CEO performance awards are based on a combination of market, accounting, and nonfinancial measures indicative of desired strategies. Large and complex firms with growth opportunities heavily weight performance awards on market measures and sales growth. Smaller firms and mature firms use a larger proportion of accounting-based measures to determine awards. The findings are consistent with optimal contracting theories.
What’s Inside?
In December 2006, the US SEC issued requirements that firms disclose the types of performance determinants for CEO awards. The authors review the newly disclosed information and find that a wide array of performance measures are used. In their sample, 79% of the performance award value is based on accounting measures, 13% on market-based measures, and 8% on nonfinancial determinants. Similar performance measures are found within similar sectors. The authors find that firms choose performance measures that are informative about CEO actions, which is consistent with contracting theories.
How Is This Research Useful to Practitioners?
The authors examine incentive contracts and their relationship with firm strategies. Past literature suggested that the environment in which a firm operates is related to specific strategies. The authors find that the life cycle and complexity of the firm (indicators of the strategies) are significantly related to the performance measures used to determine CEO awards. Stock price performance is indicative of investors’ perception of the firm’s long-term growth opportunities and is a more informative measure than accounting-based measures for how effectively the growth-firm CEO improves the firm’s growth prospects. Growth firms are found to also use sales growth to measure CEO performance. Market performance, based on all information available to investors, provides an aggregate metric for larger and multidivision firms.
Mature firms and firms with a stable or focused strategy rely more heavily on accounting returns as an indication of the CEO’s management of capital used in existing operations.
Users of the newly disclosed information may evaluate whether award contracts are providing incentives that are consistent with the firms’ strategies.
How Did the Authors Conduct This Research?
CEO compensation information as of December 2007 is collected from proxy statements on 494 S&P 500 Index firms. Approximately 90% of the sample firms grant prespecified performance-based compensation awards. The average value of the award is $4.8 million compared with the mean sample CEO base salary of $1.1 million. Performance-based compensation is paid in cash (86% of the firms), stock (52%), and options (3.85%). Firms in the sample give awards based on a combination of one to seven metrics, and 50% use two to four metrics to determine the award. The authors focus on prespecified contractual awards, as described in the proxy statement for the company, and not on those awards paid at the discretion of the board of directors.
Across all industry sectors, the largest proportion of the performance award is based on accounting metrics, with the largest weight tied to income measures.
Using Tobit regression, the authors find that firms relying more heavily on market-based performance awards are larger firms, younger firms, firms with complex activities, and firms with greater growth opportunities. Firms tying a larger fraction of the awards to accounting-based performance awards are mature firms and those with longer CEO tenure.
The authors also observe that awards given at the discretion of the board of directors and not tied to prespecified formulas are relatively large (the sample average cash bonus award is $2.7 million, stock is $3.5 million, and options are $3.9 million). Discretionary awards had no significant relationship with performance metrics.
Abstractor’s Viewpoint
Because the largest proportion of performance awards is based on accounting measures, the reliability of the accounting metrics used should be considered. Income, assets, and capital used are easily manipulated and the choice of accounting principles affects the financial results. Mergers and acquisitions, age of the balance sheet assets, financing decisions, and so on greatly affect the accounting measures. The contractual performance measures used may provide incentive for award-seeking CEOs to avoid value-creating investments or to use suboptimal financing to achieve the target returns. Further research might address the causal interaction between contracts, firm characteristics, and accounting performance measures used.