The Weight on Earnings in Incentive Contracting: Dynamic Response or Status Quo?

Abstract

As firms evolve, the tasks required to generate firm value change, as does the ability of earnings to reflect changes in that value. To the extent earnings differentially captures managers’ effort toward desire tasks, contracting theory suggests its role in incentive pay should also change. However, anecdotal evidence suggests boards often fail to alter the weights on earnings in response to changes in the firm over time, relying instead on the status quo. In this study, we use a large longitudinal sample research design to investigate whether and how boards alter the weight on earnings in bonus contracts as its contracting usefulness changes over time. Our results suggest that although some contract evolution occurs, it often lacks timeliness. We find that boards often rely on contracting decisions made in prior periods, suggesting evidence of the status quo bias. Consistent with the status quo bias affecting board decisions, we document that process accountability mitigates a lack of concurrent contract evolution with shifts in firm evolution. Finally, we show that firms trade off earnings for other more idiosyncratic performance measures, suggesting alternate measures incrementally inform manager effort in early and late stages of firm development.