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The Degradation of Distorted Performance Measures

Author

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  • Randolph Sloof

    () (University of Amsterdam, and IZA)

  • Mirjam van Praag

    () (University of Amsterdam, IZA, and Max Planck Institute of Economics)

Abstract

Baker (2002) has demonstrated theoretically that the quality of performance measures used in compensation contracts hinges on two characteristics: noise and distortion. These criteria, though, will only be useful in practice as long as the noise and distortion of a performance measure can be measured. Courty and Marschke (2007) have recently developed an elegant empirical test to detect distortion, based on the degradation of a performance measure subsequent to increasing its weight in the remuneration contract. We apply their test to assess the distortion of the often used class of performance measures that are based on ‘Residual Income’ (RI), such as ‘Economic Value Added’ (EVA). Residual income is widely used to measure and reward the performance of management boards. We use a difference-in-difference approach to account for (a) changes in economic circumstances in the period studied and (b) the self-selection of firms into the treatment and the control groups. Our results show that RI has degraded and is, therefore, a distortionary performance measure that can be gamed. Conditionally accepted for publication in the Journal of Law, Economics and Organization .

Suggested Citation

  • Randolph Sloof & Mirjam van Praag, 2008. "The Degradation of Distorted Performance Measures," Tinbergen Institute Discussion Papers 08-072/3, Tinbergen Institute.
  • Handle: RePEc:tin:wpaper:20080072
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    More about this item

    Keywords

    Residual income; EVA; degradation; distortion; performance measurement; management compensation; incentive compensation;

    JEL classification:

    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • G35 - Financial Economics - - Corporate Finance and Governance - - - Payout Policy
    • J33 - Labor and Demographic Economics - - Wages, Compensation, and Labor Costs - - - Compensation Packages; Payment Methods
    • L21 - Industrial Organization - - Firm Objectives, Organization, and Behavior - - - Business Objectives of the Firm
    • M12 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Business Administration - - - Personnel Management; Executives; Executive Compensation
    • M41 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Accounting - - - Accounting
    • M52 - Business Administration and Business Economics; Marketing; Accounting; Personnel Economics - - Personnel Economics - - - Compensation and Compensation Methods and Their Effects

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