Earnings Targets and Annual Bonus Incentives

Abstract

We examine the extent to which firms use past performance as a basis for setting earnings targets in their bonus plans and assess the implications of such targets for managerial incentives. We find that high-profitability firms commonly decrease earnings targets when their managers fail to meet prior-year targets but rarely increase targets. Conversely, we find that low-profitability firms commonly increase earnings targets when their managers meet or exceed prior-year targets but rarely decrease targets. This target-revision process yields a serial correlation in target difficulty—targets remain relatively easy (or difficult) through time. We also find that firms are reluctant to revise earnings targets below zero, resulting in an unusually high frequency of zero earnings targets that are abnormally difficult to achieve. Collectively, our findings suggest that firms incorporate past performance information into targets, yet they do so only to a limited extent. This is consistent with theoretical arguments that highlight the benefits of contractual commitments. Data Availability: Data used in this study cannot be made public due to the confidentiality agreement with the sponsoring organization.

Relative Target Setting and Cooperation

“…Consistent with prior studies (Aranda, Arellano, and Davila [], Indjejikian et al. [], Bol and Lill []), we find that the sensitivity of target revisions to past own performance depends on performance relative to peers. When high performers fail to meet their target, next‐year target is strongly revised downward.…”

“…Using this model, we replicate several findings from prior literature on target setting (Indjejikian et al. [], Bol and Lill []). For example, we show that when top‐performing BU managers fail to meet their target, the next‐period target is revised downward.…”

Contract design in dynamic agency: An experimental analysis

“…Results are in some respect consistent with empirical evidence. Indjejikian, Matějka, Merchant, and Van der Stede () find that firms take prior performance information into account when determining performance targets but not to the full extent.…”

Executive Bonus Target Ratcheting: Evidence from the New Executive Compensation Disclosure Rules

“…For example, Indjejikian et al. () find no evidence that asymmetric target ratcheting is a prevalent target‐setting practice. Using profitability target‐setting data of Dutch banks, Bol and Lill () also report no evidence of asymmetric target ratcheting.…”

“…; Indjejikian et al. ). Our finding of a serial correlation of abnormal performance from a cross‐sectionally diverse sample complements prior studies’ findings and reinforces the notion that contractual commitment is a common and prevalent practice.…”