Earnings, Cash Flows and Executive Compensation: An Exploratory Analysis

Abstract

This study examines the relationship between management compensation, earnings and cash flows. The preponderance of prior research reveals a substantial correlation between total earnings and compensation. However, the popular press indicates that many firms have switched to less traditional methods of awarding executive compensation. For example, Chrysler Corporation now bases substantial compensation on quality control in manufacturing while First Chicago bases compensation on the minimizing of loan losses. Because of their relatively high debt levels in the late 1980s, some firms are stressing cash flows in designing compensation plans. For example, the New York Times [2/25/90, p.29 in Section 3] reports that RJR Nabisco Inc. uses cash flows to compute the bonus pool while The Wall Street Journal [4/18/90, p. R26] indicates that board of directors often dump income‐based fixed compensation formulas in favor of performance goals such as cash flows. From a normative viewpoint, Holmstrom's [1979] analysis suggests that a performance evaluation scheme based on multiple signals is superior to one that is based on a single signal, provided the additional signals incorporate new information. Given these anecdotal reports indicating cash‐flow based compensation and the implications of existing theory, we explore the role of cash flows and working capital from operations in addition to total reported earnings in determining managerial compensation.

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