Earnings Targets and Annual Bonus Incentives

52 Pages Posted: 20 Jul 2013 Last revised: 20 Aug 2014

Raffi Indjejikian

University of Michigan at Ann Arbor - Accounting

Michal Matejka

Arizona State University

Kenneth A. Merchant

University of Southern California - Leventhal School of Accounting

Wim A. Van der Stede

London School of Economics & Political Science (LSE)

Abstract

We examine the extent to which firms use past performance as a basis for setting earnings targets in their bonus plans and assess the implications of such targets for managerial incentives. We find that high-profitability firms commonly reduce earnings targets when their managers fail to meet prior-year targets but rarely increase targets. Conversely, we find that low-profitability firms commonly increase earnings targets when their managers meet or exceed prior-year targets but rarely decrease targets. This target-revision process yields a serial correlation in target difficulty — targets remain relatively easy (or difficult) through time. We also find that firms are reluctant to revise earnings targets below zero resulting in an unusually high frequency of zero earnings targets that are abnormally difficult to achieve. Collectively, our findings suggest that firms incorporate past performance information into targets yet they do so only to a limited extent. This is consistent with theoretical arguments that highlight the benefits of contractual commitments.

Keywords: performance targets, earnings distributions, losses

Suggested Citation

Indjejikian, Raffi and Matejka, Michal and Merchant, Kenneth A. and Van der Stede, Wim A., Earnings Targets and Annual Bonus Incentives. The Accounting Review, Vol. 89, No. 4, pp. 1227-1258, July 2014; Marshall School of Business Working Paper No. ACC 02.13. Available at SSRN: https://ssrn.com/abstract=2296209

Raffi J. Indjejikian

University of Michigan at Ann Arbor - Accounting ( email )

701 Tappan Street
Ann Arbor, MI 48109-1234
United States

Michal Matejka (Contact Author)

Arizona State University ( email )

Tempe, AZ 85287-3706
United States
480-965-7984 (Phone)

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)

Wim A. Van der Stede

London School of Economics & Political Science (LSE) ( email )

Houghton Street
London, WC2A 2AE
United Kingdom
+44 (0)20 7955 7420 (Fax)

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