Changes in the role of earnings in compensation over the past three decades

Liu, Linxiao
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This dissertation investigates the general time-series trend in the role of accounting earnings in the executive compensation setting over the past three decades and the factors contributing to this trend. Using a sample of 16,618 firm-year observations during the period from 1976 to 2006, I present evidence that the incentive weight on accounting earnings has decreased over the past thirty years.

I investigate potential explanations for the downward trend in the relation between accounting earnings and executive compensation from two perspectives: the change in earnings quality and the change in economic environment. Using four earnings attributes -- earnings variance, earnings persistence, earnings value relevance, and accounting accruals to capture earnings quality -- I find that earnings variance and the level of accounting accruals were increasing between 1976 and 2006, whereas earnings persistence and earnings value relevance were decreasing during this time period, implying a decline in earnings quality over time. However, I find that the decline in earnings quality is not associated with the shrinking role of earnings in compensation contracts. I use two measures for economic environment: technology innovation and global diversification. I find that technology innovation has been progressing and that the degree of global diversification has increased over the last three decades. Systematic changes in technology innovation and global diversification contribute to the declining use of accounting earnings in compensation contracts. In summary, the results suggest that the role of accounting earnings in compensation has declined steadily over the past three decades, and that this decline is attributed to fundamental changes in the economic environment rather than the decline in earnings quality.

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Accounting earnings, Earnings quality, Executive compensation, Global diversification, Technology innovation