Target Ratcheting and Achievability of Earnings Targets

Abstract

A fundamental problem of incentive contracting, often referred to as the ratchet effect, is that good performance in one period may be penalized by next-period targets that are more difficult to achieve. Several studies provide evidence that favorable performance relative to target is associated with target increases in the next period. The maintained assumption in much of this literature is that target revisions upward render targets more difficult to achieve. In contrast, our study uses data from a unique survey panel to directly examine whether favorable performance relative to target leads to next-period targets that are more difficult to achieve. First, we replicate prior results that favorable performance relative to target is associated with next-period target increases. Second, and contrary to the maintained assumption in prior work, we show that favorable performance relative to target is also associated with increases in the likelihood that next-period targets will be achieved. Thus, our results suggest that firms revise performance targets in a way that allows well-performing managers to repeatedly meet their targets. This is consistent with the theory that commitment facilitates multi-period contracting and allows firms to overcome the adverse incentive consequences of the ratchet effect.