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Accounting Information and CEO Compensation: The Role of Cash Flow from Operations in the Presence of Earnings

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  • Emeka T. Nwaeze
  • Simon S. M. Yang
  • Q. Jennifer Yin

Abstract

We examine the role of cash flow from operations (CFO) in chief executive officer (CEO) cash compensation. We predict that CFO is contract†relevant in the presence of earnings, and more so when (1) the quality of earnings relative to the quality of CFO as a measure of performance is low and (2) the need for CFO as a financing source is high. Our analysis is motivated principally by normative arguments and anecdotes from financial disclosures linking CFO to managerial effort and contracts, notwithstanding the traditional role of earnings in performance measurement. We find that the weight of CFO in the compensation model is positive and significant in the presence of earnings and stock returns. We also find that the relative quality of CFO compared with that of earnings has a positive (negative) impact on the weight of CFO (earnings). We further find that the relative weight of CFO is enhanced substantially when enterprise activities crucially depend on internally generated cash flow. These findings are unaltered when we include CEO age, firm size, and risk in the model and allow the coefficients to vary across industries.

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  • Emeka T. Nwaeze & Simon S. M. Yang & Q. Jennifer Yin, 2006. "Accounting Information and CEO Compensation: The Role of Cash Flow from Operations in the Presence of Earnings," Contemporary Accounting Research, John Wiley & Sons, vol. 23(1), pages 227-265, March.
    • Handle: RePEc:wly:coacre:v:23:y:2006:i:1:p:227-265
    DOI: 10.1506/BUQJ-8KUQ-X2TF-K7T4
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    4. Emeka T. Nwaeze, 2010. "The Choice of Operating Cash Flow in Incentive Compensation," Working Papers 0008, College of Business, University of Texas at San Antonio.
    5. Elio Alfonso & Dana Hollie & Shaokun Carol Yu, 2019. "Cash Flow Restatements: Stock Market Reaction to Overstated versus Understated Restatements," Accounting and Finance Research, Sciedu Press, vol. 8(3), pages 1-1, August.
    6. Negrea Laura Georgeta & Matis Dumitru & Mustata V. Razvan, 2011. "Free Cash Flow As Part Of Voluntary Reporting. Literature Review," Annals of Faculty of Economics, University of Oradea, Faculty of Economics, vol. 1(2), pages 591-596, December.
    7. Seraina C. Anagnostopoulou & Andrianos E. Tsekrekos, 2017. "The effect of financial leverage on real and accrual-based earnings management," Accounting and Business Research, Taylor & Francis Journals, vol. 47(2), pages 191-236, February.
    8. Dechow, Patricia & Ge, Weili & Schrand, Catherine, 2010. "Understanding earnings quality: A review of the proxies, their determinants and their consequences," Journal of Accounting and Economics, Elsevier, vol. 50(2-3), pages 344-401, December.
    9. Rajiv D. Banker & Rong Huang & Ramachandran Natarajan, 2009. "Incentive Contracting and Value Relevance of Earnings and Cash Flows," Journal of Accounting Research, Wiley Blackwell, vol. 47(3), pages 647-678, June.
    10. Gao, Huasheng & Li, Kai, 2015. "A comparison of CEO pay–performance sensitivity in privately-held and public firms," Journal of Corporate Finance, Elsevier, vol. 35(C), pages 370-388.
    11. Christopher Edmonds & Ryan Leece & John Maher, 2013. "CEO bonus compensation: the effects of missing analysts’ revenue forecasts," Review of Quantitative Finance and Accounting, Springer, vol. 41(1), pages 149-170, July.
    12. Rahman, Sheehan, 2023. "Narrative tone and earnings persistence," Journal of International Accounting, Auditing and Taxation, Elsevier, vol. 52(C).
    13. Hu, Jinshuai & Kim, Jeong-Bon, 2019. "The relative usefulness of cash flows versus accrual earnings for CEO turnover decisions across countries: The role of investor protection," Journal of International Accounting, Auditing and Taxation, Elsevier, vol. 34(C), pages 91-107.
    14. Julia Koralun-Bereźnicka, 2014. "Capital Structure As A Determinant Of Working Capital Management: Empirical Evidence Across Size Groups Of Firms In The Eu Countries," Economy & Business Journal, International Scientific Publications, Bulgaria, vol. 8(1), pages 36-54.
    15. Henri Akono & Emeka T. Nwaeze, 2018. "Why and how firms use operating cash flow in compensation," Accounting and Business Research, Taylor & Francis Journals, vol. 48(4), pages 400-426, June.
    16. Inho Suk & Seungwon Lee & William Kross, 2021. "CEO Turnover and Accounting Earnings: The Role of Earnings Persistence," Management Science, INFORMS, vol. 67(5), pages 3195-3218, May.

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