Relative Weights on Performance Measures in a Principal-Agent Model with Moral Hazard and Adverse Selection

53 Pages Posted: 7 Aug 2009

See all articles by Rajiv D. Banker

Rajiv D. Banker

Temple University - Department of Accounting

Jose M. Plehn-Dujowich

Powerlytics. Inc.

Chunwei Xian

Northeastern Illinois University

Date Written: August 6, 2009

Abstract

This paper examines the role of multiple measures of performance in a principal-agent model incorporating both moral hazard and adverse selection. The outcome of interest to the principal depends stochastically on the agent’s unobservable ability and effort, while the principal implements a contract contingent on two noisy measures of the outcome. There are three main findings. First, the weights assigned the performance measures are reduced in the presence of adverse selection because the informational rent paid to the agent lowers the return to the principal of hiring the agent, but it does not affect how informative one signal is relative to another. Second, the weights assigned the signals are decreasing in the sensitivity of performance to ability. Third, a signal is assigned more weight if and only if it is more precise and sensitive to the agent’s effort; thus, the Banker and Datar (1989) result is robust to the introduction of adverse selection. An empirical test of the model is provided in the context of the CEO pay-for-performance sensitivity and the investment opportunities set (IOS) of the firms they manage. If high IOS firms are more ability-intensive, the model predicts the weights on the performance measures are decreasing in IOS. We examine a sample of 12,221 firm-year observations for 1,411 firms spanning the period 1992-2006 obtained from ExecuComp, CRSP, and Compustat. In agreement with the model, we find that CEO compensation is less sensitive to accounting and stock returns in high IOS firms.

Keywords: Adverse selection, moral hazard, pay-for-performance sensitivity, investment opportunities

JEL Classification: M46, M40

Suggested Citation

Banker, Rajiv D. and Plehn-Dujowich, Jose M. and Xian, Chunwei, Relative Weights on Performance Measures in a Principal-Agent Model with Moral Hazard and Adverse Selection (August 6, 2009). AAA 2010 Management Accounting Section (MAS) Meeting Paper. Available at SSRN: https://ssrn.com/abstract=1444844 or http://dx.doi.org/10.2139/ssrn.1444844

Rajiv D. Banker

Temple University - Department of Accounting ( email )

Philadelphia, PA 19122
United States

Jose M. Plehn-Dujowich (Contact Author)

Powerlytics. Inc. ( email )

P.O. Box 164
Mechanicsville, PA 18934
United States

Chunwei Xian

Northeastern Illinois University ( email )

5500 N. St. Louis Ave
Chicago, IL 60625
United States

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