Implications of Economic Shocks for CEO Performance Evaluation^†

† Additional materials are available in an Online Supplement at the journal's Taylor and Francis website.

Abstract

I study the implications of economic shocks for objective and subjective CEO performance evaluation. A shock perturbs pay-setting parties' information about the firm and the CEO. I argue that pay-setting parties then lack information they need for evaluating the CEO objectively, and de-emphasize objective CEO performance evaluation in favor of subjective CEO performance evaluation; over time, pay-setting parties become better informed about the firm as well as the CEO, and increasingly use again objective CEO performance evaluation. My evidence, which uses data on objective and subjective CEO performance evaluation in US executive pay between 1992 and 2013, is consistent with my argument.

Acknowledgements

This study has benefitted from suggestions of Ana Albuquerque, James Brickley, John Core, Liz Demers, Ron Jones, Andrew Leone, David Maber, Luis Marques, Artem Prokhorov, Shailendra Pandit, Zvi Singer, Randall Stone, Alessia Testa, Laurence van Lent, Joanna Wu, Jerry Zimmerman, and an anonymous reviewer, as well as seminar participants at the Instituto di Empresa in Madrid, the University of Rochester, and the meetings of the American Accounting Association, the Canadian Academic Accounting Association and the European Accounting Association. This paper is based on my Ph.D. dissertation at the University of Rochester. All errors are my own.

Supplemental Data and Research Materials

Supplemental data for this article can be accessed at 10.1080/09638180.2016.1175363.

Notes

† Additional materials are available in an Online Supplement at the journal's Taylor and Francis website.

1 I follow Mitchell and Mulherin (1996) and define shocks as unexpected structural modifications in a firm's economic environment.

2 I choose 1950 as the starting year to ensure that I correctly count the number of years since the last shock occurred for firms that experience a shock before the sample period starts in 1992. I choose 2012 as the ending year because the test of Hypothesis 1 involves counting the number of years since a shock occurred; in the last year of my sample, 2013, I then have at least one observation for firms that experience a shock in 2012.

3 The analysis includes only observations from sample firms that experience at least one shock between 1950 and 2012. Also, it excludes 247 observations whose studentized residuals have an absolute value larger than 2. Such observations are problematic since they do not conform to the estimated model (Greene, 2012).

4 Right after a firm-specific shock (i.e. ), the pay–performance sensitivity to earnings is , where 0.184 is the sum of the coefficients on interacted with controls: , where 1.84, 0.75, 0.51, 0.71 are the average values for , , and . This implies that a point increase in earnings yields a rise in CEO cash pay, or , when applied to average CEO cash pay of . When the number of years since the last firm-specific shock rises to the median (i.e. ), the pay–performance sensitivity to earnings is . This implies that a point rise in earnings gives a increase in CEO cash pay, or . The sensitivity of CEO cash pay to earnings thus increases by as the number of years since the firm-specific shock rises from 1 to the median.

5 I exclude 386 observations whose studentized residuals have an absolute value larger than 2. See footnote 3.

6 Right after a macro-economic shock (i.e. ), the pay–performance sensitivity to earnings is , where 0.088 is the sum of the undisplayed coefficients on interacted with controls. This implies that a point increase in earnings yields a rise in CEO cash pay, or , when applied to average CEO cash pay of . When the number of years since the last macro-economic shock rises to the median (i.e. ), the pay–performance sensitivity to earnings is . This implies that a point rise in earnings yields a increase in CEO cash pay, or . The sensitivity of CEO cash pay to earnings thus increases by as the number of years since the macro-economic shock rises from 1 to the median of .

Additional information

Funding

This work was supported by the RBC Professorship in Responsible Organizations; Social Sciences and Humanities Research Council Canada under Grant S01203; the Concordia University Research Fund under Grant V00473; and the Luxembourgian Scientific and Applied Research Scholarship Fund under Grant BFR02/033.