Relative Performance Evaluation and Earnings Management*
Contemporary Accounting Research · 2022 · Volume 39 · Issue 1
Abstract
Conventional agency theory suggests that firms should benchmark CEO compensation to absorb systemic risk and to more efficiently incentivize executives to work hard. Yet empirical research has found only a modest use of benchmarking in CEO compensation contracts. In this paper, I highlight one weakness of relative performance evaluation (RPE). When earnings management is possible, benchmarking creates stronger incentives for misreporting performance measures compared to benchmark-independent pay. The optimal contract will depend less on a correlated benchmark (e.g., a stock market index) if it is easier for the manager to misreport performance. Thus, the model predicts that firms with weak internal controls and bad auditors are less likely to use RPE, offering a theoretical explanation for the empirically observed lack of RPE use.
Keywords
relative performance evaluation, earnings management, CEO compensation, évaluation du rendement relatif, gestion des résultats, rémunération des PDG
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