Implicit Contracts and the Explanatory Power of Top Executive Compensation for Future Performance

Abstract:     
Work in economics on implicit contracts suggests that employment contracts may be based on performance measures that are observable only to the parties of the contract. We derive implications of this insight for the relationship between executive compensation and future firm performance. If firms are optimally using both observable and unobservable (to the researcher) measures of performance and the unobservable measures of performance are correlated with future observable measures of performance, then variation in current compensation that is not explained by variation in current observable performance measures should predict future variation in observable performance measures. Further, compensation should be more positively associated with future earnings when observable measures of performance are noisier and hence less useful for contracting. We test these assertions using panel data on executive compensation and show that (1) unexplained variation in current compensation is related to future performance, and (2) variation in compensation is more positively related to future performance when the variances of the firm's market and accounting returns are higher.

Number of Pages in PDF File: 29

JEL Classification: J41, M4

working papers series