High Non-GAAP Earnings Predict Abnormally High CEO Pay

Abstract

Using the standard academic model of executive compensation, we document excessive CEO pay for the S&P 500 firms that report non-GAAP earnings that are much higher than their GAAP earnings. We also find that, on average, such firms have weak contemporaneous and future operating performance relative to other firms. Moreover, contrary to management’s usual assertion that non-GAAP earnings more accurately convey a firm’s core earnings, we find that non-GAAP earnings do not better correlate with contemporaneous stock returns when compared to GAAP net income or operating income. This latter finding confirms prior results that firms’ reporting of non-GAAP earnings does not mislead investors, maybe because firms are simultaneously required to report GAAP earnings and a reconciliation of the adjustments to GAAP earnings. Overall, our evidence suggests that, on average, boards of directors are influenced by large positive non-GAAP earnings adjustments in justifying CEO pay that would otherwise be not supported by the firm’s stock price or GAAP earnings performance.