Value congruence and the use of performance measures in executive compensation

I investigate the relationship between the value congruence of revenue growth and margin growth and the use of these accounting performance measures in top executives' total compensation packages. The design of executive compensation plans intended to achieve incentive alignment between shareholders and managers has been a topic of great interest to both practitioners and academics. Although broad economic theory on optimal labor contracting supports the argument that the use of various performance measures should reflect these measures' ability in capturing shareholder value creation, the exact nature of such a relationship has not been explored in the contexts of multiple accounting performance signals and little systematic empirical evidence on this important research question exists in the accounting literature. The primary purpose of this study is to conduct a broad-based analysis of whether the use of accounting performance measures in US public companies' executive compensation plans is consistent with the pattern deemed to be economically efficient.; The first part of this study uses an agency theory framework to develop a stylized model of efficient compensation contracts between shareholders and managers that rely on stock returns and performance measures of revenue growth and margin growth. The theoretical analysis generates a welfare-maximizing solution to the shareholders' problem of assigning incentive weights to accounting performance measures in the compensation scheme. The solution forms the basis for testable hypotheses regarding the relationship between value congruence and incentive compensation weights. Specifically, I postulate that, to achieve incentive alignment, firms whose value creation depends more on revenue growth (margin growth) place greater weight on revenue growth (margin growth) and less weight on margin growth (revenue growth) when determining top executives' compensation. The modeling approach I adopt highlights the important economic forces underlying the link between value congruence and performance measurement.; In the second part of the study, I examine data from ExecuComp, the most comprehensive database currently available on US public firms' executive compensation plans. Using a sample of over 6,000 CEO-years in 118 industries for the period 1993--2002, I conduct empirical tests of the hypothesized link between the two accounting measures' incentive weights in CEO compensation and their value congruence. Results show that the pattern of the use of accounting measures of revenue growth and margin growth in CEO compensation plans is largely consistent with the prediction based on agency theory. The analysis and evidence presented in the study provide insight into how the design of compensation schemes is influenced by the source of value creation.