JOURNALOF

Accounting
ELSEVIER Journal of Accounting and Economics 21 (1996) 161 193
&Economids

CEO compensation:
The role of individual performance evaluation
Robert M. Bushman, Raffi J. Indjejikian*, Abbie Smith
Graduate School of Business, University of Chieayo, Chicago, IL 60637, USA

(Received July 1994; final version received December 1995)

Abstract

We investigate use of individual performance evaluation in C E O s ' annual incentive

plans. In contrast with relatively objective accounting and stock-price-based measures,
individual performance evaluation may involve discretion and subjectivity, as well as
nonfinancial and financial performance criteria. Based on agency theory, we predict that
individual performance evaluation increases with the importance of growth opportuni-
ties relative to assets in place, length of product development and product life cycles, and
noise in traditional financial measures. Using proprietary compensation data, we find
evidence that individual performance evaluation increases with growth opportunities
and product time horizon.

Key words: C E O compensation; Individual performance evaluation; Agency theory

JEL class!fication: G30; J33; M41

*Corresponding author.
The authors would like to thank John Anderson, Katie Donohue, Roberta Fox, Bill James, Kevin J.
Murphy (the referee), Mark Ubelhart, Ross Watts (the editor), Ross Zimmerman, and seminar
participants at MIT, Northwestern, Stanford, Wharton, and the 1994 Summer Symposium on
Accounting Research at Hong Kong University of Science & Technology. We are grateful to Hewitt
Associates LLC for making this research possible and for sharing their valuable insights with us, and
to Bruce Cameron and Pam Dienelt for providing Compensation Committee Reports. We would
also like to thank Susan Clady, Jennifer Milliron, and Victor Yaun for valuable research assistance.
The financial support of the Graduate School of Business of the University of Chicago is gratefully
acknowledged.

0165-4101/96/$15.00 ~C, 1996 Elsevier Science B.V. All rights reserved

SSDI O 1 6 5 - 4 1 0 1 ( 9 5 ) O O 4 1 6 - G
162 R.M. Bushman et al. / Journal o['Accounting and Economics 2 l (1996) 161 193

I. Introduction

The compensation packages negotiated with chief executive officers (CEOs) of

large U.S. corporations typically consist of a base salary component and an
incentive component. The incentive component often is comprised of both an
annual bonus plan and a long-term incentive plan, where the payoffs from these
plans depend on an intricate portfolio of performance measures. The determi-
nants of these portfolios have been the subject of much academic research.
Agency theory predicts that a particular performance measure will be included
in a portfolio of performance measures if and only if it has information content
about a manager's actions over and above other measures in the portfolio (see,
for example, Holmstrom, 1979). This theory has motivated a number of empiri-
cal investigations into the composition of the performance measures upon which
executive pay is based. ~ Much of this previous work focuses on accounting
earnings and stock-price-based performance measures. 2 In this paper, we extend
this line of research by investigating the explicit use of individual performance
evaluation in CEOs' annual incentive plans in addition to more traditional
measures of corporate performance.
We view individual performance evaluation (IPE) as part of the portfolio of
performance measures upon which the CEO's annual bonus can be based. While
it is difficult to characterize the specific performance criteria or the judgments
upon which IPE payoffs are based~ it is clear that IPE is distinctly different from
traditional accounting earnings and stock price measures of corporate perfor-
mance. If, as predicted by agency theory, a performance measure will only be
used if it provides incremental information over other measures, the use of I PE
must mean that there is value to supplementing traditional accounting and
stock price measures of corporate performance. We argue that there will be
value to supplementing these corporate measures with IPE in situations charac-
terized by high levels of information asymmetry between managers and inves-
tors, long planning and development time horizons, and substantial noise in
traditional performance measures. In particular, we predict that the use of IPE
will increase with the importance of firms' growth opportunities relative to
assets in place, the length of product development and product life cycles, and
the extent of noise in accounting earnings and stock-price-based measures. We
also consider the relation between IPE and firm size, CEO tenure, and whether
the firm is an electric utility.

1See. for example, Antic and Smith (1986),Gibbons and Murphy (1990), Lambert and Larcker( 1987,
1991), and Sloan (1993), among others.
=Traditional accounting earnings measures of performance include earnings per share, pre-tax
profit, return on assets, return on equity, and return on sales, while traditional stock price measures
include total stockholder rcturns and stock performance versus peer group.
 R.M. Bushman et al. /Journal o f Accounting and Economics 21 (1996) 161 193 163

Using proprietary data from Hewitt Associates, we measure the use of IPE as
the weight, out of a total of 100%, placed on individual performance in
determining CEO bonuses from annual incentive plans (IP/Bonus). We also
measure the use of IPE as the target bonus dollars tied to measures of individual
performance relative to salary (IP/Salary). IP/Salary incorporates not only the
percentage of the annual bonus based on 1PE, but also the magnitude of the
total target bonus relative to the CEO's salary.
Previous research has documented that the use of long-term, stock-price-
based incentive plans increases with investment opportunities (e.g., Smith and
Watts, 1992; Gaver and Gaver, 1993). Given our prediction that IPE will
increase with investment opportunities, we examine the relative importance of
IPE and long-term compensation plans as supplements to corporate accounting
measures in CEO compensation. This is accomplished by analyzing the ratio of
IP/Salary to Long-Term/Salary, where Long-Term/Salary captures the value
of annualized grants of long-term incentive plans. We refer to this ratio as
IP/Long-Term.
We document a positive and significant relation between both IP/Bonus and
IP/Salary and investment opportunities (as measured by market-to-book ratios),
and the length of product development and product life cycles. We also docu-
ment a positive and significant relation between IP/Bonus and IP/Salary and
firm sales and CEO tenure. Finally, we document a positive, significant relation
between IP/Long-Term and the length of the product development cycle and
CEO tenure. In contrast, we fail to find a significant positive relation between
measures of noise in accounting earnings and stock price measures and any of
our three measures of I PE, where noise is measured by several proxies including
the variance of stock returns and the correlation between accounting and stock
returns.
We think the evidence presented in this paper is interesting for several
reasons. First, we provide the first evidence, of which we are aware, on the use of
individual performance evaluation in CEO compensation contracts. Second,
our results suggest that prior empirical compensation studies, based solely on
measures of corporate accounting and market returns, fail to capture important
performance measures for some firms. And finally, our results provide indirect
evidence regarding the limitations of accounting data and stock prices in
measuring current aspects of executives' performance beyond the stewardship of
assets in place. The positive relation between IPE and corporate growth oppor-
tunities and product development and product life cycles suggest that ac-
counting and to some extent price-based measures are not sufficient measures of
CEO performance for some firms.
The remainder of this paper is organized as follows. Section 2 provides the
background and motivation for our hypotheses in greater detail. Section 3 de-
scribes our sample and empirical measures. Section 4 describes our empirical
methods and results, and Section 5 concludes the paper.
164 R.M. Bushman et al. / Journal o['Accounting and Economics 21 (1996) 161 193

2. Background and hypothesis development

The basis for our hypotheses is the informativeness principle (Holmstrom,

1979) which states that for contracting purposes, a performance measure will
only be included in a portfolio of performance measures if it has incremental
information content over and above the other available measures. Because all
publicly traded firms have traditional accounting and stock price performance
measures available for contracting, IPE must provide value over and above these
traditional measures to be useful for contracting. Following the work of Banker
and Datar (1989) and Bushman and Indjejikian (1993), it is convenient to think of
the pertinent contracting properties of performance measures as the sensitivity of
the measure to CEO actions, and the noise in a measure that is unrelated to CEO
actions. This implies that for IPE to add incremental value, it must provide direct
information about CEO actions either missing from or inadequately reflected in
accounting earnings and stock price taken together, or it must be useful in
alleviating the random noise in accounting earnings and stock price.
While it is straightforward to argue that stock price contains information
about a CEO's current actions over and above accounting earnings, it is perhaps
more difficult to see how IPE could contain incremental contracting information
over and above earnings and stock price together. Stock-based performance
measures often are argued to be superior to accounting-based measures because
accounting rules and conventions preclude accounting-based performance
measures from reflecting the entire value relevant information set that is im-
pounded in price. For example, while accounting returns may represent a reason-
able measure of a CEO's current management of assets in place, they do not
reflect the benefits of a CEO's current strategic planning, growth opportunities
identified, business initiatives, or investments in the discovery and development of
new products or technologies with deferred returns. However, the stock price itself
may not fully reflect or may inadequately reflect valuable contracting information,
because managers may have better information than investors about how their
activities and efforts are being directed to increase firm value in the long run.
Stock prices may fail to reflect certain information because investors can find
cheaper and more precise information about easily measurable and quantifiable
aspects of a firm's value, such as current earnings and sales, than about aspects
that are harder to measure, such as strategic planning and product development
activities. In fact, managers may go to great lengths to protect the proprietary
nature of information about the development of new products, markets, and
other strategic activities. As a result, market prices naturally will be more
sensitive to components of value that the market can easily measure. 3

3For a discussion of the contracting propertics of an equilibrium market price in a moral hazard
setting, see Bushman and Indjejikian (1993), Paul (1992), and Holmstrom and Tirole (1992), among
others. For an expanded discussion and synthesis of this literature, see Milgrom and Roberts (1992).
 R.M. Bushman et al. / Journal o f Accounting and Economics 21 (1996) 161-193 165

Consequently, an executive who is evaluated on market measures exclusively

may overemphasize measurable activities fully reflected in price at the expense
of activities whose benefits will not be reflected in price for a long period of
time.
In a principal-agent framework, H o l m s t r o m and Milgrom (1991) illustrate
these inefficiencies by showing how a compensation contract that makes pay
sensitive to performance on one task may result in suboptimal effort being
devoted to other tasks that are not easily measurable or quantifiable. They also
show that one result of this inability to contract explicitly on all aspects of
performance is to reduce the efficiency of incentives even on easily measurable
and contractible dimensions. The implication is that alternative performance
measures such as I P E can be valuable for two related reasons, in addition to its
role in reducing r a n d o m noise. First and foremost, I P E can focus on aspects of
managerial performance that are not fully captured in current accounting and
market-price-based measures of performance. 4 Second, greater use of individual
performance measures can allow for more efficient use of accounting and
price-based corporate performance measures since the latter now serves to
evaluate better those aspects of performance that are easily measurable or
quantifiable.
The above insights from agency theory provide the basis for our empirical
tests. We conjecture that I P E will be used when various value-enhancing actions
of a C E O either are missing from or are imperfectly captured by corporate
financial measures. These are likely to be situations in which there is substantial
information asymmetry between a C E O and investors about at least some
subset of the executive's actions. Since formal agency theory offers little guid-
ance in determining empirically which firms should exhibit high information
asymmetry, we use proxy variables indicative of a firm's growth and investment
opportunities and the length of product development and product life cycles as
measures of information asymmetry. 5 We also develop proxies for the random
noise inherent in accounting and stock-price-based measures of managerial
performance.

4A related explanation for IPE can be found in Baker, Gibbons, and M u r p h y (1994). They argue that
discretionary awards m a y be a way to offset certain dysfunctional aspects of an objective incentive
system (e.g., earnings management).
s For example, Smith and Watts (1992), a m o n g others, argue that a manager's actions are tess readily
observable as the firm's investment opportunity set increases. This leads to their prediction that, the
larger the proportion of a firm's value represented by growth options, the more likely a firm is to
offer contingent compensation.
166 R.M. Bushman et al. / Journal q[ Accounting and Economics 21 (1996) 161 193

3. Sample and measures

3.1. S a m p l e

The sample consists of 396 firms and 1476 firm-year observations drawn from
Hewitt Associates' compensation surveys of public domestic companies for six
years, 1990-1995. To deal with multiple observations for a given firm, we specify
our empirical tests using 396 aggregated firm observations. An aggregated
observation is formed by measuring the dependent and independent variables at
the firm-year level and then for each firm, averaging the variables representing
individual firm-year observations across years (from 1990 to 1995). The Hewitt
data are collected annually using a mail survey. Participant firms pay a fee to
gain access to the survey results and incur direct costs to complete the extensive
survey questionnaire. That is, the Hewitt survey works much like a trade
association in which firms confidentially contribute private information and in
return receive information summarized across all contributing firms. Hewitt
also follows up on individual firm surveys with telephone conversations to verify
accuracy. As a result, we believe that the data have a high degree of accuracy.
To be included in our sample, a firm has to satisfy the following criteria:
(i) have at least one year of information about the weight placed on a CEO's
individual performance in determining annual bonuses during the six-year
period; (it) have Compustat share price, shares outstanding, and stockholder's
equity information for three consecutive years preceding at least one year for
which the weight on the CEO's individual performance is reported, and sales for
one preceding year; (iii) have a ratio of the market-to-book value of equity
greater than or equal to zero; 6 and (iv) report information about the tenure of
the CEO corresponding to the year for which the weight on the CEO's indi-
vidual performance is reported.
The 396 public companies that satisfy the above criteria represent a number of
different industries. Table 1, panel A shows the distribution of the sample across
single-digit SIC codes. Table I, panel B provides additional descriptive data
about our sample firms, where all dollar amounts have been CPl-adjusted to
1989 dollars. The sample consists primarily of large firms with mean (median)
sales of $5 billion ($1.9 billion). More than 50 percent of our sample firms are
included on the 1994 list of Fortune 500 industrial companies. Panel B also
provides descriptive data on the compensation packages of our sample firms.
The mean base salary for CEOs is $554,134, while for the incentive portion of

~'Highmarket-to-book values due to small positive values of book equity may be as problematic as
negative market-to-book values due to negative book equity. However, this was not a major
problem in the present study. As described in Section 4.2. we performed sensitivity analysis to rule
out potential market-to-book outlier problems.
 R.M. Bushman et al. / Journal of Accounting and Economics 2l (1996) 161 193 167

Table 1
Distribution of the sample by one-digit SIC code and compensation and size characteristics
Sample consists of 396 aggregated firm observations and 1476 firm-year observations. An aggreg-
ated observation is formed by measuring observations at the firm-year level and averaging observa-
tions for the same firm across years (from 1990 to 1995). All dollar amounts are CPI-adjusted to 1989
equivalent dollars.

Panel A: Sample distribution by one-digit SIC-code

SIC code Industry Frequency

1 Primary 20
2 Manufacturing (nondurables) 115
3 Manufacturing (durables) 144
4 Transportation and utilities 76
5 Wholesalers and retailers 28
6 8 Financial, business, and consumer services 13
Total 396

Panel B: Descriptive statistics on sample.firm characteristics

No. of
Characteristic firms Mean Std. dev. Q1 Median Q3

Sales($millions) 396 $5,033 $10,014 $768 $1,891 $5,615

Base salary 396 $554,134 $207,971 $409,214 $537,105 $660,509
Target bonus 347 $345,966 $195,660 $213,088 $304,399 $447,890
Long-term 396 $818,724 $983,415 $218,044 $554,048 $1,099,633
compensation

The sample selection criteria are (i) at least one year of information about the weight placed on
a CEO's individual performance in determining his annual bonus, (ii) share price, shares outstand-
ing, and stckholders' equity information on Compustat for three consecutive years preceding the
year for which the weight placed on a CEO's individual performance is reported, and sales for one
year, (iii) positive average market to book value of equity over the three years preceding the year for
which the weight placed on a CEO's individual performance is reported, and (iv) information about
the tenure of the CEO corresponding to the year for which the weight on a CEO's individual
performance is reported in the Hewitt survey.

t h e p a c k a g e t h e m e a n t a r g e t a n n u a l b o n u s is $ 3 4 5 , 9 6 6 a n d t h e m e a n a n n u a l
l o n g - t e r m c o m p e n s a t i o n a w a r d is $818,724.

3.2. M e a s u r e s o f I P E a n d l o n g - t e r m c o m p e n s a t i o n

O u r first m e a s u r e o f t h e i m p o r t a n c e o f I P E is t h e w e i g h t p l a c e d o n a g i v e n
C E O ' s i n d i v i d u a l p e r f o r m a n c e in t h e d e t e r m i n a t i o n o f his a n n u a l b o n u s . E a c h
sample firm reports this weight, IP/Bonus, in response to a survey question
requesting the weights placed on performance measured at the corporate, group,
d i v i s i o n a l , a n d p l a n t levels, a n d t h e w e i g h t p l a c e d o n i n d i v i d u a l p e r f o r m a n c e
in d e t e r m i n i n g a n n u a l i n c e n t i v e b o n u s e s t o b e a w a r d e d t o t h e C E O . T a b l e 2
168 R.M. Bushman et al. / Journal o[Accounting and Economics 21 (1996) 161-193

Table 2
Sample distribution of dependent variables
Sample consists of 396 aggregated firm observations and 1476 firm-year observations. An aggre-
gated observation is formed by measuring observations at the firm-year level and averaging obser-
vations for the same firm across years (from 1990 to 1995). All dollar amounts are CPI-adjusted to
1989 equivalent dollars.

No. of No. of Distribution for nonzero observations

observa- nonzero
tions observations Mean Std. dev. Q1 Median Q3

Distribtion of lP/Bonus by year

1995 225 75 46.6 27.7 25 50 50
1994 290 96 41.9 23.2 25 50 50
1993 263 93 43.7 23.9 25 50 50
1992 256 94 43.4 24.4 25 47.5 50
1991 231 91 43.3 24.0 25 50 50
1990 211 83 43.9 23.9 25 45 50

Distribution of ay.qregated firm observations

IP/Bonus 396 156 36.0 23.6 20 30 50
IP/Salary 347 134 21.0 15.0 10 17.5 28.4
Long-Term/Salary 396 373 160.9 358.5 63.8 115.3 173.3
IP/Long-Term 329 127 27.3 43.3 9.5 16.0 28.6

IP/Bonus = Percentage of CEOs" annual bonus based on individual (i.e., noncorporate) perfor-
mance. IP/Salary = IP/Bonus multiplied by target bonus dollars expressed as a percentage of base
salary; 49 firms in our sample of 396 firms do not report target bonus information. Long-
Term/Salary = annualized value of grants of long-term plans (stock options, stock appreciation
rights, performance units, performance shares, phantom stock, and restricted stock) as a percentage
of base salary. IP/Lonq-Term = ratio of lP/Bonus multiplied by target bonus dollars to the
annulized value of long-term compensation (stock options, stock appreciation rights, performance
units, performance shares, phantom stock, and restricted stock).

presents descriptive evidence on the weight placed on CEO's individual perfor-

m a n c e f o r t h e f i r m s in o u r s a m p l e for e a c h o f t h e y e a r s 1 9 9 0 - 1 9 9 5 as well as f o r
the aggregated observations. Table 2 indicates that approximately a third of the
sample firms use some individual performance evaluation in determining CEO's
b o n u s e s w i t h a few f i r m s b a s i n g t h e e n t i r e b o n u s o n i n d i v i d u a l p e r f o r m a n c e .
Because of the large number of sample firms that report no use of IPE, we
present descriptive information for those firms who reported a positive amount
for I P / B o n u s . F o r n o n z e r o o b s e r v a t i o n s , t h e m e a n I P / B o n u s v a r i e s f r o m a h i g h
o f 4 6 . 6 % in 1995 t o a l o w o f 4 1 . 9 % in 1994. O n a n a g g r e g a t e d b a s i s , t h e m e a n
f o r f i r m s w i t h a v e r a g e I P / B o n u s g r e a t e r t h a n z e r o is 3 6 % .
I n t h e H e w i t t s u r v e y , t h e i n f o r m a t i o n o n p e r f o r m a n c e m e a s u r e w e i g h t s is
c o n s t r u c t e d s u c h t h a t t h e w e i g h t s r e p o r t e d for e a c h b o n u s p l a n s u m t o 1 0 0 % .
 R.M. Bushman et al. /Journal of Accounting and Economics 21 (1996) 161-193 169

Thus, one minus the weight on individual performance equals the sum of the
weights placed on performance measured at the corporate, group, divisional,
and plant levels. In almost all cases, the non-IPE portion of the annual bonus is
based exclusively on performance measured at the corporate level.
We focus on annual incentive plans to capture the definition of individual
performance evaluation for two reasons. First, short-term bonus plans based on
current accounting profits are often blamed for managerial myopia, i.e., en-
couraging a preoccupation with current operations and short-term results, and
discouraging strategic initiatives and long-term investments in new products,
processes, and markets with deferred and highly uncertain returns. 7 Thus, the
value of IPE in capturing aspects of CEO performance not reflected in current
profits is arguably high in the short-term incentive component of a CEO's
compensation package. Second, data are available on precise weights placed on
CEOs' individual performance for annual incentive plans only. This may be
a reflection of the more pervasive and explicit use of IPE in annual incentive
plans vis-a-vis other components of managerial compensation, s
Although lP/Bonus captures the importance of IPE for determining the
annual bonus payout, differences in the targeted dollar amount of the total
annual bonus can affect the incentive power derived from individual perfor-
mance evaluation. For example, a higher individual performance weight multi-
plied by a lower bonus amount may imply lower overall compensation from
IPE. Therefore, we develop a second measure of the use and importance of IPE,
the percentage of the target bonus amount subject to individual performance
evaluation to base salary,
IP/Bonus x Taryet bonus dollars
IP/Salary =
Base salary

Table 2 documents that for our aggregated sample, nonzero values for IP/Salary
have a mean (median) of 21.0 (17.5) percent.
Our final measure of the importance of IPE is motivated by the conjecture
that situations which promote IPE may also promote the use of long-term
incentive plans. Information about long-term incentive plans for firms in our
sample includes the annualized expected value of grants of long-term plans
including options (valued using the Black-Scholes option pricing model with
adjustment for employee forfeiture possibilities and early-exercise provisions),
the target payout for performance units, performance shares and phantom
stock, and restricted stock (valued at the price of the shares at the date of the

7See, for example, Narayanan (1985) and Stein (1989). Stock-price-based plans are also sometimes
criticized for providing incentives to myopically manipulate short-term stock prices.
Slndividual performance may also enter into the determination of long-term compensation. For
example, discretion may be exercised in determining the number of stock options granted to an
executive in a particular year. We do not address this possibility in the present paper.
170 R.M. Bushmanet al. / Journal ~?fAccounting and Economics 21 (1996) 161 193

grant adjusted for dividend and vesting restrictions). 9 Long-term c o m p e n s a t i o n is

measured as the percentage of the value of long-term compensation to base salary,

Long- Term/Salary
Annualized value of grants of long-term compensation plans x 100
Base salary
The d e t e r m i n a n t s of l o n g - t e r m c o m p e n s a t i o n for C E O s have been the subject
of previous research (e.g., G a v e r a n d Gaver, 1993; Smith a n d Watts, 1992;
Lewellen, Loderer, a n d M a r t i n , 1987). O u r objective in this paper is to c o m p a r e
the relative use of l o n g - t e r m c o m p e n s a t i o n a n d IPE. The analysis of L o n g -
T e r m / S a l a r y is m e a n t to serve as a base line against which to investigate the
relative i m p o r t a n c e of the two measures.
T o capture the relative i m p o r t a n c e of the two measures we use the ratio of the
target b o n u s subject to I P E to long-term c o m p e n s a t i o n . T h a t is,

I P/Bonus x Target bonus dollars

IP/Long- Term =
Value of annualized long-term compensation grants"
Descriptive data in Table 2 d o c u m e n t that, on an aggregate basis, n o n z e r o
values of I P / L o n g - T e r m have a m e a n (median) value of 27.3 (16.0) percent.
To provide a d d i t i o n a l insight into the n a t u r e of 1PE, we reviewed in detail 284
c o m p e n s a t i o n committee reports c o n t a i n e d in the 1994 proxy statements of
public firms in the 1994 Hewitt survey that reported I P / B o n u s . Of these 284
firms, 93 reported I P / B o n u s > 0 a n d 191 reported I P / B o n u s = 0. The objective
of the analysis is to examine the relation between the use of I P E as reported in
the Hewitt survey a n d the use of n o n f i n a n c i a l measures a n d qualitative evalu-
ations of the C E O ' s performance.We were able to isolate 58 firms of the total
284 firms that appeared to base the a n n u a l b o n u s exclusively on financial
p e r f o r m a n c e measures, giving n o i n d i c a t i o n that any part of the b o n u s p a y o u t s
was d e t e r m i n e d subjectively or subject to the discretion of the b o a r d of
directors, t° O f these 58 firms, 4 reported I P / B o n u s > 0 a n d 54 reported

9Because one of Hewitt's objectives is to generate an annual compensation amount for the
executives reported by survey participants, they utilize an annualizing procedure for long-term
grants that are not granted on an annual basis. This involves scaling the value of a multi-period
grant to reflect an annual amount. Payouts from performance units and performance shares are
typically a function of accounting and/or share price performance over a multi-year period, while the
other components of long-term compensation typically depend on share price performance only.
~°Financial measures are defined as accounting (e.g., EPS, pre-tax profit, ROE, sales) or external
market measures (e.g., total stockholder retm'n, stock performance versus peer group). The Hewitt
survey and our review of proxies indicate that the financial measures used in annual bonuses are
primarily accounting-based, and seldom rely on stock price performance. This is also consistent with
the findings in Ittner, Larcker, and Rajan (1995). Examples of excerpts from compensation com-
mittee reports for this subsample are included in the Appendix.
 R.M. Bushman et al. / Journal of Accounting and Economics 21 (1996) 161 193 171

IP/Bonus = 0. This result suggests that I P E is used to supplement traditional

corporate financial measures. The remainder of the firms were difficult to
classify in a systematic fashion, reporting a complex variety of nonfinancial and
qualitative performance measures, and sometimes vague references to the use of
discretion or subjectivity in determining awards.
Several compensation committee reports specifically mention the use of IPE
and give an explicit description of the basis for the [PE award. We include
several examples of these reports in the Appendix. These reports mention a wide
variety of underlying criteria for I PE that include explicit nonfinancial perfor-
mance criteria such as quality improvements and customer satisfaction, various
aspects of managerial input such as idea leadership, and indications of discretion
or subjectivity in determining the awards. In a related analysis, Ittner, Larcker,
and Rajah (1995) document a positive but imperfect relationship between I P E
and the use of nonfinancial performance measures. They report that a cross-
sectional regression between IP/Bonus and a measure of nonfinancial perfor-
mance measure usage produced an R 2 of 28 % (35 %) for 1993 (1994) data. Thus,
while I P E appears positively related to the use of nonfinancial measures and
discretion, our reading of the compensation committee reports and the Ittner,
Larcker, and Rajan analysis indicates that I P E is not a sufficient statistic for the
use of either of these control instruments.

3.3. Explanatory variables

We investigate the influence of eight variables: market-to-book value of

equity, product development cycle, product life cycle, correlation between ac-
counting and stock returns, variance of stock returns, C E O tenure, firm size, and
an electric utility d u m m y variable.

Market-to-book value
M a r k e t - t o - b o o k ratios often are used to capture the spirit of Myer's (1977)
characterization of a firm's growth opportunities relative to assets in place. For
example, Collins and Kothari (1989) and Smith and Watts (1992) argue that the
difference between the market value and book value roughly represents the
value of investment opportunities facing a firm. Other papers which use mar-
ket-to-book ratios as proxies for growth or investment opportunities include
Chung and Charoenwong (1991), Gaver and Gaver (1993), Holthausen and
Larcker (1991), Kole (1991), and Lewellen, Loderer, and Martin (1987). In the
context of managerial performance evaluation, the typical intuition underlying
the explanatory power of this ratio is that it captures the consequences of
managerial actions and decisions that are reflected in market price but not
reflected in accounting numbers. Thus, consistent with this intuition, we expect
m a r k e t - t o - b o o k values to be positively related to the use of price-based perfor-
mance measures (Long-Term/Salary). Moreover, to the extent that some of
172 R.M. Bushman et al. / Journal c~['Accounting and Economics 21 (1996) 161 193

these dimensions of managerial performance captured in price are also captured

in IPE, we expect market-to-book values to be positively related to IP/Bonus
and IP/Salary as well. However, we make no prediction about the relation
between the market-to-book ratio and I P/Long-Term.
We measure the ratio of the market value of c o m m o n stock to book value of
stockholders' equity based on an average of the three consecutive years preced-
ing the year for which the weight placed on a CEO's individual performance is
reported. Firms with negative market to book ratios are deleted from the
sample.

Product time horizon

Time horizon, as related to planning, decision making, and execution, can
represent a crucial aspect of the competitive performance of a firm. However,
there is no single definition of time horizon as it can manifest in many different
ways with different implications. Examples of time horizons in company acti-
vities include the time required to commercialize a new product that depends on
the development and deployment of new technology, the time needed to build
critical skill bases and teams or develop long-lived assets to improve producti-
vity, the expected time between investment in development of a new technology
and payoff, the time it takes for a new market to develop and become saturated,
and the time it takes for a competitor to copy a product and get it to market. 1
Long time horizons can be indicative of information asymmetries between
investors and managers. For example, Bizjak, Brickley, and Coles (1993) argue
that informational asymmetries are more likely within firms that have long
product development cycles because private information about new products
being developed is least likely to be objectively quantifiable or measurable in
a short time horizon. Thus, the length of the product development cycle may
adversely affect the amount of information reflected in both current price and
accounting earnings, which in turn can make I P E potentially valuable.
To investigate the relation between time horizon and C E O compensation, we
categorize firms into short or long time horizon using a classification scheme
reported in National Academy of Engineering (1992). The scheme classifies
industries along the two dimensions of product development cycle time and
product life cycle time. Product development cycle represents the time it takes to
develop and bring to market a new product, and is likely to be associated with
high levels of information asymmetry (e.g., substantial proprietary information).
Product life cycle represents the market life of a product, and is associated with
situations where C E O decisions have substantial multi-period impacts.
We utilize both dimensions in classifying our firms as short or long time horizon.
We conjecture that both long product development cycles and long product

11For a more thorough discussion of these issues, see National Academy of Engineering (1992).
 R.M. Bushman et al. /Journal of Accounting and Economics" 21 (1996) 161 193 173

life cycles will be associated with the use of more I P E and more long-term
compensation.
We classify a firm as having either a short product development cycle or
a short product life cycle if its industry product development cycle or industry
product life cycle is reported as less than or equal to four years in the National
Academy of Engineering scheme. We classify a firm as having a long product
development cycle or a long product life cycle if its industry product develop-
ment cycle or its industry product life cycle is greater than four years in the
National Academy of Engineering scheme. The exact number of years that
classifies a firm as short or long is admittedly open to debate, and thus a large
number of classification possibilities exist. However, given that our objective is
not to find the ideal classification scheme, we select a cutoff of four years as at
least reasonable for exploring hypotheses about the use of IPE.~2
The National Academy of Engineering scheme reports cycle times by industry
groups that are not explicitly linked to SIC classifications. We use both the
firm's four-digit SIC code and the description of its business included in the 10K
report to classify our sample firms into the Academy's industry groups. The
results of this classification process are shown in Table 3 by industry description.
Using product development cycles, 123 firms are classified as short and 131 as
long, while using product life cycle, 92 are classified as short and 162 as long. We
are unable to classify 142 of our sample firms because their industries are not
included in the National Academy of Engineering classification scheme.

Correlation between accounting and stock returns

Agency theory suggests that noise in a performance measure is one determi-
nant of its use in compensation contracts. The usual empirical representations of
noise are the variance of accounting returns and the variance of stock returns,
or their ratio as a measure of relative noise (Lambert and Larcker, 1987;
Holthausen and Larcker, 1991). 13 A related measure that we consider for the
noise in accounting returns is the time-series correlation between accounting
returns and stock returns, despite the fact that this measure is more likely to
capture noise from the perspective of assessing firm value rather than a

12In a previous version of the paper we utilized product development cycle only and classified firms
into short (one year or less), medium (between one and five years), and long (greater than five years)
categories. Using a one-year sample, we found that use of IPE increased significantly as development
cycle increased from short to medium, but found no significant difference between medium- and
long-cycle firms.
13At the same time, others have characterized variances of accounting and market returns as
measures of the variability of underlying cash flows rather than noise. The superiority of the one or
the other interpretation is not immediately apparent.
174 R.M. Bushman et al. / Journal q/Accounting and Economics 21 (1996) 161 193

Table 3
Time horizon classification of firms by industry
254 firms from our sample of 396 firms are classified as short or long along two dimensions of time
horizon: product development cycle and product life cycle. Product development and life cycle
classifications are adapted from National Academy of Engineering (1992).

No. of Product development Product life

Industry sample tirms cycle cycle

Aircraft 10 Long Long

Autos 14 Short Short
Biotechnology 2 Long Short
Chemicals 20 Long Long
Communications 20 Long Long
Computers 26 Short Short
Dental I Short Short
Financial services 1 Short Short
Food 24 Short Long
Hotel 1 Short Long
Metal products 14 Short Short
Mining 3 Short Long
Oil and gas 43 Long Long
Paper 12 Long Long
Pharmaceuticals 14 Long Long
Photography 4 Short Short
Publishing 2 Short Long
Software 2 Short Short
Timber 3 Long Long
Tobacco 3 Short Long
Transportation 7 Long Long
Wholesale/retail 28 Short Short
Total 254 Long = 131 Long = 162
Short = 123 Short = 92

m a n a g e r ' s p e r f o r m a n c e . ~4 A h i g h c o r r e l a t i o n is i n t e r p r e t e d as a s e t t i n g w h e r e
a c c o u n t i n g e a r n i n g s a r e h i g h ' q u a l i t y ' , a n d reflect well t h e a c t i o n s o f t h e C E O .
T h u s , we e x p e c t f i r m s w i t h a h i g h c o r r e l a t i o n will rely m o r e o n a c c o u n t i n g -
b a s e d m e a s u r e s a n d less o n I P E a n d p r i c e - b a s e d p e r f o r m a n c e m e a s u r e s , c e t e r i s
p a r i b u s . T h i s i m p l i e s a n e g a t i v e s i g n o n t h e c o r r e l a t i o n v a r i a b l e in t h e I P / B o n u s ,
I P / S a l a r y , a n d L o n g - T e r m / S a l a r y r e g r e s s i o n s . W e m a k e n o p r e d i c t i o n for t h e
sign o n c o r r e l a t i o n in t h e I P / L o n g - T e r m a n a l y s i s .

~4Salamon and Smith (1979) suggest that the correlation between accounting numbers and market
prices provides an explicit measure of the amount of 'managerial misrepresentation' in accounting
numbers.
 R.M. Bushman et al. / Journal of Accounting and Economics 2l (1996) 161 193 175

This variable is estimated as the time-series correlation between annual

accounting returns (income before extraordinary items over average c o m m o n
equity) and annual stock returns measured over a m a x i m u m of ten years (with
a m i n i m u m of six years) preceding the year for which the weight placed on
a C E O ' s individual performance is reported.

Variance of stock returns

We use the variance of stock returns as a measure of the noise in stock price
relative to the C E O ' s actions. To the extent that the variance of returns captures
the contracting noise in price, we predict that IP/Bonus, IP/Salary, and
I P / L o n g - T e r m will increase and that L o n g - T e r m / S a l a r y will decrease as this
variance increases. We measure this variability as the natural logarithm of the
variance of stock market returns estimated over a 60-month period (with
a m i n i m u m of 36 months) preceding the year for which the weight placed on
a C E O ' s individual performance is reported.
A l t h o u g h there is precedence in the literature for using variance of returns as
a proxy for noise (e.g., L a m b e r t and Larcker, 1987), no general consensus exists
as to the best measure of contracting relevant noise. F o r example, Lewellen,
Loderer, and Martin (1987) and Sloan (1993) argue that the general m o v e m e n t
of stock prices (i.e., systematic risk) represent events not under the control of
managers. But, if a m a n a g e r is responsible for the industries in which the firm
invests, then all of this variability m a y not represent noise. Some also argue that
variability of stock returns is an i m p o r t a n t consideration in the design of
executive c o m p e n s a t i o n arrangements because it proxies for growth opportuni-
ties. G a v e r and G a v e r (1993) and Smith and Watts (1992) suggest that variability
of returns is an indicator of a firm's investment o p p o r t u n i t y set with greater
variability c o r r e s p o n d i n g to greater investment opportunities. As a result of this
lack of consensus, we try alternative measures of noise, including both the beta
of the c o m m o n stock and the variance of market model residuals.

CEO tenure
We conjecture that C E O tenure, measured by the n u m b e r of years the C E O
has been in that position as of the year of the compensation survey, m a y be
related to the use of individual performance evaluation for at least several
reasons. First, it m a y be the case that the b o a r d of directors is better able to
evaluate the leadership of a C E O , the quality of his strategic plans, his ability to
identify g r o w t h opportunities, and other qualitative aspects of his performance
as his tenure increases without exclusively relying on corporate financial
measures. 15 Alternatively, it is possible that the longer the tenure, the more

5Gerhart and Milkovich (1990) argue that high human capital investments in the form of education
and experience (or tenure) are likely to be associated with high potential impact on performance, and
therefore, positively associated with the use of contingent pay. This argument is consistent with the
intuition that IP/Salary and Long-Term/Salary increase with tenure.
176 R.M. Bushman et al. / Journal qf Accounting and Economics 2l (1996) 161-193

power the C E O exerts over the board. Thus, a powerful C E O may use his
influence to procure I P E which may be more prone to manipulation. 16 At the
other extreme, it is possible that new C E O s are evaluated relatively more
intensively on individual performance since corporate performance measures
tend to be heavily influenced by the actions of the previous CEO. These effects
are obviously countervailing. Thus, we make no prediction about the relation
between individual performance evaluation and C E O tenure.

Firm size
In the compensation literature, firm size has shown to be positively related to
the level of cash compensation, and has proxied for growth and investment
opportunities (Gaver and Gaver, 1993; Smith and Watts, 1992) and the cost or
difficulty of monitoring an agent (Eaton and Rosen, 1983; Holthausen and
Larcker, 1991). We make no specific predictions about the effects of firm size on
the components of managerial compensation but include firm size in our tests to
preserve comparability with related work in lhis literature. We measure firm size
as the natural logarithm of sales revenue for the fiscal year preceding the year for
which the weight placed on a CEO's individual performance is reported.

Utility dummy variable

A distinguishing feature of electric utilities is that they are regulated. Some
regulatory authorities appear to regulate compensation policy directly, placing
limits on the nature and amount of payments to executives. More generally,
regulation restricts managers' authority and investment discretion and reduces
their marginal impact on the value of the firm. Prior research (e.g., Smith and
Watts, 1992; Bushman, Indjejikian, and Smith, 1994) documents in cross-
sectional analyses that the compensation packages of utility firm executives
contain lower incentive compensation portions (annual bonuses and long-term
compensation) than those of nonutility executives. Thus we expect the utility
d u m m y to be negatively related to Long-Term/Salary. While the previous
argument might also be used to support a prediction of lower IP/Bonus and
IP/Salary for utility CEOs, there are countervailing forces that introduce
ambiguity.
As discussed in Ittner, Larcker, and Rajah (1995), the compensation packages
of utility executives are likely to reflect the extent to which the utility regulators
link rate increases to the achievement of nonfinancial goals. Since, as discussed
above, 1PE may be related to the use of nonfinancial performance measures, I P E
might be higher for utilities. Due to the existence of these competing forces, we
make no prediction about the sign of the utility d u m m y in the IP/Bonus,
IP/Salary, and I P / L o n g - T e r m regressions.

J6See Lambert, Larcker, and Weigell (1993) and Inner, Larcker, and Rajan (1995) for further
discussion and analysis of the CEO power theory.
 R.M. Bushman et al. / Journal o f Accounting and Economics 21 (1996) 161-193 177

Table 4 presents descriptive s t a t i s t i c s ( p a n e l A) a n d a correlation matrix

( p a n e l B) f o r t h e e x p l a n a t o r y variables. The market value to the book value of
equity ratio has a mean and median o f 2.37 a n d 1.82 r e s p e c t i v e l y . A n a l o g o u s
statistics for the c o r r e l a t i o n b e t w e e n a c c o u n t i n g a n d s t o c k r e t u r n s are 0.079 a n d
0.086, a n d f o r C E O t e n u r e a r e 6.58 a n d 5 y e a r s . T h e v a r i a n c e o f r e t u r n s a n d s a l e s

Table 4
Distribution and correlations of explanatory variables of sample firms
Sample consists of 396 aggregated firm observations and 1476 firm-year observations. An aggre-
gated observation is formed by measuring observations at the firm-year level and averaging obser-
vations for the same firm across years (1990 to 1995). Sales are CPI-adjusted to 1989 equivalent
dollars.

Panel A: Descriptive statistics on explanatory variables

Exogenous Available
variables observations Mean Std. dev. QI Median Q3

Mtb 396 2.37 1.71 1.39 1.82 2.73

Corr 360 0.079 0.285 - 0.134 0.086 0.281
Variance 369 - 4.96 0.66 5.35 - 4.98 - 4.54
Size 396 7.60 1.36 6.64 7.55 8.63
Ceoten 396 6.58 5.83 3 5 8.25

Panel B: Correlations of explanatory variables

Mtb Corr Variance Devcycle Lifecycle Size Ceoten

Mtb 1.00
Corr - 0.17* 1.00
Variance -- 0.07 0.02 1.00
Devcycle -- 0.09 - 0.05 -- 0.32* 1.00
Lifecycle 0.18* 0.05 - 0.46* 0.75* 1.00
Size 0.02 - 0.21 * - 0.29* 0.06 0.13 1.00
Ceoten 0.00 0.04 0.11 - 0.03 0.03 -- 0.16" hO0

Mtb = ratio of market value of common stock to book value of equity based on an average of the
three consecutive years preceding the year which the weight placed on a CEO's individual perfor-
mance is reported. Corr = time series correlation between annual accounting returns (income before
extraordinary items over average common equity) and annual stock returns estimated over a max-
imum of 10 years (with a minimum of 6 years) preceding the year for which the weight placed on
a CEO's individual performance is reported. Variance - natural log of the variance of monthly
stock returns estimated over a maximum of 60 months (with a minimum of 36 months) preceding the
year for which the weight placed on a CEO's individual performance is reported. Devcycle = 1 if
a firm is classified as having long product development cycle (Table 3), otherwise it equals zero.
Lifecycle = 1 ifa firm is classified as having long product life cycle (Table 3), otherwise it equals zero.
Size = natural log of sales revenue for the fiscal year preceding the year for which the weight placed
on a CEO's individual performance is reported. Ceoten = number of years the CEO has been in that
position as of the year of the compensation survey.
*p-value < 0.01.
178 R.M. Bushman et al. / Journal ol Accounting and Economics 21 (1996) 161 193

are reported as the natural log of the variable due to significant positive
skewness. The results in panel B indicate significant (0.01 probability level)
negative pairwise correlations between the market-to-book ratio and the cor-
relation between accounting and stock returns, and a positive correlation
between the market-to-book ratio and product life cycle. There is also a signifi-
cant negative correlation between the variance of returns and product develop-
ment cycle and product life cycle, and between firm size and the correlation
between accounting and stock returns, CEO tenure, and the variance of returns.
Product development cycle and product life cycle are highly positively corre-
lated (0.75).

4. Empirical results

We test for a positive relation between the use of IPE and proxies for product
time horizon, corporate growth opportunities, and noise in accounting and
stock return measures. We consider the percentage weight placed on the indi-
vidual performance of the CEO in determining his annual bonus (IP/Bonus) in
Table 5 and the dollar value of the CEO's target bonus based on individual
performance as a percentage of salary (lP/Salary) in Table 6. For comparison
purposes, in Table 7 we also test the significance of model variables in explaining
the dollar value of annualized grants of long-term incentive plans relative to
salary (Long-Term/Salary). Our interest in long-term compensation, which is
usually linked to the value of stock, is motivated in part by the fact that
stock-based compensation often is argued to be most appropriate in settings
characterized by high information asymmetry between shareholders and man-
agers. For example, Gaver and Gaver (1993), Lewellen, Loderer, and Martin
(1987), and Smith and Watts (1992) all lind an association between stock-based
compensation and various proxies for firms' growth opportunities. We expect
Long-Term/Salary to increase with corporate growth opportunities, the time
horizon as determined by the product development and life cycles in the
industry, and the noise of accounting earnings, similar to our predictions for
IPE. We expect Long-Term/Salary to decrease with the noise in stock returns.
Finally, to provide evidence of the use of IPE relative to stock-based compensa-
tion, in Table 8 we test the significance of model variables in explaining the
dollar value of the CEO's target bonus based on individual performance as
a percentage of long-term compensation (I P/Long-Term).
We use OLS regression to estimate the relation between IP/Bonus, IP/Salary,
Long-Term/Salary, and IP/Long-Term and model variables. However, the
distribution of the weight on individual performance has two features which
violate the OLS normality assumption; the preponderance of zero values and
the censoring at values of zero and 100 percent. Zero values for IP/Bonus imply
zero values for IP/Salary and IP/Long-Term as well. To check the robustness of
 R.M. Bushman et al. /Journal o f Accounting and Economics 2l (1996) 161 193 179

the OLS results, we reestimate models for IP/Bonus, IP/Salary, and IP/Long-
Term using a Tobit technique as reported in Table 9.

4.1. Individual performance evaluation

Table 5 presents OLS regression results for four models of IP/Bonus. Collec-
tively the four models test for a positive relation between IP/Bonus and proxies
for corporate growth opportunities, time horizon, and noise in accounting and
stock return measures. The proxy for corporate growth opportunities, the
market-to-book value of equity averaged over the prior three years, appears in
all models. The proxies for product time horizon, unavailable for 142 firms, and
proxies for the noise in accounting and stock returns, unavailable for 45 sample
firms, are excluded from Model 1 to enable a test of the significance of the
m a r k e t - t o - b o o k value of equity for the full sample of 396 firms. Model 2 adds
the noise variables, Corr and Variance, to Model 1. Models 3 and 4 include the
time horizon proxies, classified on the basis of the estimated length of the
product development cycle (Devcycle) in the industry in Model 3 and on the
basis of the estimated length of the product life cycle (Lifecycle) in the industry in
Model 4. We include the two time horizon proxies in separate models to avoid
a multicollinearity problem, as the correlation between Devcycle and Lifecycle is
0.75 (Table 4). Models 3 and 4 exclude the 142 sample firms whose industry time
horizons are not classified and an additional 33 firms for which our noise
variables are missing. The four models in Table 5 also include two control
variables: a measure of firm size (natural log of sales in the preceding year stated
in 1989 equivalent dollars) and the tenure of the CEO. Finally, Models 1 and 2
include a control variable for electric utilities. The control variable for electric
utilities is unnecessary in Models 3 and 4 whose estimation samples exclude
electric utilities due to missing time horizon variables. We make no predictions
about the sign of the coefficients of the three control variables.
The results of Model 1 indicate a significant positive coefficient (probability
level < 0.01), as predicted, on the market-to-book value of equity for the full
sample of 396 firms.17 The coefficient on the electric utility d u m m y is negative
and significant (0.10 probability level) and implies that classification as an
electric utility is associated with a 7 percent reduction in IP/Bonus. The OLS
coefficients on the natural log of sales (in 1989 equivalent dollars) and the tenure
of the C E O are both positive and highly significant (probability level < 0.02).
The latter results suggest that I P E is more important in determining the annual
bonuses of highly seasoned CEOs of large firms.

~VAll reported p-values derive from two-tailed tests, including those variables for which we are
making a unidirectional prediction.
180 R.M. Bushman et al. Journal ~?/'Accounting and Economics 21 (1996) 161 193

Table 5
Estimated O L S regression models of the percentage of C E O annual b o n u s based on individual
performance (IP/Bonus)
Sample consists of 396 aggregated firm observations and 1476 firm-year observations. An aggregated
observation is formed by measuring observations at the firm-year level and averaging observations
for the same firm across years (from 1990 l o 1995). Sales are CPI-adjusted to 1989 equivalent dollars.

Regression coefficients (t-statistics)

Predicted
Explanatory variable sign Model I Model 2 Model 3 Model 4

Intercept 13.18 - 21.02 15.48 - 7.50

( 1.89) ( - 1.80) (- 1.04) (-0.49)
Mth 2.06*** 2.59*** 3.67*** 3.04***
+ (3.10) (3.20) (3.72) (3.13)
Corr -- 3.61 0.07 - 1.23
-- ( -- 0.81) ( 0.01) ( - 0.20)
Variance -- 2.58 0.02 2.24
+ ( - - 1.07) (0.01) (0.66)
Devcycle 8.19"**
+ (2.34)
L(fec yele 11.91"**
+ (3.02)
Size 2.63"** 1.95** 2.00 2.17
? (3.14) (1.94) (1.44) (1.56)
Ceoten 0.46** 0.46** 0.60** 0.55**
'~ (2.35) (2.17) (2.22) (2.03)
Utility 7.03* - 9.74*
? ( 1.66) ( - 1.81)

No. of observations ~ 396 351 221 221

Probability > F 0.0001 0.0001 0.0002 0.0001
Adjusted R 2 5.94% 7.01% 8.87% 10.37%

IP/Bonus = percentage of C E O s ' annual bonus based on individual (i.e., noncorporate) perfor-
mance. Mtb - ratio of market value of c o m m o n stock to book value of equity based on an average
of the three consecutive years preceding lhc year for which the weight placed on a C E O ' s individual
performance is reported. Corr - time series correlalion between annual accounting returns (income
before extraordinary items over average c o m m o n equity) and annual stock returns estimated over
a m a x i m u m of 10 years (with a m i n i m u m of 6 years) preceding the year for which the weight placed
on a C E O ' s individual performance is reported. Variance = natural log of the variance of m o n t h l y
stock returns estimated over a m a x i m u m of 60 m o n t h s (with a m i n i m u m of 36 months) preceding the
year for which the weight placed on a C E O ' s individual performance is reported. Devcycle = 1 if
a firm is classified as having long product development cycle (Table 3), otherwise it equals zero.
Lifecycle - 1 ira firm is classified as having long product life cycle (Table 3), otherwise it equals zero.
Size = natural log of sales revenue for the fiscal year preceding the year for which the weight placed
on a C E O ' s individual performance is reported. Ceoten = n u m b e r of years the C E O has been in that
position as of the year of the compensation survey. Utility - 1 if a firm is an electric utility (SIC
codes 4911 and 4931), otherwise it equals zero.
Asterisks denote p-values < 0.10 (*), < 0.05 (**), and < 0.01 (***); two-tailed test.
aFor Model 2, 45 firms from our sample of 396 firms have insufficient data for calculating the
variables Corr and Variance. F o r Models 3 and 4, 33 of the 254 firms that are classified by time
horizon in Table 3 have insufficient data for calculating the variables Corr and Variance.
 R.M. Bushman et al. / Journal o f Accounting and Economics 21 (1996) 161- 193 181

The relation between IP/Bonus and the variables in Model 1 is largely

unchanged with the addition of the noise variables (and the exclusion of 45 firms
with missing data) in Model 2. The noise variables do not support our predic-
tion that IP/Bonus increases with noise in accounting and stock returns. The
coefficient on our proxy for the noise of accounting earnings, Corr, is negative as
predicted, but insignificant. The coefficient on our proxy for the noise of stock
returns, Variance, is insignificant and of the opposite sign to that predicted.
The results for Models 3 and 4 indicate a significant positive relation (prob-
ability level < 0.01) between IP/Bonus and time horizon, classified by industry
on the basis of the length of the product development cycle (Model 3) and the
length of the product life cycle (Model 4). The magnitude of the regression
coefficients indicates that a shift from an industry whose product development
cycle is classified as short to an industry classified as long is associated with an
increase in IP/Bonus of 8.19 percent. Analogously, a shift from an industry
whose product life cycle is classified as short to an industry classified as long is
associated with an increase in IP/Bonus of 11.9 percent. The market-to-book
ratio is still positive and significant (probability level < 0.01) with the inclusion
of the time horizon variables in Models 3 and 4 and the magnitude of the
coefficient implies that an increase in the market-to-book ratio of 1.0 is asso-
ciated with between a 3 and 3.7 percent increase in IP/Bonus. As in Model 2, the
noise variables for accounting and stock returns are insignificant at conven-
tional levels.
We also ran the four models in Table 5 using only those observations for
which IP/Bonus is strictly greater than zero. 18 This allows us to distinguish
between whether the variation in IP/Bonus a m o n g firms with IP/Bonus > 0
contribute to our results, or whether it is strictly the existence of I P E that
matters. The results of these regressions (not reported) show that for all four
models, market-to-book continues to be positive and highly significant, while in
Models 3 and 4 neither product development cycle nor product life cycle have
a significant coefficient.
Table 6 presents analogous models for IP/Salary. The sample sizes in Table
6 are smaller than Table 5 due to missing data for the CEO's target bonus
dollars for 49 sample firms. The results for IP/Salary reported in Table 6 are
somewhat consistent with the results for IP/Bonus reported in Table 5. The
coefficient on the market-to-book ratio is positive and significant (probability
level < 0.10) in Models 3 and 4. The magnitude of the coefficient on the market-
to-book ratio varies from 0.58 in Model 1 to 1.64 in Model 3, indicating that an
increase in the market-to-book ratio of 1.0 is associated with an increase in the
expected bonus dollars as a percentage of salary of less than 2 percent, after

l SRestricting the tests to observations with positive IP/Bonus reduces the sample to 156 observa-
tions for Model 1, 141 for Model 2, and 101 for both Models 3 and 4.
182 R.M. Bushman et al. / Journal ~)/'Accounting and Economics 21 (1996) 161 193

Table 6
Estimated OLS regression models of CEO target bonus based on individual performance as
a percentage of base salary (IP/Salary)
347 aggregated firm observations from the sample of 396 firm have target bonus information to
compute IP/Salary. An aggregated observation is formed by measuring observations at the firm-
year level and averaging observations for the same firm across years (from 1990 to 1995). Sales are
CPl-adjusted to 1989 equivalent dollars.
Regression coefficients (t-statistics)
Predicted
Explanatory variable sign Model 1 Model 2 Model 3 Model 4

Intercept 14.02 15.05 10.56 5.42

( 3.07) I -- 2.01) ( 1.08) ( 0.55)
Mtb 0.58 0.84 1.64"* 1.17"
+ (1.30) (1.53) (2.30) (1.68)
Corr -- 0.78 0.93 0.38
I 0.28) (0.23) (0.09)
Variance 0.07 2.39 3.85*
+ (0.05) (1.15) (1.78)
Devcycle 5.41 **
+ (2.39)
L![ecycle 8.20***
+ (3.26)
Size 2.49*** 2.59*** 2.78*** 2.90***
'~ (4.53) (3.98) (2.97) (3.14)
Ceoten 0.40*** 0.41 *** 0.60*** 0.52**
? (2.79) (2.65) (2.77) (2.45)
Utility 6.53*** -- 6.12"
? ( - 2.46) ( -- 1.85)
No. of observations ~ 347 307 189 189
Probability > F 0.0001 0.0001 0.0007 0.0001
Adjusted R z 8.12% 8.61% 8.97% 11.30%
I P / S a l a r y = IP/Bonus multiplied by target bonus dollars expressed as a percentage of base salary;
49 firms in our sample of 396 firms do report target bonus information. M t b = ratio of market value
of common stock to book value of equity based on an average of the three consecutive years
preceding the year for which the weight placed on a CEO's individual performance is reported.
Corr = time series correlation between annual accounting returns (income before extraordinary
items over average common equityl and ammal stock returns estimated over a maximum of 10 years
(with a minimum of 6 years} preceding the year for which the weight placed on a CEO's individual
performance is reported. Variance - natural log of the variance of monthly stock returns estimated
over a maximum of 60 months (with a minimum of 36 months) preceding the year for which the
weight placed on a CEO's individual performance is reported. Devcw'le = 1 if a firm is classified as
having long product development cycle (Table 3), otherwise it equals zero. L f e c y c l e = 1 if a firm is
classified as having long product life cycle (Table 3), otherwise it equals zero. Size - natural log of
sales revenue for the fiscal year preceding the year for which the weight placed on a CEO's individual
performance is reported. Ceoten - number of years the CEO has been in that position as of the year
of the compensation survey. Utility = 1 if a firm is an electric utility (SIC codes 4911 and 4931),
otherwise it equals zero.
Asterisks denote p-values < 0.10 (*), < 0.05 (**), and < 0.01 (***); two-tailed test.
~For Model 2, 40 firms from our sample of 347 tirms with the target bonus information have
insufficient data for calculating the variables Corr and Variance. For Models 3 and 4, 33 of the 254
firms that are classified by time horizon in Table 3 have insufficient data for calculating the variables
Corr and Variance.
 R.M. Bushman et al. / Journal q]'Accounting and Economics 21 (1996) 161 193 183

controlling for other model variables. The coefficients on the time horizon
variables are both positive and significant, as predicted, in Models 3 and 4. The
magnitude of the coefficient on the time horizon variable in Model 3 indicates
that a shift from an industry whose product development cycle is classified as
short to an industry classified as long is associated with an increase in the target
bonus tied to I P E as a percentage of salary of 5.4 percent. The time horizon
coefficient in Model 4 indicates that a shift from an industry whose product life
cycle is classified as short to an industry classified as long is associated with an
increase in the target bonus tied to IPE as a percentage of salary of 8.2 percent.
The coefficients on the measures of noise in accounting returns and stock
returns are insignificant in Models 2 and 3. However, in Model 4 the coefficient
on the variance of stock returns is positive and significant at the 0.10 level.
Finally, as for IP/Bonus, IP/Salary increases significantly with firm size and
C E O tenure, and decreases with membership in the electric utility industry.
Overall the results in Tables 5 and 6 are consistent with the prediction that the
use of IPE in determining CEOs' annual bonuses increases with the growth
opportunities and with the product development and product life cycles of the
firm. The results fail to provide consistent support for the prediction that the use
of IPE increases with the noise in traditional accounting and stock return
measures. Finally, the results suggest that the use of IPE is lower in the electric
utility industry and higher in large firms with highly seasoned CEOs.

4.2. L o n g - t e r m c o m p e n s a t i o n a n d I P E

To provide evidence on the extent to which the value of annualized grants of

long-term incentive plans relative to salary (Long-Term/Salary) is associated
with the same factors as IPE, Table 7 presents OLS regression results for models
analogous to Models 2, 3, and 4 of Tables 5 and 6. We analyze Long-
Term/Salary in natural log form due to its highly positively skewed distribution.
To take logs we must delete 23 sample firms which report no long-term incentive
plans. 19
Collectively the regression results in Table 7 indicate that Long-Term/Salary
is positively and significantly related to the market-to-book value of equity and
product life cycle. These results suggest that both Long-Term/Salary and IPE
increase with corporate growth opportunities and the length of the time horizon
for product life cycles. The coefficient on the product life cycle in Table 7 is more
than twice as large as that on the product development cycle. The relative
magnitude of these coefficients may be due to the more proprietary nature of

~gWe also ran the models in Table 7 including the 23 sample firms with no long-term plans by
adding 1.0 before taking logs. The results are qualitatively similar to those in Table 7 and are not
reported.
184 R.M. Bushman et al. / Journal ~?/'Accounting and Economics 21 (1996) 161 193

Table 7
Estimated OLS regression models of the natural logarithm of Long-Term/Salary
338 aggregated firm observations frona the sample of 396 firms report nonzero values for Long-
Term/Salary and have sufficient information to compute Corr and Variance. An aggregated
observation is formed by measuring observations at the firm-year level and averaging observations
for the same firm across years (from 1990 to 1995). Sales are CPI-adjusted to 1989 equivalent dollars.

Regression coefficients (t-statistics)

Predicted
Explanatory variable sign Model 1 Model 2 Model 3

Intercept 2.39 2.10 2.34

(5.77} (4.53) (4.91)
Mtb 0.10"** 0.09*** 0.08***
+ (3.304) (3.02) (2.66)
Corr -- 0.02 0.05 0.02
(0.134) (0.255) (0.083)
Variance 0.003 0.003 0.07
(0.034) ( 0.03) (0.668)
Devcycle O.10
+ (0.94)
Lifecycle 0.27"*
+ (2.166)
Size 0.28*** 0.30*** 0.30***
? (7.65J (6.79) (6.98)
Ceoten -- 0.02** -- 0.01 -- 0.01
? ( -- 2.21) ( -- 1.40) ( 1.60)
Utility -- 0.88***
? ( - 4.40)
No. of observationsa 338 217 217
Probability > F 0.0001 0.0001 0.0001
Adjusted R 2 27.43% 24.72% 26.05%

Long-Term~Salary = (annualized value of long-term compensation x 100)/base salary. Mtb = ratio

of market value of common stock to book value of equity based on an average of the three
consecutive years preceding the year for which the weight placed on a CEO's individual performance
is reported. Corr = time series correlation between annual accounting returns (income before
extraordinary items over average common equity) and annual stock returns estimated over a max-
imum of 10 years (with a minimum of 6 years) preceding the year for which the weight placed on
a CEO's individual performance is reported. Variance' = natural log of the variance of monthly
stock returns estimated over a maximum of 60 months (with a minimum of 36 months) preceding the
year for which the weight placed on a CEO's individual performance is reported. Devcycle - 1 if
a firm is classified as having long product development cycle (Table 3), otherwise it equals zero.
Lifecycle = 1 ira firm is classified as having long product life cycle (Table 3), otherwise it equals zero.
Size = natural log of sales revenue for the fiscal year preceding the year for which the weight placed
on a CEO's individual performance is reported. Ceoten := number of years the CEO has been in that
position as of the year of the compensation survey. Utility = 1 if a firm is an electric utility (SIC
codes 4911 and 4931), otherwise it equals zero.
Asterisks denote p-values < 0.10 (*), < 0.05 (**), and < 0.01 (***); two-tailed test.
aFor Models 2 and 3, 33 of the 254 firms that are classified by time horizon in Table 3 have
insufficient data for calculating the variables Corr and Varianee, and 4 firms report no long-term
compensation.
 R.M. Bushman et al. /Journal of Accounting and Economics 21 (1996) 161 193 185

information about managers' product development activities than about pro-

duct life cycles, reducing the extent to which stock price is sensitive to current
product development activities. The coefficients on both Corr and Variance are
not significantly different from zero. Finally the results in Table 7 indicate that
long-term incentives increase with the size of the firm, decrease with the tenure
of the CEO, and are lower for electric utilities.
A comparison of the results for IP/Salary in Table 6 and the results for
Long-Term/Salary in Table 7 reveals that both IP/Salary and Long-
Term/Salary increase with proxies for corporate growth opportunities and for
the product development and life cycles which are predicted to reduce the
sufficiency of accounting returns as a measure of CEO performance. Table
8 tests the relation between IP/Long-Term and variables considered in prior
models to provide evidence on the complementary relationship of IPE and
long-term compensation in situations with high growth opportunities and
significant time horizon problems.
Collectively the results in Table 8 suggest that IP/Long-Term increases
significantly with the product development cycle, but not with the product life
cycle or the market-to-book ratio. These results, taken together with the results
in Tables 5 through 7, are consistent with the interpretation that the role of both
IPE and long-term incentive plans increases with the value of a firm's growth
opportunities relative to assets in place and with the length of the firm's product
life cycle. However, IPE takes on a relatively more important role in firms with
long product development cycles, perhaps due to the ability of IPE to incorpor-
ate the Board's proprietary information about the CEO's current product
development activities not fully reflected in the stock price upon which long-
term plans primarily are based. These results are consistent with our interpreta-
tion that IPE may be a valuable alternative to price-based performance
measures in settings where prices do not reflect (or inefficiently reflect) the
consequences of certain valuable managerial activities.
To check the robustness of the results in Table 8 to the exclusion of firms with
zero values for Long-Term/Salary we include firms with zero Long-Term/Salary
using two alternative treatments. First, for observations with IP/Salary > 0 and
Long-Term/Salary = 0, we set values of IP/Long-Term that are greater than
150 percent equal to150 percent, which represents the fourth largest sample
value for IP/Long-Term. Second, we run OLS regressions on ranks of the data,
assigning the observations with IP/Salary > 0 and Long-Term/Salary = 0 the
highest values for IP/Long-Term. The results associated with both treatments of
zero values for Long-Term/Salary are consistent with those reported in Table 8.
Table 9 presents results of Tobit regressions for IP/Bonus, IP/Salary, and
IP/Long-Term to provide evidence on the robustness of the results with respect
to violations of the OLS normality assumptions due to censored dependent
variables and the preponderance of zero values. One model only is reported for
IP/Bonus, IP/Salary, and IP/Long-Term for parsimony. The Tobit results for
186 R.M. Bushman et al. / Journal o[ Accounting and Economics 21 (1996) 161 193

Table 8
Estimated OLS regression models of CEO target bonus based on individual performance as
a percentage of the annualized value of long-term compensation (IP/Long-Term)
296 aggregated firm observations from our sample of 396 firms have target bonus information,
positive values of long-term compensation, and have sufficient information to compute Corr and
Variance. An aggregated observation is formed by measuring observations at the firm-year level and
averaging observations for the same firm across years (from 1990 to 19951. Sales are CPI-adjusted to
1989 equivalent dollars.

Regression coefficients (t-statistics)

Predicted
Explanatory variable sign Model l Model 2 Model 3
Intercept 6.45 17.63 21.33
(0.29) (0.75) (0.88)
Mtb 0.12 1.13 0.32
9 (0.07) (0.66) (0.191
CoFF 12.43 7.18 6.35
9 ( 1.471 (0.72) (0.63)
Variance -- 2.17 4.36 4.47
+ - 0.46) (0.86) (0.83)
Devcycle I 1.41"*
q
(2.09)
Lifecycle 9.11
9 (1.461
Size 1.88 0.88 0.97
? 0.94) ( 0.39) ( 0.42)
Ceoten 1.59"** 2.46*** 2.38***
? (3.4(/) (4.74) (4.52)
Utility - 12.99
? ( - - 1.25)
No. of observations" 296 186 186
Probability > F 0.0(162 0.0001 0.0002
Adjusted R z 4.05% 11.65% 10.57%

l P / L o n g - T e r m - target bonus dollars based on individual performance as a percentage of the

annualized value of long-term compensation. M t b = ratio of market value of common stock to book
value of equity based on an average of the three consecutive years preceding the year for which the
weight placed on a CEO's individual performance is reported. Corr - time series correlation between
annual accounting returns (income before extraordinary items over average common equity) and
annual stock returns estimated over a maximum of 10 years (with a minimum of 6 years) preceding the
year for which the weight placed on a CEO's individual performance is reported. Variance = natural
log of the variance of monthly stock returns estimated over a maximum of 60 months (with
a minimum of 36 months) preceding the year for which the weight placed on a CEO's individual
performance is reported. Devcycle - 1 if a firm is classified as having long product development
cycle (Table 3), otherwise it equals zero. L(lbcycle - 1 ifa firm is classified as having long product life
cycle (Table 3), otherwise it equals zero. Size - natural log of sales revenue for the fiscal year
preceding the year for which the weight placed on a CEO's individual performance is reported.
Ceoten = number of years the CEO has been in that position as of the year of the compensation
survey. Utility = 1 ifa firm is an electric utility (SIC codes 4911 and 49311, otherwise it equals zero.
Asterisks denote p-values < 0.10 (*), < 0.05 (**), and < 0.01 (***); two-tailed test.
"For Models 2 and 3, 68 of the 254 lirms that are classified by time horizon in Table 3 have
insufficient data for calculating IP/Long-Term and the variables Corr and Variance.
 R.M. Bushman et al. /Journal o f Accounting and Economics 21 (1996) 161 193 187

Table 9
Estimated Tobit (normal) regression models of the percentage of CEO annual bonus based on
individual performance (IP/Bonus), CEO target bonus based on individual performance as a per-
centage of base salary (IP/Salary), and CEO target bonus based on individual performance as
a percentage of the annualized value of long-term compensation (IP/Long-Term)

Dependent variable a

IP/Bonus 1P/Salary P/Long-Term

Coefficient Coefficient Coefficient

Explanatory variable (Z z statistic) ()~2 statistic) (7.2 statistic)

Intercept -- 69.20 -- 41.94 42.86

(4.08) (4.19) (0.90)
Mtb 6.33*** 2.42* 2.53
(8.49) (2.85) (0.63)
Corr - 6.35 -- 0.77 1.98
(o.2o) (O.Ol) (O.Ol)
Variance 2.15 4.16 8.54
(0.09) (0.95) (0.81)
Devcycle 23.49* * * 14.45 * ** 31.74 ** *
(8.62) (9.23) (9.08)
Size 5.01 4.95*** 2.61
(2.53) (6.52) (0.37)
Ceoten 1.14" 1.14"** 3.88***
(3.68) (7.44) (17.99)
Left censored values 120 103 101
Right censored values 8 0 0
Noncensored values 93 86 85
No. of observations 221 189 186

IP/Bonus = percentage of CEOs' annual bonus based on individual (i.e., noncorporate) performance.
IP/Salary = IP/Bonus multiplied by target bonus dollars expressed as a percentage of base salary;
49 firms in our sample of 396 firms do report target bonus information. IP/Lony-Term = target
bonus dollars based on individual performance as a percentage of the annualized value of long-term
compensation. Mtb = ratio of market value of common stock to book value of equity based on an
average of the three consecutive years preceding the year for which the weight placed on a CEO's
individual performance is reported. C o r r = time series correlation between annual accounting
returns (income before extraordinary items over average common equity) and annual stock returns
estimated over a maximum of 10 years (with a minimum of 6 years) preceding the year for which the
weight placed on a CEO's individual performance is reported. Variance = natural log of the
variance of monthly stock returns estimated over a maximum of 60 months (with a minimum of 36
months) preceding the year for which the weight placed on a CEO's individual performance is
reported. Devcycle = 1 if a firm is classified as having long product development cycle (Table 3),
otherwise it equals zero. Size = natural log of sales revenue for the fiscal year preceding the year for
which the weight placed on a CEO's individual performance is reported. Ceoten = number of years
the CEO has been in that position as of the year of the compensation survey.
Asterisks denote p-values < 0.10 (*), < 0.05 (**), and < 0.01 (***); two-tailed test.
aThe estimated models correspond to Model 3 in Tables 5 and 6 and Model 2 in Table 8.
188 R.M. Bushman et a L / Journal (?/ Accounting and Economics 21 H996) 161 193

the models in Table 9 as well as the Tobit results for the nonreported models are
qualitatively similar to the OLS results.
As an additional check on the robustness of our results, we estimated OLS
regression models with the natural log of the market-to-book ratio due to its
positively skewed distribution, and winsorized the market-to-book ratio at the
mean plus three and four standard deviations. In addition, we used alternative
proxies for the noise of accounting and stock returns, including the variance of
annual accounting and stock returns, and both the beta of the c o m m o n stock
and the natural log of the variance of the market model residuals each estimated
over a m a x i m u m of 60 months (with a minimum of 36 months) preceding the
year for which IP/Bonus is reported. The results in all cases are qualitatively
similar to those reported.
Finally we examine the possibility that zero values of IP/Bonus (and
IP/Salary) proxy for poorly performing firms, with low market-to-book ratios,
forgoing bonus payments. If poorly performing firms report IP/Bonus equals
zero when they fail to achieve certain financial targets required for bonus
payments, then the observed positive association between IP/Bonus (and
IP/Salary) and market-to-book ratios is potentially spurious. To address this
concern, we compare the IP/Bonus of sample firms that actually paid a bonus to
the C E O for 1992 performance with the IP/Bonus of sample firms that did not
pay a bonus. If the results are due simply to a tendency to report IP/Bonus = 0
when financial targets are not met, we would expect a lower frequency of
positive weights (IP/Bonus > 0) in the subsample of firms which did not pay
a bonus to the CEO. However, the percentage of each subsample which reported
IP/Bonus > 0 is approximately the same, 35 percent of firms with no bonus
payments and 38 percent of firms with a bonus payment. In addition, we
examine the stability of IP/Bonus over time for individual firms. If the reported
IP/Bonus numbers are sensitive to actual financial results from year to year, we
would expect to observe changes in IP/Bonus from one year to the next.
However, we find that changes in IP/Bonus are uncommon. Of the 1,016 annual
firm-years we examine prior to 1994, there is no change in IP/Bonus in 926 cases
(91.1 percent).

5. Discussion and summary

Most prior research that examines the structure of executives' financial

incentives attempts to infer their structure fi'om the empirical relation between
pay and traditional measures of corporate performance. These studies generally
suggest a positive association between traditional measures of corporate perfor-
mance (e.g., ROA, ROE, net income, stock returns) and C E O pay. In this
literature, the feasible set of performance variables investigated is generally
limited to publicly available measures of performance. However, a potentially
 R,M. Bushman et al. / Journal ~?fAccounting and Economics 21 (1996) 161 193 189

important function of the compensation committee of the Board of Directors is

to expand the set of feasible criteria for determining CEOs' bonuses beyond
traditional corporate performance variables observed by investors and re-
searchers. The proprietary survey data collected by Hewitt Associates, LLC
allows us to examine the structure of executives' financial incentives using
relatively precise estimates of a range of performance measures used in deter-
mining a CEO's bonus opportunities. We think an important advantage ex-
ploited in this study is the ability to examine the role of individual performance
evaluation in determining CEOs' bonuses.
Our evidence suggests that the weight placed on CEOs' individual perfor-
mance varies considerably across firms, ranging from 0 to 100 percent. Approx-
imately two-thirds of the sample firms report no weight on the CEO's individual
performance. In these cases, bonuses from annual incentive plans are deter-
mined almost entirely on the basis of corporate performance measures. In
contrast, the remaining one-third of the sample firms do explicitly weigh the
individual performance of the CEO in determining bonuses from annual incen-
tive plans, in amounts averaging 36 percent and ranging up to 100 percent.
These results suggest that prior empirical compensation studies, based exclus-
ively on traditional measures of corporate performance, fail to capture impor-
tant performance measures for some firms.
Our examination of the cross-sectional determinants of individual perfor-
mance evaluation shows that its importance increases with length of product
development and product life cycle, market-to-book value of equity, CEO
tenure, and firm size, and is lower for utilities. We conjecture that these
differences are related to cross-sectional differences in types of managerial
activities and decisions that create firm value. The positive relation between IPE
and growth opportunities and product development and product life cycles
suggest that corporate performance measures alone are inadequate indicators of
CEO performance for some firms.

Appendix: Excerpts from compensation committee reports

A. 1. Examples of firms using financial criteria only

Firm in retail industry

For executive officers, the bonus awards are based exclusively upon the
Company's achievement of its financial goals for the fiscal year measured by
pre-tax earnings.

Firm in the tire and rubber industry

Compensation paid under the Performance Plan for 1992 was, as in prior
years, based on the EBIT and cash flow performance of the operating units to
190 R.M. Bushman et al. / Journal of Accounting and E~onomkw 21 (1996) 161 193

which the officer is assigned or, as in the case of certain officers of the Company
(including the CEO), on the performance of the entire Company, ranging from
0 to 150 percent of the target amounts depending on the extent to which
applicable EBIT and cash flow goals were achieved.

Firm in the metal fabricating industry

Annual incentive compensation is payable to officers and other key employees
under the Annual Incentive Plan. This Plan, which is administered by the
Compensation Committee, provides for cash awards based on a stipulated
percentage of a participant's salary earnings (not exceeding 100 percent) and the
extent to which corporate and (or) business unit performance standards based
on return on operating assets are achieved for the year.

Firm in the machinery industry

The Committee uses the Management Incentive Compensation Plan (MICP)
to compensate executives based on the Corporation's return on shareholders'
equity. For those executives included in the Table (includes CEO) these awards
are based on the return on shareholders' equity, with the targeted performance
of 16 percent, maximum award when return is 19.5 percent, and with no
incentive payment if the return is less than 9 percent.

A.2. Examples of firms using IPE

Firm in hotel, gaming, recreation, to3,s, school industry

The CEO Incentive Plan, a cash bonus plan, provides a format for the
assignment of specific goals for the Chief Executive Officer designed to create
and enhance shareholder value. The Compensation Committee, in conjunction
with the CEO, develops these goals which include various strategic initiatives to
be achieved at specified times and reflect the vision of the Chief Executive Officer
as reviewed and approved by the full Board of Directors. The goals include the
continuing identification of growth opportunities for the Company, succession
planning, technological development, improvements in quality, productivity
and serving customers, expansion of the global presence of the Company's
product lines, the strengthening of the Company's balance sheet through right-
sizing and investment as appropriate, and the divestiture of those businesses
which do not fit the company's overall strategy. The goals are designed to
provide for the future health and well-being of the Company.

Firm in Jood industry

Bonus awards for the CEO and other executive officers are based 50 percent
on personal performance and 50 percent on the Company's overall performance
against profit targets approved by the Board of Directors. Personal ratings can
 R.M. Bushman et al. / Journal o f Accounting and Economics 21 (1996) 161 193 191

include such factors as quality of strategic plans, organizational and manage-

ment development, and special project or idea leadership.

Firm in aerospace industry

At the beginning of each year performance goals for purposes of determining
annual incentive compensation are established for each business ... specific
weighting is assigned for identified financial, strategic, and management practice
goals. Financial goals include sales growth, operating earnings, return on assets,
and cash flow; while strategic goals focus on such factors as new product
development, new business initiatives, and increasing market shares. Manage-
ment practices goals include productivity and quality improvement, workplace
diversity, management development, and environmental management. At the
end of each year, performance against these goals is determined on an arithmetic
scale with the preestablished weighting.
In evaluating the performance and setting the incentive compensation of the
Chief Executive Officer and the Corporation's other senior management, the
Committee has taken particular note of management's success in restructuring
the Corporation's businesses ..., increasing or maintaining market shares ....
and management's consistent commitment to the long-term success of the
Corporation through development of new or improved products as evidenced
by the Corporation's expenditure over the last five years of $8.2 billion, includ-
ing $2.4 billion that was company-initiated, for research and development. In
doing so, the Committee has recognized that while the company-initiated
expenditures reduce current reported earnings, they provide the basis for help-
ing to achieve management's objective of sustained significant long-term earn-
ings growth.

Firm in petroleum industry

Annual incentive awards are determined in the following manner under the
Executive Incentive Plan. A guideline incentive award is established for each
participant. The guideline incentive award, a percentage of base salary which is
dependent on the participant's job level, is divided into two parts. One part is
adjusted for the company's financial performance and the other part is adjusted
for the executive's individual performance. A larger percentage of the guideline
award is subject to a company performance factor at the level of the named
executive officers. Hence, 70 percent of the named executive officer's guideline
incentive award is based upon Company performance and 30 percent of the
guideline incentive award is based upon individual performance. These compo-
nents are assessed separately and then combined to arrive at an incentive award.
For purposes of the Company performance portion of the incentive award,
the Committee determines annual performance targets for the Company, based
on one or more factors. At the end of the year, the Committee determines the
192 R.M. Bushman et al. / Journal q/Accounting and Economics 21 (1996) 161 193

extent to which the performance targets have been met and the appropriate
factor, ranging from 0 to 200 percent, to apply to this part of the guideline
incentive award. For 1992, the Company's financial performance target was
based upon a single factor: the achievement of a predetermined level of after-tax
income before special items.
Annual incentive awards are also influenced by the executive's individual
performance. Qualitative factors associated with strategic planning, achieve-
ment of operational goals, organizational and management development, and
constituency relations are included in an assessment to arrive at the individual
performance portion of the incentive award. Personal assessment ratings can
range from 0 to 150 percent.

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