The Relation between Nonrecurring Accounting Transactions and CEO Cash Compensation

Abstract

This study investigates the role of alternative earnings components in the CEO cash compensation function. We concentrate on a simple partition of net income: "above the line" versus "below the line" items. This partition is selected to examine the differential treatment of permanent and transitory earnings items in determining executive pay. We find that cash compensation is significantly positively related to above the line earnings, as long as results are positive. Compensation is shielded from the effects of above the line losses. Similarly, below the line transactions that increase income flow through to compensation, but below the line losses do not. This effect is noted for gains and losses that arise both from extraordinary transactions and discontinued operations. Further, unusual gains that do not qualify for below the line treatment are significantly positively weighted in the compensation function. Compensation is shielded from unusual losses. Thus, the data tell a remarkably consistent story: gains flow through to compensation, but losses do not. The position of the transaction on the income statement is of relatively little importance. If above versus below the line disclosure conveys information about the effect of the item on permanent earnings, the results suggest that this distinction is not emphasized in compensation decisions.

JEL Classification: M41, J33