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Executive bonus compensation when abnormal earnings and the state of the economy are correlated

Listed author(s):
  • Kim, Hwa-Sung
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    This paper investigates executive earnings-based bonuses in a general equilibrium economy. Unlike the existing study, combining the two frameworks in the fields of accounting and economics allows us to examine different earnings characteristics determined by the correlation between normal/abnormal earnings and the state of the economy. We derive a formula for the cost of executive earnings-based bonuses and obtain two key findings. First, we show that the typical bonus plan is beneficial to both shareholders and executives. To decrease the volatility of their wealth, shareholders prefer countercyclical earnings. Under this typical bonus plan, executives with countercyclical earnings can be greatly rewarded. Second, we find that the correlation between abnormal earnings and the state of the economy has a greater impact on bonuses than does the correlation between normal earnings and the state of the economy. This finding suggests that it is important to consider the relationship between abnormal earnings and the state of the economy when compensating an executive through an earnings-based bonus.

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    File URL: http://www.sciencedirect.com/science/article/pii/S0264999313000412
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    Article provided by Elsevier in its journal Economic Modelling.

    Volume (Year): 32 (2013)
    Issue (Month): C ()
    Pages: 58-65

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    Handle: RePEc:eee:ecmode:v:32:y:2013:i:c:p:58-65
    DOI: 10.1016/j.econmod.2013.01.038
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30411

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    1. Dechow, Patricia M. & Sloan, Richard G., 1991. "Executive incentives and the horizon problem : An empirical investigation," Journal of Accounting and Economics, Elsevier, vol. 14(1), pages 51-89, March.
    2. Kanagaretnam, Kiridaran & Sarkar, Sudipto, 2011. "Managerial compensation and the underinvestment problem," Economic Modelling, Elsevier, vol. 28(1), pages 308-315.
    3. Ahn, Chang Mo & Thompson, Howard E, 1988. " Jump-Diffusion Processes and the Term Structure of Interest Rates," Journal of Finance, American Finance Association, vol. 43(1), pages 155-174, March.
    4. Chen, Ming-Yuan, 2010. "Managerial pay adjustments: Decomposition and impact on firm productive efficiency," Economic Modelling, Elsevier, vol. 27(1), pages 196-207, January.
    5. Holmstrom, Bengt & Milgrom, Paul, 1987. "Aggregation and Linearity in the Provision of Intertemporal Incentives," Econometrica, Econometric Society, vol. 55(2), pages 303-328, March.
    6. Gaver, Jennifer J. & Gaver, Kenneth M. & Austin, Jeffrey R., 1995. "Additional evidence on bonus plans and income management," Journal of Accounting and Economics, Elsevier, vol. 19(1), pages 3-28, February.
    7. Murphy, Kevin J., 2000. "Performance standards in incentive contracts," Journal of Accounting and Economics, Elsevier, vol. 30(3), pages 245-278, December.
    8. Healy, Paul M., 1985. "The effect of bonus schemes on accounting decisions," Journal of Accounting and Economics, Elsevier, vol. 7(1-3), pages 85-107, April.
    9. Cox, John C & Ingersoll, Jonathan E, Jr & Ross, Stephen A, 1985. "An Intertemporal General Equilibrium Model of Asset Prices," Econometrica, Econometric Society, vol. 53(2), pages 363-384, March.
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