Analysis of Corporate Disclosures on Relative Performance Evaluation
Bannister, James W., Newman, Harry A., Accounting Horizons
SYNOPSIS: The relative performance evaluation (RPE) hypothesis states that firms benefit from comparing their own performance to that of a peer group when evaluating the CEO's performance. Although in theory firms should be employing relative performance to evaluate the CEO, indirect empirical tests in the 1980s and 1990s generally fail to support the RPE hypothesis. This paper examines RPE-related disclosures found in the compensation committee reports provided in proxy statements to determine whether firms actually employ RPE, and to offer insight into why indirect tests generally fail to support the RPE hypothesis.
We find that firms do use RPE in determining executive compensation, thus supporting the RPE hypothesis, although RPE usage is not widespread. We also find that several key assumptions underlying prior indirect tests are misspecified for many firms, helping to explain the difficulty in detecting RPE in random samples of firms and suggesting improvements to methodologies employing indirect tests for RPE.
Our results also beg the question of why some firms use RPE while other firms do not. We find that RPE usage is positively related to greater monitoring and stakeholder concern about pay and performance, but that performance and CEO power and insulation from pressure do not explain cross-sectional variation in RPE usage. We also examine disclosures related to peer groups and adverse performance-related events since they indirectly relate to RPE and find that many firms filter out negative-performance-related events, but not positive ones. This is equivalent to using one-sided RPE, where a firm excuses the CEO from factors that affect industry performance adversely, but credits the CEO for factors that aid industry performance.
Keywords: disclosure; relative performance evaluation; peer group; compensation committee report.
Data Availability: Data used in this study are publicly available from sources identified in the paper.
The relative performance evaluation hypothesis states that firms benefit from comparing their own performance to that of a peer group when evaluating the CEO's performance (Holmstrom 1979, 1982). In theory, relative performance evaluation (hereafter RPE) filters out aspects of firm performance that the CEO cannot control. Hence, it provides a better basis for CEO performance evaluation and compensation. However, empirical research generally does not support the use of RPE in practice (e.g., Janakiraman et al. 1992; Aggarwal and Samwick 1999a, 1999b). Most empirical tests of the RPE hypothesis have been indirect since, prior to 1993, data were not publicly available to perform direct tests.
In 1992, the Securities and Exchange Commission (SEC) adopted extensive rule changes affecting the reporting of executive compensation in proxy statements. Firms must provide a report outlining the compensation committee's policies governing executive compensation, including the basis for making compensation decisions (SEC 1992). Further, the report must discuss the relationship of firm performance to the CEO's compensation and describe each firm performance measure that affects the CEO's compensation (SEC 1993).
This paper examines disclosures in 1993 compensation committee reports related to 1992 CEO compensation and performance. We report the frequency of RPE use in determining short-and long-term components of 1992 executive compensation and the performance metrics employed in the evaluation process. The observed practices explain the lack of empirical support for the RPE hypothesis and point to adjustments in methodology that should lead to more powerful indirect tests. We also perform a preliminary investigation of why some firms adopt RPE while other firms do not.
We further examine two disclosures indirectly related to RPE: compensation peer groups, and adverse performance-related events. Peer groups of firms are necessary to implement RPE. …