THE EFFECT OF RESTRUCTURING CHARGES ON EXECUTIVES CASH COMPENSATION

Top executives' compensation contracts typically provide for annual incentive awards that link executives' cash compensation and reported earnings. This link has been confirmed empirically by Lambert and Larcker (1987), who document a positive association between the cash compensation of chief executive officers (CEOs) and their firms' contemporaneous earnings performance. The widespread use of earnings-based incentives has prompted concerns that executives may select real decisions and accounting procedures to maximize their earnings-based compensation, irrespective of the impact on the economic well-being of the firm (Kaplan and Atkinson 1989, 724; Watts and Zimmerman 1986, 204). These concerns presume that the earnings-based performance measures specified in compensation contracts are strictly adhered to in setting executive compensation. In practice, however, these plans are administered by compensation committees, who could adjust compensation to prevent executives from engaging in opportunistic behavior. Existing research provides mixed evidence as to whether compensation committees adjust earnings-based compensation. For example, Abdel-khalik (1985) finds evidence that CEO compensation is adjusted in response to accounting procedure changes. In contrast, Healy et al. (1987) find no evidence that CEO compensation is adjusted for the effects of accounting procedure changes on reported earnings. This study provides evidence suggesting that compensation committees do adjust earnings-based incentive compensation. It documents reliable and systematic evidence that CEOs' cash compensation is adjusted for restructuring charges. We investigate a sample of 182 restructuring charges taken by 91 Fortune 500 firms between 1982 and 1989. The short-term incentive plans of the sample firms do not include explicit provisions for restructuring charges to be excluded from the definition of earnings used to determine executives' incentive compensation. The empirical analysis, however, indicates that CEO cash compensation is shielded from restructuring charges relative to other components of earnings. The results also suggest that the degree to which executive compensation is adjusted for a restructuring charge depends on the characteristics of the restructuring. Our evidence is consistent with the hypothesis that compensation committees systematically override the provisions of incentive plans to avoid providing executives with incentives to behave opportunistically. Restructurings typically require a large charge to earnings but can have a positive impact on the economic well-being of a firm. By adjusting executive compensation for restructuring charges, the compensation committee ensures that executives are not deterred from undertaking value-enhancing restructurings.