Value Relevance of Internal Earnings Relative to Annual Bonus Targets

Prior studies examine how the use of earnings for valuation purposes is related to the use of earnings in contracting. I extend this literature by examining the value relevance of internal earnings relative to targets, a performance measure widely used in annual bonus contracts. Internal earnings relative to targets could be value relevant because they reflect board’s private information or the quality of firm’s management control systems. However, any internal performance measure could also be manipulated by the board or management, which would undermine its reliability and relevance to capital market participants. Using hand-collected data on internal earnings and annual bonus targets in Chief Executive Officer (CEO) cash bonus plans, I find that internal earnings relative to targets strongly predict annual stock returns. This effect is incremental to that of Generally Accepted Accounting Principles (GAAP) and street earnings surprises, as well as management earnings guidance surprises. Moreover, this effect is stronger for firms with more detailed disclosure about compensation contracts and with better governance. Buttressing the stock return results, I further show that internal earnings relative to targets predict future cash flows. This evidence suggests that the value of internal earnings relative to targets extends beyond its traditional role in contracting.