Essays on the target setting in executive annual bonus contracts

Abstract

My dissertation examines the determinants on the target setting of executive annual bonus contracts. Prior research in managerial accounting has documented that external information, such as peer performance, is typically used in target setting. However, there is only limited evidence of what specific information is actually used in this process. My first essay examines how analysts annual earnings forecasts influence target setting for executives bonus contracts. I provide novel evidence that analyst forecasts are positively associated with firms bonus target revisions. Furthermore, the use of analyst forecasts in target setting is less pronounced when the forecasts are noisier, and it is more prominent when analysts have an informational advantage over managers. I find that target ratcheting is attenuated for favorable performance and becomes severe for unfavorable performance when past performance is greater than analyst forecasts. Finally, the results from additional analyses are not consistent with alternative explanations that both bonus target revisions and analyst forecasts are influenced by internal planning information or that analyst forecasts are influenced by bonus target revisions (i.e., reverse causality). Recent studies have suggested that annual bonus has an incentive effect comparable to stock compensation (Frydman and Jenter 2010

Jensen and Murphy 2011

Guay, Kepler, and Tsui 2016). However, only a limited number of papers have addressed annual bonuses. The aim of my second essay is 1) to overview the comprehensive landscape of executive bonus plans 2) and to investigate the determinants of pay-for-performance sensitivity (hereafter, PPS) and the convexity of annual incentives. I find that the 80/120% rule for target setting holds on average, with differences across industries. I also show that firms growth options are one of the key elements in determining bonus PPS and the convexity of bonus payouts after controlling for peer information and other economic factors.