The use of non-financial performance measures in CEO compensation contracts and stock price crash risk

ABSTRACT

This study examines whether the use of non-financial performance measures (NFPMs) in chief executive officer (CEO) compensation contracts is related to stock price crash risk. The literature on NFPMs suggests that incorporating NFPMs into executive compensation contracts motivates managers to engage less in short-term oriented behaviors such as earnings management, while the literature on crash risk focuses on short-term oriented behaviors, such as bad news hoarding, as the main cause for stock price crashes. Based largely on these literatures, we predict that the use of NFPMs in CEO compensation contracts reduces managers’ tendency to hide bad news primarily by over-estimating accruals, thereby leading to a decline in future crash risk. Consistent with this prediction, we find a negative association between the use of NFPMs and subsequent crash risk. Overall, this study enhances our understanding of stock price implications of incorporating NFPMs into CEO compensation contracts.

KEYWORDS:

• Non-financial performance measures
• CEO compensation
• stock price crash risk

Acknowledgments

We are grateful for the helpful comments of seminar participants at the 2017 AAA (American Accounting Association) Annual Meeting, the 2017 Conference on the Convergence of Financial and Managerial Accounting Research (co-hosted by the University of Calgary and Temple University), and the 2017 SKKU-NTPU (Sungkyunkwan University and National Taipei University) Joint Accounting Workshop. We also thank Huiqi Gan, Hyelin Kim, Hui Dong Kim, and Melloney Simerly for their assistance regarding the collection of data on non-financial performance measures used in CEO compensation. This work was supported by the Ministry of Education of the Republic of Korea and the National Research Foundation of Korea (NRF-2017S1A5A8019861).

Data availability

Data are available from the public sources cited in the text.

Disclosure statement

No potential conflict of interest was reported by the authors.

Notes

1. For example, Nagar and Rajan (2001) show that nonfinancial quality measures, including on-time deliveries and defect rates, are leading indicators of future sales. Ittner and Larcker (1998a) find that, for firms in the telecommunication industry, customer satisfaction is positively associated with future financial performance.

2. Consistent with this definition, several recent studies on crash risk use conditional skewness measures inferred from the option markets (e.g., Kim and Zhang 2014; Kim et al. 2016).

3. Banker and Data (1989) show that multiple performance measures are available for evaluating managerial performance. If the intensity of any measure is greater, the optimal performance evaluation will depend on earnings number and the more intense measure.

4. Prior research has also examined the value relevance of NFPMs, regardless of whether NFPMs are used in compensation contracts. For example, Ittner and Larcker (1998a) find that the public release of customer satisfaction measures is significantly associated with excess stock market returns over a ten-day announcement period. Hughes (2000) examines whether market value of equity is associated with nonfinancial pollution measures (i.e., toxic emissions) that capture firms’ exposure to future environmental liabilities. He finds evidence that investors discount the market value of environmentally exposed firms. Relatedly, Matsumura, Prakash, and Vera-Muñoz (2013) find evidence that markets penalize firms for their carbon emissions, but firms that do not disclose emissions information face a further penalty.

5. For example, Ittner and Larcker (1998a, 1) state that ‘improvements in areas such as quality, customer or employee satisfaction, and innovation represent investments in firm-specific assets that are not fully captured in current accounting measures.’

6. Note that this argument does not necessarily imply an asymmetric treatment of bad vs. good news with respect to NFPMs. That is, we do not rule out the possibility that the use of NFPMs provides an early signal of improvements in future performance. In this case, firms will need to continue the operations with positive signals. However, we do not focus on this possibility, which has little clear implication for crash risk.

7. In addition, prior research documents that using NFPMs in a firm’s performance measurement system may provide more direct feedback on managerial efforts than financial measures do (Barua, Kriebel, and Mukhopadhyay 1995; Said, HassabElnaby, and Wier 2003).

8. S&P 500 firms are similarly used in related studies on the use of NFPMs in CEO compensation contracts (e.g., Ibrahim and Lloyd 2011; Simerly 2015).

9. We first searched the various keywords addressed in Ittner et al. (2009) to identify firms using NFPMs in CEO compensation contracts. We, then, classified firms that use both financial and non-financial performance measures into NFPM firms; accordingly, firms that use only financial performance measures in CEO compensation contracts were categorized as Non-NFPM firms. In addition, we also collected the information, if available, for the weights assigned to non-financial performance measures over financial performance measures. We use this continuous NFPM measure for an additional test to check the relative importance.

10. The results are qualitatively similar when a caliper width of 0.01 or 0.05 is used instead.

Additional information

Funding

This work was supported by the National Research Foundation of Korea [NRF-2017S1A5A8019861].