Information asymmetry may never be more pronounced than in the imbalance between managers and board members. Simply put, management knows more than the board. To level the playing field, the board can implement performance-based incentive systems. But as these authors point out, to what extent should boards integrate financial and non-financial measures of performance in corporate incentive plans?

The separation of ownership and control in the modern corporation has created a governance challenge for boards of directors. The challenge – and the dilemma – resides in the fact that while the board is legally accountable for protecting shareholder interests, senior management has the inside track on knowing how well the company is fulfilling these obligations. There is a knowledge gap, and to close it, the board needs to set up mechanisms to monitor management’s performance. One way to align senior managers’ decisions with shareholders’ interests is to design compensation systems that are linked to the company’s performance. We describe how to design those systems in this article.

Performance-contingent compensation

Executives whose compensation is contingent on their performance have a monetary incentive to maximize a company’s value. Cash bonuses and stock option plans are two popular practices that companies use to reward executives.

Stock option plans are forward-looking, since they link executive compensation to the company’s share price at some future date. In contrast, cash bonuses are awarded on the basis of more immediate, measurable performance drivers. The board’s choice of performance measures will facilitate the collection and processing of information about the performance of the company and its management, and help it to assess whether corporate goals are being realized. At the same time, the bonus plan reinforces for senior management the importance of making decisions that are in the best interests of shareholders.

Choosing performance measures

The effectiveness of a cash bonus depends on the accuracy of the performance measures, and how well it reflects success factors that may be outside management’s control and influence. For best results, performance measures should motivate senior executives without rewarding inadequate performance or discouraging reasonable risk-taking. At the same time, it makes sense to devise a measurement system that is not too costly to manage. These factors make the task of designing an effective incentive contract one of the most critical components of the governance process. In the past, traditional accounting- and market-based performance measures such as net income, earnings per share, return on equity/capital employed and share-price return were the most common indicators employed in incentive contracts. More recently, perceived inadequacies in these traditional financial measures have led to innovations such as the balanced scorecard, which integrates financial and non-financial criteria.

Traditional accounting and market-based performance measures

Accounting information has many characteristics that help explain its widespread use in performance evaluation and compensation systems. For instance, accounting information is subject to a variety of internal controls and audits that enhance its reliability. Since the majority of today’s business systems already track monthly and quarterly accounting data, it is a relatively simple matter to link incentive plans with existing accounting systems. In addition, senior management can more easily see the direct impact of their actions on the company’s financial performance than on non-financial or market-based indicators.

There are some drawbacks, however, to linking a bonus plan to traditional accounting performance measures. By their very nature, general accounting standards and practices (GAAP) allow some flexibility with respect to accounting choices for various cost-benefit reasons, that, in return, can offer managers some opportunities to manage earnings. Further, accounting measures are perceived as being focused on the short-term and backward-looking, which can leave directors incapable of fully measuring management’s ability to maximize cash flows or to efficiently use capital. While financial returns may be a good measure of how well executives are managing the company’s existing assets, they do not accurately reflect executive performance in areas with deferred returns-for example, strategic planning, growth opportunities, business initiatives, or investments in the discovery and development of new products and technologies. It is clear, then, that incentive plans based solely on accounting measures can induce senior management to make short-term business decisions, and compromise investment opportunities with the promise of deferred or non-monetary returns.

Performance measures based strictly on share price may not fully reflect those executive actions that are intended to increase the company’s value in the long run. For that matter, a company’s need to protect proprietary information about new products and markets and other strategic activities could depress its share price in the short term. This highlights the reality that a company’s market value can be affected by factors that are largely beyond executive control and/or influence. An executive who is evaluated and rewarded exclusively on the basis of the share price may overemphasize measurable activities that are immediately reflected in the share price at the expense of activities whose benefits are only reflected in the share price over a longer period of time. Some experts have suggested that this practice could be eliminated by introducing alternative measures of economic or shareholder value; most companies, however, use existing accounting data to calculate these measures, so the problems remain.

Non-financial performance measures

Non-financial factors such as product quality, customer satisfaction, innovation and the environment are recognized contributors to a company’s market value. Given that non-financial measures are less aggregate, more forward-looking and more closely linked to operations, they can reorient a manager’s focus and help directors do a better job in evaluating management’s efforts. The value of non-financial performance information is of even greater importance in certain contexts such as very competitive product markets and short product life cycles. Such external forces tend to decrease the accuracy of the more aggregate accounting performance measures and their ability to be a good surrogate for executives’ efforts in creating long-term value.

The business environment today places new importance on intangible assets such as innovation, process improvement, employee knowledge and experience. This has given rise to the so-called “balanced scorecards” and other such frameworks that integrate financial and non-financial performance measures. There should be little doubt, therefore, that accounting and market-based parameters alone are not enough to measure decision-making. This begs the question: To what extent should boards of directors integrate financial and non-financial measures of performance in corporate incentive plans?

To investigate this issue, we analyzed performance measures in the bonus contracts of 97 Canadian publicly traded companies in two distinct economic sectors knowledge-and capital-based. We distinguished between the two sectors in an attempt to better identify and investigate how market forces influenced each company’s use of performance measurement information.

Knowledge-based versus capital-based companies

Our knowledge-based subgroup included companies in various stages of early development, with major R&D funding, but few tangible assets. These companies were often years away from significant revenue streams. In contrast, our capital-based subgroup was comprised of long-established companies with high levels of capital invested in tangible assets, a large number of employees and a centralized decision process. Table 1 presents the general characteristics of the sample by subgroup.

Exhibit 1 and Table 2 provide evidence that companies have integrated financial and non-financial performance measures in their CEO bonus contracts. Across the sample of 97 companies, two companies in the knowledge-based subgroup use exclusively nonfinancial measures to arrive at the CEO’s cash bonus, in contrast with 12 capital-based companies that use only one accounting indicator such as earnings per share or return on equity. The data also indicate other significant differences in the way the two subgroups combine financial and non-financial performance measures.

Table 2 documents that knowledge-based companies tend to integrate a relatively wider range of financial and non-financial performance indicators in their CEOs’ bonus contracts. More detailed analysis also suggests that these companies favour a more balanced weighting of financial and non-financial measures of performance in their bonus plans.

This is consistent with the view that the value-enhancing actions of a CEO of a knowledge-based company are either missing from, or imperfectly captured by, traditional financial performance measures. Established alliances, joint ventures and product development indicators are among the most important criteria for managerial performance in the knowledge-based subgroup, indicating that significant efforts have been made to collect and assess relevant information on strategic R&D activities.

Among the financial performance measures, share price performance is the financial indicator most often used in the bonus contracts of knowledge-based companies. The evidence suggests that market-based performance remains more important than accounting information among knowledge-based companies. The emphasis on share-price performance might reflect the directors’ efforts to align executives’ decisions with the knowledge-based companies’ use of equity financing as a source of operating capital.

As shown in Table 2, the mix of performance measures in the bonus contracts of CEOs of capital-based companies is significantly more homogeneous and focused on accounting performance measures than in the knowledge-based group. Earnings per share and return on equity are the most common performance metrics in our capital-based sample. The most frequently used non-financial indicator is based on individual performance targets. While it is difficult to characterize the specific performance criteria or judgments on which individual performance rewards are based, it is clear that they are distinctly different from traditional accounting earnings and share-price measures of corporate performance.

The evidence leads to the conclusion that nonfinancial components of managerial activities are not likely to be emphasized as much in capital-based companies as they are in knowledge-based companies. It also suggests that when non-financial performance is valued in capital-based companies, it tends to be accompanied by a certain degree of subjectivity.

We also investigated the extent to which the choice of financial and non-financial measures of performance in CEO bonus contracts is associated with the monitoring efforts of boards of directors.

Consistent with the previously mentioned information gap between directors and executives, we expect that a more independent board of directors would be more likely to use non-financial measures of performance in CEO bonus plans. It is only appropriate that the limitations of traditional accounting and stock-based performance indicators for measuring current aspects of executives’ performance beyond the stewardship of assets should lead vigilant boards of directors to integrate more non-financial performance measures in bonus contracts.

Exhibit 2 documents the association between the use of non-financial performance measures in CEO bonus contracts and the independence of the board of directors. For a board of directors to be considered independent from management, more than 50 per cent of its members must come from outside the company. Independent boards are more likely to make tough decisions about executive compensation, to evaluate executives objectively, and to explore new strategies in order to improve performance.

Exhibit 2 shows that the proportion of companies with independent boards is larger among knowledge-based companies. Further analysis also shows that the directors of knowledge-based companies have a relatively broader range of expertise, and are less likely to be shareholders of the company. Knowledge-based companies are also more likely to separate the chairman’s job from that of the CEO. These board attributes seems to be driven by the industry’s greater growth opportunities, the need for external contacts that are valuable to the company and an understanding of specific technologies and processes related to the business.

Along this line, Exhibit 2 and respective statistical tests also illustrate that the use of non-financial performance measures in CEO bonus contracts is, for the most part, associated with independent boards for the total sample, and for the knowledge-based subsample. This association, however, does not hold for the capital-based sub-sample. Our data indicate that independent boards of capital-based companies still seem to focus mainly on traditional financial performance measures.

Linking executive compensation to managerial performance is a crucial task for a board of directors, making the design of performance-contingent bonus contracts a critical element in the governance challenge.

Companies have realized the limitations of using strictly accounting-based or market-driven indicators of performance. The introduction of balanced scorecards and other frameworks in numerous organizations indicates the presence of an important trend in measuring both financial and non-financial performance.

We show that this trend is also reflected in the choice of measures being used to establish CEO bonus targets by both knowledge-based and capital-based firms. Knowledge-based companies focus more on nonfinancial measures. Nevertheless, independent boards of directors also tend to use a greater mix of financial and non-financial measures of performance to reduce the information gap.