The Role of Stock Returns in CEO Performance Evaluation: A New Interpretation

It has been well-established that both stock prices and accounting earnings are used to evaluate and compensate CEOs. Prior studies often interpret the higher sensitivity of compensation revisions to stock prices (relative to accounting earnings) as the superior role of price formation versus financial reporting in conveying information about CEO effort. Using an information perspective that parses out firm-initiated news events during the year when stock prices impound the future implications of the information released in these events, we show that a significant part of the explanatory power of stock returns for CEO compensation occurs during trading days when financial accounting information is publicly released to the market. Further, the greater pay-for-performance sensitivity of information-event returns for CEO compensation is pronounced for events that are informative about CEO effort and especially those that are associated with accounting disclosures. Additional cross-sectional tests based on shocks to auditor reputation, internal control weaknesses, and large shareholder attention demonstrate the role of financial reporting credibility and corporate governance in our inferences. Overall, our study illustrates the co-dependence between price-based and accounting-based measures for CEO performance evaluation, and presents a framework that exploits this complementarity.