Relative performance evaluation and project selection

Article Abstract:

Relative performance evaluation (RPE) happens when a manager's compensation is conditioned by his output relative to others. Agency theory states that RPE will be used for managerial compensation when other companies' outputs indicate new information about the manager that cannot be determined from his output alone. RPE shows little contracting improvement if a manager has limited choices. However, when a large number of projects can be accessed, RPE effectively contains the moral hazard problem. Tournaments, a simple form of RPE, pays managers relative to outputs of rivals. Depending on the availability of private information, he will either operate where his relative talent is greatest or where his absolute talent is greatest. Options reduce usage of RPE but when numbers are large enough, it can be applied. The major nonmonotonic factor to consider for RPE use is the amount of alternative projects available.

Compensation management, Employee performance appraisals, Performance appraisals

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Risk, return, and moral hazard

Article Abstract:

The agency literature is extended by examining the principal-agent contracting problem. This problem involves a manager who has private information and control over the mean and variance of outputs, whose outputs comprise a sample of independently distributed cash flows with mean and variance set by the manager's action choices, and whose private information and actions are affected by the contract designed by the principal. The manager privately selects among projects with various risk-return frontiers, and this effort choice changes the risk-return frontier of the project selected. The results of the analysis lead to the conclusion that a downward bias is always present in a manager's optimal report of the selected project's mean and that the extent of this bias is directly related to the manager's risk aversion, the project's production and the bonus component of the manager's compensation.

Risk (Economics), Contracts, Return on investment, Agency (Law), Rate of return

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Earnings management in an overlapping generations model

Article Abstract:

Research examines reasons why shareholders might not be inclined to eliminate the tendency for managers to engage in earnings management. An 'internal demand for earnings management' exists if shareholders have designed a contract to encourage management to follow their preferred action by making it cost effective for management to do so. An 'external demand for earnings management' exists if they can improve their firm's contractual terms with outsiders by managing earnings. The research concentrated on the external demand for earnings management induced by attempts to alter future investors' perceptions of the firm's value.

Analysis, Stockholders, Beliefs, opinions and attitudes, Valuation

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