The Relation between CEO Compensation and Past Performance

The Harvard Law School Forum on Corporate Governance and Financial Regulation 2012-11-07

Summary:

Editor's Note: The following post comes to us from Rajiv Banker, Professor of Accounting at Temple University; Masako Darrough, Professor of Accountancy at City University of New York; Rong Huang, Assistant Professor of Accountancy at City University of New York; and Jose Plehn-Dujowich, Assistant Professor Accounting at Temple University.

Most of the empirical work on executive compensation investigates the role of contemporaneous performance measures in setting cash compensation, ignoring the relevance of past performance measures and the structure of cash compensation. In our paper, The Relation between CEO Compensation and Past Performance, forthcoming in The Accounting Review, we focus on the relation between cash compensation components (salary and bonus) and past performance measures as signals of a CEO’s ability.

We first develop a simple two-period principal-agent model with moral hazard and adverse selection. Our model suggests that salary is adjusted to meet the reservation utility and information rent, and is positively correlated over time to reflect ability. Bonus serves to address moral hazard and adverse selection problems by separating agents into contracts with different levels of risk. Agents are screened and receive different bonus arrangements according to their types. The higher an agent’s type, the more sensitive his bonus is to contemporaneous performance. A higher ability agent receives a larger portion of his compensation in the form of bonus and less as salary. For a given agent, salary increases with his past performance and higher current salary predicts higher future performance. Current bonus, however, is negatively correlated with both past and future performance.

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Link:

http://blogs.law.harvard.edu/corpgov/2012/11/07/the-relation-between-ceo-compensation-and-past-performance/

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Tags:

academic research empirical research executive compensation performance measures executive performance moral hazard bonuses adverse selection jose plehn-dujowich masako darrough rajiv banker rong huang

Authors:

R. Christopher Small, Co-editor, HLS Forum on Corporate Governance and Financial Regulation,

Date tagged:

11/07/2012, 10:28

Date published:

11/07/2012, 08:48