Executive bonus compensation when abnormal earnings and the state of the economy are correlated

This paper investigates executive earnings-based bonuses in a general equilibrium economy. Unlike the existing study, combining the two frameworks in the fields of accounting and economics allows us to examine different earnings characteristics determined by the correlation between normal/abnormal earnings and the state of the economy. We derive a formula for the cost of executive earnings-based bonuses and obtain two key findings. First, we show that the typical bonus plan is beneficial to both shareholders and executives. To decrease the volatility of their wealth, shareholders prefer countercyclical earnings. Under this typical bonus plan, executives with countercyclical earnings can be greatly rewarded. Second, we find that the correlation between abnormal earnings and the state of the economy has a greater impact on bonuses than does the correlation between normal earnings and the state of the economy. This finding suggests that it is important to consider the relationship between abnormal earnings and the state of the economy when compensating an executive through an earnings-based bonus. (C) 2013 Elsevier B.V. All rights reserved.