5.BANKER Et Al-2009-Journal of Accounting Research

DOI: 10.1111/j.1475-679X.2009.00335.
x
Journal of Accounting Research
Vol. 47 No. 3 June 2009
Printed in U.S.A.
Incentive Contracting and Value

Relevance of Earnings and
Cash Flows
RAJIV D. BANKER,∗ RONG HUANG,†
AND RAMACHANDRAN NATARAJAN‡
Received 14 April 2006; accepted 3 January 2009
ABSTRACT
Accounting performance measures such as earnings and cash flows are

useful for both valuation and performance evaluation purposes. However, little
evidence exists on whether there is any association between these two roles. In
this study, we provide large sample empirical evidence that the value relevance
of earnings explains a significant amount of the cross-sectional variation in the
pay-sensitivity of earnings and the incremental value relevance of cash flows
explains variation in the marginal pay-sensitivity of cash flows. We document
that while both value relevance and compensation weight on earnings decline
from the subperiod of 1993 to 1997 to the subperiod of 1998 to 2003, both
value relevance and compensation weight on cash flows increase from the
earlier subperiod to the later subperiod. Overall, our results provide additional
evidence that value relevance of a performance measure plays a significant role
in its use for performance evaluation.
1. Introduction
This study examines the association between pay-sensitivity and value rel-
evance of earnings and cash flows. Accounting performance measures such
as earnings and cash flows serve a variety of purposes in organizations and
markets, including valuation and performance evaluation. While a number
∗ Temple University; †City University of New York—Baruch College; ‡The University of Texas
at Dallas. We thank seminar participants at Temple University, City University of New York—
Baruch College, The University of Texas at Dallas, and the American Accounting Association
2006 Annual meeting, Merle Erickson and the anonymous referee for helpful comments and
suggestions.
647
Copyright
C , University of Chicago on behalf of the Institute of Professional Accounting, 2009
648 R. D. BANKER, R. HUANG, AND R. NATARAJAN
of prior studies have examined the valuation roles and incentive-contracting

roles of accounting performance measures separately, very little evidence
exists on whether there is any association between these two roles. Using
CEO compensation and accounting data for a large number of U.S. firms,
we examine the empirical association between value and incentive relevance
of earnings and cash flows over an 11-year period from 1993 to 2003. The
graph in figure 1 shows that the relative compensation weight on cash flows
versus earnings tracks remarkably closely to their relative valuation rele-
vance for our sample period from 1993 to 2003. The correlation between
the relative compensation weight and the relative valuation relevance is as
high as 0.87. When we analyze the data more formally to control for other
influential factors at the firm level, the results confirm that compensation
weight on each of earnings and cash flows is higher for firms that exhibit
high levels of value relevance for the performance measure. The evidence
also indicates that both value relevance and compensation weight for earn-
ings decline from the subperiod of 1993 to 1997 to the subperiod of 1998 to
2003, while both the value relevance and the compensation weight for cash
flows increase from the earlier subperiod to the later subperiod.
Gjesdal [1981] puts forth the basic premise that the incentive-
informativeness of performance measures that determines their compen-
sation weights may be different from their valuation-informativeness. He
considers differential uses of accounting information in organizations and
shows that the ranking of information systems for valuation purposes need
not align with the ranking of those information systems for control pur-
poses. Lambert [1993] expands on this issue by remarking that valuing the
firm is not the same as evaluating the manager’s contribution to the value of
the firm. The observations made by Gjesdal [1981] and Lambert [1993] are
based on single-action, single-period settings where optimal compensation
contracts assign lower (higher) weights on performance measures that have
lower (higher) sensitivity-to-noise ratio (Banker and Datar [1989]).
The implication of the above observations for empirical accounting re-
searchers is that the association between value relevance and incentive-
informativeness of performance measures is context-specific and varies
across agencies. However, it appears that these implications may have
been misunderstood as indicating instead that there is no association be-
tween value-relevance and incentive-informativeness. A notable exception
is Bushman, Engel, and Smith [2006] who examine linkages between the
weight placed on earnings in compensation contracts and the weight placed
on earnings in stock price formation. They show that valuation earnings co-
efficients and compensation earnings coefficients are positively associated
and point out that further theoretical and empirical investigation of this as-
sociation remains an interesting challenge for future research. 1 Our main
1 In a related context, Engel, Hayes, and Wang [2003] find that the weight on earnings infor-
mation in CEO turnover decisions is increasing in the timeliness of earnings where timeliness
is measured as the contemporaneous association between earnings and stock returns.
INCENTIVE CONTRACTING AND VALUE RELEVANCE 649
Relative weight of cash flows vs. earnings

0.8
Relative weight 0.6
0.4
0.2
0
1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
Calendar year
Relative valuation weight of cash flows vs. earnings

Relative compensation weight of cash flows vs. earnings
FIG. 1.—Relative weights on earnings and cash flows for valuation and compensation
purposes. This figure shows relative valuation and compensation weights of earnings and cash
flows over the years 1993 to 2003. We obtain valuation weights on earnings (α 1 ) and cash flows
(α 2 ) from the year-by-year cross-sectional regression of the following model:
P i,t = α0 + α1 EPSi,t + α2 CPSi,t + α3 BPSi,t + εit .
Pit is price per share of firm i at the end of the third month after fiscal year-end t. EPS it is
earnings per share of firm i during year t, defined as earnings before extraordinary items
(Compustat annual #18) scaled by number of common shares outstanding adjusted for stock
splits and stock dividends. CPS it is cash flows per share of firm i during year t, defined as cash
flows from operation (Compustat annual #308) scaled by number of common shares outstand-
ing adjusted for stock splits and stock dividends. BPS it is book value per share of firm i during
year t, defined as book value of common equity (#60) scaled by number of common shares
outstanding adjusted for stock splits and stock dividends.
We obtain compensation weights on earnings (β 1 ) and cash flows (β 2 ) from the year-by-year
cross-sectional regression of the following model:
log(CASHCOMP ) i,t = β0 + β1 EPS i,t + β2CPS i,t + εit
CASHCOMPit is CEO’s total cash compensation (salary + bonus) for firm i in year t.
The relative valuation weight of cash flows versus earnings is defined as α2 /α1 . The relative
compensation weight of cash flows versus earnings is defined as β2 /β1 .
motivation behind this study stems from a similar desire to provide evidence
on the positive association between the valuation roles and incentive con-
tracting roles in settings where multiple accounting performance measures
are used to evaluate top managers.
We consider two primary accounting performance measures, earnings
and cash flows, for the purposes of this study. We focus on these perfor-
mance measures for several reasons. First, since cash flows is a component
of earnings, the research setting lends itself to examining incremental value
relevance and marginal pay-performance sensitivity of cash flows when cash
flows information is available in addition to earnings for valuation and per-
formance evaluation purposes. Second, a number of studies have estab-
lished that earnings and cash flows have differential implications for firm
value (Rayburn [1986], Bowen, Burgstahler, and Daley [1986], Ali [1994],
Sloan [1996]). Prior studies have also shown that the incremental value of
cash flows over earnings varies cross-sectionally depending on factors such
as the persistence of earnings and cash flows (Sloan [1996], Xie [2001],
Richardson et al. [2005]), the time interval over which performance is
measured, the volatility of the firm’s working capital requirements, and the
length of the firm’s operating cycle (Dechow [1994], Dechow, Kothari, and
Watts [1998]). Third, studies examining the stewardship value of compo-
nents of earnings have found that there is significant cross-sectional variation
in the way cash flows and earnings are used in determining top management
compensation (Natarajan [1996], Nwaeze, Yang, and Yin [2006]). Fourth,
very limited empirical evidence exists on whether the incremental value
relevance and the marginal pay-performance sensitivity of cash flows have
changed over time since cash flow information was first made available to
shareholders in 1987 through Statement of Financial Accounting Standards
(SFAS) 95.
To understand the structural factors influencing the context-specific na-
ture of the above-mentioned association, we first derive pay-sensitivities and
value relevance measures using a highly stylized principal-agent setting char-
acterized by two performance measures. 2 The two performance measures
are each modeled as consisting of a distinct managerial effort component, a
common pay-off relevant noise term and a specific nonvalue-relevant noise
component. We show that the context-specific nature of the association be-
tween valuation weights and compensation weights is critically dependent
on the cross-sectional differences in the variances of the pay-off relevant
noise and idiosyncratic noise of the performance measures under consid-
eration. The insights provided by our stylized model are used to generate
empirical proxies of the variances of the relevant noise terms from the firm-
specific variance–covariance matrix of earnings and cash flows and to explic-
itly quantify the co-movement of the theoretical, endogenously determined,
valuation, and compensation weights at various deciles of the cross-section of
a large sample of Compustat firms. The analysis based on estimated values of
the variances of the relevant noise terms suggests an expected positive asso-
ciation between compensation weights and valuation weights when earnings
and cash flows are the performance measures under consideration.
We formally test this prediction using actual compensation, valuation, and
performance measure data. We use a sample of 7,076 CEO-years spanning
the period 1993 to 2003 in our empirical analysis. In the first stage of our
analysis, we estimate value relevance of earnings and incremental value rel-
evance of cash flows for each firm-year using a time-series of 8 to 10 years
of past data on earnings, cash flows, and stock prices, and adapting the
metrics suggested in prior literature (Ohlson [1995], Collins, Maydew, and
2 As observed by Bushman, Engel, and Smith [2006], any economic model that links pay-
sensitivities and value relevance measures should account for the fact that these constructs are
endogenously determined. We pay particular attention to this issue in our model development.
Weiss [1997], Barth et al. [1999], Engel, Hayes, and Wang [2003], Bushman
et al. [2004]) to our context. In the second stage, we estimate cross-sectional
yearly regressions that use CEO and firm level data on cash compensation,
earnings, cash flows, value relevance of earnings and cash flows, as well as
a variety of control variables that have been identified in prior literature as
determinants of cross-sectional variation in pay-performance sensitivity of
earnings and cash flows. The regression coefficients from the second stage
regression enable us to estimate the average magnitude of the association
between value relevance and pay-performance sensitivity during our sample
period for both earnings and cash flows.
The empirical results support our predictions. The estimated association
between pay-performance sensitivity and the value relevance is significantly
positive for both earnings and cash flows. We evaluate the robustness of our
findings by considering cash flows as the primary performance measure and
earnings as the supplementary performance measure, by using total com-
pensation instead of cash compensation and by employing changes rather
than levels in earnings and cash flows as performance measures. These re-
sults also support our predictions.
Our study contributes to a stream of research that has examined the asso-
ciation between the valuation and performance evaluation roles of account-
ing performance measures. Two notable studies that belong to this stream
are Bushman, Engel, and Smith [2006] and Engel, Hayes, and Wang [2003].
In contrast to Bushman, Engel, and Smith [2006], who empirically examine
the association between the valuation and incentive contracting role of ac-
counting earnings, we focus on a pair of correlated accounting performance
measures namely, accounting earnings and cash flows. Our empirical results
confirm Bushman, Engel, and Smith’s [2006] findings that the higher the
value relevance of earnings, the higher the pay-sensitivity of earnings. More
importantly, we also provide evidence that the higher the incremental value
relevance of cash flows, the higher the incremental pay-sensitivity of cash
flows.
Engel, Hayes, and Wang [2003] employ a research design somewhat sim-
ilar to ours to examine the association between CEO turnover probability
and accounting earnings. They predict that CEO turnover probability is de-
creasing in the timelines of earnings and find empirical evidence consistent
with their predictions. “Timeliness” of earnings is measured through its as-
sociation with contemporaneous stock returns.
There are however, some significant differences between Engel, Hayes,
and Wang [2003] and our study. Our study focuses on the compensation
decision while Engel, Hayes, and Wang [2003] examine turnover decisions.
The empirical model in Engel, Hayes, and Wang [2003] is similar to Sloan
[1993] and Lambert and Larcker [1987] in that the primary focus is on the
relative weights on accounting earnings and stock returns for performance
evaluation. In contrast, we focus on the association between valuation and
performance evaluation roles of two accounting performance measures, for
example, earnings and cash flows. The empirical analysis in Engel, Hayes,
and Wang [2003] is based on the predictions of a two-period model where

current earnings, by construction, reflect only a portion of current period
managerial effort, and that predicts that relative weight on earnings increases
with timeliness of current period earnings. In contrast, our analytical char-
acterization underlines the influence of cross-sectional differences in the
variances of pay-off relevant noise and idiosyncratic noise of performance
measures on the association between compensation and valuation weights
of performance measures and does not make any directional predictions
for this association.
To summarize, our study contributes in three ways to the existing liter-
ature on the use of accounting performance measures in valuation and
performance evaluation. First, it confirms and quantifies the positive associ-
ation between value relevance and pay-performance sensitivity for earnings
and cash flows. Second, it quantifies the decline in value relevance and pay-
performance sensitivity of earnings and corresponding increase in value rel-
evance and pay-performance sensitivity of cash flows over the past decade.
Third, it provides evidence that value relevance of performance measures
plays a significant role in the choice of accounting performance measures
for performance evaluation in organizations.
The remainder of this paper proceeds as follows. Section II develops the
main hypotheses. Section III discusses the research design and sample selec-
tion. Section IV presents the empirical results. Finally, Section V concludes
the paper.
2. Theory Development
Lambert’s [1993] remark that valuing the firm is not the same as evaluat-
ing the manager’s contribution to the value of the firm is intuitively appeal-
ing but provides limited guidance to empirical researchers on the similari-
ties and differences in the way value relevance measures and pay-sensitivities
are influenced by the underlying agency and performance measure char-
acteristics. Since both the pay-sensitivities and value relevance measures are
endogenously determined and are functions of the characteristics that dif-
fer across the agencies in the cross-section, it is important to understand
the impact of the variation of the various characteristics on the association
between these endogenous variables in the cross-section. Changes in some
of the characteristics result in changes in valuation and contracting weights
that are of the same sign while changes in other characteristics may have
opposing effects on these weights. The stylized model that we develop in
this section and the analysis of performance measure data to quantify the
insights from the model are oriented towards understanding the dominant
characteristics that drive the cross-sectional distribution of the set of agen-
cies (firms) under consideration.
We formally consider a simple, single period, two-action, two-signal
principal-agent setting based on the LEN (linear contract, negative
exponential utility, and normally distributed random variables) frame-

work to better understand the factors influencing the association between
value relevance measures and pay-sensitivities of performance measures.
Complete details of the model are provided in the appendix and we briefly
describe the setting here.
The setting we consider involves a risk-averse manager who is in charge
of two distinct productive activities. These productive activities along with
factors beyond the control of the manager determine the unobservable out-
come and generate two observable, contractible, performance measures.
Each performance measure is driven by one of the productive activities
while the outcome or value to the principal is influenced by both activities.
The two performance measures also contain a common as well as a spe-
cific random component. From a valuation point of view, the performance
measures are useful because the common component they contain is a key
component of the outcome. Market participants, therefore, use these sig-
nals to update their beliefs about the outcome. From a contracting point of
view, the performance measures are useful because they are informative
about the agent’s unobservable activities. Without loss of generality, we nor-
malize the risk-aversion coefficient and the sensitivities of the performance
measures to managerial actions to unity to focus on a minimal set of param-
eters that vary across agencies. 3
While the setting we consider is highly stylized, it captures some neces-
sary elements of a contracting environment where accounting performance
measures such as earnings and cash flows are key determinants of execu-
tive compensation. The two performance measures have a positive correla-
tion by construction, which is representative of the empirically documented
positive correlation between earnings and cash flows (Dechow [1994]). Pro-
ductive managerial activities, which may differentially impact cash flows and
earnings, ultimately contribute to increases in firm value and this essential
aspect is also captured in the way the unobservable outcome is modeled.
Investor beliefs about firm value get updated on the release of informa-
tion about realizations of earnings and cash flows (Rayburn [1986], Bowen,
Burgstahler, and Daley [1986]) and we operationalize this by modeling the
random components of the performance measures as garbled versions of
the random component of the outcome. Our simplified set up, however,
does not capture the effect of prior period productive actions on current
period earnings and cash flows as well as the effect of earnings management
practices on reported accounting numbers.
In this model, we can completely characterize the pay-sensitivities and
value relevance metrics of the performance measures in terms of the ele-
ments of the variance–covariance matrix of the performance measures. The
3 As we show later, empirical proxies of these agency-specific parameters can be esti-
mated from the sample variance–covariance matrix of the performance measures under
consideration.
elements of the variance–covariance matrix are functions of two specific vari-

ances and a common variance. 4 In our model, different agencies (firms) are
characterized by different values for the three-component, positive-valued,
variance vector.
We show in the appendix that both the valuation and compensation
weights decrease when the total variance of the performance measure in-
creases due to an increase in the specific or idiosyncratic variance. How-
ever, if the source of the increase in the total variance of a performance
measure is the common variance then the performance measure becomes
more informative for valuation purposes but less informative for contract-
ing purposes. We also characterize the exact magnitudes of the change in
valuation and compensation weights in the neighborhood of a particular
agency as functions of the levels and changes of the common and specific
variances. We point out that if one is examining a set of agencies (or firms)
where the variation across agencies is primarily driven by the variation in
those characteristics that have similar directional influence on valuation and
compensation weights, it is more likely that one would observe a positive as-
sociation between these weights. If, on the other hand, the set of agencies
primarily varies along those characteristics whose changes lead to opposing
effects in changes in valuation and contracting weights the cross-sectional
association will be, on average, negative.
We estimate firm-specific values of the common variance, specific variance
of earnings and specific variance of cash flows for a sample of 1,351 Compu-
stat firms using time-series data of earnings-per-share (EPS) and cash-flows-
per-share (CFPS) and use the decile values of the estimated variances to
construct representative firms that characterize the cross-sectional distribu-
tion of the firms. Table A1 in the appendix provides the estimated variances
as well as the estimated compensation and valuation weights for these firms.
As expected, when the specific as well as common variances increase the
compensation weights decline. What is interesting is that the value relevance
measures also decline when we go from lower deciles to higher deciles. It
appears that from a valuation perspective, the reduction in the valuation
weight triggered by the increase in specific variance dominates the increase
triggered by the increase in the common variance, leading to an overall
decline. Overall, the empirical evidence based on the joint distribution of
earnings and cash flows suggests a possible positive association between the
valuation and compensation weights.
It is possible that factors other than the specific and common variances
of the performance measures can also play a role in determining the asso-
ciation between valuation and compensation weights. For instance, Engel,
Hayes, and Wang [2003] and Bushman, Engel, and Smith [2006] describe
4 The total variance of any of the performance measures is the sum of the common vari-
ance and the specific variance of that performance measure. The covariance between the two
performance measures is equal to the common variance.
alternative scenarios in which current earnings do not fully reflect multi-

period effects of managerial actions on firm value that can result in com-
pensation weights and valuation weights having a positive association. Bush-
man, Engel, and Smith [2006] also argue that a positive association between
the two roles can arise in a world where the marginal product of effort and
the sensitivity of earnings to managerial actions are positively correlated
random variables.
To summarize, our theoretical setup enables us to gain insights into the
context-specific association between valuation and contracting roles in case
of the possible use of earnings and cash flows as performance measures.
We analyze the performance measure data using theoretical expressions
for the change in compensation weight and change in valuation weight in
firm-specific neighborhoods for representative firms at various deciles. The
evidence is supportive of a positive association between the contracting and
valuation roles of earnings and cash flows. We formally test this prediction in
our subsequent empirical analysis using actual compensation and valuation
data.
Next, we discuss the research design that we use in the study to examine
the above conjecture and provide details on the sample.
3. Research Design and Sample Selection

A direct way to test our hypotheses developed in the previous section is
to estimate pay-sensitivities and value relevance measures on a firm-specific
basis and examine the association between these measures in the cross-
section. However, this approach suffers from a number of limitations, es-
pecially in the estimation of firm-level pay-performance sensitivity mea-
sures. Issues such as short time-series of firm-specific compensation data,
the unrealistic assumption of time-invariant pay-performance sensitivity,
and CEO-turnover, lead to substantial noise in the estimated firm level
pay-performance sensitivities. To address these issues, we follow previous
compensation studies in accounting (Sloan [1993], Baber, Janakiraman,
and Kang [1996], Baber, Kang, and Kumar [1998], Nwaeze, Yang, and Yin
[2006]) and adopt a cross-sectional approach to test our hypotheses.
Typical cross-sectional pay-performance studies model annual CEO com-
pensation as a function of the various performance measures as well as
the performance measures interacted with firm-level control variables to
capture the cross-sectional variation in pay-performance sensitivities across
firms. We include additional terms that interact the performance mea-
sures with their firm-specific value relevance counterparts. 5 Specifically, the
cross-sectional relationship we examine is:
5 While there is no economic theory to motivate the inclusion of main effects of value
relevance measures, we include them in the empirical model for econometric reasons. Our
results hold when we remove these main effects from the empirical model.
Compensation ∝ f (earnings, cash flows, earnings ∗ value relevance of earnings,

cash flows ∗ incremental value relevance of cash flows, value
relevance of earnings, incremental value relevance of cash flows,
earnings ∗ control, cash flows ∗ control).
We operationalize the above relationship in an ordinary least square (OLS)
framework using annual CEO compensation and firm-level data. 6 Specifi-
cally, we estimate, on an annual basis
log(COMPi ) = γ0 + ηe (ROAi ) + ηc (CFOAi ) + we (ve i ∗ ROAi )
+ wc (vci ∗ CFOAi ) + θe vei + θc vci + δe Control ∗ ROAi
+ δc Control ∗ CFOAi + ui
where, for firm i,
COMPi = CEO cash compensation (salary + bonus),
ROA i = net income before extraordinary items (#18)/average total assets
(#6),
CFOA i = cash flows from operations (#308)/average total assets (#6),
v ei = value relevance of earnings,
v ci = incremental value relevance of cash flows from operations, and
Control i = decile rank values for various control variables.
A significant positive value for w e , the regression coefficient on v ei ∗ ROA i ,
is expected to provide support for the argument that the association between
value relevance of earnings and pay-sensitivity of earnings is positive and,
in a similar vein, a significant positive value for w c provides support for the
argument that the association between incremental value relevance of cash
flows and marginal pay-sensitivity of cash flows is positive.
3.1 VARIABLE MEASUREMENT

We obtain measures for value relevance of earnings and the incremental
value relevance of cash flows from firm-year-specific estimation of the fol-
lowing time-series regressions using data from a 10-year rolling window. We
require that each firm have data available for at least eight years starting
from 1980.
Pi,t = α0 + α1 BPSi,t + e it . (1)
Pi,t = β0 + β1 EPSi,t + β2 BPSi,t + uit . (2)
Pi,t = γ0 + γ1 EPSi,t + γ2 CPSi,t + γ3 BPSi,t + εit . (3)
6 We use a “level” specification similar to those employed in Core, Holthausen, and Larcker
[1999] and Smith and Watts [1992]. We also repeat our analysis with a “change” specification
in a later section as a sensitivity check.
P it is price per share of firm i at the end of the third month after fiscal year-
end t, EPS it is earnings per share of firm i during year t, CPS it is cash flows per
share of firm i during year t and BPS it is book value per share of firm i during
year t. The above models are derived from Ohlson’s [1995, 1999] valuation
model and modified from Collins, Maydew, and Weiss [1997]. CPS (cash
flow per share) can be interpreted as pertaining to “other information” in
the Ohlson [1999] model. Following Collins, Maydew, and Weiss [1997], we
first obtain coefficients of determination from equations (1), (2), and (3)
denoted as R 2bv , R 2earnbv , and R 2total , respectively. Value relevance of earnings
(v e ) is measured as (R2earnbv − R2bv )/(1 − R2b v ) and the incremental value
relevance of cash flows (v c ) is measured as (R2total − R2earnbv )/(1 − R2earnbv ).
By construction, both of these measures take values in the range 0 to 1.
To accommodate the possibility that cash flows may be perceived as the
primary performance measure and earnings as the supplementary perfor-
mance measure, we also modify equation (2) to obtain value relevance of
cash flows and incremental value relevance of earnings as follows:
Pi,t = η0 + η1 CPSi,t + η2 BPSi,t + uit . (4)
Denoting the coefficient of determination of equation (4) as R 2cfobv , we mea-

sure value relevance of cash flows (v c ) as (R2cfobv − R2b v )/(1 − R2b v ) and the
incremental value relevance of earnings (v e ) as (R2total − R2cfobv )/(1 − R2cfobv )
for use in later analysis. By construction, once again, both of these measures
take values in the range 0 to 1.
Our R 2 measures are related to the R 2 measure used in Bushman et al.
[2004] (equation (2) on page 173) except that (1) we use a “level” speci-
fication of the Ohlson [1995] model while Bushman et al. [2004] adopt a
“change” specification of the Ohlson [1995] model, (2) we add cash flows
per share as the “other information” component in Ohlson [1999] since
we are interested in the incremental value relevance of cash flows over and
above earnings, and (3) we do not include earnings level in our return val-
uation model to be consistent with the compensation specification and to
link our R 2 measure more directly to pay-sensitivities.
An alternative R 2 measure is used by Engel, Hayes, and Wang [2003] to ex-
amine the association between CEO turnover probability and earnings time-
liness. Similar to Engel, Hayes, and Wang [2003], our paper seeks to provide
a directional prediction of how a valuation-based R 2 measure moderates the
relation between the dependent variable and performance measures. While
the research designs in both Engel, Hayes, and Wang [2003] and our study
are similar in the use of an interaction term involving accounting earnings
and a valuation-based R 2 measure, our paper significantly differs from En-
gel, Hayes, and Wang [2003] in the following ways: (1) We are interested in
compensation decision while Engel, Hayes, and Wang [2003] are interested
in turnover decisions. Therefore our dependent variable is compensation as
contrasted to turnover in Engel, Hayes, and Wang [2003]. (2) Our value rele-
vance measure is different from the timeliness measure in Engel, Hayes, and
Wang [2003]. (3) The empirical model in Engel, Hayes, and Wang [2003]
is more related to Sloan [1993] and Lambert and Larcker [1987]. They
consider one accounting performance measure, earnings, and one market
performance measure, market returns. Our empirical model is more closely
related to Natarajan [1996] by considering two accounting performance
measures, earnings, and cash flows. (4) In their setup, where earnings and
returns are performance measures, Engel, Hayes, and Wang [2003] predict
that relative weight on earnings increases with timeliness. However, in our
setup, the compensation weight on accounting performance measures can
increase or decrease with their value relevance depending on the context.
The control variables that we include in our empirical specification are
taken from prior studies that have examined sensitivity of CEO pay to ac-
counting performance measures in the cross-section. We include proxies for
investment opportunity sets (IOS), leverage, performance measure noise,
trading cycle, and performance measure persistence. Growth opportuni-
ties reduce the pay-for-performance sensitivities of accounting performance
measures (Smith and Watts [1992], Gaver and Gaver [1993]). Leverage is ex-
pected to reduce the pay-sensitivity of earnings and increase the incremental
pay-sensitivity of cash flows (Natarajan [1996]). Longer trading cycles de-
crease the incremental stewardship value of cash flows (Dechow [1994],
Natarajan [1996]). Performance measure noise (Banker and Datar [1989],
Lambert and Larcker [1987], Sloan [1993]) leads to a reduction in the com-
pensation weights on performance measures. Earnings persistence is shown
to be positively related to the reliance of CEO compensation on earnings
(Baber, Kang, and Kumar [1998]). Finally, we include size and stock returns
as additional control variables and expect the level of CEO pay to be posi-
tively associated with size and stock returns (Smith and Watts [1992], Core,
Holthausen, and Larcker [1999]).
3.2 SAMPLE SELECTION

We obtain data from Compustat 2004, Center for Research in Security
Prices (CRSP) 2004, and ExecuComp 2004. We impose the following re-
strictions on the sample: (1) No CEO change during the year, (2) CEO
served in the same company for at least two consecutive years, and (3) book
value and total assets are positive. The final sample contains 7,076 CEO-year
observations from 1993 to 2003. The number of observations varies from
410 in 1993 to 690 in 1999.
4. Empirical Results
Table 1 shows descriptive statistics of sample characteristics. The mean
and median values of EPS (1.201 and 1.096) are close to those reported in
Collins, Maydew, and Weiss [1997]. CPS is higher than EPS, indicating that
on average accruals are income-decreasing. The empirical distributions of
the control variables appear to be similar to those documented in other
TABLE 1
Descriptive Statistics of Sample Characteristics
MEAN STD Q1 MEDIAN Q3
log(CASHCOMPit ) 6.617 0.736 6.096 6.576 7.099
log(CASHCOMPit ) −1.630 1.332 −2.371 −1.567 −0.794
log(TOTALCOMPit ) 7.356 1.054 6.590 7.284 8.049
log(TOTALCOMPit ) −1.126 1.469 −1.931 −1.058 −0.182
EPSit 1.201 1.929 0.508 1.096 1.794
ROAit 0.052 0.067 0.025 0.053 0.086
ROAit −0.016 0.427 −0.038 0.000 0.029
CPSit 2.720 3.184 1.018 2.052 3.667
CFOAit 0.104 0.071 0.061 0.100 0.145
CFOAit −0.006 0.477 −0.070 0.000 0.067
BPSit 11.486 10.991 5.603 9.133 14.419
IOS i,t −0.056 0.244 −0.201 −0.130 −0.002
Leverage i,t 0.377 0.658 0.045 0.182 0.462
Trade Cycle i,t 79.559 115.285 30.932 67.727 111.813
EARN Noise i,t 0.089 0.132 0.026 0.048 0.095
EARN Persistence i,t 0.756 0.459 0.441 0.786 1.075
CFO Noise i,t 0.137 0.146 0.057 0.092 0.166
CFO Persistence i,t 0.505 0.384 0.177 0.505 0.748
CASHCOMPit = total cash compensation (salary + bonus) in year t; TOTALCOMP it = CEO’s total com-
pensation in year t, comprising salary, bonus, other annual, total value of restricted stock granted, total value
of stock options granted (using Black–Scholes), long-term incentive payouts, and all other total; EPSit =
earnings per share defined as earnings before extraordinary items (Compustat annual #18) scaled by
number of common shares outstanding adjusted for stock splits and stock dividends; CPSit = cash flows per
share defined as cash flows from operation (#308 if the firm-year observation is after 1988, and #110 − #4 +
#1 + #5 − #34 if the firm-year observation is before 1988) scaled by number of common shares outstanding
adjusted for stock splits and stock dividends; BPSit = book value of common equity (#60) scaled by number
of common shares outstanding adjusted for stock splits and stock dividends; ROAit = earnings before
extraordinary items (#18) scaled by average book value of assets (#6); CFOAit = cash flows from operation
(#308 if the firm-year observation is after 1988, and #110 − #4 + #1 + #5 − #34 if the firm-year observation
is before 1988) scaled by average book value of assets (#6); IOS i,t is a proxy for investment opportunity set
from factor analysis of the following: the ratio of market to book value of equity, the ratio of the market
value of equity plus book value of debt to the book value of assets, the ratio of market value of equity plus
book value of debt to gross plant, property, and equipment; Leverage i,t = the ratio of long-term debt to
year-end market value of equity;

(ARi,t + ARi,t−1 )/2 (I N Vi,t + I N Vi,t−1 )/2 (APi,t + APi,t−1 )/2
Trade Cycle i,t = + − ;
Sales/360 COGS/360 Purchases/360
EARN Noise i,t is the time-series standard deviation of ROAit for each firm starting from 1980; CFO Noise i,
is the time-series standard deviation of CFOAit for each firm starting from 1980; EARN Persistence i,t is the
estimate of (1 − ), computed from an IMA (1,1) earnings process starting from 1980;
EARN i,t − EARN i,t−1 = U E (EARN i,t ) − U E (EARN i,t−1 );
CFO Persistence i,t is the estimate of (1 − ), computed from an IMA (1,1) cash from operations process
starting from 1980:
CFO i,t − CFO i,t−1 = U E (CFO i,t ) − U E (CFO i,t−1 );

denotes change from year t − 1 to year t.
executive compensation studies. Our sample is biased towards large,

profitable firms similar to many studies that have used ExecuComp data.
4.1 VALUE RELEVANCE OF EARNINGS AND CASH FLOWS
We first obtain value relevance measure of earnings and incremental
value relevance measure of cash flows. Panel A of table 2 presents de-
scriptive statistics of pricing coefficients, coefficient of determination, and
value relevance measures. Similar to the results in Collins, Maydew, and

Weiss [1997], we observe that the pricing coefficient on EPS (β 1 ) is higher
than the pricing coefficient on BPS (β 2 ) in firm-specific regressions of stock
price on earnings and book value. The mean and median coefficients on EPS
are 4.265 and 2.107, comparable to the pooled cross-sectional time-series
coefficient of 3.41 on EPS reported in Collins, Maydew, and Weiss [1997].
The mean and median coefficients of determination for the earnings and
book value regressions are 0.568 and 0.598, comparable to the coefficient of
determination of 0.536 in Collins, Maydew, and Weiss [1997]. The pricing
coefficients and coefficients of determination from estimating the regres-
sion of stock price on earnings, cash flows, and book value are comparable to
Barth et al. [1999], although we use different estimation methods and focus
on a different sample period. Combining the coefficients of determination
from the three different regression specifications, we estimate the value rel-
evance of earnings (mean = 0.262, median = 0.198), and the incremental
value relevance of cash flows (mean = 0.195, median = 0.115).
We also present descriptive statistics of pricing coefficients, coefficients
of determination, and value relevance measures using cash flows as the
primary performance measure and earnings as the supplementary perfor-
mance measure in panel B of table 2. The distribution of pricing coefficients,
coefficients of determination, and consequently the value relevance mea-
sures is similar to those reported in panel A of table 2. The mean and median
values of value relevance of cash flows are 0.195 and 0.117, respectively. The
mean and median values of incremental value relevance of earnings are
0.258 and 0.186, respectively.
4.2CASH COMPENSATION WEIGHT AND VALUE RELEVANCE OF EARNINGS

AND CASH FLOWS
To examine the linkage between compensation weight and value rele-
vance for earnings and cash flows, we run the analysis in a cross-sectional
setting using the logarithm of cash compensation (salary plus bonus) as the
dependent variable. We focus our analysis on cash compensation following
prior studies that have focused on pay-sensitivities of accounting perfor-
mance measures (Lambert and Larcker [1987], Gaver and Gaver [1993],
Sloan [1993], Natarajan [1996]). Cash compensation is more closely tied
to accounting performance measures than total compensation. Moreover,
Core, Guay, and Verrecchia [2003] find that results from cash compensation
support predictions from standard agency models while results from total
compensation do not seem to be consistent with the predictions. We repeat
our analysis using total compensation as a robustness check. When estimat-
ing the model, we removed influential observations with Studentized resid-
uals greater than three or Cook’s D statistic greater than one (Belsley, Kuh,
and Welsch [1980]). We performed White’s [1980] test for heteroskedas-
ticity and found that heteroskedasticity was not a problem for our models.
We tested for multicollinearity using the Belsley, Kuh, and Welsch [1980])
diagnostics. The condition indices for all explanatory variables of interest
were less than 10, well below the suggested cutoff.
TABLE 2
Value Relevance of Primary Performance Measure and Incremental Value Relevance of Supplementary
Performance Measure
Panel A: Value relevance of earnings and incremental value relevance of cash flows
We obtain the value relevance of earnings and of cash flows from firm-specific regression of the
following equations using a 10-year rolling window estimation method. We require each firm to
have at least eight years of data available starting from 1980. We designate earnings as the primary
performance measure and cash flows as the supplementary performance measure.
2
Rbv is obtained from: Pi,t = α0 + α1 BPS i,t + e it (1)
2
Rearnbv is obtained from: Pi,t = β0 + β1 EPS i,t + β2 BPS i,t + uit (2)
2
Rtotal is obtained from: Pi,t = γ0 + γ1 EPS i,t + γ2 CPS i,t + γ3 BPS i,t + εit (3)
Value relevance of earnings (v e ) is (R2earnbv − R2b v )/(1 − R2bv ), and incremental value relevance of cash
flows (v c ) is (R2total − R2earnbv )/(1 − R2earnbv ).
Mean STD Q1 Median Q3
α1 1.824 3.394 0.343 1.321 2.684
β1 4.265 14.783 0.175 2.107 5.877
β2 1.162 4.219 −0.132 0.800 2.087
γ1 3.872 16.389 −0.087 1.917 5.895
γ2 0.713 10.185 −1.187 0.201 2.095
γ3 1.088 4.321 −0.251 0.730 2.046
R 2bv 0.402 0.305 0.109 0.368 0.671
R 2earnbv 0.568 0.265 0.360 0.598 0.794
R 2total 0.652 0.239 0.486 0.698 0.852
ve = [(R2earnbv − R2b v )/(1 − R2b v )] 0.262 0.237 0.053 0.198 0.423
vc = [(R2total − R2earnbv )/(1 − R2earnbv )] 0.195 0.210 0.027 0.115 0.301
Panel B: Value relevance of cash flows and incremental value relevance of earnings
following equations using a 10-year rolling window estimation method. We require each firm to
have at least eight years of data available starting from 1980. We designate cash flows as the primary
performance measure and earnings as the supplementary performance measure.
2
Rbv is obtained from: Pi,t = δ0 + δ1 BPS i,t + e it (1)
2
Rcfobv is obtained from: Pi,t = η0 + η1 CPS i,t + η2 BPS i,t + uit (2)
2
Rtotal is obtained from: Pi,t = λ0 + λ1 C P Si,t + λ2 EPS i,t + λ3 BPS i,t + εit (3)
Value relevance of cash flows (v c ) is (R2cfobv − R2b v )/(1 − R2bv ), and incremental value relevance of
earnings (v e ) is (R2total − R2cfobv )/(1 − R2cfobv ).

δ1 1.824 3.394 0.343 1.321 2.684
η1 1.498 8.522 −0.690 0.515 2.652
η2 1.535 3.655 0.120 1.098 2.437
λ1 0.713 10.185 −1.187 0.201 2.095
λ2 3.872 16.389 −0.087 1.917 5.895
λ3 1.088 4.321 −0.251 0.730 2.046
R 2bv 0.402 0.305 0.109 0.368 0.671
R 2cfobv 0.521 0.282 0.279 0.538 0.768
R 2total 0.652 0.239 0.486 0.698 0.852
v c = [(R2cfobv − R2b v )/(1 − R2b v )] 0.195 0.208 0.028 0.117 0.302
v e = [(R2total − R2cfobv )/(1 − R2cfobv )] 0.258 0.242 0.047 0.186 0.419
Variables are defined in table 1.
Table 3 shows the average association between pay-sensitivity and value

relevance of earnings and that between the marginal pay-sensitivity of cash
flows and the incremental value relevance of cash flows. We use earnings
deflated by average total assets and cash flow from operations deflated by
average total assets as our performance measures (Antle and Smith [1986],
Sloan [1993]). We use year-by-year regressions and report the average regres-
sion coefficients and associated t-statistics. Our specification also includes
industry dummies defined at the two-digit SIC level to partially control for
differences in benchmarks for the performance measures across different
industries (Antle and Smith [1986], Janakiraman, Lambert, and Larcker
[1992]). The mean coefficient on v e ∗ ROA is positive and significant af-
ter we control for other factors that may influence the pay-for-performance
TABLE 3
Association between Pay-Sensitivity and Value Relevance of Primary Performance Measure and
Incremental Value Relevance of Supplementary Performance Measure
We estimate year-by-year regressions of the following equation from 1993 to 2003. We obtain
value relevance of primary performance measure and incremental value relevance of supple-
mentary performance measure from the estimated equations in table 2.
log(COMP i ) = γ0 + ηe (ROAi ) + ηc (CFOAi ) + we (ve i ∗ ROAi ) + wc (vci ∗ CFOAi )
+ θe ve i + θc vci + δe Control i ∗ ROAi + δc Control i ∗ CFOAi + ui
Panel A: Cash compensation and value relevance of performance measures
Earnings as the Primary Cash Flows as the Primary

Performance Measure Performance Measure
Mean (Fama–MacBeth Mean (Fama–MacBeth
Variable Predict Coefficient t-Statistic) Coefficient t-Statistic)
Intercept 5.714 (126.71) 6.063 (154.85)
ROAit 2.190 (4.72) 1.955 (5.28)
CFOAit −0.981 (−2.39) −0.841 (−2.62)
ve ROAit + 2.146 (2.79) 2.347 (5.09)
vc CFOAit + 1.533 (2.31) 1.655 (1.97)
ve −0.037 (−0.47) −0.082 (−2.19)
vc −0.118 (−1.90) −0.152 (−1.03)
IOS i,t ∗ ROAit −0.543 (−0.61) −0.794 (−1.22)
Leverage i,t ∗ ROAit 0.325 (0.55) −0.085 (−0.15)
EARN Noise i,t ∗ ROAit −0.759 (−2.50) −0.659 (−2.17)
EARN Persistence i,t ∗ ROAit −0.627 (−1.41) −0.290 (−0.79)
Trade Cycle i,t ∗ ROAit −0.903 (−2.33) −0.127 (−0.27)
IOS i,t ∗ CFOAit 1.041 (1.78) 0.946 (2.01)
Leverage i,t ∗ CFOAit −0.606 (−1.43) 0.189 (0.67)
CFO Noise i,t ∗ CFOAit 1.422 (6.53) 1.230 (5.66)
CFO Persistence i,t ∗ CFOAit −0.988 (−4.58) −0.799 (−3.43)
Trade Cycle i,t ∗ CFOAit 0.210 (1.13) −0.733 (−3.25)
Return it 0.268 (7.76) 0.263 (10.58)
Log (Total Assets) 1.461 (48.19) 1.569 (106.28)
Mean adj. R 2 41.8% 40.7%
N 6,976 6,955
(Continued)
T A B L E 3 — Continued
Panel B: Total compensation and value relevance of performance measures

Mean (Fama–MacBeth Mean (Fama–MacBeth
Variable Predict Coefficient t-Statistic) Coefficient t-Statistic)
Intercept 5.990 (63.96) 6.111 (49.27)
ROAit −0.679 (−0.59) −0.974 (−1.09)
CFOAit −1.956 (−2.59) −0.820 (−1.43)
ve ROAit + 1.772 (2.13) 1.785 (2.46)
vc CFOAit + 2.699 (2.16) 1.984 (2.34)
ve 0.062 (0.67) −0.008 (−0.14)
vc −0.155 (−1.01) −0.075 (−0.66)
IOS i,t ∗ ROAit −0.229 (−0.19) −0.854 (−0.85)
Leverage i,t ∗ ROAit 1.890 (1.59) 1.546 (1.92)
EARN Noise i,t ∗ ROAit 0.705 (1.03) 0.355 (0.57)
EARN Persistence i,t ∗ ROAit −2.558 (−3.94) −1.661 (−3.34)
Trade Cycle i,t ∗ ROAit 0.446 (0.61) 1.597 (1.86)
IOS i,t ∗ CFOAit 3.407 (5.56) 3.265 (4.87)
Leverage i,t ∗ CFOAit −2.211 (−4.89) −1.662 (−4.92)
CFO Noise i,t ∗ CFOAit 1.779 (4.20) 0.937 (2.80)
Trade Cycle i,t ∗ CFOAit 0.315 (0.87) −1.456 (−3.26)
Cashflow Shortfall i,t −0.165 (−2.23) −0.093 (−1.58)
Net Operating Loss i,t −0.174 (−2.09) −0.048 (−0.65)
Dividend Constraint I ,t 0.406 (6.64) 0.446 (9.43)
Stock Return i,t −1 0.276 (2.99) 0.361 (4.30)
Stock Return i,t 0.355 (3.62) 0.369 (4.57)
Log (Total Assets) 2.098 (30.10) 2.276 (26.97)
Mean adj. R 2 42.5% 42.8%
N 6,891 6,950
Cash flow shortfall is the three-year average of [(common and preferred dividends + cash flow from
investing – cash flow from operations)/total assets]. Net operating loss is an indicator variable equal to one
if firm has net operating loss carry-forwards in any of the three previous years.
Dividend constraint is an indicator equal to one if the firm is dividend constrained in any of the three
previous years. We categorize a firm as dividend constrained if [(retained earnings at year-end + cash
dividends and stock repurchases during the year)/the prior year’s cash dividends and stock repurchases],
is less than two. If the denominator is zero for all three years, we also categorize the firm as dividend
constrained. Stock return is the cumulative return for firm i over the 12-month period of the fiscal year.
Other variables are defined in table 1. We assign a value from 0 to 0.9 to each control variable (IOS, Leverage,
Trade cycle, EARN Noise, EARN Persistence, CFO Noise, CFO Persistence) based on its yearly decile ranking.
Industry dummies based on two-digit SIC code are included.
sensitivities of earnings in the cross-section. The yearly mean coefficient on

v e ∗ ROA is 2.146 (Fama–MacBeth t-statistic = 2.79). This result indicates
that the compensation weight on earnings is increasing in value relevance
of earnings. Similarly, the mean coefficient on v c ∗ CFOA is positive and
significant (coefficient = 1.533, Fama–MacBeth t-statistic = 2.31). This is in
support of the conjecture that the marginal compensation weight on cash
flows is positively related to the incremental value relevance of cash flows.
Using information from tables 2 and 3, we calculate the total pay-sensitivity
on ROA for a representative median firm in our sample to be 1.487. The
incremental pay-for-performance sensitivity on CFOA for a representative
median firm is −0.319. The net effect of the two is the total pay-sensitivity
on cash flows. This means that for a representative median firm, the total
pay-sensitivity on cash flows is 1.168. The results indicate that 29% of the
pay-sensitivity of accruals of a representative median firm can be attributed
to the value relevance of earnings and 15% of the total pay-sensitivity of
cash flows can be explained by the contribution of the incremental value
relevance of cash flows.
The above results are based on value relevance measures calculated under
the assumption that earnings is the primary performance measure and cash
flows is the supplementary performance measure. We also present results
using cash flows as the primary performance measure and earnings as the
supplementary performance measure. Our results in the third and fourth
columns of panel A of table 3 provide support for the positive association
between pay-sensitivity and value relevance of performance measures. The
yearly mean coefficient on v c ∗ CFOA is 1.655 (Fama–MacBeth t-statistic =
1.97). This result indicates that the compensation weight on cash flows is
increasing in value relevance of cash flows. Similarly, the mean coefficient
on v e ∗ ROA is positive and significant (coefficient = 2.347, Fama–MacBeth
t-statistic = 5.09). This is in support of the notion that the marginal com-
pensation weight on earnings is positively related to the incremental value
relevance of earnings. Overall, the results in panel A of table 3 confirm
a positive association between pay-sensitivity and value relevance for both
earnings and cash flows independent of which one of these is designated as
the primary performance measure.
4.3TOTAL COMPENSATION WEIGHT AND VALUE RELEVANCE OF EARNINGS

AND CASH FLOWS
Core, Guay, and Verrecchia [2003] indicate that predictions from stan-
dard agency theory find support when CEO cash compensation is used, but
not when total compensation is used. To address this concern, we repeat our
analysis using total compensation. Panel B of table 3 shows the average asso-
ciation between pay-for-performance sensitivities and value relevance using
the logarithm of total compensation as the dependent variable. We include
additional control variables that have been shown to influence equity incen-
tives (Yermack [1995], Core and Guay [1999]) in our specification. Firms
that have lower free cash flows and higher net operating loss carry-forwards
use more stock options as a substitute for cash pay (Yermack [1995], Mat-
sunaga [1995], Dechow, Hutton, and Sloan [1996]). We measure the degree
of cash flow shortfall as the three-year average of [(common and preferred
dividends + cash flows from investing – cash flows from operations)/total
assets]. Net operating loss is an indicator variable equal to one if a firm has
net operating loss carry-forwards in any of the three previous years. The use
of stock options is more when a firm faces earnings constraints and has lim-
ited ability to pay dividends. We categorize a firm as dividend-constrained if
(retained earnings at year-end + cash dividends and stock repurchases dur-
ing the year)/the prior year’s cash dividends and stock repurchases, is less
than two in any of the previous three years. If the denominator is zero for
all three previous years, we also categorize the firm as dividend constrained
(Dechow, Hutton, and Sloan [1996]). We also control for the potential rela-
tion between total CEO compensation and firm performance by including
current year and prior year stock returns (Baber, Janakiraman, and Kang
[1996], Core and Guay [1999]).
Our results in panel B of table 3 once again support the argument that
a positive association exists between pay-sensitivities on earnings and value
relevance of earnings. The mean value of yearly regression coefficients on
v e ∗ ROA is positive and significant after we add control variables (coefficient
= 1.772; Fama–MacBeth t-statistic = 2.13). We also find a positive linkage
between the incremental pay-sensitivity of cash flows and the incremental
value relevance of cash flows (coefficient = 2.699; Fama–MacBeth t-statistic
= 2.16). As before, these associations are not sensitive to designating earn-
ings rather than cash flows as the primary performance measure.
4.4 VALUE RELEVANCE OF CHANGE IN EARNINGS AND CHANGE

IN CASH FLOWS
So far, our analysis considered the levels of earnings and cash flows as the
relevant performance measures. Several compensation studies have focused
on change in accounting performance measures based on the argument that
the correct benchmark for performance is immediate past performance
(Lambert and Larcker [1987], Sloan [1993], Baber, Janakirman, and Kang
[1996], Core, Guay, and Verrecchia [2003]). Next, we test our hypotheses
assuming that change in earnings and change in cash flows are the appro-
priate performance measures. Accordingly, we use an alternative model in
the first stage of our analysis where market-adjusted stock returns are re-
gressed on change in earnings and change in cash flows to calibrate the
value relevance of change in earnings and the incremental value relevance
of change in cash flows (Bernard and Stober [1989], Jennings [1990], Ali
[1994]). We construct the value relevance measures of change in earnings
and change in cash flows from the following firm-specific regressions using
a 10-year rolling window estimation method. We require that each firm has
data available for at least eight years starting from 1980.
2
Rearn is obtained from Ri,t = α0 + α1 EARNi,t + e it . (5)
2
Rtotal is obtained from: Ri,t = β0 + β1 EARNi,t + β2 CFOi,t + εit . (6)
Value relevance measure of earnings (v e ) isR2earn and incremental value rele-
vance measure of cash flows (v c ) is(R2total − R2earn )/(1 − R2earn ). We also obtain
R 2cfo from
Ri,t = δ0 + δ1 CFOi,t + e it , (7)

and estimate value relevance measure of cash flows (v c ) as R2cfo and incre-
mental value relevance measure of earnings (v e ) as (R 2total − R 2cfo )/(1 −
R 2cfo )for the case where cash flows is designated as the primary performance
measure.
Table 4 reports descriptive statistics of variables and estimation coeffi-

cients from firm-specific time-series regressions. Panel A shows results us-
ing earnings as the primary performance measure and cash flows as the
supplementary performance measure. A positive v e implies that earnings
information is value relevant to the investors. A positive v c implies that the
market attaches incremental value to cash flows over and above earnings.
The mean and median values of v e (0.232 and 0.158) and the mean and
median values of v c (0.168 and 0.095) are lower in magnitude compared to
their counterparts’ estimated using levels. Panel B provides the descriptive
statistics for the value relevance of change in cash flows and the incremental
value relevance of change in earnings.
4.5PAY-SENSITIVITY AND VALUE RELEVANCE OF CHANGE IN EARNINGS AND
CHANGE IN CASH FLOWS
Table 5 shows the results for year-by-year regressions of change in loga-
rithm of cash compensation on change in earnings, change in cash flows,
value relevance of change in earnings, incremental value relevance of
change in cash flows and other control variables. We obtain value relevance
measures from the analysis presented in table 4. Panel A presents results
using change in logarithm of cash compensation as the dependent variable.
This change specification focuses on innovation in earnings and cash flows
that affects pay-for-performance sensitivities (Baber, Janakiraman, and Kang
[1996]). The mean coefficients of v e ∗ ROA (2.157) is positive and signif-
icant (Fama–MacBeth t-statistic = 2.43). This supports the conjecture that
pay-sensitivity for change in earnings is increasing in the value relevance of
change in earnings. The mean coefficient on v c ∗ CFOA (1.667) is posi-
tive and significant (Fama–MacBeth t-statistic = 2.20). We find support for
the notion that the incremental pay-sensitivity of change in cash flows is
increasing in the incremental value relevance of change in cash flows. The
results are qualitatively the same when we use change in cash flows as the pri-
mary performance measure and change in earnings as the supplementary
performance measure.
Panel B of table 5 presents results of the analysis using change in log-
arithm of total compensation as the dependent variable. Again, we find
evidence in support of the conjecture that pay-sensitivity is positively associ-
ated with value relevance of change in earnings (coefficient of v e ∗ ROA =
3.865; Fama–MacBeth t-statistic = 1.97) and that incremental pay-sensitivity
is increasing in incremental value relevance of change in cash flows (coeffi-
cient of v c ∗ CFOA = 1.621; Fama–MacBeth t-statistic = 1.77). The results
when using change in cash flows as the primary performance measure and
earnings as the supplementary performance are slightly weaker.
4.6 INDUSTRY-SPECIFIC ESTIMATION OF VALUE RELEVANCE AND
PAY-SENSITIVITY
As an additional robustness check, we also carry out industry-specific
estimation of regressions with market-adjusted stock returns and change
TABLE 4
Value Relevance of Change in Primary Performance Measure and Incremental Value Relevance
of Change in Supplementary Performance Measure
Panel A: Value relevance of change in earnings and incremental value relevance of change in
cash flows
following equations using a 10-year rolling window estimation method. We require each firm
to have at least eight years of data available starting from 1980. We designate earnings as the
primary performance measure and cash flows as the supplementary performance measure.
2
Rearn is obtained from: Ri,t = α0 + α1 EARNi,t + e it (5)
2
Rtotal is obtained from: Ri,t = β0 + β1 EARNi,t + β2 CFOi,t + εit (6)
2 , and incremental value relevance of change
Value relevance of change in earnings (ve ) is Rearn
2
in cash flows (vc ) is (Rtotal − Rearn
2 )/(1 − R2 ).
earn
α1 2.885 8.255 0.204 1.388 3.818
β1 2.820 9.550 0.087 1.369 4.037
β2 0.432 6.742 −0.610 0.121 1.118
R 2earn 0.232 0.226 0.041 0.158 0.370
R 2total 0.361 0.242 0.155 0.328 0.541
v e [R2earn ] 0.232 0.226 0.041 0.158 0.370
v c [(R2total − R2earn )/(1 − R2earn )] 0.168 0.190 0.022 0.095 0.251
Panel B: Value relevance of change in cash flows and incremental value relevance of change in
earnings
We obtain the value relevance of earnings and of cash flows from firm-specific regression of
the following equations using a 10-year rolling window estimation method. We require each
firm to have at least eight years of data available starting from 1980. We designate cash flows as
the primary performance measure and earnings as the supplementary performance measure.
Rc2f o is obtained from: Ri,t = δ0 + δ1 CFOi,t + e it (7)
2
Rtotal is obtained from: Ri,t = η0 + η1 CFOi,t + η2 EARNi,t + εit (6)
Value relevance of change in cash flows (v c ) isR2cfo , and incremental value relevance of change
in earnings (v e ) is(R2total − R2cfo )/(1 − R2cfo ).
δ1 0.843 5.035 −0.318 0.289 1.395
η1 0.432 6.742 −0.610 0.121 1.118
η2 2.820 9.550 0.087 1.369 4.037
R 2cfo 0.166 0.189 0.022 0.094 0.248
R 2total 0.361 0.242 0.155 0.328 0.541
v c [R2cfo ] 0.166 0.189 0.022 0.094 0.248
v e [(R2total − R2cfo )/(1 − R2cfo )] 0.233 0.228 0.040 0.158 0.373
R i,t = the cumulative market-adjusted return for firm i over the 12-month period of the fiscal year;
EARNit = change in earnings before extraordinary items (#18) from year t − 1 to year t, scaled by
beginning-of-year market value of equity; CFOit = change in cash flows from operation (#308 if the
firm-year observation is after 1988, and #110 − #4 + #1 + #5 − #34 if the firm-year observation is before
1988), scaled by beginning-of-year market value of equity.
in logarithm of cash compensation as dependent variables and change in

earnings and change in cash flows scaled by market value of equity as com-
mon independent variables (Bushman, Engel, and Smith [2006]). Further,
we split the sample into two subperiods, 1993 to 1997 and 1998 to 2003, and
let the regression coefficients vary across these subperiods. Specifically, we
estimate
Ri,t = α + Ve ∗ EARN i,t + Ve ∗ EARN2 i,t + Vc ∗ CFO i,t

+ Vc ∗ CFO2 i,t + εi,t , (8)
TABLE 5
Association between Pay-Sensitivity and Value Relevance of Change in Primary Performance Measure
and Incremental Value Relevance of Change in Supplementary Performance Measure
We estimate year-by-year regressions of the following equation from 1993 to 2003. We obtain
value relevance of primary performance measure and incremental value relevance of supple-
mentary performance measure from the estimated equations in table 4.
log(COMPi ) = γ0 + ηe (ROAi ) + ηc (CFOAi ) + we (vei ∗ ROAi )
+ wc (vci ∗ CFOAi ) + θe vei + θc vci + δe Controli ∗ ROAi
+ δc Controli ∗ CFOAi + ui
Panel A: Cash compensation and value relevance of change in performance measures
(Fama– (Fama–
Mean MacBeth) Mean MacBeth
Variable Predict Coefficient t-statistic) Coefficient t-statistic)
Intercept 0.100 (1.60) 0.095 (1.49)
ROAit 1.284 (2.74) 1.255 (3.27)
CFOAit 0.229 (0.38) 0.135 (0.29)
ve ROAit + 2.157 (2.43) 2.816 (2.25)
vc CFOAit + 1.667 (2.20) 1.433 (2.93)
ve −0.044 (−2.72) −0.043 (−1.97)
vc −0.002 (−0.05) −0.011 (−0.25)
IOS i,t ∗ ROAit −0.982 (−3.51) −1.148 (−3.78)
EARN Persistence i,t ∗ ROAit 1.071 (2.38) 0.973 (2.57)
IOS i,t ∗ CFOAit −0.097 (−0.36) −0.013 (−0.06)
Leverage i,t ∗ CFOAit 0.204 (0.94) 0.072 (0.34)
CFO Noise i,t ∗ CFOAit −0.730 (−3.47) −0.489 (−3.08)
CFO Persistence i,t ∗ CFOAit 0.195 (0.87) 0.269 (1.31)
Trade Cycle i,t ∗ CFOAit 3.595 (1.12) 3.455 (1.41)
Return it 0.140 (8.25) 0.142 (8.49)
Mean adj. R 2 16.6% 16.2%
N 5,764 5,766
(Continued)
T A B L E 5 — Continued
Panel B: Total compensation and value relevance of change in performance measures
(Fama– (Fama–
Mean MacBeth) Mean MacBeth
Variable Predict Coefficient t-statistic) Coefficient t-statistic)
Intercept 0.167 (1.55) 0.231 (1.20)
ROAit 0.427 (0.90) 0.454 (1.22)
CFOAit 0.184 (0.60) 0.307 (0.97)
ve ROAit + 3.865 (1.97) 4.531 (1.95)
vc CFOAit + 1.621 (1.77) 0.147 (0.09)
ve −0.145 (−1.69) −0.084 (−1.14)
vc −0.013 (−0.15) −0.106 (−0.94)
IOS i,t ∗ ROAit −0.009 (−0.01) 0.083 (0.08)
EARN Persistence i,t ∗ ROAit 0.610 (1.47) 0.677 (1.71)
IOS i,t ∗ CFOAit −0.897 (−0.89) −0.646 (−0.76)
Leverage i,t ∗ CFOAit 0.390 (1.08) 0.434 (1.25)
CFO Noise i,t ∗ CFOAit −1.272 (−1.27) −1.131 (−1.17)
Trade Cycle i,t ∗ CFOAit 0.001 (0.48) 0.001 (0.33)
Cashflow Shortfall i,t 0.294 (3.84) 0.309 (4.51)
Net Operating Loss i,t −0.030 (−1.04) −0.030 (−1.05)
Dividend Constraint I ,t −0.010 (−1.04) −0.004 (−0.34)
Stock Return i,t −1 −0.002 (−0.05) −0.001 (−0.02)
Stock Return i,t 0.110 (2.29) 0.117 (2.53)
Mean adj. R 2 9.2% 9.2%
N 5,054 5,064
EARN Noise i,t = the time-series standard deviation of ROAit for each firm starting from 1980;
CFO Noise i, = the time-series standard deviation of CFOAit for each firm starting from 1980.
and
log(CASHCOMP i,t ) = α + We ∗ EARN i,t + We ∗ EARN2 i,t
+ Wc ∗ CFO i,t + Wc ∗ CFO2 i,t + Wr ∗ RET i,t
+ Wr ∗ RET2 i,t εi,t , (9)
where

EARNi,t if t ≥ 1997
EARN2i,t =
0 otherwise

CFOi,t if t ≥ 1997
CFO2i,t =
0 otherwise

RETi,t if t ≥ 1997
RET2i,t = .
0 otherwise
We estimate the valuation equation (8) for each two-digit SIC industry and
report the descriptive statistics of coefficient estimates in panel A of table 6.
We require at least 20 observations for each industry–subperiod combina-
tion. Panel A of table 6 shows that the valuation coefficients of earnings have
declined from subperiod 1 (1993 to 1997) to subperiod 2 (1998 to 2003).
The mean and median coefficients for V e are −0.297 and −0.207, respec-
tively, and the aggregate Z -statistic across the 29 industry groups is −2.83
(p < 0.01). On the other hand, the incremental valuation coefficients of
cash flows have increased from subperiod 1 to subperiod 2. The mean and
median coefficients for V e are 0.156 and 0.148, respectively, and the aggre-
gate Z -statistic is 2.71 (p < 0.01).
We then estimate the compensation equation (9) for each two-digit SIC
industry and report the descriptive statistics of coefficient estimates in panel
B of table 6. Consistent with the temporal change in valuation coefficients,
we find that the compensation weights on earnings have declined from the
earlier subperiod to the later subperiod (mean = −0.349, median = −0.231
and Z -statistic = −3.88 with a two-sided p-value less than 0.01). We also find
that the incremental compensation weights on cash flows have increased
between the two subperiods (mean = 0.146, median = 0.062, and Z -statistic
= 2.30 with a two-sided p-value of 0.02). We further examine the correlation
between V e /Ve and W e /W e as well as the correlation between V e /Vc
and W c /W c . Both these correlations are significantly positive, once again,
supporting our main hypotheses.
5. Conclusions and Implications

Accounting performance measures such as earnings and cash flows seek
to serve multiple purposes in organizations. Prior studies have investigated
their usefulness for valuation and incentive contracting purposes sepa-
rately. However, except for a recent study by Bushman, Engel, and Smith
[2006], which examines the association between the valuation and incentive-
contracting roles of accounting earnings, little evidence exists on the linkage
between these two roles. In this study, we examine the association between
pay-sensitivities and value relevance of earnings and cash flows. We derive
measures of pay-sensitivities and value relevance using a stylized principal-
agent setting characterized by two performance measures. Application of
the insights from the model to earnings and cash flows data of a large sam-
ple of Compustat firms leads to the conjecture that a positive association
exists between value relevance and pay-performance sensitivity of earnings
and cash flows.
Using CEO compensation and accounting data for a large number of U.S.
firms over an 11-year period from 1993 to 2003, we find that pay-sensitivity
of earnings is higher for firms that exhibit high value relevance of earnings.
We also find that marginal pay-sensitivity of cash flows is positively associated
with the incremental value relevance of cash flows. As the value relevance of
cash flows increases relative to that of earnings in the later years during our
TABLE 6
Industry-Specific Estimation of Value Relevance and Pay-Sensitivity for Change in Earnings and Change
in Cash Flows over 1993 to 1997 and 1998 to 2003
Panel A: Industry-by-industry coefficient estimates from regressing market-adjusted return on
change in earnings and change in cash flows in two subperiods 1993 to 1997 and 1998 to 2003
Ri,t = α + Ve · EARNi,t + Ve · EARN2i,t + Vc · CFOi,t + Vc · CFO2i,t + εi,t
Ve V e Vc V e
Mean 0.544 −0.297 0.009 0.156
Median 0.365 −0.207 −0.029 0.148
Std. dev. 0.515 0.512 0.367 0.358
Z -stat 5.91 −2.83 0.33 2.71
(p-value) (< 0.01) (< 0.01) (0.76) (< 0.01)
Mean adj. R 2 32.1%
N 29
Panel B: Industry-by-industry coefficient estimates from regressing change in cash

compensation on change in earnings and change in cash flows in two subperiods 1993 to 1997
and 1998 to 2003
log(CASHCOMPi,t ) = α + We · EARNi,t + We · EARN2i,t + Wc · CFOi,t

+ Wc · CFO2i,t + Wr · RETi,t + Wr · RET2i,t + εi,t
We W e Wc W c Wr W r
Mean 0.592 −0.349 −0.015 0.146 0.039 −0.039
Median 0.494 −0.231 −0.033 0.062 0.044 −0.036
Std. dev. 0.520 0.521 0.272 0.308 0.134 0.177
Z -stat 6.40 −3.88 0.17 2.30 1.89 −2.21
(p-value) (< 0.01) (< 0.01) (0.87) (0.02) (0.06) (0.03)
Mean adj. R 2 16.7%
N 29
Variable definitions:

EARNi,t if t ≥ 1997
EARN2i,t =
0 otherwise

CFOi,t if t ≥ 1997
CFO2i,t =
0 otherwise

RETi,t if t ≥ 1997
RET2i,t =
0 otherwise
where RET is cumulative return for firm i over the 12-month period of the fiscal year.
We define industries at the two-digit SIC level. We require at least 20 observations for each industry–
subperiod combination. Aggregate Z -statistics are computed from t-statistics in the industry–subperiod
regressions, assuming cross-sectional independence among industries:
1 N
tj
Z= √
N j =1 k j
(k j − 2)
where t j is the t-statistic for industry j, k j is the degree of freedom in regression for industry j, and N is the
number of industries in the sample. The Z -statistic is distributed asymptotically as standard normal. p-value
is based on two-tailed Z -statistics.
sample period, we find that the compensation weight on cash flows relative
to that on earnings increases as well. Overall, our results suggest that value
relevance of performance measures plays an important role in the choice
of accounting performance measures for incentive contracting purposes.
APPENDIX
A Two-Action, Two-Signal Principal-Agent Model to Investigate the Association

between Valuation Relevance and Compensation Weight on Signals
We consider a special case of the basic model described in Feltham and
Xie [1994] to investigate the association between compensation weights and
value relevance measures. The principal is risk neutral and the outcome x
of value to her takes the form:

x = a 1 + a 2 + ε1 ε1 ∼ N 0, σ12 .
While x is not contractible, the two actions a 1 and a 2 also generate two
performance measures, y and z, which are observable and available for con-
tracting 7 :

y = a 1 + ε1 + ε2 ε2 ∼ N 0, σ22 ,

z = a 2 + ε1 + ε3 ε3 ∼ N 0, σ32 .
All noise terms are independently distributed. We denote σ 21 as the common
variance stemming from the stochastic term ε 1 in the expressions for x, y
and z; σ 22 as the specific variance of ε 2 in the expression for y; and σ 23 as
the specific variance of ε 3 in the expression for z. The total variance of y is
σ 21 + σ 22 and that of z is σ 21 + σ 23 . The covariance between y and z is σ 21 .
The agent is risk averse and incurs direct personal costs C (a) = 12 (a12 +
2
a2 ). The agent’s preferences are represented by a negative exponential util-
ity function characterized by unit absolute risk aversion, that is, U (Z ) =
−e −Z where Z = W − C (a) is his net wealth. Following Feltham and Xie
[1994], we consider a compensation contract that is linear in the signals, that
is, W = α + wy y + wz z. We refer to wy and w z as the compensation weights
on y and z, respectively, in the discussion that follows. The optimal compen-
sation weights for this agency problem can be completely characterized by
the three-parameter vector {σ 21 , σ 22 , σ 23 }. Applying Feltham and Xie’s solu-
tion [1994, p. 433] to our setting, we can derive the optimal compensation
weights

w y = 1 + σ32 D and wz = 1 + σ22 D

where D = 1 + σ12 + σ22 1 + σ12 + σ32 − σ14 .
7 We normalize the marginal product of effort as well as the sensitivities of the two per-
formance measures to the respective effort components to unity. This is done for notational
simplicity and helps us focus on a parsimonious set of exogenous parameters.
Our main objective is to analyze how these compensation weights are associ-
ated with the informativeness of these performance measures about the out-
come to the principal. We designate y as the primary signal and z as the sup-
plementary signal. We follow Collins, Maydew, and Weiss [1997] and define
value relevance of a signal in terms of its informativeness. Accordingly, we
specify R 1 as the informativeness (value relevance) of signal y, and R 2 as the
incremental informativeness (incremental value relevance) of signal z over
and above y. The conditional variance of the outcome x given the realization
of y is var(x | y ) = σ12 σ22 /(σ12 + σ22 ) and the conditional variance given the
realizations of both y and z is var(x | y , z) = σ12 σ22 σ32 /(σ12 σ22 + σ22 σ32 + σ12 σ32 ).
These expressions for the conditional variances imply that,

1/σ22
R1 = 1 − var(x | y ) σ12 = 1 − σ22 σ12 + σ22 = (A1)
1/σ12 + 1/σ22
and

σ12 σ22 σ32
σ12 σ22 + σ22 σ32 + σ12 σ32
R2 = 1 − {var(x | y , z)/var(x | y )} = 1 −

σ12 σ22 σ12 + σ22

1 1 1 1
= 2 + 2+ 2 . (A2)
σ3 σ12 σ2 σ3
The value relevance measures R 1 and R 2 are scaled measures of the preci-
sions of specific performance measures.
The Association between Compensation Weight and Value Relevance Measures

Since agencies are completely characterized by the three-parameter vec-
tor {σ 21 , σ 22 , σ 23 }, we describe below the distinct and opposing effects the
variance of the payoff-relevant term (σ 21 ) and the variance of the idiosyn-
cratic noise terms (σ 22 , σ 23 ) have on the association between valuation and
incentive-contracting roles.
We first derive the partial derivatives that capture the change in compen-
sation weights with respect to changes in the variances of the noise terms.
The partial derivatives wy 1 , wy 2 , wy 3 , wz1 , wz2 , wz3 (where w y1 = ∂w y /∂σ12
and so on) and their respective signs are:

w y 1 = − 1 + σ32 2 + σ22 + σ32 D 2 < 0, (A3)

w y 2 = − 1 + σ32 1 + σ12 + σ32 D 2 < 0, (A4)

w y 3 = σ12 1 + σ22 D 2 > 0, (A5)

wz1 = − 1 + σ22 2 + σ22 + σ32 D 2 < 0, (A6)

wz2 = σ12 1 + σ32 D 2 > 0, (A7)

wz3 = − 1 + σ22 1 + σ12 + σ22 D 2 < 0. (A8)

Similarly, we also derive the partial derivatives that capture the change in
value relevance measures with respect to changes in the variances of noise
terms. The partial derivatives R 11 , R 12 , R 13 , R 21 , R 22 , R 23 (where R 11 =
∂ R1 /∂σ12 and so on) and their respective signs are:

R11 = (1 − R1 ) σ12 + σ22 > 0, (A9)

2
R12 = −R1 σ1 + σ22 < 0, (A10)
R13 = 0, (A11)

R21 = R22 σ32 σ14 > 0, (A12)

R22 = R22 σ32 σ24 > 0, (A13)

R23 = −R22 σ12 + σ22 σ12 σ22 < 0. (A14)

The own derivatives of compensation weights with respect to the correspond-
ing idiosyncratic noise variances (w y 2 and w z 3 ) and the own derivatives of
value relevance measures with respect to the idiosyncratic noise variances
(R 12 and R 23 ) are both negative. This confirms that both valuation and
compensation weights decrease when performance measure noise increases
due to an increase in the volatility of the nonvalue relevant stochastic term.
However, the derivatives of compensation weights with respect to the payoff-
relevant noise variance (w y 1 and w z 1 ) are both negative while the derivatives
of value relevance measures with respect to the payoff-relevant noise vari-
ance (R 11 and R 21 ) are both positive. This indicates that an increase in the
variance of the value relevant noise term makes the performance measures
more informative for valuation purposes but less informative for contracting
purposes. 8
More generally, the changes in compensation weights (wy and wz ) and
valuation weights (R 1 and R 2 ) with respect to small changes in the common
variance (σ 21 ) and idiosyncratic variances (σ 22 and σ 23 ) in the neighborhood
of an agency characterized by the triple {σ 21 , σ 22 , σ 23 } are:
W y = σ12 w y 1 + σ22 w y 2 + σ32 w y 3 , (A15)
Wz = σ12 wz1 + σ22 wz2 + σ32 wz3 , (A16)
R1 = σ12 R11 + σ22 R12 + σ32 R13 , (A17)
8 We present the results for the more general case of a two-action, two-signal model to high-
light different managerial actions that may have different implications for earnings and cash
flows. The sensitivities of compensation and value relevance measures to underlying agency
parameters and the insights derived from the model in understanding the context-specific
nature of association between the valuation and incentive-contracting roles of accounting per-
formance measures are qualitatively similar if we use a single-action, two-signal setup.
R2 = σ12 R21 + σ22 R22 + σ32 R23 . (A18)

W
The sign of R1y as well as that of W z
R2
can be positive or negative depend-
ing on the relative magnitudes of the various variances σ 21 , σ 22 , and σ 23 and
the relative magnitudes of the change in these variances, that is, σ 21 , σ 22 ,
and σ 23 . In other words, the association between the valuation and com-
pensation weights is dependent on the distribution of σ 21 , σ 22 , and σ 23 in
the observed cross-section of firms. To understand how cross-sections with
different σ 21 , σ 22 , and σ 23 distributional characteristics can exhibit different
associations between the valuation and contracting roles, consider the fol-
lowing scenarios.
Assume that, for example, the cross-section of firms is characterized by
equal changes in the firm characteristics in the neighborhood of any firm,
that is, σ 21 = σ 22 = σ 23 . Further, assume that the idiosyncratic variances
of the performance measures are equal, that is, σ 22 = σ 23 for every firm in
this cross-section. For this group of firms, the sign of the association between
valuation and contracting is dependent entirely on whether the pay-off vari-
ance σ 21 is greater or less than the idiosyncratic variance σ 22 (or σ 23 ). If it is
greater, then the association is always positive and negative otherwise. This
is because the reduction in valuation weight triggered by an increase in id-
iosyncratic variance is greater in magnitude than the increase in valuation
weight triggered by an increase in the payoff variance for the firms with
σ 21 > σ 22 . As a consequence, both valuation and compensation weights de-
cline for these firms when there is an increase in the variance vector. The
opposite scenario happens and valuation weight increases and compensa-
tion weight decreases when σ 21 < σ 22 .
Next, consider a different cross-section of firms with the property that
all firms in this group have identical payoff variance, that is, these agencies
are characterized by no variation in σ 21 (i.e., σ 21 = 0). Further, assume
that the variances of the idiosyncratic error terms of the two signals are
equal in magnitude and variation (i.e., σ 22 = σ 23 and σ 22 = σ 23 ). This
particular set of agencies exhibits the property that the changes in valuation
and compensation weights triggered by changes in the idiosyncratic error
term variances always have the same sign in the neighborhood of any agency
in the set.
Finally, consider the case when the cross-section of the agencies is char-
acterized by no variation in σ 22 and σ 23 (σ 22 = 0, σ 23 = 0). The differ-
ence between two agencies is entirely due to the difference in σ 21 . For this
W
particular group of agencies R1y as well as W R2
z
are always negative in the
neighborhood of any agency in the set.
The various cases described above highlight the context-specific associ-
ation between valuation and compensation weights for a correlated two
performance-measure setup. The interesting question is whether the actual
cross-sectional distribution of the performance measure variance charac-
teristics is conducive to a predominantly positive or negative association be-
tween the valuation and contracting roles for the sample firms under consid-
eration. Our stylized two performance measure setup provides a simple and
TABLE A1
Estimated Variances, Compensation Weights, and Valuation Weights for Representative Firms
Decile σ 21 σ 22 σ 23 Wy R1 Wz R2 Wy /R 1 Wy /R 2
1 0.036 0.027 0.055 0.910 0.571 0.886 0.221 + +
2 0.070 0.058 0.124 0.837 0.547 0.788 0.204 + +
3 0.115 0.102 0.208 0.757 0.528 0.690 0.206 + +
4 0.171 0.170 0.329 0.670 0.501 0.590 0.206 + +
5 0.237 0.256 0.510 0.592 0.481 0.492 0.194 + +
6 0.345 0.410 0.839 0.495 0.458 0.379 0.182 + +
7 0.510 0.658 1.381 0.396 0.437 0.276 0.172 − +
8 0.894 1.141 2.655 0.281 0.439 0.165 0.159 + −
9 1.973 2.610 5.413 0.149 0.431 0.084 0.172 − +
effective way to answer this question through the estimation of firm-specific

values of the triple {σ 21 , σ 22 , σ 23 } from the variance–covariance structure of the
two performance measures. 9 Further, the change in compensation weight
as well as the change in valuation weight namely can be estimated in the
neighborhood of any representative firm in the cross-sectional distribution.
We apply the above insights to estimate compensation weights and valua-
tion weights when the accounting performance measures under considera-
tion are y = EPS and z = CFPS. To obtain stable measures of variance and
covariance matrix, we require each firm to have a minimum of 10 years of
EPS and CFPS data during the period 1980 to 2004. We also remove firms
for which any of the estimates of σ 21 , σ 22 , and σ 23 is negative. For a final sam-
ple of 1,351 firms, we estimate the triple {σ 21 , σ 22 , σ 23 } and use the decile
values of the estimated variances to construct nine representative firms that
characterize the cross-sectional distribution of the firms. Table A1 provides
the values of σ 21 , σ 22 , and σ 23 , the theoretical compensation and valuation
weights W y , R 1 , W z , and R 2 as well as the sign of the ratios of change in
compensation weight and the change in valuation weight (Wy /R 1 and
W z /R 2 ) in the neighborhood of these representative firms. 10
The cross-sectional analysis based on the performance-measure charac-
teristics reveals that the compensation weights and valuation weights are
high (low) at low (high) levels of variances of the payoff relevant stochastic
term and the idiosyncratic error terms. Further, an increase in the variance
vector {σ 21 , σ 22 , σ 23 } in the neighborhood of representative agencies results
in a decline in both valuation as well as compensation weights for seven out
of nine agencies for earnings and eight out of nine agencies for cash flows,
suggesting that, in general, the association between the two is positive.
9 Note that var(y) = σ 2 + σ 2 , var(z) = σ 2 + σ 2 and cov(y, z) = σ 2 . This implies that σ 2 =

1 2 1 3 1 1
cov(y, z), σ 22 = var(y) – cov(y, z), and σ 23 = var(z) – cov(y, z) can be estimated from the sample
variance–covariance matrix of y and z.
10 The change in the various variance measures, that is, σ 2 , σ 2 or σ 2 , as the case may
1 2 3
be, is estimated as 1% of the inter-quartile range of the corresponding variance measures in
the estimation of Wy , W z , R 1 , and R 2 .
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5.BANKER Et Al-2009-Journal of Accounting Research

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DOI: 10.1111/j.1475-679X.2009.00335.

Incentive Contracting and Value

Received 14 April 2006; accepted 3 January 2009

Accounting performance measures such as earnings and cash flows are

of prior studies have examined the valuation roles and incentive-contracting

Relative weight of cash flows vs. earnings

Relative valuation weight of cash flows vs. earnings

log(CASHCOMP ) i,t = β0 + β1 EPS i,t + β2CPS i,t + εit

and Wang [2003] is based on the predictions of a two-period model where

exponential utility, and normally distributed random variables) frame-

3 As we show later, empirical proxies of these agency-specific parameters can be esti-

elements of the variance–covariance matrix are functions of two specific vari-

alternative scenarios in which current earnings do not fully reflect multi-

3. Research Design and Sample Selection

Compensation ∝ f (earnings, cash flows, earnings ∗ value relevance of earnings,

3.1 VARIABLE MEASUREMENT

Pi,t = β0 + β1 EPSi,t + β2 BPSi,t + uit . (2)

Pi,t = γ0 + γ1 EPSi,t + γ2 CPSi,t + γ3 BPSi,t + εit . (3)

Pi,t = η0 + η1 CPSi,t + η2 BPSi,t + uit . (4)

Denoting the coefficient of determination of equation (4) as R 2cfobv , we mea-

3.2 SAMPLE SELECTION

CFO i,t − CFO i,t−1 = U E (CFO i,t ) − U E (CFO i,t−1 );

executive compensation studies. Our sample is biased towards large,

value relevance measures. Similar to the results in Collins, Maydew, and

4.2CASH COMPENSATION WEIGHT AND VALUE RELEVANCE OF EARNINGS

Mean STD Q1 Median Q3

Table 3 shows the average association between pay-sensitivity and value

Earnings as the Primary Cash Flows as the Primary

Earnings as the Primary Cash Flows as the Primary

sensitivities of earnings in the cross-section. The yearly mean coefficient on

4.3TOTAL COMPENSATION WEIGHT AND VALUE RELEVANCE OF EARNINGS

4.4 VALUE RELEVANCE OF CHANGE IN EARNINGS AND CHANGE

Ri,t = δ0 + δ1 CFOi,t + e it , (7)

Table 4 reports descriptive statistics of variables and estimation coeffi-

in logarithm of cash compensation as dependent variables and change in

Ri,t = α + Ve ∗ EARN i,t + Ve ∗ EARN2 i,t + Vc ∗ CFO i,t

5. Conclusions and Implications

Ri,t = α + Ve · EARNi,t + Ve · EARN2i,t + Vc · CFOi,t + Vc · CFO2i,t + εi,t

Panel B: Industry-by-industry coefficient estimates from regressing change in cash

 log(CASHCOMPi,t ) = α + We · EARNi,t + We · EARN2i,t + Wc · CFOi,t

A Two-Action, Two-Signal Principal-Agent Model to Investigate the Association

w y = 1 + σ32 D and wz = 1 + σ22 D

The Association between Compensation Weight and Value Relevance Measures

w y 1 = − 1 + σ32 2 + σ22 + σ32 D 2 < 0, (A3)

w y 2 = − 1 + σ32 1 + σ12 + σ32 D 2 < 0, (A4)

w y 3 = σ12 1 + σ22 D 2 > 0, (A5)

wz1 = − 1 + σ22 2 + σ22 + σ32 D 2 < 0, (A6)

wz2 = σ12 1 + σ32 D 2 > 0, (A7)

wz3 = − 1 + σ22 1 + σ12 + σ22 D 2 < 0. (A8)

R21 = R22 σ32 σ14 > 0, (A12)

R22 = R22 σ32 σ24 > 0, (A13)

R23 = −R22 σ12 + σ22 σ12 σ22 < 0. (A14)

Wz = σ12 wz1 + σ22 wz2 + σ32 wz3 , (A16)

R1 = σ12 R11 + σ22 R12 + σ32 R13 , (A17)

R2 = σ12 R21 + σ22 R22 + σ32 R23 . (A18)

effective way to answer this question through the estimation of firm-specific

9 Note that var(y) = σ 2 + σ 2 , var(z) = σ 2 + σ 2 and cov(y, z) = σ 2 . This implies that σ 2 =

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CFO i,t − CFO i,t−1 = U E (CFO i,t ) − U E (CFO i,t−1 );

Ri,t = δ0 + δ1 CFOi,t + e it , (7)

Ri,t = α + Ve ∗ EARN i,t + Ve ∗ EARN2 i,t + Vc ∗ CFO i,t

Ri,t = α + Ve · EARNi,t + Ve · EARN2i,t + Vc · CFOi,t + Vc · CFO2i,t + εi,t

log(CASHCOMPi,t ) = α + We · EARNi,t + We · EARN2i,t + Wc · CFOi,t

Wz = σ12 wz1 + σ22 wz2 + σ32 wz3 , (A16)

R1 = σ12 R11 + σ22 R12 + σ32 R13 , (A17)

R2 = σ12 R21 + σ22 R22 + σ32 R23 . (A18)