An Analysis of the Use of Accounting and

Market Measures of Performance in Execu

tive Compensation Contracts
Mok Tsz Chung, Calvin (124087)
Ho Man Lan (124090)
Law Yiu Hang (124091)
Tsang Wing Han (124095)
Li Kin Yip (124096)
Shiu Shuk Kwan (124124)

Introduction

Introductio
n

Backgroun
d

Objectives

Hypothesis

Methodolo
gy

Implication

Findings

Limitation
and
Conclusion

Introduction
How to determine the compensation of the executives
The important limitation of studies is the virtual absence of any
cross-sectional analyses.
Such as the problems related to the environment
Compensation contracts should be reflected characteristics of t
he manager, the firm, and the environment.

Objectives
Attempt to address some of these complexities
Employ an analytical agency theory model with respect to the ag
ent's actions
Provide a structure for controlling for other factors
Examine whether the relative use of security market and accounti
ng measures of performance in executive compensation

Background
Agency Theory

Provide insights into the use of accounting or Provide a framework for structuring our
market numbers as specific measures of
empirical analysis
Specify the properties of any two generic
performance in compensation contracts
variables that are relevant for evaluating an
agent's performance
Functional form: informational properties of the
performance variables to parameters of the
agent's compensation scheme
A Means: controlling for "other" effects on the
form of the compensation scheme
The analysis can focus on informational
properties

Single Period
Agency
Model

Multi-Period
Consideratio
n

Background
Single-period agency models (Holmstrom [1979])
The "standard" agency model
The agent's action (the amount of effort supplies) to the cash flow
Must rely on measures of the agent's actions for both evaluation and motivation
E.g. his output and other information
Equation provides guidance regarding the functional form of the relation between the
agent's compensation and the performance measures x and y

Background
Single-period agency models
= Lagrange multiplier
that specifies the lower
bound on the level of
expected utility that
the contract can
provide to the agent
U() =
agent's
utility
function for
money

x = agent's output

+
= Lagrange
multiplier that
ensures the
agent's choice of
effort be incentive
compatible

a = a function of his
action

y = other
information

Background
Single-period agency models

].

Background(hold)
agency models
Single-period

Equation implies that the ratio of the slope coefficients is a function of the ratio of th
e "signal-to-noise" ratios of the two performance variables
An increase in either the precision of a performance variable or its sensitivity to the a
gent's actions
Increase the relative weight the variable receives in the compensation function
Signal-to-noise ratio =

Signal-to-noise ratio

Background
Multi-period agency models
Compensation contracts have "memory" (e.g., Lambert [1983] and Rogerson [1985])
Compensation will depend on the realizations of the performance measures in that p
eriod and prior periods
Equation expresses optimal Contract
the agent's utility function is additively separable over time
t = time
the expected values for the performance measures are conditioned upon the actio
ns in current and prior realizations
the slope coefficients are permitted to depend on the prior realizations

]|]

Background
agency models
Multi-period

The slope coefficients (x and y) are proportional to the time-series average of the sign
al-to-noise ratios of the performance measures
the slope coefficients for each firm using time-series data for compensation, market p
erformance and accounting performance
used to analyze whether the relative weights assigned to security market and acco
unting numbers in compensation contracts are related to the signal-to-noise ratios
of these performance variables

] | ].

Methodology & Desig

n

Methodology & Design

Sample
Forbes
survey

annual

compensation
48 3

Final Sample: 370 firms

Includes
data
on
cash
compensation for:
The chief executive officer
(CEO)
Years as CEO
Years with the company
Years 1970 to 1973 the
value of shares owned by
the CEO

25
188
77
29

Industrial firms
Natural resource or petroleum-processing firms
Utilities or transportation companies
Retail or hotel firms
Banks or insurance companies
Firms in unique industrial groups

Estimation of the Slope Coefficients on the

Performance Measures
Agency theory

relevant accounting (variable y)

security market (variable x) performance indexes

Increase the comparability

express variables in terms of rates of return

1. Measurement Of The Performance Varia

bles
A. Security market return (RET)
sum of the firm's capital gains and dividends divided by the stock pric
e
at the beginning of the year

B . Return on Equity (ROE)

the firm's earnings before extraordinary items and discontinued oper
ations divided by the average common shareholders' equity

2. Measurement Of Compensation
Includes
Cash
compensation
(salary +
annual bonus)
represents
between 80%
to 90% of total
compensation.

Excludes
changes in the
value of the
manager's
holdings of stock
stock options

2. Measurement Of Compensation
may depend on the structure of the remainder of the manage
r's wealth
i.e. the relative weight
market vs. accounting performance

the manager's other wealth is tied to the firm's stock price?

3. BOX-COX Estimation
Analytical agency model
expressed in equation (10)
estimating regression equations
separately for each firm

Results Of BOX-COX And Multiple Regressi

on Analysis

Results Of BOX-COX And Multiple Regressi

on Analysis
ROE slope
RET slope
cash compensation
related to both RET and changes in ROE

Results Of BOX-COX And Multiple Regressi

on Analysis(hold)
relation between compensation and RET and ROE
using standard OLS multiple regression
more highly associated with differences in accounting returns t
han with levels of security market returns

Findings

Preceding Analysis (Hypotheses)

The relative weight of RET & ROE in the cash compensation cont
ract :
-> noise ratios of RET & ROE

-> the degree to which the firm is in the "early" stages of investm
ent
-> the extent to which the manager's other wealth is tied to stock
price

Correlation Analysis
The Pearson correlations (after applying the logarithmic transformation) among th
e proxies
Generally consistent with the hypotheses made
REAL CONCERNS: correlation among the underlying constructs
E.G

1. A positively related to B,
2. C negatively related to D

How it is possible if A positively related to B, while the relation C negatively relate

d to D?
Difficult to assess the relation due to the presence of some factors

Latent Variable Analysis

To mitigate the measurement and interpretation problems
Latent Variable Structural Equation Model

PERF MIX = Y0 + Y1NOISE + Y2CORR + Y3GROWTH + Y4OTHER + f

Results of the Latent Variable Analysis(To

LKY)
PERF MIX = Y0 + Y1NOISE + Y2CORR + Y3GROWTH + Y4OTHER +
f
NOISE and GROWTH are significantly negatively correlated
GROWTH and OTHER constructs are significantly positively corr
elated