Firms’ Commitment to Mitigate the Ratchet Effect under Annual Bonus Plans with Multiple Performance Measures

50 Pages Posted: 16 Jul 2012

See all articles by Byung Hyun Choi

Byung Hyun Choi

LG Economic Research Institute

Simon Jonghwan Kim

University of Manchester - Division of Accounting and Finance

Kenneth A. Merchant

University of Southern California - Leventhal School of Accounting

Date Written: July 15, 2012

Abstract

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

Choi, Byung Hyun and Kim, Jonghwan and Merchant, Kenneth A., Firms’ Commitment to Mitigate the Ratchet Effect under Annual Bonus Plans with Multiple Performance Measures (July 15, 2012). AAA 2013 Management Accounting Section (MAS) Meeting Paper. Available at SSRN: https://ssrn.com/abstract=2108368 or http://dx.doi.org/10.2139/ssrn.2108368

Byung Hyun Choi

LG Economic Research Institute ( email )

701 Exposition Blvd
Los Angeles, CA 90089
United States
714-515-0939 (Phone)

Jonghwan Kim (Contact Author)

University of Manchester - Division of Accounting and Finance ( email )

Booth Street West
Manchester, M13 9SS
United Kingdom

Kenneth A. Merchant

University of Southern California - Leventhal School of Accounting ( email )

Los Angeles, CA 90089-0441
United States
213-740-4842 (Phone)
213-747-2815 (Fax)

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