Relative Performance Evaluation and Earnings Management†

Abstract

The conventional view suggests that firms should benchmark CEO compensation to absorb systemic risk and to more efficiently incentivize executives to work hard. Yet, empirical research has found only a modest use of benchmarking in compensation contracts. In this paper, I highlight one weakness of relative performance evaluation. When earnings management is possible, benchmarking creates stronger incentives for misreporting performance measures compared to competitor-independent pay. The optimal contract will depend less on a correlated benchmark if it is easier for the manager to misreport performance. This result may explain why benchmarking CEO compensation is not as widespread in the business world as previously predicted.