The Impact of Using Inappropriate Procedures to Neutralize For Inflation in Recent Executive Compensation Studies

During the last several years, a considerable number of empirical studies have been published that link executive compensation with accounting performance measures or earnings components. The extant research relies on regression models based on agency theory. The objective of the research is to evaluate the extent to which the accounting-based managerial-performance measures explain executive compensation. In order to accomplish the statistical analysis, authors of several of these studies believed it necessary to adjust the time-series data for the effects of inflation. In doing so, they applied general price-level adjustments to figures drawn from successive year's financial statements, or scaled the accounting variables against other variables taken from the same year's financial statements, in order to neutralize for inter-year inflation. In this paper we show that the adjustment process followed in these studies will significantly bias the results and thereby call the conclusions into question. We conclude by calling on researchers to address the limitations of their efforts due to the adjustment process employed and by offering an alternative approach to conducting the analysis.