compustat #12.
Firm age the scal year of the observation minus the year the rm rst appeared on CRSP.
Leverage debt divided by total assets (compustat (#9+ #34)/ #6).
Book-to-market common equity divided by market value of equity (available on ExecuComp).
a
D 1 if DROA is negative and 0 otherwise. ROA is dened as net income divided by beginning of the year
total assets (compustat #172/ #6).
b
D 1 if DROA is negative and 0 otherwise. ROA is dened as operating income divided by beginning of the
year total assets (compustat #178/ #6).
c
D 1 if the rm reported negative unusual items, dened as the sum of special items (compustat data item
#17) adjusted for tax effect, and extraordinary items and discontinued operations (compustat data item #48).
Otherwise, D 0. ROA is dened as net income divided by beginning of the year total assets (compustat
#172/#6).
d
D 1 if market-adjusted unexpected unrealized gains are negative, and 0 otherwise. Unexpected unrealized
gains are computed by subtracting unexpected cash ows from the change in market value. Unexpected cash ows
are proxied for by the residuals from rm-specic regressions of the change in operating cash ows on lagged
changed in operating cash ows. Unexpected unrealized gains are deated by beginning of the year market value
of equity.
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The coefcients on the control variables sales, rm age, leverage, and book-to-market ratio
are suppressed in the table, though these variables are included in the estimation. In
column (1) of Table 8, instead of dening D based on market-adjusted returns, D equals 1
if DROANI is negative and 0 otherwise. In column (2) DROAOI replaces DROANI, and D
equals 1 if DROAOI is negative. In column (3), DROANI is again the independent variable
representing DROA but D equals 1 if the rm reported negative unusual items, dened as
the sum of special items net of taxes, extraordinary items, and discontinued operations,
and 0 otherwise.
In column (4) we proxy for unrealized losses based on future unexpected cash ows. In
calculating current year unexpected cash ows, we estimate rm-level time-series
regressions of changes in operating cash ows on lagged changes in operating cash ows
to account for the negative autocorrelations in cash ows (Dechow et al., 1998). We
require at least seven years of observations for each rm over the period of 19712003 for
the time-series regressions. We subtract current year unexpected operating cash ows from
the change in market value of equity during the year, and deate the difference by
beginning of the year market value of equity. We then calculate the market-adjusted
unexpected future cash ows for each rm by subtracting the mean of all sample rms for
each year. The resulting ratio reects the changes in expectations about future cash ows,
another proxy for unrealized gains and losses. D equals 1 if the resulting market-adjusted
unexpected future cash ows measure is negative and 0 otherwise.
In all of the regressions reported in Table 8, both stock returns and accounting earnings
remain positively related to cash compensation in the good news case. Consistent with
Hypothesis 1, the return interactive terms (DR) are signicantly positive (po0.01) in all
four models. The earnings interactive term (DDROA) is not signicantly different from
zero, except in column (3), where unrealized losses is proxied by negative unusual items in
earnings. In this model, the coefcient on DDROA is -0.453 and statistically signicant
(po0.01). The signicant negative coefcient on DDROA is consistent with the previous
nding in the literature that CEOs are shielded from accounting losses (Gaver and Gaver,
1998). To reconcile this negative coefcient with the insignicant coefcient on DDROA
reported in Table 4, note that bad news is dened as negative changes in market-adjusted
returns in Table 4 while here it is based on the existence of negative unusual earnings items
(special items, extraordinary items and discontinued operations).
Since the change in CEO cash compensation is positively related to stock returns, to the
extent that stock returns impound unrealized losses before they are recognized in earnings,
it is possible that the CEO has already been penalized for the unrealized loss when it is
recognized in accounting earnings. To then reduce the CEOs cash compensation when
accounting earnings recognize the loss amounts to double counting the loss. Further, if a
rm-value enhancing project results in an accounting loss, for example in the case of a
restructuring, the board may shield CEO compensation from such accounting losses so
that the CEO is not deterred from undertaking the project (Dechow et al., 1994).

5.7. Asymmetry in CEO cash compensation and CEO horizon

Since the ex post settling up problem should intensify for CEOs with shorter horizons,
one might expect the observed asymmetry in pay-performance sensitivity for cash
compensation to increase as a CEO approaches retirement. Using several variables (CEO
age, tenure, and years to retirement) to proxy for short horizon CEOs, we are unable to
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document that the asymmetry in the pay-performance sensitivity for cash compensation
increases for short horizon CEOs. However, since the true employment horizon is
unobservable to researchers and is likely measured with error, these tests lack power.
Alternative mechanisms such as continued board membership for retired CEOs can also
help mitigate ex post settling up. Furthermore, Gibbons and Murphy (1992) document
that boards increase pay-performance sensitivity for retiring CEOs to counteract weak
career concerns facing these CEOs. If boards increase compensation sensitivity to positive
returns for short horizon CEOs, it confounds our tests of ex post settling up.17 In addition,
if equity compensation generally vests when CEOs step down, equity compensation
becomes a less effective tool to substitute for cash in order to reduce ex post settling up
costs.

5.8. Use of non-accounting information in bonus plans

In Section 3, we argue that CEO cash compensation is positively related to stock returns
through various mechanisms such as board discretion (Murphy and Oyer, 2003) and
formal links between cash bonus and non-nancial performance measures (Murphy, 1999).
In this subsection, we provide evidence on boards use of non-accounting information in
setting CEO bonuses. We provide evidence that among rms with very good accounting
performance (top quintile of the change in ROA), there is still signicant variation in
bonus changes that is related to stock returns.
We identify rms in the highest quintile of DROA. These are companies that are unlikely
to cut CEO bonuses according to formal earnings-based bonus plans. We then rank and
group these companies into terciles based on the change in bonus (DBonus), which is equal
to this years bonus minus last years bonus deated by last years salary. Table 9 reports
mean DBonus, DROA, R, and RADJ, for each of the three groups (Highest, Middle, and
Lowest in DBonus). RADJ, is market-adjusted returns, where market returns are based on
the CRSP value-weighted index. The results in Table 9 suggest that within this group of
good accounting performance rms (top quintile of DROA), CEO bonuses are strongly
positively correlated with company stock performance. Firms in the lowest tercile of
DBonus (mean of .275), had substantial bonus cuts even though they exceeded last years
ROA by an average of 0.081. Because the DROA is so strong, we infer that the bonus cuts
are likely attributable to non-earnings factors that are related to stock returns. Consistent
with this, the lowest bonus change group had stock returns that are substantially lower
than the highest bonus change group (R of 9.0% versus 30.8% for the highest group, and
RADJ of 8.92% versus 11.0% for the highest group). The evidence in Table 9 is consistent
with boards of directors incorporating non-accounting information formally (through
non-nancial performance measures) or informally (through discretion) in determining
CEO bonuses.18
17
Using CEOs with three years or less remaining in ofce to proxy for short horizon, we nd that CEOs facing
shorter horizons are punished more for negative stock returns, however, they are also rewarded more for positive
returns consistent with Gibbons and Murphy (1992).
18
Since we do not directly observe the various parameters in the bonus plans, including the target performance
levels, we cannot rule out the alternative explanation that for rms in the lowest DBonus tercile, the ROA target
for the current year is much higher than last years ROA. While the CEO beat last years ROA by a wide margin,
the performance could still be well short of expectations. This causes both bonuses and stock returns to be lower
for these rms.
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Table 9
Comparison of bonus changes to stock returns for rms with good accounting performance

Means

Portfolio based on Dbonus DBonus DROANI R RADJ

Highest 0.936a 0.070b 30.8%a 11.0%a


Middle 0.192 0.071 24.7% 6.9%
Lowest 0.275 0.081 9.0% 8.2%

This table reports means for the subsample of CEO-year observations in the top quintile of DROANI. The 1,971
CEO-year observations (9,858  20%) representing the top quintile, are divided into terciles based on DBonus,
where DBonus is equal to (bonustbonust1)/salaryt1. The highest, middle, and lowest portfolios are rm-year
observations in the top tercile, middle tercile, and bottom tercile, respectively, of DBonus.
R cumulative monthly raw returns for the scal year from CRSP.
DROANI change in ROANI.
ROANI net income divided by beginning of the year total assets (compustat #172/ #6).
RADJ market-adjusted return, where market return is dened as CRSP value-weighted index.
a
A t-test of differences in the means between the highest and lowest terciles are signicant at po.01. For
example, in the case of DBonus, the mean of the highest, 0.936, is signicantly different from lowest, 0.275.
b
A t-test of differences in the means between the highest and lowest terciles are signicant at po.05.

6. Conclusion

We argue that efcient cash compensation contracts should be conservative, in the sense
that cash compensation should be more sensitive to unrealized losses than to unrealized
gains. By excluding most unrealized gains and including most unrealized losses in CEO
cash compensation (salary plus bonus), boards of directors reduce costly ex post settling up
for the shareholders (Watts, 2003a). Since returns include both unrealized gains and
unrealized losses, we expect cash compensation to be less sensitive to stock returns when
returns contain unrealized gains (good news) than when returns contain unrealized losses
(bad news). On the other hand, since equity-based compensation such as option and
restricted stock grants adjust to unrealized gains that disappear (assuming the options and
restricted stock have not yet vested), ex post settling up costs are smaller for stock-based
compensation. Hence, option and restricted stock grants should not react asymmetrically
to returns containing unrealized gains (good news) and unrealized losses (bad news).
Using data from ExecuComp from 1993 to 2003, we nd that cash compensation is
twice as sensitive to negative stock returns as to positive stock returns. Equity-based
compensation reacts symmetrically to negative and positive returns. But this latter nding
could be due to our tests lacking power. Our results are robust to alternative explanations
and specications, where we use different proxies for unrealized losses and control for
various rm and CEO characteristics.
Our ndings make several contributions to the literature. We hypothesize and document
the asymmetric sensitivity of cash compensation to stock returns containing unrealized
gains and losses, but not in equity-based compensation. These results are consistent with
costly ex post settling up in cash compensation, but not in equity-based compensation. We
also contribute to the research on accounting conservatism by offering indirect evidence
consistent with the conjecture that conservatism arose, at least partially, because it is part
of the efcient management compensation contracting technology.
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While our results are consistent with boards of directors awarding cash compensation in
ways that mitigate costly ex post settling up, we offer the following caveat. We are
unable to document cross-sectional variations in the asymmetric relation between cash
compensation and stock returns with CEO horizon, a proxy for the severity of ex post
settling up problem. While ex post settling up is a plausible explanation for the asymmetric
sensitivity of cash compensation to negative and positive stock returns that we document,
future research is required on the issue of ex post settling up in executive compensation.

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