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Journal ArticleDOI

Managerial Expertise, Private Information, and Pay-Performance Sensitivity

01 Mar 2008-Management Science (INFORMS)-Vol. 54, Iss: 3, pp 429-442
TL;DR: This paper characterizes optimal pay-performance sensitivities of compensation contracts for managers who have private information about their skills, and those skills affect their outside employment opportunities, and identifies plausible circumstances under which risk and incentives are positively associated.
Abstract: This paper characterizes optimal pay-performance sensitivities of compensation contracts for managers who have private information about their skills, and those skills affect their outside employment opportunities. The model presumes that the rate at which a manager's opportunity wage increases in his expertise depends on the nature of that expertise, i.e., whether it is general or firm specific. The analysis demonstrates that when managerial expertise is largely firm specific (general), the optimal pay-performance sensitivity is lower (higher) than its optimal value in a benchmark setting of symmetric information. Furthermore, when managerial skills are largely firm specific (general), the optimal pay-performance sensitivity decreases (increases) as managerial skills become a more important determinant of firm performance. Unlike the standard agency-theoretic prediction of a negative trade-off between risk and pay-performance sensitivity, this paper identifies plausible circumstances under which risk and incentives are positively associated. In addition to providing an explanation for why empirical tests of risk-incentive relationships have produced mixed results, the analysis generates insights that can be useful in guiding future empirical research.

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Citations
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Posted Content
TL;DR: This article developed a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993-2006, finding that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly-hired CEOs.
Abstract: This study focuses on the relation between current compensation and past performance measures as signals of a CEO’s ability. We develop a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993-2006. Consistent with the predictions, we find that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly-hired CEOs. We also find that while current salary is positively associated with future performance, current bonus is not. As the model suggests, 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 by separating high-ability agents into riskier contracts. Our results indicate that it is important to disaggregate cash compensation into salary and bonus components to understand the dynamic interaction between incentives and performance.

105 citations


Cites background from "Managerial Expertise, Private Infor..."

  • ...(A.9) We infer that the coefficient )( 00 aβ belongs to a direct revelation mechanism if it is increasing in Period 0 ability (i.e., 0) ≥( 00′ aβ ), in agreement with Salanie (2005, p. 31) and Dutta (2008)....

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  • ...21 2 1001 2 1100111001110011 2 ccRayaaayadzayzraya a a σδββλβλα −−−+= ∫ 9 This is a common assumption in mechanism design (Bolton and Dewatripont 2005; Salanie 2005; Dutta 2008)....

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  • ...Second, the agent’s ability could be multidimensional (McAfee et al. 1989; Dutta 2008)....

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  • ...As in Dutta (2008), Datar et al. (2001), Holmstrom and Milgrom (1987), and Feltham and Xie (1994), we also assume the agent has constant absolute risk aversion (utility) with a coefficient of absolute risk aversion (CARA) of R such that his Period 0 utility is: ]}2/)())),((,([exp{))()),),((,(( 0 2…...

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Journal ArticleDOI
TL;DR: This paper developed a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993-2006, finding that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly hired CEOs.
Abstract: This study focuses on the relation between current compensation and past performance measures as signals of a chief executive officer's (CEO's) ability. We develop a simple two-period principal-agent model with moral hazard and adverse selection and test theoretical predictions using CEO compensation data from 1993–2006. Consistent with the predictions, we find that salary (bonus) is positively (negatively) associated with past performance for both continuing and newly hired CEOs. We also find that while current salary is positively associated with future performance, current bonus is not. As the model suggests, 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 by separating high-ability agents into riskier contracts. Our results indicate that it is important to disaggregate cash compensation into salary and bonus components to understand the dynamic intera...

87 citations

Posted Content
TL;DR: This paper developed an agency model to examine the effects of a CEO's power to pressure a CFO to bias a performance measure, like earnings, which has implications for incentive compensation, reporting quality, firm value, and information rents.
Abstract: Building on archival, anecdotal, and survey evidence on managers' roles in accounting manipulations, I develop an agency model to examine the effects of a CEO's power to pressure a CFO to bias a performance measure, like earnings. This power has implications for incentive compensation, reporting quality, firm value, and information rents. Predictions from the model provide potential explanations for the differing results from recent empirical studies on the impact of regulatory interventions like SOX and the extent to which the CEO's or CFO's incentives significantly impact on earnings management. The model also identifies conditions under which either a powerful or a non-powerful CEO can extract rents, which can help explain mixed empirical results on the association between CEO power and "excessive" compensation.

77 citations


Additional excerpts

  • ...Similar to this paper, Dutta (2008) features countervailing incentives in a LEN model with adverse selection, but in Dutta (2008), countervailing incentives are driven by the correlation between a productive agent s productivity and her outside option or reservation wage....

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Journal ArticleDOI
TL;DR: This paper investigated managerial skills that are essential for managers' job promotion and found that a manager's own experience, expertise, and network size positively affect promotion odds, while strong colleagues decrease promotion odds.
Abstract: Based on the talent management literature, this paper investigates managerial skills that are essential for managers’ job promotion. Using arguments from the human and social capital literature and following tournament logic, we claim that a manager’s own experience, expertise, and network size positively affect promotion odds, while strong colleagues decrease promotion odds. Studying 7,003 promotions to middle management and 3,147 promotions to senior management, we find broad support for our hypotheses, but find also that network size no longer predicts promotion to senior management. Our findings have implications for individual career development and talent management programs.

67 citations


Cites background from "Managerial Expertise, Private Infor..."

  • ...We distinguish between managers’ experience (e.g., Schmidt, Hunter, & Outerbridge, 1986) – defined as their work tenure (Fisher & Govindarajan, 1992) – and managers’ expertise (e.g., Dutta, 2008) – defined as their focus in a specific work domain....

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Journal ArticleDOI
TL;DR: This paper developed an agency model to examine the effects of a CEO's power to pressure a CFO to bias a performance measure, like earnings, which has implications for incentive compensation, reporting quality, firm value, and information rents.

67 citations

References
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Journal ArticleDOI
TL;DR: In this article, the authors investigate whether the greater use of stock options in the IT industry can be explained on the basis of general economic relationships that apply to firms in all industries.
Abstract: An innovative business practice attributed to the information technology (IT) industry is the aggressive use of employee stock options to compensate executives and other employees. In this study, we investigate whether the greater use of stock options in the IT industry can be explained on the basis of general economic relationships that apply to firms in all industries. To examine differences in compensating top executives, we estimate a system of simultaneous equations that is designed to accommodate interconnections between performance, the level of compensation, and the mix of compensation components. We document that the shares of both bonus and option pay increase with performance and that the pay level and the extent of incentive pay positively affect firm performance. We identify economic factors that may influence the use of options and show that there are significant differences in these factors between IT and other industries. We find that, while much of the greater use of options by IT firms is explained by the economic factors, significant residual differences remain. We also find that, when performance and other factors are considered, the level of executive pay in the IT industry is not higher than in other industries.

233 citations


"Managerial Expertise, Private Infor..." refers background in this paper

  • ...…higher pay-performance sensitivities in compensation contracts of managers in new economy knowledge-based firms.20 Consistent with this prediction, Anderson et al. (2000), Core and Guay (2001), Ittner et al. (2003), and Murphy (2003) find that performance-based compensation is more prominent in…...

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  • ...Empirical evidence in Anderson et al. (2000), Core and Guay (2001), Ittner et al. (2003), and Murphy(2003) suggest that performance-based pays (through stock options and other performance measures) play a more prominent role in knowledge-intensive new-economy firms than in traditional firms....

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Posted Content
TL;DR: The authors investigated whether the positive associations between discretionary accrual proxies and beating earnings benchmarks hold for comparisons of groups segregated at other points in the distributions of earnings, earnings changes, and analysts-based unexpected earnings.
Abstract: We investigate whether the positive associations between discretionary accrual proxies and beating earnings benchmarks hold for comparisons of groups segregated at other points in the distributions of earnings, earnings changes, and analysts-based unexpected earnings. We refer to these points as "pseudo" targets. Results suggest that the positive association between discretionary accruals and beating the profit benchmark extends to pseudo targets throughout the earnings distribution. We find similar results for the earnings change distribution. In contrast, we find few positive associations between discretionary accruals and beating pseudo targets derived from analysts-based unexpected earnings. We develop an additional analysis that accounts for the systematic association between discretionary accruals and earnings and earnings changes. Results suggest that the positive association between discretionary accruals and earnings intensifies around the actual profit benchmark (i.e., where earnings management incentives may be more pronounced). We find similar effects around the actual earnings increase benchmark. However, analogous patterns exist for cash flows around the profit and earnings increase benchmarks. In sum, we are unable to eliminate other plausible explanations for the associations between discretionary accruals and beating the profit and earnings increase benchmarks.

190 citations

Journal ArticleDOI
TL;DR: This paper investigated whether the positive associations between discretionary accrual proxies and beating earnings benchmarks hold for comparisons of groups segregated at other points in the distributions of earnings, earnings changes, and analysts-based unexpected earnings.
Abstract: We investigate whether the positive associations between discretionary accrual proxies and beating earnings benchmarks hold for comparisons of groups segregated at other points in the distributions of earnings, earnings changes, and analystsbased unexpected earnings. We refer to these points as “pseudo” targets. Results suggest that the positive association between discretionary accruals and beating the profit benchmark extends to pseudo targets throughout the earnings distribution. We find similar results for the earnings change distribution. In contrast, we find few positive associations between discretionary accruals and beating pseudo targets derived from analysts‐based unexpected earnings. We develop an additional analysis that accounts for the systematic association between discretionary accruals and earnings and earnings changes. Results suggest that the positive association between discretionary accruals and earnings intensifies around the actual profit benchmark (i.e., where earnings management i...

176 citations

Journal ArticleDOI
TL;DR: In this paper, a multi-period principal-agent model is presented in which a divisional manager has superior information regarding the profitability of an investment project available to his division, and the manager also contributes to the periodic operating cash flows of his division through personally costly effort.
Abstract: This paper examines a multiperiod principal-agent model in which a divisional manager has superior information regarding the profitability of an investment project available to his division. The manager also contributes to the periodic operating cash flows of his division through personally costly effort. We demonstrate that it is optimal for the principal to delegate the investment decision and to base the manager's compensation on the residual income performance measure. Our analysis points to a class of depreciation rules and to a particular capital charge rate which together ensure that a profitable (unprofitable) project makes a positive (negative) contribution to residual income in every period. As a consequence, the compensation parameters for each period can be chosen freely so as to address the moral hazard problems without impacting the manager's investment incentives.

102 citations

Journal Article
TL;DR: In this article, the authors develop a simple model in which optimal contracts display this feature, even in the absence of transactions costs, and apply it in regulatory, labor, and legal settings.
Abstract: In practice, contracts involve "standard terms" or "rules," allowing for variations only under "exceptional" circumstances. We develop a simple model in which optimal contracts display this feature, even in the absence of transactions costs. Rules arise when an agent has "countervailing incentives" to misrepresent private information. These incentives are created by endowing the agent with a critical factor of production ex ante. Applications in regulatory, labor, and legal settings

97 citations


"Managerial Expertise, Private Infor..." refers background or methods or result in this paper

  • ...See also Lewis and Sappington (1989b). where a∗ ≡ λ k denotes the induced effort choice....

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  • ...This contrasts with Lewis and Sappington (1989a) in which the firm’s dominant reporting incentive (and hence the nature of distortion in the optimal production schedule) varies with the firm’s marginal cost parameter θ because the first-best production quantity is a function of θ ....

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  • ...In contrast Lewis and Sappington (1989a) find that optimal mechanisms would generally induce under-production from some types and over-production from others....

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  • ...The assumption of full participation is also imposed in Dutta (2003), Lewis and Sappington (1989a) and (1989b), and Maggi and Rodriguez-Clare (1995)....

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  • ...Dutta (2003), Lewis and Sappington (1989a), and Maggi and Rodriguez-Clare (1995) also consider settings in which the agent’s reservation utility depends on his type....

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Trending Questions (1)
What are the specific information of does are pay?

The specific information about pay in the paper is related to the optimal pay-performance sensitivity of compensation contracts for managers with private information about their skills.