Firms’ Commitment to Mitigate the Ratchet Effect under Annual Bonus Plans with Multiple Performance Measures
50 Pages Posted: 16 Jul 2012
Date Written: July 15, 2012
Prior literature has documented ratcheting targets and a potential adverse incentive problem it may cause, and, as a remedy to the problem, proposed a firm’s commitment to incomplete use of past performance in setting future targets. In this paper, we examine whether a firm makes such a commitment, whether it behaves differently depending on the past target achievement level, the type of a performance measure, and the importance weight. Using a confidential dataset that consists of 1,208 performance-measure-year observations with the complete set of information including targets, actual performance, and importance weights for all performance measures used in the short-term incentive plan, we find that (1) the firm makes a credible commitment; (2) the firm’s target revision behavior, however, varies with the previous target achievement level — rewarding past good performance, eliminating excess good luck, and compensating for excess bad luck; (3) the firm’s behavior also varies with the type of performance measure — making stronger commitments for good financial and common measures while penalizing bad performance in the measures; and (4) contrary to our prediction, importance weights do not affect the firm’s target revision behavior. Overall, generally consistent with prior literature, our study adds empirical evidence with novel findings, making the best use of the unique dataset.
Keywords: performance targets, performance measures, inter-temporal performance manipulation, target difficulty, adverse incentive, the ratchet effect
JEL Classification: M41, M52, J33
Suggested Citation: Suggested Citation