Performance-Based Incentives for Internal Monitors

Posted by David F. Larcker, Stanford Graduate School of Business, on Friday March 12, 2010 at 9:04 am
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Editor’s Note: David Larcker is the James Irvin Miller Professor of Accounting at Stanford University.

In the paper, Performance-Based Incentives for Internal Monitors, which was recently published on SSRN, my co-authors (Christopher Armstrong and Alan Jagolinzer) and I investigate the choice of performance-based incentives for the general counsel (GC) and chief internal auditor (IA) and assess whether these incentives enhance or impair monitoring.

We use proprietary and public data that provide details about the incentive-compensation contracts of the GC and the IA to identify the determinants of performance-based incentives of internal monitors. More importantly, we also examine the impact these incentives have on either alleviating or exacerbating agency problems within the firm. We draw inferences regarding the implications of compensating internal monitors with performance-based incentives using a propensity score matched-pair research design, which helps address econometric concerns related to the endogenous design of compensation contracts.

We find that internal monitors receive greater incentives when their job duties contribute more to the firm’s production function. Internal monitors also receive greater incentives when they are more highly ranked within the firm and when the firm’s CEO receives greater incentives, consistent with standardization in compensation contracts within the executive suite. In addition, monitors receive lower incentives at firms with greater ex ante litigation risk, consistent with risk-averse monitors demanding less risky compensation when their human capital is more at risk. Finally, we find some evidence that incentive levels are greater when there is more demand for internal monitoring.

To better understand the implications of internal monitor incentives, we examine the association between internal monitor incentive levels and the frequency of adverse firm outcomes, which we use to proxy for unresolved agency problems within the firm. After matching monitors on observable characteristics of their contracting environments using a propensity score approach, we find a lower frequency of adverse outcomes (e.g., regulatory enforcement actions and internal-control material-weakness disclosures) at firms that provide their monitors with greater performance-based incentives. These results are consistent across a variety of alternative measures of incentives and outcomes and appear to be generally robust to omitted variable bias.

Overall, our results support the notion that performance-based incentives enhance the internal monitoring function, perhaps by providing incentives for better monitoring efforts or by facilitating the selection of more talented monitors. These results may allay concerns raised in the economics and legal literatures regarding whether performance-based incentives are an appropriate form of compensation for internal monitors. These results also provide new insights into the implications of providing management with incentive-based compensation by focusing directly on the implications of providing incentives to corporate officers who are responsible for overall governance within the firm.

The full paper is available for download here.

 

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