Performance Pay and Credibility of Performance Measurement: Evidence from CEO Incentive Compensation

This paper investigates the credibility of performance measurement from the evidence of a link between CEO incentive compensation and CEOs’ overstatement of their firms’ earnings, measured by stock return sensitivities to firms’ earnings announcements. It empirically analyzes whether the stock market response to announced earnings is positively related to the CEO’s performance pay. It appears that stock return sensitivities to firms’ earnings announcements increased with CEO pay-performance ratio in all earnings categories. Using stock return sensitivities as indicators of a CEO’s overstatement of firm earnings, this suggests not only that such overstatements exist, but also that overstatements are more severe among CEOs with high incentive compensation. This suggests that performance measurements based on performance pay are not credible. In addition to tightening market monitoring, regulatory authorities should develop measures that can reduce overstatement, such as making CEO compensation better linked to long-term performance, which is more difficult to embellish.