CSR-sensitive industry sectors and the use of non-financial
performance measures in CEO annual incentive bonus plans
Abstract
This study empirically examines the relationship between CSR-sensitive industry sectors and the use of non-financial performance measures in CEO annual incentive bonus plans. Based on literature, this study predict that firms in the manufacturing industry sector make more use of non-financial performance measures in CEO annual incentive bonus plans than firms operating in the financial services industry sector. Using hand-collected data from 100 proxy statements of US S&P 500 firms in the year 2016, this study find insufficient evidence to support the prediction. The results do suggest, however, that the differences in CSR-sensitivity between industry sectors impact the use of non-financial performance measures in CEO annual incentive bonus plans. This study extend the literature on determinants of the use of non-financial performance measures in CEO annual incentive bonus plans by focusing on CSR-sensitive industry sectors and by documenting the effects on the use of non-financial performance measures in CEO annual incentive bonus plans.
University of Groningen Stephanie Hofstetter
Faculty of Economics and Business S3272494
MSc Accountancy Damstersingel 8B4
9713 EV Groningen Master thesis
Supervised by: Dr. R.C. Trapp 06 – 17 94 19 79
Co-assessor: Dr. V.A. Porumb s.hofstetter@student.rug.nl
June 25, 2018 Word count: 7.578
Table of contents
1. Introduction 2 2. Theory 5 2.1. Literature review 5 2.2. Theoretical background 9 2.3. Hypothesis development 10 3. Research design 12 3.1. Sample 12 3.2. Variable measurement 133.2.1. Use of non-financial performance measures 13
3.2.2. CSR-sensitive industry sectors 14
3.2.3. Control variables 14
3.3. Empirical test of hypothesis 18
4. Results 20
4.1. Descriptive statistics 20
4.2. Correlation matrix 21
4.3. Regression analysis 22
5. Discussion and conclusion 24
5.1. Research objective, theoretical expectations and empirical approach 24 5.2. Interpretation and implication of findings 25
5.3. Limitations and recommendations 27
1. Introduction
Corporate Social Responsibility (CSR) reporting has become the standard practice for all midcap and large firms worldwide. 78 percent of the firms participating publish this type of information, suggesting the relevance of CSR reporting for both share- and stakeholders (KPMG, 2017). As a result of this development, the adoption of CSR criteria (e.g. non-financial performance measures) in CSR contracts (e.g. Chief Executive Officer (CEO) annual incentive bonus plans) of firms operating in CSR-sensitive industry sectors is gaining momentum (Flammer et al., 2017; Merchant, 2006; Ittner et al., 1997; Grougiou et al., 2016; Eccles et al., 2014). Despite the increased relevance, research lacks empirical evidence about the relationship between CSR-sensitive industry sectors and the adoption of non-financial performance measures in CEO annual incentive bonus plans.
Firms respond to the increasing importance of including CSR criteria in CEO annual incentive bonus plans by focusing on long-term performance and shareholder value (Flammer et al., 2017). This focus can be achieved by including non-financial performance measures, such as customer satisfaction and product quality, in CEO annual incentive bonus plans, because these measures are characterized by their long-term orientation (Merchant, 2006). Ittner and Larcker (1998) find that yesterday‟s customer satisfaction measures are leading indicators of, for example, future‟s customer purchase behavior. Satisfied customers improve financial performance by enhancing firm reputation and by decreasing marketing costs (Anderson et al., 1994). Therefore, such non-financial performance measures appear to be relevant in driving sustainable shareholder value (Ittner and Larcker, 1998; Amir and Lev, 1996). In sum, CSR pressure will increase the importance of including CSR criteria in CEO annual incentive bonus plans, where CSR criteria are set by including non-financial performance measures in these plans. CSR pressure might be higher in certain industry sectors because of, for example, the higher probability that they are involved in environmental pollution (Grougiou et al., 2016). Therefore, such industries are more CSR-sensitive than others. This implies that, firms operating in CSR-sensitive industry sectors use non-financial performance measures in their CEO annual incentive bonus plans (Eccles et al., 2014).
The purpose of this study is to explore if CSR-sensitive industry sectors affect the use of non-financial performance measures in CEO annual incentive bonus plans. Based on agency theory, this paper examines whether a firm uses non-financial performance measures in their CEO annual incentive bonus plan, in order to provide better information about the congruence between the CEO‟s actions and the outcomes desired by the shareholders (Ittner et al., 2003; Bushman et al., 2006). Based on legitimacy theory, this paper examines whether a firm uses non-financial performance measures in their CEO annual incentive bonus plans in order to provide better information about the CEO‟s actions and the outcomes desired by the society (Flammer et al., 2017; Eccles et al., 2014). Thus, when firms operating in CSR-sensitive industry sectors act in line with the agency theory and legitimacy theory, they include non-financial performance measures in their annual incentive bonus plans.
Previous studies about the determinants of the use of non-financial performance measures in CEO annual incentive bonus plans do not distinguish between industry-level determinants (e.g. CSR-sensitivity) that arise from differences in industry sectors (Chen et al., 2015; Matějka et al., 2009). Moreover, prior research about the industry effects on compensation practices do not look into the performance measures used in compensation plans (e.g. CEO annual incentive bonus plans) that affect the actual pay (Murphy, 1999; Karuna, 2007). This study aims to narrow this gap in the literature by examining the relationship between CSR-sensitive industry sectors and the use of non-financial performance measures in CEO annual incentive bonus plans. Therefore the research question is as follows: do CSR-sensitive industry sectors affect the use of
non-financial performance measures in CEO annual incentive bonus plans?
The research question is empirically tested through ordinal logit regressions based on data collected from proxy statements of 100 United States (US) firms of the Standard & Poor‟s (S&P) 500 index. Evidence suggest that CSR-sensitive industry sectors are an important determinant to predict the propensity of using non-financial performance measures in CEO annual incentive bonus plans. However, the results show that there is no significant support for the direct relation between the use of non-financial performance measures in CEO annual incentive bonus plans and CSR-sensitive industry sectors. Therefore, the findings are partially consistent based on prior literature and theory.
This study extends prior literature about CSR contracting (Flammer et al., 2017) and contributes to previous research on the determinants of the use of non-financial performance measures in CEO annual incentive bonus plans (Ittner et al., 1997, Matějka et al., 2009; Chen et al., 2015) by documenting that CSR-sensitive industry sectors are an important determinant to use non-financial performance measures in CEO annual incentive bonus plans (e.g. CSR contracts). Moreover, this paper contributes by taking a step forward into more uniformity of CEO annual incentive bonus plans used by firms that belong to a CSR-sensitive industry sector (Murphy, 1999; Karuna, 2007).
From a practical point of view, this study will activate organizations to look more critically towards the performance measures they use in their CEO annual incentive bonus plan to ensure the alignment between the interests of the CEO, the shareholders and society. As such, the findings shed light on the creation of more uniformity on the use of non-financial performance measures (e.g. CSR criteria) in CEO annual incentive bonus plan (e.g. CSR contracts) of firms operating in a CSR-sensitive industry sector. Firms can set up a comparative industry benchmark and use industry specific practices while designing a CEO annual incentive bonus plan and monitoring performance, which might in turn reduce agency costs (Chen et al., 2015). Moreover, the findings create awareness for auditors. Because of the subjective character of non-financial performance measures (Murphy, 1999), firms operating in a CSR-sensitive industry sector might carry a higher audit risk as a result of using non-financial performance measures in CEO annual incentive bonus plans.
This paper continues as follows. Section 2 provides the theoretical framework and the hypothesis development. Section 3 describes the research design used to measure the variables and to analyze the data. The results of the analysis are presented in section 4. Finally, in section 5, the results are discussed and implications and limitations are given.
2. Theory
Section 2 deals with a review of the literature and the hypothesis development. First, some background information and a review of the literature which leads to a research gap and the contribution are provided (2.1). Second, the theoretical background is explained (2.2). Third, the development of the hypothesis is given (2.3).
2.1. Literature review
Performance measurement
From an agency perspective, a CEO annual incentive bonus plan can provide an incentive for the CEO to act in the best interest of the shareholders (Gregoriou and Rouah, 2002; An et al., 2011), because a CEO annual incentive bonus plan is used to measure and reward CEOs‟ performance (Gregoriou and Rouah, 2002; Merchant, 2006). A CEO annual incentive bonus plan is a representation of a contract between the CEO and the shareholders and includes the bonus agreements of the CEO based on several performance measures. Performance measures used in CEO annual incentive bonus plans are closely linked to the strategy of the organization to ensure that managers‟ incentives are aligned with organizational goals (Ittner et al., 1997; Banker et al., 2004). Performance measurement involves a comparison of results against expectations and benchmarks to assess how well an organization is performing in order to find room for improvement and learning to do better (Rouse and Putterill, 2003).
A performance measurement system (PMS) should be designed in line with the organization‟s strategy and consist of a selection of indicators (e.g. performance measures) that drive organizational performance (Kaplan and Norton, 1996; Banker et al., 2004). Among the most widely cited PMSs are: the SMART (Lynch and Cross, 1991), the Balanced Scorecard (Kaplan and Norton, 1996) and other related ideas such as the „value chain scoreboard‟ (Lev, 2001). Firms whose PMS is inconsistent with the characteristics of the firm have a lower performance compared to firms whose PMS is consistent with the characteristics of the firm (Matolcsy and Wright, 2011). Therefore, a PMS and subsequent performance measures are firm specific. In case of the CEO, these firm specific performance measures are included in a CEO annual incentive bonus plan.
Performance measures used in CEO annual incentive bonus plans
A CEO annual incentive bonus plan can contain financial and/or non-financial performance measures. Financial performance measures, or accounting-based measures, are generally short-term oriented and can be absolute measures like net income and operating profit, or they can be ratio measures like return on investment and earnings per share (Merchant, 2006; Ittner et al., 1997). Non-financial performance measures are based on other than financial drivers of performance and are future-oriented like customer satisfaction, safety and product quality (Merchant, 2006; Ittner et al., 1997).
Academics wrote a lot about the shortcomings of financial performance measures. Merchant (2006), for example, states that financial performance measures do not reflect firm value and value changes perfectly for several important reasons. First, performance evaluations based on financial performance measures are reliable, comparable and well accepted, but they are also backward looking. This means that there is no guarantee that past performance is a reliable indicator of future performance. Second, financial performance measures are transaction based: value created by receiving a patent won‟t lead to a transaction, so it does not affect financial performance (Merchant, 2006). Third, multiple measurement methods are available for identical events which affect profit (Merchant, 2006). In addition, Bourne et al. (2002) argue that financial performance measures ignore performance drivers (e.g. factors critical to business success) as knowledge, reputation, brands and relationships by focusing too much on the internal organization. Ignoring firm performance drivers that create value and reflect value changes may not be beneficial for shareholder value.
There is evidence that non-financial performance measures can be used to mitigate the shortcomings of financial performance measures. Ittner and Larcker (1998), for example, find that yesterday's customer satisfaction measures are leading indicators for future‟s customer purchase behavior (e.g. retention, revenue and growth), growth in the number of customers and accounting performance (e.g. business-unit revenues, profit margins and return on sales). Based on the marketing literature, satisfied customers improve financial performance by increasing loyalty of existing customers, enhancing firm reputation and decreasing marketing costs (Anderson et al., 1994). Merchant (2006) concludes that a combination of financial and
non-financial performance measures in CEO annual incentive bonus plans can be used to ensure that managers do not maximize short-term value at the expense of future financial performance by, for example, decrease R&D expenses to reach earnings targets (earnings management). Therefore, non-financial performance measures appear to be value relevant by driving sustainable shareholder value (Ittner and Larcker, 1998; Amir and Lev, 1996).
Performance measures and CSR-sensitive industry sectors
According to Flammer et al. (2017), a recent development is the integration of CSR criteria in executive compensation, such as CEO annual incentive bonus plans. This development is known in the academic literature as „CSR contracting‟ (Flammer et al., 2017), and is often employed by companies in addition to CSR reporting, in order to ensure CEO alignment of interest on environmental and social performance. Firms use CSR reporting to influence the public policy process and to show their commitment to society (Dhaliwal et al., 2011). In relation to performance measurement, the adoption of CSR criteria in CSR contracts leads to an increase in long-term orientation and shareholder value (Flammer et al., 2017). This is generally associated with the characteristics of non-financial performance measures (Merchant, 2006; Ittner et al., 1997). Consequently, it is likely to expect that including CSR criteria in CSR contracting will impact the use of non-financial performance measures in CEO annual incentive bonus plans.
There is evidence that certain industries are impacted more by CSR related issues because of the higher probability that they are involved in environmental pollution, or simply because of media attention for or legislative pressure on those industries (Grougiou et al., 2016). Firearm manufacturers, for example, are increasingly considered as the facilitators of tragedies relating to small firearms misuse and, therefore, remain under the social microscope of value judgments constantly (Vergne, 2012). Therefore, such industries are more CSR-sensitive than others.
Following legitimacy theory, firms must react not only to the formal legal environment, but also to society when issues such as gender-equality, environmental impact etc. emerge (Patten, 1992). Firms operating in CSR-sensitive industry sectors are more likely to deal with interest groups that start to doubt whether the activities of the company still fit within what society considers legitimate. To remove this image, firms operating in a CSR-sensitive industry sector can provide
greater transparency by providing CSR reports (Deegan, 2002; Dhaliwal et al., 2011) and can link the CEO remuneration to CSR criteria to ensure that the CEO really pays attention to (environmental) matters that society is calling into question. As a consequence, CSR-sensitive industry sectors use CSR contracting to reward their CEO in order to make sure that the interests of the CEO are aligned with environmental and social performance (Flammer et al., 2017). Given that CSR contracting is associated with the use of non-financial performance measures in CEO annual incentive bonus plans (Flammer et al., 2017), one can imply that CSR-sensitive industry sectors might rely more heavily on non-financial performance measures in CEO annual incentive bonus plans (Eccles et al., 2014).
Research gap
Prior studies on CEO compensation are mainly focused on the influence of firm-level characteristics (Matolcsy and Wright, 2011; Flammer et al., 2017). Although, Murphy (1999) documents variations in CEO compensation level and composition of pay across four industry groups: mining and manufacturing, financial services, utilities and other industries. Furthermore, Karuna (2007) suggests that industry effects may even dominate firm effects in influencing compensation practices. Murphy (1999) and Karuna (2007), however, do not look into the performance measures used in compensation plans that affect the actual pay. Research focused on the use of non-financial performance measures in CEO annual incentive bonus plans found an association between competition and the use of non-financial performance measures in CEO annual incentive bonus plans (Chen et al., 2015). However, they do not distinguish competitive differences that arise from differences in industry sectors. In addition, Matějka et al. (2009), find that emphasis on non-financial performance measures is greater in loss-making than in profitable firms. However, they do not focus on industry-level determinants that may affect the use of non-financial performance measures in CEO annual incentive bonus plans.
Today, the social and societal pressure to provide non-financial statements in addition to financial statements is more intense than ever (KPMG, 2017). As mentioned earlier, firms operating in CSR-sensitive industry sectors feel this social and societal pressure and therefore, have a greater tendency than CSR-non-sensitive industry sectors to present non-financial statements (e.g. CSR reports) as well as financial statements (Grougiou et al., 2016).
Consequently, these CSR reports required in CSR-sensitive industries are an important reason of the increasing relevance of non-financial performance (Flammer et al., 2017; Merchant, 2006; Ittner et al., 1997). Therefore, measuring and rewarding a CEO using non-financial performance measures in CEO annual incentive bonus plans is important to contribute to the norms set by society and the expectations of society regarding non-financial performance (Flammer et al., 2017; Eccles et al., 2014). Today, however, there is no empirical evidence that CSR-sensitive industry sectors determine the use of non-financial performance measures in CEO annual incentive bonus plans. This study aims to narrow the gap in prior literature by examining the relation between the use of non-financial performance measures in CEO annual incentive bonus plans and CSR-sensitive industry sectors while controlling for firm-level determinants.
2.2. Theoretical background
While measuring and rewarding CEO‟s using a CEO annual incentive bonus plans, two fundamental concepts of agency theory arise. First, agency problems by misalignment of
interests may occur when one person or entity, „the agent‟, is able to make decisions and/or take
actions on behalf of another person or entity, „the principal‟ (Eisenhardt, 1989). Shareholders (principals) are interested in shareholder value created and/or influenced by managerial actions (agents), while the CEO and managers (agents) are primarily interested in accomplishment of their performance targets to receive a bonus. If agents do not communicate relevant information to the principal's, a second agency conflict arises where the two parties have asymmetric
information, such that the principal cannot directly ensure that the agent is always acting in the
principal‟s best interest (Bebchuk and Fried, 2005). CEO annual incentive bonus plans are designed with relevant performance measures to mitigate these „principal-agent‟ problems (Gregoriou and Rouah, 2002). Agency research suggest that non-financial performance measures, given that these measures are the predictors of future performance (Merchant, 2006; Ittner et al., 1997), provide better information about the congruence between the agent‟s actions and the outcomes desired by the principal and should, therefore, be included in CEO annual incentive bonus plans (Ittner et al., 2003; Bushman et al., 2006). Therefore, the use of non-financial performance measures in CEO annual incentive bonus plans contributes to solving agency problems between the agent and the principal.
According to An et al. (2011), legitimacy theory deals with the relationship between the firm and society, where firms have to meet social expectations and standards and have to react when issues such as gender-equality, environmental impact etc. emerge (Patten, 1992). The idea of legitimacy is related to the concept of a „social contract‟: when society is not satisfied that a firm is operating in a legitimate manner, then society will revoke the firm‟s „contract‟ to continue its operations (Deegan, 2002). Legitimacy research suggest that firms operating in CSR-sensitive industries are more likely to link the CEO remuneration (e.g. a CEO annual incentive bonus plan) to CSR criteria (e.g. non-financial performance measures) to ensure that the CEO really pays attention to (environmental) matters that society is calling into question. Therefore, the use of non-financial performance measures in CEO annual incentive bonus plans of CSR-sensitive industry sectors contributes to improve the relationship between firms operating in CSR-sensitive industry sectors and the society.
2.3. Hypothesis development
Based on the framework presented by An et al. (2011), the use of non-financial performance measures in CEO annual incentive bonus plans of CSR-sensitive industry sectors, will, based on agency theory, reduce information asymmetry and will, based on legitimacy theory, report the extent to which a firm meets the expectations of the society. Based on the literature review (2.1), one can imply that CSR-sensitive industries make more use of non-financial performance measures in CEO annual incentive bonus plans than CSR-non-sensitive industry sectors to meet the expectations of the shareholders and society.
The expectations of the society might be higher in specific industry sectors. This paper focuses on the manufacturing industry sector and the financial services industry sector because of their opposite characteristics. In order to effectively monitor (firm) performance, manufacturing firms need more performance measures because the normal operations of manufacturing firms are more complex than any other type of industry sector (Zabri et al., 2016). Furthermore, quality delivered by manufacturing firms is measured by the tangible output (the product) of their operations, while the quality delivered by financial services firms is measured by the intangible output (the service) of their operations (Flynn et al., 1994). As a result, the output measures for
manufacturing firms are much more precise, specific and directly related to the input in contrast to financial services firms (Flynn et al., 1994).
Manufacturing firms receive way more pressure from society than financial services firms because they make use of (limited) natural resources and have a larger direct impact on the environment through, for example, CO2 emissions, pollution, waste management and water use (Windahl et al., 2004; Williamson et al., 2006). Therefore, the manufacturing industry sector is expected to be more CSR-sensitive than the financial services industry sector. As a consequence, the manufacturing industry sector is expected to make more use of non-financial performance measures in CEO annual incentive bonus plans compared to the financial services industry sector. Therefore, the following hypothesis is presented:
Hypothesis: The propensity to use non-financial performance measures in CEO annual incentive bonus plans is higher in the manufacturing industry sector than in the financial services industry sector.
3. Research design
Section 3 consists of the research design that is used to test the hypothesis. First, the sample is explained (3.1). Next, the variable measurement (3.2) of the dependent variable (3.2.1), independent variable (3.2.2) and control variables (3.2.3) is given. Lastly, the empirical test of hypothesis is provided (3.3).
3.1. Sample
The sample used in this paper to test the hypothesis is based on data from proxy statements of US S&P 500 firms in 2016. Prior research about the determinants of non-financial performance measures, used proxy statements to measure the use of non-financial performance measures in CEO compensation plans such as a CEO annual incentive bonus plan (Ittner et al., 1997; Chen et al., 2015). Since 2006, it is mandatory for US S&P 500 firms to disclose a „Compensation Discussion and Analysis‟ (CD&A) in their proxy statements (Chen et al., 2015). After the disclosure rules, firms improved their disclosure regarding CEO annual incentive bonus plans (De Angelis and Grinstein, 2011). Thus, there is the ability to collect detailed data on the use of non-financial performance measures in CEO annual incentive bonus plans for a large sample of US S&P 500 firms and that is why this study uses data from proxy statements of US S&P 500 firms. As a consequence of the improved disclosure in the years after making the disclosure of the CD&A mandatory, one can expect that the disclosure of information about the use of non-financial performance measures in CEO annual incentive bonus plans in 2016 is of good quality. The focus on 2016 aims to make the outcome more relevant and is best suited to measure the current impact of CSR on industry sectors and the related consequences for the use of non-financial performance measures in CEO annual incentive bonus plans.
Table 1 presents the sample distribution of the manufacturing and financial services industry sectors. Industry categorization of the US S&P 500 firms was made according to the US classification codes (SIC). As shown in table 1, the total sample consists of 279 manufacturing and financial services firms. For this study, a sample of 100 firms is randomly selected, consisting of proportionally 67 manufacturing and 33 financial services firms. However, the extent to which firms disclosed the information regarding their CEO annual incentive bonus
plans varies across firms. Some firms did not disclose the performance measures they use in their CEO annual incentive bonus plans; therefore, one cannot say if this particular company uses non-financial performance measures to reward their CEO. Due to a couple of disclosing issues, it was not possible to collect the dependent variable of 15 proxy statements, so the original sample consists of 85 firms. Therefore, 15 extra firms were randomly selected.
Table 1: Sample distribution by industry sector 2016
Industry SIC code
Industry sector Number of companies
2016
Sample
20 - 39 Manufacturing 183 (67%) 67 (67%)
60 - 67 Finance, insurance and real estate
90 (33%) 33 (33%)
Total 279 (100%) 100 (100%)
To control for firm-level determinants, additional strategy and accounting data from Compustat and regulation data from RegData1 is obtained. A wide range of archival data is available in these databases with respect to US S&P 500 firms; therefore the use of the control variables did not lead to a decrease in the total sample.
3.2. Variable measurement
3.2.1. Use of non-financial performance measures
In the CD&A section of each proxy statement the compensation elements paragraph is used. This paragraph often starts with providing a distinction between the different types of compensation, for example, base salary, compensation at risk (annual cash incentive and long-term equity incentive) and benefits (retirement programs etc.). Often this distinction overview refers to the
1
See 2018 RegData US 3.1 Annual.
specific element „CEO annual incentive bonus plan‟. In here the details about the performance measures used in CEO annual incentive bonus plans are given. To measure the use of non-financial performance measures in CEO annual incentive bonus plans, the indicator variable, use
of non-financial performance measures, is created. The indicator variable takes on the value 1 if
a firm uses non-financial performance measures in their CEO annual incentive bonus plan given in the proxy statement (category 1), and 0 otherwise (category 2).
Table 2 reports that 16 manufacturing firms (24%) and 8 financial services firms (24%) belong to category 1; 51 manufacturing firms (76%) and 25 financial services firms (76%) belong to
category 2. Summing the firms in category 1, 24% of the firms used in my sample include
non-financial performance measures in their annual incentive bonus plans. Noticeable is that 24% of firms operating in the manufacturing industry sector, as well as 24% of firms operating in the financial services industry sector, use non-financial performance measures in their CEO annual incentive bonus plans.
3.2.2. CSR-sensitive industry sectors
The unit of analysis in this study is CSR-sensitive industry sectors. This study focuses on two industry sectors namely manufacturing and financial services, where the manufacturing industry sector is expected to be more CSR-sensitive than the financial services industry sector (please refer to section 2.3 for a detailed explanation). An indicator variable, CSR-sensitive industry
sector, is created, which takes on the value 1 in case of the manufacturing industry sector, and 0
in case of the financial services industry sector.
3.2.3. Control variables
This study controls for other firm-specific attributes influencing the use of non-financial performance measures in CEO annual incentive bonus plans in order to isolate the effect of the CSR-sensitive industry sector on the use of non-financial performance measures in CEO annual incentive bonus plans. This study controls for the following five firm-specific attributes namely: differentiation competitive strategy, restrictions by regulation, CEO long-term incentive, earnings per share and leverage.
Table 2: Sample distribution manufacturing and financial services industry sector 2016 Manufacturing 2016 Financial services 2016 Full sample
Category Description Number
of firms Percentage Number of firms Percentage Number of firms Percentage
1 The firms‟ proxy statement of 2016 (CD&A, CEO annual incentive bonus plan) use non-financial performance measures
16 24% 8 24% 24 24%
2 The firms‟ proxy statement of 2016 (CD&A, CEO annual incentive bonus plan) does not use non-financial performance measures
51 76% 25 76% 76 76%
Prior research find that firms with differentiation competitive strategies make more use of leading indicators like non-financial performance measures in their CEO annual incentive bonus plans (Chen et al., 2015; Ittner et al., 1997). Ittner et al. (1997) found that firms following a quality-oriented strategy, and firms facing regulatory and competitive pressure, use non-financial performance measures to improve non-financial dimensions as safety and customer satisfaction. Following Chen et al. (2015) and Ittner et al. (1997), this study considers three firm-level proxies for a firm‟s differentiation competitive strategy: (1) R&D to sales ratio, (2) market-to-book ratio, and (3) the ratio of employees to sales. The higher all of these ratios are, the more the differentiated and competitive the strategy of a firm. First all the ratios were ranked (ascending: the higher the ratio, the higher the ranking) and after that all the 3 ratios are taken together as one and ranked again (descending: the higher the total of the 3 ranks, the lower the final ranking).
Second, as mentioned above, regulated firms may use non-financial performance measures because regulators often link rate increases in regulatory restrictions to the achievement of non-financial goals (Ittner et al., 1997). As a consequence, Ittner et al. (1997) and Chen et al. (2015) find that regulated firms are more likely to incorporate non-financial performance measures in their CEO annual incentive bonus plans. Therefore, one can predict a positive sign on the
regulated industry indicator variable which means that the higher the restrictions because of
regulation, the more a firm will make use of non-financial performance measures in their CEO annual incentive bonus plans. All the restrictions are ranked (the more regulation, the higher the ranking), so the higher the ranking the more non-financial performance measures used in CEO annual incentive bonus plans is expected.
Third, following Ittner et al. (1997) and Chen et al. (2015) this study controls for other long-term incentives in CEO compensation (stocks and exercisable options) to rule out the possibility that these other long-term incentives are substitute for or complement to non-financial performance measures used in CEO annual incentive bonus plans to motivate CEO‟s to take a long-term perspective. Long-term incentive is calculated by dividing the CEO‟s annual salary and bonus by the CEO‟s equity holdings (stock and exercisable options). The higher the ratio, the less focus on the long-term incentive in case of equity compensation, the more focus CEO annual incentive bonus plans will place on the long-term (e.g. non-financial performance measures).
Lastly, this study controls for earnings per share (EPS) and leverage as proxies for firm performance (Matolcsy and Wright, 2011). Murphy (1999) find that firm performance affect the composition of pay. Based on Merchant (2006) and Ittner and Larcker (1998), high firm performance is caused by the use of non-financial performance measures in CEO annual incentive bonus plans because, as mentioned in section 2, non-financial performance measures are leading indicators of future performance. According to the proxies used for firm performance, high EPS is associated with high firm performance. So the higher EPS is, the more likely it becomes that firms use non-financial performance measures. High leverage might indicate that a firm made investments, financed with debt, with the expectation to increase future firm performance (Campello, 2006). High leverage might also indicate that the interest expenses are high, which may negatively affect the availability of funds for investment and operations which can in turn lead to negative effects on performance (Campello, 2006). Therefore, leverage can impact firm performance in two directions. Table 3 underneath shows an overview of all variables.
Table 3: Variable table
Variable Description Data
source
NFPM The use of non-financial performance measures in CEO annual incentive bonus plans measured by a dummy variable, which takes 1 when using non-financial performance measures and 0 otherwise
Proxy statements
SECTOR Categorization by two industry sectors measured by a dummy variable, which takes 1 in case of manufacturing and 0 in case of financial services
SIC
STRATEGY The extent to which a firm handles a differentiation competitive strategy, measured by the mean of the R&D to sales ratio, the market-to-book ratio, and the ratio of employees to sales
REGULATION The extent to which a firm if affected by regulation, measured by the amount of regulatory restrictions a firm is concerned with
Compustat, RegData
INCENTIVE To capture long-term incentives measured as CEO annual salary and bonus to CEO equity holdings
Compustat
EPS To capture firm performance measured by EPS as earnings before interest and taxes to total shares outstanding
Compustat
LEVERAGE To capture firm performance measured by leverage as total debt to total assets
Compustat
3.3. Empirical test of hypothesis
This study hypothesizes that the propensity that a firm incorporates non-financial performance measures in CEO annual incentives bonus plans is conditional on whether an industry sector is CSR-sensitive. First, to test this hypothesis, an ordinal logit regression analysis between the dependent and the control variables is comprised in order to test the effects of the firm-level determinants on the use of non-financial performance measures in CEO annual incentive bonus plans. After that, all the variables are included in the regression. These two regressions are performed to compare the results of both regressions in order to argue about the relevance of adding the independent variable. Therefore, the following ordinal logit regressions are estimated:
Use of non-financial performance measures = ß0 + ß1Strategy + ß2Regulation + ß3Incentive + ß4EPS
Use of non-financial performance measures = ß0 + ß1Sector + ß2Strategy + ß3Regulation + ß4Incentive + ß5EPS + ß6Leverage + e.
4. Empirical results
This section includes respectively the descriptive statistics (4.1), a correlation matrix (4.2) and the results of the regression models (4.3). The results show the ability of addressing the hypothesis, which stated the positive effect of the use of non-financial performance measures in CEO annual incentive bonus plans on CSR-sensitive industry sectors.
4.1. Descriptive statistics
Table 4 shows the descriptive statistics of all variables used. Corresponding with my sample the N is always 100. The mean of the use of non-financial performance measures (NFPM) is 0,24, which means (as mentioned earlier in table 2) that 24% of the total sample use of non-financial performance measures.
As stated in the research design (3.2.3), the outcomes of the differentiation competitive strategy (STRATEGY) and restrictions by regulation (REGULATION) variable were ranked. A mean of
50,14 and a standard deviation of 29,003 in case of strategy and a mean of 48,87 and a standard
deviation of 28,699 in case of regulation suggests that there is sufficient variation between the level of regulation and the level of differentiation competitive strategy within the 100 observed firms. Therefore, the data is suitable to perform ordinal logit regression analysis.
Table 4: Descriptive statistics
N Minimum Maximum Mean Std. Deviation
SECTOR 100 0 1 ,67 ,473
NFPM 100 0 1 ,24 ,429
STRATEGY 100 1 99 50,14 29,003
REGULATION 100 1 99 48,87 28,699
EPS 100 -2,58 19,29 4,5296 3,63923 LEVERAGE 100 ,36 1,13 ,7468 ,16987 Valid N (listwise) 100 4.2. Correlation matrix
Table 5 shows the correlation of all variables. The matrix reports that STRATEGY has a strong negative significant correlation with SECTOR (ß = -,558 ; p < ,001). This implies that a firm‟s differentiation competitive strategy depends on the industry sector a firm is operating in, which is in line with the findings of Ittner et al. (1997). SECTOR also seems to be negatively and significantly correlated with both INCENTIVE (ß = ,287 ; p < ,001) and LEVERAGE (ß =
-,412 ; p < ,001). This correlation suggest that the need for CEO motivation (INCENTIVE) and
financing (LEVERAGE) depend on the industry sector a firm is operating in, which can be explained by the fact that the manufacturing and financial services industry sector carry different characteristics (Zabri et al., 2016; Flynn et al., 1994). Furthermore, EPS has a negative significant correlation with NFPM (ß = -,204 ; p < ,050), indicating that high EPS may lead to low NFPM. This is inconsistent with the prediction based on Ittner et al. (1997).
VIF scores, which have to be below 10 to run the regression with all variables, were calculated to further assess possible multicollinearity issues. All the VIF scores are below 1,3, which means that multicollinearity is far from being an issue in the ordinal logit regression model. Therefore, the regression analysis can be performed with all variables included.
Table 5: Correlation matrix 1 2 3 4 5 6 7 1 NFPM 1,000 2 SECTOR -,004 1,000 3 STRATEGY ,048 -,558*** 1,000 4 REGULATION -,093 -,058 ,177 1,000 5 INCENTIVE -,025 -,287*** ,177 ,131 1,000 6 EPS -,204** -,028 -,103 ,079 ,163 1,000 7 LEVERAGE -,007 -,412*** ,303*** ,159 ,153 ,014 1,000
* Significant at the 10% level ** Significant at the 5% level *** Significant at the 1% level
4.3. Regression analysis
Before performing the two ordinal logit regression analysis, the Goodness-of-Fit is tested in order to see if these regression analysis are appropriate to perform. The significance levels of both Goodness-of-Fit tests are greater than 0,05, therefore, both regression analysis can be performed. Table 6 shows the multiple regression results of the use of non-financial performance measures in CEO annual incentive bonus plans and CSR-sensitive industry sectors. The table consist of two models, model A and model B. Model A includes the dependent variable NFPM and the control variables. Model B introduces the independent variable SECTOR.
As shown in model B, the regression coefficient for SECTOR indicates that CSR-sensitive industry sectors are not significant and negatively related to the use of non-financial performance measures in CEO annual incentive bonus plans (ß = -,067 ; p > ,100). This finding does not support the hypothesis, which stated that the propensity to use non-financial performance measures in CEO annual incentive bonus plans is higher in the manufacturing sector than in the
financial service sector. Of the control variables, EPS has a significant but negative impact on the use of non-financial performance measures in CEO annual incentive bonus contracts with a regression coefficient of (ß = -,175 ; p < ,050) and (ß = -,174 ; p < ,050) respectively in model A and B. Furthermore, CSR-sensitive industry sectors (SECTOR) seems to be an important variable in the model to predict the propensity of using non-financial performance measures in CEO annual incentive bonus plans (NFPM) based on the significant F-statistic in model B (13,128) and the comparison of the R2 between model A (,006) and B (,382).
Table 6: Regression model - Non-financial performance measures and CSR-sensitive industry sectors
Model A: Ordinal logit regression (dependent variable: NFPM)
Model B: Ordinal logit regression (dependent variable: NFPM)
Variable name Coefficient estimate Std. Error Coefficient estimate Std. Error
Constant ,161 1,162 ,205 1,234 SECTOR -,067 ,642 STRATEGY ,003 ,009 ,003 ,010 REGULATION -,011 ,009 -,011 ,009 INCENTIVE ,433 2,792 ,490 2,848 EPS -,175** ,088 -,174** ,088 LEVERAGE ,003 1,470 ,050 1,532 N 100 100 F-statistics 1,118 13,213*** Adjusted R2 ,006 ,382 * Significant at the 10% level
** Significant at the 5% level *** Significant at the 1% level
5. Discussion and Conclusion
This section summarizes the research objective, the theoretical expectations and empirical approach (5.1). After that, the results are presented and compared to previous findings and implications are discussed (5.2). Finally, the limitations of this research are provided and some directions for future research are given (5.3).
5.1. Research objective, theoretical expectations and empirical approach
As discussed in the introduction, the literature on the relationship between CSR-sensitive industry sectors and the use of non-financial performance measures in CEO annual incentive bonus plans lacks empirical evidence. On one hand, Murphy (1999) and Karuna (2007) found differences in compensation practices among industry sectors, but do not look into the performance measures used in compensation plans (e.g. CEO annual incentive bonus plans) that affect the actual pay. On the other hand, Chen et al. (2015) and Matějka et al. (2009) found firm-level effects on the use of non-financial performance measures in CEO annual incentive bonus plans, but do not distinguish between industry-level effects. This paper has aimed to link CSR-sensitive industry sectors to the use of non-financial performance measures in CEO annual incentive bonus plans. Therefore, the research question was: “Do CSR-sensitive industry sectors
affect the use of non-financial performance measures in CEO annual incentive bonus plans?”
Through the concepts of agency and legitimacy theory, CSR-sensitive industries were argued to make use of non-financial performance measures in CEO annual incentive bonus plans to meet the expectations of the shareholders and society. This paper provides new insights as previous research has mostly been done based on firm-level determinants and CEO pay composition. It was hypothesized that the propensity to use non-financial performance measures in CEO annual incentive bonus plans is higher in the manufacturing sector than in the financial service sector, where the manufacturing industry sector was expected to be more CSR-sensitive than the financial services industry sector. This expectation was based on the legitimacy theory, which deals with the relationship between the firm and society, where firms have to meet social expectations and standards.
The hypothesis is empirically tested through ordinal logit regressions based on a sample of 100 US S&P 500 firms in 2016. For the data, proxy statements, the industry SIC codes and the Compustat database were used. These data sources appeared to be appropriate in defining the variables.
5.2. Interpretation and implication of findings
The results of the analysis do not provide significant support for the hypothesis, which stated that the propensity to use of non-financial performance measures in CEO annual incentive bonus plans is higher in the manufacturing sector than in the financial service sector. Although the relation between the use non-financial performance measures in CEO annual incentive bonus plans and CSR-sensitive industry sectors is not significant, the CSR-sensitivity of industry sectors seems to be an important determinant to predict the propensity of using non-financial performance measures in CEO annual incentive bonus plans. All in all, the answer on the research question is: no, CSR-sensitive industry sectors do not affect the use of non-financial performance measures in CEO annual incentive bonus plans, but CSR-sensitive industry sectors are an important determinant.
There are some potential reasons why there is no significant support for the hypothesis. First, this paper does not focus on the weight placed on non-financial performance measures in CEO annual incentive bonus plans. This study uses a dummy variable which indicated if a firm uses non-financial performance measures or not. One might get more spread results by using the weight placed on non-financial performance measures, which might result in a different output. Second, even if non-financial performance measures are used within an (internal) reporting system (e.g. CEO annual incentive bonus plans), the company might not disclose this information in their proxy statement because it might be interesting for competitors and therefore, it could harm the company‟s competitive position (Bescos et al., 2007). Thus, despite the increasing quality of US S&P 500 firm‟s proxy statements (De Angelis and Grinstein, 2014), there might be uncertainty about the disclosure of performance measures in the observed 100 proxy statements seen from a strategic perspective.
The contribution to the academic literature is threefold. First, this paper extends prior literature about CSR contracting (Flammer et al., 2017) by finding insufficient evidence that firms operating in CSR-sensitive industry sectors impact the use of non-financial performance measures in CEO annual incentive bonus plans to meet CSR criteria. Second, this study contributes to the existing literature on the determinants of the use of non-financial performance measures in CEO annual incentive bonus plans (Ittner et al., 1997, Matějka et al., 2009; Chen et al., 2015). By documenting that CSR-sensitive industries are an important determinant, this study extends prior literature and enhances our understanding of the use of non-financial performance measures in CEO annual incentive bonus plans. Third, this paper contributes by taking a step forward into more uniformity of CEO annual incentive bonus plans used by firms that belong to a CSR-sensitive industry sector (Murphy, 1999; Karuna, 2007).
The findings suggest that CSR-sensitive industry sectors are an important determinant to predict the propensity of using non-financial performance measures in CEO annual incentive bonus plans. Therefore, from a practical point of view, the results encourage firms operating in the same industry sector to create more uniformity regarding the use of non-financial performance measures in CEO annual incentive bonus plans. More uniformity might, in turn, reduce agency costs because firms in the same industry can set up a comparative benchmark and use industry specific best practices while designing a CEO annual incentive bonus plan and monitoring performance (Chen et al., 2015). In addition, this study will activate organizations to look more critically towards the performance measures they use in their CEO annual incentive bonus plan in order to align CEOs‟ interests with shareholder and society needs. Lastly, because of the possible subjective character of non-financial performance measures (Murphy, 1999), CSR-sensitive industry sectors carry a high audit risk as a result of the expected extensive use of non-financial performance measures in CEO annual incentive bonus plans in such industries. Subjective measures are harder to measure and to control, therefore the results of this study might be relevant for auditors, to pay extra attention to CSR-sensitive industries.
5.3. Limitations and recommendations
This research has some limitations. First, this study is restricted to manufacturing and financial services industry sectors only. Therefore, generalizing the results reported in this paper to other sectors should be done cautiously. Future research can concentrate on or include other (CSR-sensitive) industry sectors to test the effect of CSR-sensitive industry sectors on the use of non-financial performance measures in CEO annual incentive bonus plans.
Second, the sample size used in this research is a limitation because it is very small; this study used 100 out of 279 possible observations. This research could be repeated with a larger sample size in order to test if the results are consistent for the entire dataset. The dataset and sample are also limited to the US. Adding data from other countries might help improving the robustness and generalizability of the findings.
For future research, it would be interesting to replace the dummy variable, created for the use of non-financial performance measures in CEO annual incentive bonus plans, in the explicit weight placed on non-financial performance measures in CEO annual incentive bonus plans. As a consequence, the dependent variable becomes more precise. Therefore, placing explicit weights might result in a different outcome.
Moreover, following De Angelis and Grinstein (2011), future research can repeat the analysis based on the same regression model, extending this research with panel data to see if there is a reasonable trend in the use and disclosure of non-financial performance measures in CEO annual incentive bonus plans in CSR-sensitive industries over a time period.
Lastly, it might also be interesting to investigate which measures are more common in (CSR-sensitive) industry sectors and why. This might improve our understanding of the differences between industry sectors and the use of non-financial performance measures, both in general as well as in CEO annual incentive bonus plans.
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