Operating Cash Flows and Earnings Target Revision: Evidence from Annual Cash Bonus Plans for CEOs

We empirically examine the impact of operating cash flows on future earnings targets in CEOs' annual cash bonus plans. Using target and actual compensation earnings-per-share (EPS) disclosed in proxy statements of large U.S. public firms, we find that operating cash flows have no significant incremental effects on the revision of future earnings targets in the presence of current earnings. We also observe a positive association between future target achievability and current operating cash flows, indicating that firms with higher operating cash flows set significantly easier future earnings targets for their CEOs. These findings suggest that the higher persistence of operating cash flows in predicting future earnings is not fully incorporated into target setting. Further analyses reveal that the positive association between future target achievability and current operating cash flows is attributable to both expectation bias and contractual considerations to reward CEOs who deliver greater cash flows and to limit activities that sacrifice cash flows.