The use of nonfinancial performance measures in CEO bonus compensation

• Author: Yan Yan,MyoJung Cho,Salma Ibrahim
• Published date: 01 July 2019
• Date: 01 July 2019
• DOI: http://doi.org/10.1111/corg.12280

ORIGINAL ARTICLE

The use of nonfinancial performance measures in CEO bonus

compensation

MyoJung Cho

1

*|Salma Ibrahim

2

*|Yan Yan

3

*

1

Lubin School of Business, Pace University,

New York City, New York

2

Kingston Business School, Kingston

University, Kingston Upon Thames, UK

3

Senior Research Fellow, PBC School of

Finance, Tsinghua University, Beijing, China

Correspondence

Salma Ibrahim, Associate Professor and

Research Director, Department of Accounting,

Finance and Informatics, Kingston Business

School, Rm. 2003, Kingston University,

Kingston Upon Thames, UK.

Email: s.ibrahim@kingston.ac.uk

Funding information

British Academy of Management Grant/

Award: Researcher Development Grants

Scheme

Abstract

Research Question/Issue: In this study, we explore the relationship between the

use of nonfinancial performance measures in Chief Executive Officer (CEO) bonus

plans and CEO power, moderated by compensation committee monitoring. Further-

more, we investigate whether the inclusion of nonfinancial performance measures

is associated with higher CEO bonus pay sensitivity to shareholder returns.

Research Findings/Insights: Using a sample of FTSE 350 firms during the period

2007–2013, we find that CEO power is significantly negatively related to the propen-

sity of using nonfinancial performance measures. This negative relationship, however,

is moderated by higher levels of compensation committee monitoring. We also find

that firms combining nonfinancial and financial performance measures in CEO bonus

plans tend to have stronger CEO bonus pay sensitivity to shareholder returns than

firms using financial measures alone. Thus, our results suggest that boards of direc-

tors adopting nonfinancial performance measures are able to better align CEO incen-

tives with shareholder interests. We find similar results when using the weight of

nonfinancial performance measures in the bonus plan in our analyses.

Theoretical/Academic Implications: This study empirically supports the managerial

power theory whereby powerful CEOs influence the choice of performance measures

in their bonus plans. However, effective compensation committees are found to

attenuate the influence of powerful CEOs and to better align their interests with

those of shareholders. Our result of stronger bonus pay sensitivity to shareholder

returns for firms combining nonfinancial with financial performance measures implies

that the informativeness of these measures enhances the firm's ability to tie CEO

bonus compensation to shareholder wealth.

Practitioner/Policy Implications: This study offers insights to members of boards

of directors, especially compensation committee members, who are interested in

improving the design of executive incentive contracts to better align managerial

incentives to shareholder interests. Furthermore, the findings inform regulators about

the importance of alternative performance measures in pay‐performance sensitivity

and may warrant increased firm disclosure of the details of the pay structure.

*All authors contributed equally to this manuscript.

Received: 21 July 2017 Revised: 15 February 2019 Accepted: 20 March 2019

DOI: 10.1111/corg.12280

Corp Govern Int Rev. 2019;27:301–316. © 2019 John Wiley & Sons Ltdwileyonlinelibrary.com/journal/corg 301

KEYWORDS

Corporate governance, CEO power, compensation committee monitoring, nonfinancial

performance measures, pay‐performance sensitivity

1|INTRODUCTION

In this study, we explore the relationship between the use of nonfi-

nancial performance measures in Chief Executive Officer (CEO) bonus

compensation and CEO power, and the moderating role of the com-

pensation committee monitoring on this relationship. Furthermore,

we investigate whether the inclusion of nonfinancial performance

measures in CEO bonus plans, alongside financial measures, is associ-

ated with higher CEO bonus pay sensitivity to shareholder returns.

Prior literature finds that nonfinancial performance measures are

informative about unobservable managerial actions and allow a more

balanced assessment of the CEO's performance (Epstein & Roy,

2004; Ittner, Larcker, & Rajan, 1997; Schiehll & Bellavance, 2009).

Therefore, we hypothesize that firms whose CEOs have greater power

over the boards are less likely to use nonfinancial performance mea-

sures in CEO bonus plans.

To test our hypothesis, we use a sample of FTSE firms in the

United Kingdom during the period 2007–2013. We focus on a U.K.

sample because a series of corporate governance reforms in the past

decades has encouraged companies to implement performance‐

related compensation in the United Kingdom (Cadbury, 1992;

Greenbury, 1995; UK Government, 2013), as well as requiring the for-

mation of compensation committees consisting of independent direc-

tors (e.g., UK Corporate Governance Code, 2010). We find that CEO

power is significantly negatively related to the propensity of using

nonfinancial performance measures in CEO bonus contracts. This is

in line with the finding in Schiehll and Bellavance (2009) that the use

of nonfinancial measures in incentive contracts may be a substitute

for CEO ownership, a proxy for CEO power.

CEO power is a relative concept based on the relationship

between the CEO and other board members (Schiehll, Lewellyn, &

Muller‐Kahle, 2018). Therefore, we examine the moderating role of

the compensation committee in the choice of nonfinancial perfor-

mance measures. We find that effective compensation committee

monitoring attenuates the influence of CEO power over board deci-

sions. Specifically, the negative relationship between CEO power and

the use of nonfinancial performance measures is less pronounced

when the compensation committee monitoring function is more effec-

tive. We also investigate whether the use of nonfinancial performance

measures, which are informative of CEO actions, in bonus compensa-

tion can strengthen CEO bonus pay‐performance sensitivity. We

expect and find that integrating nonfinancial performance measures

in CEO bonus plans helps align CEO and shareholder interests. This

effect is more pronounced when compensation committees are more

independent. In addition, we find that CEO bonus pay sensitivity to

shareholder returns becomes stronger as the contractual weight of

nonfinancial performance measures increases.

Our study contributes to the literature in the following ways. First,

we investigate the relative dynamics of CEO power and compensation

committee monitoring in the choice of performance measures in CEO

bonus plans. Our study extends prior work, such as Schiehll and

Bellavance (2009), which tends to examine the stand‐alone effect of

CEO power and board monitoring on the choice of integrating nonfi-

nancial performance measures in CEO bonus plans. Second, our mea-

sure of CEO power covers all four dimensions of power discussed by

Finkelstein (1992). This contribution highlights the significance of our

findings because prior studies tend to infer CEO power from one or

two variables (e.g., duality and number of board members appointed

following the CEO's appointment in Ittner et al., 1997; CEO ownership

in Schiehll & Bellavance, 2009). Third, we shed light on the monitoring

role of compensation committees in an alternative setting of perfor-

mance evaluation measure choices. Prior literature tends to investi-

gate the committee's role in decisions of executive compensation

levels (Daily, Johnson, Ellstrand, & Dalton, 1998) or pay structure

(Anderson & Bizjak, 2003), rather than the choice of performance

measures. Lastly and most importantly, our study is the first to report

the positive impact of nonfinancial performance measures on the link

between CEO bonus compensation and shareholder returns.

Our results have important implications for boards of directors and

policy makers, who are interested in aligning CEO and shareholder

interests. Specifically, boards of directors and compensation commit-

tees may consider adopting nonfinancial performance measures in

executive incentive contracts. Regulators may contemplate providing

further recommendations on the choice of performance measures in

CEO compensation contracts. Current regulations do not discuss this

choice (UK Corporate Governance Code, 2018). Furthermore, regula-

tors may improve pay‐performance sensitivity if they require

enhanced disclosure of CEO pay structure with detailed description

of alternative performance measures in bonus plans.

The remainder of the paper is organized as follows. We review the

institutional environment of the United Kingdom and related literature

in the next section. This is followed by the hypotheses development.

The sample, estimation methods, regression models, and variables

are then documented, followed by a discussion of the results. We

present the conclusion, implications, and limitations in the last section.

2|INSTITUTIONAL ENVIRONMENT IN THE

UNITED KINGDOM

The United Kingdom renders a unique setting for examining the

choice of performance measures in executive compensation due to

the extensive regulation on governance and performance‐related

pay. Specifically, the Cadbury report (Cadbury, 1992) recommended

302 CHO ET AL.