Incentive System Design When Earnings Congruence is Low

Recent studies have shown that the congruence (i.e. value relevance) of accounting earnings-based measures of performance (e.g., earnings, residual income) has been declining significantly over an extended period of time. We confirm this prior finding, and examine the implications of poor earnings congruence on the design of short-term management incentive plans and the future performance effects of those design choices. We find that when earnings congruence is low, firms tend to (1) substitute cash flow from operations (CFO) for earnings as the primary performance measure if it is more congruent, (2) add more measures, most of which are nonfinancial in nature, to the incentive plan to compensate for the poor earnings congruence, and/or (3) allow subjectivity in the performance evaluations linked to the incentive awards. These alternatives can be used individually or in combination. However, we find positive future performance effects only when using a more congruent performance measure or allowing evaluation subjectivity, indicating that ex-post subjective adjustment may be a better tool than ex-ante contractual adjustments (i.e. using CFO or adding non-financial measures) to overcome the drawbacks stemming from the low earnings congruence.