Earnings Dynamics and CEO Compensation: Exploring the Effect of Sales Change Direction

This study examines the impact of sales change direction on earnings’ time-series characteristics and their role in executive incentive schemes. First, we analyze whether earnings persistence decreases during the periods of sales-decrease. This could be due to sticky cost behavior, as earnings are mechanically lowered when managers deliberately choose to retain unutilized resources during these periods. Secondly, we investigate the effect of sales change direction on the role of earnings in CEO incentive schemes. We expect that optimal CEO compensation schemes will assign a lower weight to earnings during periods of sales-decrease. This adjustment reflects the understanding that earnings may not accurately reflect the value of managerial efforts to overcome a sales decline during these periods. Using a sample of U.S. firms from 1993 to 2016, we find that earnings persistence decreases following sales declines. Additionally, our results show a significant decrease in the weight assigned to earnings in determining CEO compensation during sales decline periods. This finding remains consistent across all forms of compensation, including salary, bonuses, and equity-based compensation. Our findings highlight the economic importance of sales revenue information in understanding earnings quality and its impacts on CEO pay-for-performance sensitivity.