CFO Fiduciary Responsibilities

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CFO Fiduciary Responsibilities
and Incentives for Financial Performance

RAFFI INDJEJIKIAN

MICHAL MATĚJKA

Ross School of Business*
University of Michigan

Preliminary and Incomplete
(please do not quote)
November, 2007

*
Contact information: 701 Tappan St., Ann Arbor, MI 48109. e-mail: raffii@umich.edu, matejka@umich.edu.
We acknowledge the support of the AICPA in this research project. We also wish to thank numerous colleagues
who provided us with feedback on the survey instrument used to collect data. The paper has benefited from
comments and suggestions of workshop participants at the University of Pennsylvania.
CFO Fiduciary Responsibilities
and Incentives for Financial Performance

Abstract

We examine how firms evaluate and compensate their chief financial officers (CFOs). CFOs

participate in decision making much like other executives, but unlike most other executives they

have fiduciary responsibilities for reporting firms’ financial results and safeguarding the integrity

of financial reporting. Since incentives for financial performance may be necessary to motivate

CFOs to perform their decision-making responsibilities, an important question that arises is to

what extent CFOs’ incentive compensation should be based on performance measures CFOs

themselves generate. In this paper, we provide a framework that characterizes CFO incentive

compensation practices as a tradeoff between CFOs’ decision-making responsibilities and their

fiduciary duties over financial reporting. In particular, we predict that incentives for financial

performance increase with the importance of CFO value-enhancing effort, decrease with the

susceptibility of firms’ accounting systems to misreporting problems, and decrease with the costs

of misreporting borne by firms. Our empirical evidence is consistent with these insights and

corroborates the idea that CFO fiduciary responsibilities affect CFO incentive design. For

instance, we find that, after the enactment of Sarbanes-Oxley legislation, public entities (in

contrast to private entities) have reduced the emphasis on financial performance measures in

CFO compensation.
1. Introduction

In response to a number of prominent corporate failures, recent regulations have called for

reforms aimed at strengthening financial reporting, executive compensation and other

governance practices (e.g., Chang et al. 2006; Zhang 2007). Executives most affected by these

governance reforms are the chief executive officer (CEO) and chief financial officer (CFO).

Although much is written about the role of CEOs and their compensation in corporate

governance, there is very little research examining the role of CFOs and their incentives. In this

paper, we examine how firms evaluate and compensate their CFOs.

CFOs have significant fiduciary responsibilities safeguarding the integrity of financial

reporting and other internal organizational controls, areas most recently targeted for governance

reform (Geiger and North 2006; Mian 2001). Fiduciary responsibilities for financial reporting

raises the question of whether it is appropriate to award CFOs incentive compensation based on

reported financial performance. Indeed, according to the IRS commissioner (testifying before the

Senate Finance Committee), CFOs, top corporate attorneys, and board chairs who are charged

with ―minding the cookie jar‖ should have little or no incentives and instead should get

―generous but fixed compensation‖ (Katz 2006). While the commissioner’s argument is a prima

facie reasonable, it belies the fact that CFOs also typically serve as productive members of firms’

senior executive team with significant managerial responsibilities especially in their areas of

expertise such as financing and risk management (Siegel and Sorensen 1999). Since incentives

for financial performance may be necessary to motivate CFOs to perform their decision-making

responsibilities, fiduciary duties may as a consequence get less attention. In this paper, we

provide evidence to suggest that CFO incentive compensation practices reflect a tradeoff

between CFOs’ fiduciary and decision-making responsibilities.

3
To provide a framework for structuring and motivating our empirical analysis, we rely on

a principal-agent model where a firm hires a CFO-agent to perform a productive task (under

conditions of moral hazard) but also entrusts the CFO with fiduciary responsibilities to generate

a profitability report that reflects firm performance as accurately as possible. Consistent with

prior insights in the literature (e.g., Dye (1988), Evans and Sridhar (1996), Goldman and Slezak

(2006) and Crocker and Slemrod (2007)), we find that if the profitability report is to be used to

motivate productive effort, then the optimal incentive contract will allow for some misreporting

in the form of overstatements of reported performance. In addition, we find that the incentive

weight on self-reported profit increases with the importance of CFO value-enhancing effort,

decreases with the susceptibility of the accounting system to misreporting, and decreases with

the costs of misreporting borne by the firm.

We rely on these insights to structure our empirical investigation of how firms evaluate

and compensate their CFOs. Our data are drawn from a unique database of CFO compensation

practices obtained by surveying members of the American Institute of Certified Public

Accountants.1 We find that annual bonuses are by far the most common incentive component of

CFO compensation plans in our sample and that, on average, 50% of CFO bonuses is based on

accounting-based financial performance. More importantly, we find that CFO bonuses

contingent on financial performance are greater in rapidly growing entities, in industries

characterized by high long-term debt, and for CFOs with longer tenure (our proxies for the

importance of CFO value-enhancing effort). In contrast, we find that CFO bonuses contingent on

financial performance are lower when a CEO has recently been appointed. This finding is

1
Our dataset includes information corresponding to both corporate and business unit entities. In what follows, the
label CFO refers to corporate chief financial officers (for corporate level entities) as well as business unit
controllers (for business unit entities). Similarly, CEO refers to the top executive either at the corporate or business
unit level.

4
consistent with our theory given prior literature suggesting that the period surrounding CEO

turnover that is characterized by greater susceptibility of accounting systems to misreporting

(Murphy and Zimmerman 1993; Pourciau 1993).

In addition, we find evidence that public entities have lowered the percentage of CFO

bonuses contingent on financial performance in the post-Sarbanes-Oxley (post-SOX)

environment. Specifically, we compare the bonus weight on financial performance measures that

is expected in 2007 with the actual bonus weight in 2003 (indicative of incentives in the pre-SOX

environment) and find marked differences for public versus private entities. For example,

predicted values from one of our regressions suggest that a public company (with median sample

characteristics) has lowered the percentage of its CFO’s bonus that depends on financial

performance by about 8% while a comparable private company with similar characteristics has

increased the percentage by about 5%.

Taken together, these findings are broadly consistent with our theoretical predictions and

contribute to the literature in at least three ways. First, we provide unique evidence pertaining

directly to the use of accounting-based financial performance measures in evaluating and

compensating CFOs. Second, our findings inform the corporate governance debate whether

CFOs should be earning incentive compensation contingent on the results reported in firms’

external financial reports. Both our theory and evidence corroborate the notion that CFO

fiduciary responsibilities are inconsistent with high-powered incentive compensation. At the

same time, our results suggest that some incentive compensation is necessary, and more so in

settings where CFOs make value-enhancing contributions. Finally, we show that the greater

regulatory scrutiny in the post-SOX environment has indirectly affected executive compensation

5
practices. For example, in the post-SOX environment, public entities have reduced their

emphasis on short-term financial performance, at least in compensating their CFOs.

The rest of the paper is organized as follows. In the next section, we briefly outline our

theoretical model and characterize the optimal contract based on self-reported measures.

Subsequently, we rely on this model to formulate our empirical hypotheses. In section 3, we

describe our data and empirical measures. In section 4, we present our results and sensitivity

analyses. Finally, in section 5 we discuss our findings and offer some concluding remarks.

2. Hypotheses Development

2.1. Background and Literature

A key fiduciary responsibility of a CFO is to produce financial statements that represent a true

and fair view of a firm’s financial condition. Although overseeing the financial reporting process

of a firm is a collective responsibility of all executives, CFO effort in this regard is likely to be

the most important determinant of financial reporting quality (Mian 2001). For example, Geiger

and North (2006) find that discretionary accruals decrease significantly following the

appointment of a new CFO and stress that their finding is not driven by a concurrent appointment

of a new CEO. Prior research also underscores the importance of CFO qualifications in

improving internal controls and financial reporting quality (e.g., Aier et al. 2005; Li et al. 2007).

In addition to fulfilling their fiduciary responsibilities, CFOs may also have significant

decision-making responsibilities since they often serve as members of firms’ senior executive

team (Siegel and Sorensen 1999).2 Since incentives for financial performance may be necessary

2
There is some evidence that CFOs’ fiduciary and decision-making responsibilities have countervailing
consequences. For example, Indjejikian and Matějka (2006) show that when business unit CFOs focus more on
helping local managers (as opposed to focusing on corporate-level fiduciary responsibilities), local decision
making is improved but at the expense of less control that manifest in the form of local managers enjoying greater
budgetary slack.

6
to motivate CFOs to perform their decision-making responsibilities, fiduciary responsibilities

over financial reporting effectively means that CFOs are rewarded based on performance

measures they themselves generate.

The issue of how to motivate productive effort of an agent who can self-report his

performance has often been addressed in theoretical work. For example, Dye (1988) and Evans

and Sridhar (1996) show that optimal contracts allow for some ―earnings management‖ as a way

to induce productive effort. More recent work by Goldman and Slezak (2006) and Crocker and

Slemrod (2007) also suggest that incentive strength is positively related to both productive effort

and the extent of misreporting.

Despite the large body of research on executive compensation issues, empirical research

specifically addressing the design of incentive compensation for CFOs is only emerging. Gore et

al. (2007) find CFO incentive strength is negative associated with the presence of a board finance

committee and a CEO with financial expertise. Hoitash et al. (2007) find that CFO bonuses are

negatively associated with the disclosure of internal control material weaknesses and that this

relationship is moderated by CFO expertise and reputation, and board of director strength. Burks

(2007) finds no association between CFO bonuses and accounting restatements but a greater

likelihood of CFO turnover following a restatement. There are also two studies closely related to

our work in that they examine changes in CFO compensation in the post-SOX environment.

Carter et al. (2007) show that the sensitivity of CFO and CEO bonuses to earnings has increased

following the enactment of SOX legislation. Wang (2006) finds that the sensitivity of CFO cash

compensation to stock returns has also increased in the post-SOX environment but only in firms

with a weak board structure.

7
We contribute to this literature by examining CFO performance evaluation and

compensation practices using detailed survey data on CFO incentives in public as well as private

companies. To structure our empirical inquiry, we first derive empirically testable predictions

from an agency model where the principal designs a compensation contract for an agent who can

self-report his performance. Subsequently, we describe our data and test the predictions of our

model.

2.2. Theoretical Model

To characterize a setting where CFOs’ fiduciary and decision-making responsibilities are

considered jointly, we rely on an agency model where a risk-neutral principal (firm) hires a risk-

averse agent (a CFO) to perform two tasks: (i) exert productive effort that enhances the firm’s

real profits, and (ii) after observing firm profits, perform fiduciary duties and generate a

profitability report that may be used to evaluate his (i.e., CFO’s) performance. The timeline is as

follows.

In the first stage, at the time of contracting, both the firm and the CFO are symmetrically

informed about firm profit x [ x, x ] with beliefs characterized by f ( x; e) and F ( x; e) . In the

second stage, subsequent to employment, the CFO provides value-enhancing effort e

(unobservable by the firm) which shifts the distribution of firm profitability to the right in the

sense of first-order stochastic dominance, i.e., Fe ( x; e)  0 . We let h(e)  1 he2 be the
2

opportunity cost of value-enhancing effort e borne by the agent where h  0 . In the third stage,

after performing task e , the CFO privately observes real profit x. In the fourth stage, after

observing real profit x , the firm’s profitability R( x, g )  x  kg is reported to the principal

where g represents gaming or misreporting activities that characterize the accounting system

and k  0 is a parameter representing the marginal impact of misreporting on R .

8
We assume the agent-CFO has a fiduciary responsibility to ensure that R( x, g ) is

reported as accurately as possible. In particular, we assume that the CFO has the opportunity to

reduce g or eliminate g altogether, and that failure to do so entails a personal cost to him of

c( g )  1 cg 2 (with c  0 ) and a cost to the firm of L( g )  1 Lg 2 (with L  0 ).
2 2

Let x  S ( R)  L( g ) be the firm’s net profit where S ( R) is the wage or contract offered

to the CFO at the beginning of the employment relationship; S is a function of R the only

variable observed by the firm. Also, let u ( S ( R)  c( g ))  h(e) be the agent-CFO’s utility net of

his personal costs of performing value enhancing activities and the costs of misreporting. We

also assume u(.)  0 and u(.)  0 .

In what follows, we illustrate the model in a LEN (linear-exponential-normal) framework

and relegate a more general characterization of the optimal contract to Appendix A. In

particular, we assume x N ( x ,  2 ) , u ( z )   exp rz and restrict the contract to be linear as in

S ( R)     R . Lastly we assume that the CFO’s productive effort e affects the mean but not

the variance of firm profit (i.e., dx
de  0, d2x
de 2
 0, d 2
de  0) .

We begin with the fourth stage (i.e., reporting stage) where, having already performed e

and observed x (and thus resolved all uncertainty about his performance), the CFO performs his

fiduciary duties (i.e., selects g ) to maximize  exp[r (   R  1 cg 2 )]  1 he2 . The optimal
2 2

g * is given by the solution to

 k  cg  0 (1)

9
where the sufficient second order condition ( c  0) is met by assumption.3 Note that the

marginal cost of performing fiduciary duties is the potential decrease in compensation that

accompanies reductions in reported performance R. In contrast, the marginal benefit of

performing fiduciary duties is the lower costs (i.e., lower c ( g ) ) personally borne by the CFO.

Of course, if the CFO is offered a fixed wage (i.e.,   0 ), then we have g *  0 , and R( x, 0)  x .

Now, anticipating u ( x, g * )  u ( S ( R( x, g * ))  c( g * )) in the second stage, the CFO

provides value-enhancing effort e to maximize E[u( x, g * )  1 he2 ] , which in certainty
2

equivalent form is simply    E[ x  kg * ]  1 c( g * )2  2  2 2  1 he2 ). Hence, the optimal e*
2
r
2

is given by the solution to

he   dx
de 0 (2)

and where the sufficient second order condition ( h  0) is met by assumption.

At the contracting stage, the principal maximizes E[ x  S ( R)  L( g * )] subject to g * in

(1), the IC constraint in (2), and the IR constraint expressed as    E[ x  kg * ] 

1
2 c( g * )2  1 h(e* )2  2  2 2  U . The optimal  * is given by
2
r

 dx 
2

 *
 de
. (3)
 de   c 1  L   rh 2
dx 2 k h
2

Expression (3) implies that the optimal incentive weight on reported profit is a function

of (i) the susceptibility of the accounting system to misreporting reflected in the terms

k (or dR( x, g ) / dg ) and c , (ii) the costs of misreporting borne by the firm reflected in the term

3
Note that the optimal g does not depend on x since R  k is a constant and the contract is assumed to be
g
linear. This means that g can be selected at the same time as e (i.e., prior to the observation of x ) rendering the
problem equivalent to multitasking LEN models popularized by Holmstrom and Milgrom (1991). The timing of
g is much more salient in the general characterization of the model considered in Appendix A.

10
L , as well as the sensitivity (dx / de) and noise (  2 ) constructs usually considered in this

literature. For instance, everything else equal, higher values of dx / de implies incentives are

steeper in order to motivate the CFO to provide more productive effort e . In contrast, if k is

high or c is low so that the CFO is more inclined to tolerate overstatements of firm

performance, then incentives are muted to mitigate the payment of excessive compensation.

Finally, when the costs borne by the firm for overstating performance are high (i.e., L is high),

incentives are muted so as to reduce the CFO’s tolerance for overstatements.

2.3. Hypotheses

The preceding observations suggest three empirical hypotheses assuming that self-reported profit

(the variable R in our model) corresponds to financial performance measures that reportedly

underlie CFO compensation practices of our sample firms. We have:

HYPOTHESIS 1: The weight on financial performance measures in CFO incentive compensation

increases with the importance of CFO value-enhancing effort.

HYPOTHESIS 2: The weight on financial performance measures in CFO incentive compensation

is lower when the accounting system is more susceptible to misreporting.

HYPOTHESIS 3: The weight on financial performance measures in CFO incentive compensation

decreases with the costs of misreporting borne by the firm.

As the next section explains in more detail, we exploit various cross-sectional

characteristics of our sample entities to proxy for the importance of CFO value-enhancing effort

(H1) and the susceptibility of the accounting system to misreporting (H2). Further, we expect

that the cost of misreporting borne by the firm have increased since the enactment of the SOX

legislation in 2002 and test H3 by examining changes (pre- and post-SOX) in the weight on

financial performance measures in CFO incentives.

11
3. Empirical Design

3.1. Data Collection

We collect our data by surveying 29,857 members of the American Institute of Certified Public

Accountants (AICPA). This population is comprised of all AICPA members working in industry

(rather than in public accounting firms) as corporate or business unit (BU) CFOs (controllers, VP

finance) or CEOs (general managers).4 In March 2007, an e-mail (with AICPA endorsement)

was sent inviting the AICPA members to participate in our on-line survey (by using an

individual log-in key). This was followed by two subsequent e-mails within two weeks of the

initial e-mail to request participation of those who had not responded. By the end of May, 2,037

AICPA members fully or partially completed our on-line questionnaire yielding a response rate

of 6.8%.

The on-line survey instrument consisted of 8 questionnaires with similar content that

were customized depending on the type of respondent (there was a corporate- and BU-level

version of the questionnaire for each of the following four types of respondents: CFO, CEO,

other respondent informed about CEO/CFO compensation, other respondent not informed).5 All

respondents participated anonymously and the questionnaire did not include any questions about

firm affiliation. The total number of items on the questionnaires ranged between 61 and 88

depending on the type of respondent. The median respondent took 11 minutes to complete the

questionnaire.

4
In addition, we also surveyed AICPA members with other titles such as president or chief operating officer who
are likely to be informed about executive compensation issues.
5
The survey instrument was extensively pre-tested by the authors, numerous colleagues with survey and/or
management accounting expertise, and also by a sample of 24 AICPA members and other CFOs/CEOs who
participated in earlier surveys of the authors (their responses are included in our data; excluding these 24
observations does not materially affect our results).

12
3.2. Measures

Incentive Weight on Financial Performance Measures:

We ask several questions to collect information on CFO incentives. The first question (Question

1a in Appendix B) asks respondents to report the percentage of CFO bonus earned in 2006 that

can be attributed to the achievement of (i) financial performance targets (denoted FIN06_CFO),

(ii) financial performance targets of higher levels such as the firm or business group

(HLF06_CFO) where appropriate (e.g., for BU CFOs), (iii) non-financial performance targets

(NFIN06_CFO), and (iv) achievements evaluated subjectively without pre-set targets

(SUB06_CFO). The question is based on an instrument commonly used in prior research

(Abernethy et al. 2004; Gupta and Govindarajan 1984). Variations of this question (Question 1b

and 1c) ask respondents to report the corresponding percentages in 2003 and the expected

percentages in 2007 assuming performance exactly meets the targets on all measures. 6

Question 2 in Appendix B asks respondents to report the dollar amount of bonus (denoted

as BONUS_CFO), long-term cash compensation, equity-based compensation, and other

incentive compensation earned by CFOs in 2006. Question 3 asks respondents to report CFO

annual salaries for 2006 (SALARY_CFO) and Question 4 asks respondents to report the dollar

amount of bonuses expected in 2007 if performance exactly meets targets on all measures

(BONUS07_CFO).

Given that annual bonuses represent the primary incentive compensation vehicle for most

CFOs (only about 15% CFOs in our sample are eligible for a long-term cash incentive, and 22%

for equity incentives), in what follows we focus exclusively on the choice of performance

measures underlying annual bonuses. Specifically, we calculate FINBON06, the incentive weight
6
We use abbreviations similar to those above to denote various components of CFO bonus plans, e.g., FIN07_CFO
is the percentage of 2007 CFO bonus expected to be based on financial performance targets. We also have
information on the components of CEO bonus in 2006 which we denote FIN06_CEO, HLF06_CEO, etc.

13
on financial performance measures for 2006, as bonuses earned for financial performance in

2006 divided by annual salary:

(4)

We note that FINBON06 is an ex post measure of incentive strength while our theoretical

construct is the ex ante incentive strength (e.g., FINBON06 can be zero due to poor performance

in 2006 even if the compensation contract at the beginning of the year allowed for a large bonus

contingent on performance). Thus, as an alternative measure of incentive strength, we calculate

FINBON07 as bonuses expected for 2007 (if financial performance exactly meets targets on all

measures) divided by annual salary:7

(5)

Importance of CFO Value-Enhancing Effort:

We consider four proxies for the importance of value-enhancing effort. First, we expect the

marginal product of effort of all executives (including the CFO) to be greater in high-growth

settings because of the high opportunity cost of missed investment opportunities (Baber et al.

1996; Smith and Watts 1992). We measure GROWTH by asking respondents about the

percentage increase in sales in their organization relative to the prior year (Question 5 in

Appendix B). We winsorize GROWTH at the 1% level to mitigate the influence of outlier

observations.

Second, we expect the marginal product of CFO effort to be greater for firms and

industries that rely more on external long-term debt financing since CFO input and expertise is

likely to be more critical in these settings. We construct the median industry ratio of long-term

7
We use 2006 CFO salaries since 2007 salaries are not available.

14
debt over total assets by averaging the ratio (Data51/Data44) for each firm in the Compustat

quarterly data file over all 20 quarters during 2001–2005. We then calculate LDEBT as the

industry (SIC-2 digit) median. We assign values of LDEBT to observations in our sample by

matching respondents’ descriptions of their industries (Questions 6 in Appendix B) with the SIC

industry classification. We assign missing values whenever a description does not allow for an

unambiguous classification.

Third, we expect the marginal product of CFO effort to be greater for firms and industries

with high inventories and/or accounts receivable where CFO involvement in working capital

management has a greater impact on firm profits. We calculate INREC, the median industry ratio

of inventory and receivables over total assets ((Data37+Data38)/Data44) in a similar way as

described above for LDEBT.

Finally, we expect the marginal product of CFO effort to increase over his tenure as the

CFO becomes more familiar and knowledgeable about his firm’s operations. We calculate

TENURE as the log of the number of years served as the CFO (we use the logarithm

transformation to reduce deviations from normality).

Susceptibility of Accounting Systems to Misreporting:

Identifying circumstances where firms’ accounting systems are more or less susceptible to

misreporting is a challenging task. For instance, the prior literature on earnings management

typically has relied on detailed information from firms’ financial statements and other

corroborating sources to infer misreporting behavior, often with varying success. Unfortunately,

since our respondents’ firm affiliations are unknown, we cannot replicate misreporting or

earnings management proxies commonly employed in the literature.

15
Nevertheless, our survey does include information about CEO turnover which the prior

literature has identified to be an important predictor of earnings management. For example, prior

literature has shown that the period surrounding CEO turnover is associated with greater

frequencies of asset write-offs, accounting method changes, and recordings of large accruals

(e.g., Murphy and Zimmerman 1993; Pourciau 1993). In this spirit, we use an indicator variable

NEWCEO as a proxy for susceptibility of the accounting system to misreporting.8

Control Variables:

We also use a number of variables to control for ownership status of entities in our sample, the

organizational level employing the CFO (corporate vs. BU), as well as the size of the entity.

Specifically, we use the following indicator variables: (i) PUBLIC for publicly listed

(independent) companies, (ii) PRIVATE for privately owned companies, (iii) PUBLIC_BU for

business units of publicly listed companies, and (iv) PRIVATE_BU for business units of

privately-owned companies. Our proxy for size, labeled SIZE, is the log of the number of

employees at a company or a BU in our sample.

We recognize that size, ownership status, or entity level (corporate vs. BU) may also

proxy for the importance of CFO value-enhancing effort, the susceptibility of accounting

systems to misreporting, or the cost of misreporting borne by the firm. Nonetheless, absent

theoretical guidance or empirical precedent, we make no prediction regarding the effect of these

variables in our tests.

8
NEWCEO equals one if a new CEO was appointed in the last two years. Given that respondents answer the
question between March and May 2007, it includes all entities with a new CEO during 2006.

16
4. Results

In what follows we first provide extensive descriptive evidence on the choice of financial and

non-financial measures in CFO annual bonus plans. Although this evidence does not always

directly pertain to our hypotheses, it is the first evidence (at least that we are aware of) on the

choice of performance measures in CFO contracts and it reinforces the main point of the paper

that performance measure choice is a function of the importance of CFO fiduciary

responsibilities. Subsequently, we test our hypotheses by examining the determinants of CFO

incentive weights on (self-reported) financial performance measures and by examining the

changes in the emphasis on financial performance measures since the enactment of the SOX

legislation.

4.1. Descriptive Statistics

Although 2,037 respondents participated in our survey, we report descriptive statistics for 1,353

corporate and BU entities which meet our sample requirements. In particular, we exclude 684

observations where (i) we lack data on the type of entity (public vs. private or corporate vs. BU

level), or (ii) the respondent is neither CFO/CEO nor informed about their compensation, or (iii)

the entity is a governmental or not-for-profit institution, or (iv) the SIC-2 industry classification

code is greater than 81 (incl. educational, social services; museums; membership organizations;

engineering, accounting, research services), or (v) sales are smaller than $10 million. The

respondents are CFOs (77% of the 1,353 cases), CEOs (5%), or other executives informed about

CFO/CEO compensation (18%).

[Insert Table 1]

Table 1 shows that 69% of the 1,353 entities are private companies, 13% are public

companies, 9% are BUs of privately-owned companies, and 10% are BUs of public companies.

17
The median number of employees in our sample entities is 200 employees and these entities

typically exhibit strong growth in sales (median increase in 2006 sales as compared to the year

before is 10%). The median industry ratio of long-term debt over total assets is 14% while the

median industry ratio of inventory and receivables over total assets is 27%. The median tenure of

a CFO in our sample is 6 years and about 16% of CEOs in our sample have been appointed in the

last two years.

[Insert Table 2]

Table 1 also shows that median CFO salary and bonus in 2006 are $142,000 and $32,000,

respectively. Table 2 provides additional information on the type of performance targets used in

CFO bonus plans and allows for a comparison with CEO bonus plans. Panel A of Table 2 is

specific to corporate entities, while Panel B focuses on BU-level entities. Clearly, the most

important determinants of CFO bonuses are financial performance targets. On average, the

percentage of bonus linked to financial performance measures is about 50% for corporate CFOs

and 46% for BU CFOs. Still, we find that these percentages are significantly lower than in the

case of CEOs. Combining both corporate and BU entities into a sample of 870 entities, where

information on both CFO and CEO performance measures is available, we estimate that the

percentage of bonus linked to financial performance measures is lower for CFOs than CEOs by

4.4% (p<.001).

Table 2 also shows that, on average, 14% of corporate CFOs’ bonuses are contingent on

meeting explicit non-financial targets, and about 34% are determined subjectively. For BU

CFOs, a significant portion of the bonuses is also based on higher-level (corporate or business

group) financial performance. Such higher-level measures account on average for 16% of BU

18
CFO bonuses, while 15% is contingent on meeting explicit non-financial targets, and 20% is

determined subjectively. Table 2 also shows that these percentages vary widely in our sample.

[Insert Table 3]

Table 3 provides additional details on the type of non-financial targets used in CFO

bonus plans. This table is based on respondents’ descriptions of the most important non-financial

targets in their 2006 annual bonus available in a sample of 278 entities. We classify these

descriptions into four major categories (with several subcategories) defined in the footnote to

Table 3. We find that the most common type of non-financial measures in CFO bonus plans

relates to common management tasks such as improving operations, customer orientation,

strategic and/or people management—59% of the 278 bonus plans included at least one non-

financial target from this category. For comparison, 35% included at least one target related to

CFO reporting tasks (such as compliance and control targets, efficiency of reporting,

implementation of IT systems, and support of internal decision making) and 19% included

targets related to CFO role in obtaining capital, managing finances, and mergers and

acquisitions.

[Insert Table 4]

It is noteworthy that most of the non-financial performance targets in CFO bonus plans

aim at motivating value-enhancing activities rather than at reinforcing CFO fiduciary

responsibilities. Only about 14% of the 278 entities report the use of at least one target related to

CFO compliance and control activities (incl. clean audit, no restatements, external/tax reporting,

SOX compliance, documentation of procedures, risk management, or regulatory reporting).

Table 4 shows how this percentage varies across different types of entities. The frequency of

using at least one compliance and control target is highest (26%) in public corporate-level

19
entities where CFO fiduciary responsibilities are arguably most important and lowest (8%) in

private corporate-level entities (the difference is highly significant, p=.002). Thus, although it is

not very common to rely on non-financial targets to motivate CFO compliance and control effort,

variation in the frequency of using these targets seems to be related to the importance of CFO

fiduciary responsibilities.

[Insert Table 5]

Finally, Table 5 provides additional information on who awards discretionary bonuses to

CFOs. Discretionary bonus awards can be decided by a CEO at the same level or by an executive

at a higher-level in the corporate hierarchy (discretionary bonuses can be awarded by the board

of directors in case of corporate CFOs or by corporate executives in case of BU CFOs). Table 5

summarizes responses to a question asking who decides on CFO discretionary bonuses using the

following 5-item (Likert) scale: (i) CEO decision, (ii) Largely CEO, (iii) Joint decision, (iv)

Largely the Board, (v) Board decision (similarly for BU-level entities; see also Question 8 in

Appendix B). The last column of Table 5 reports the frequency of responses (iii)–(v), i.e., the

percentage of entities where board of directors or higher-level executives are closely involved in

the decision to award a discretionary bonus to a CFO. As in Table 4, these percentages reflect the

importance of CFO fiduciary responsibilities. Specifically, boards of directors are closely

involved in CFO discretionary bonus decisions in 61% of public companies but only in 30% of

private companies (the difference in means for these types of entities is highly statistically

significant, p<.001). A higher-level CFO is closely involved in 51% of BUs of public companies

and in 66% of BUs of private companies.

20
4.2. Cross-Sectional Determinants of CFO Incentive Weights

Our hypotheses predict that the weight on financial performance measures in CFO incentive

compensation increases with the importance of CFO value-enhancing effort (H1) and decreases

with susceptibility of the accounting system to misreporting (H2). To test H1 and H2, we regress

the weight on financial performance measures in CFO bonuses on several proxies for the

importance of CFO value-enhancing effort and susceptibility of the accounting system to

misreporting. We use two measures of the incentive weight: FINBON06 is the proportion of

annual CFO salary that was earned as bonus based on financial performance measures in 2006

(see expression 4). For a subset of our sample we also have data to proxy for the ex ante

incentive weight, FINBON07, which is based on the expected bonus if financial performance

targets are met in 2007 (see expression 5).

Table 6 presents the results of our Tobit estimates that take into account that some of our

sample entities provide no bonus based on financial performance measures (thus, our dependent

variables can be described as continuous variables with a positive probability mass at zero).9

Most of our proxies have a significant effect in the predicted direction in at least one of the

regressions. Column 1 shows the results for FINBON06 which include the largest number of

observations with non-missing data (we impose an additional sampling criterion that CFOs have

been in their position for at least two years before participating in our survey during March–May

2007).10 As predicted by H1, the 2006 incentive weight on financial performance measures in

CFO bonus plans is positively associated with two of our proxies for high CFO impact on firm

9
We obtain qualitatively similar results when we estimate OLS regressions both for the whole sample and for the
sample excluding observations with zero values on the dependent variable.
10
This excludes all entities with CFO turnover in 2006 because values of FINBON06 for incoming CFOs may not
be representative. When estimating our model of FINBON07, we require that CFOs be in their position for at least
one year prior to participating in our survey (this excludes all CFOs incoming during 2007 but retains CFOs
incoming during 2006 who are in their second year on the job in 2007).

21
value—growth in sales (p=.011) and CFO tenure (p=.002). Our industry-level variables

reflecting demand for short-term and long-term financial management are not significant

predictors of the incentive weight.

Table 6 also shows that the incentive weight on financial performance measures in CFO

bonus plans is lower (p=.015) if a new CEO has recently been appointed. Specifically, the

incentive weight on financial performance measures in CFO bonus plans is lower by about 10%

in entities with recent CEO turnover as compared to entities without CEO turnover (this

comparison relies on coefficient estimates in Column 1 and assumes all other predictors are

constant at their sample medians). This finding is consistent with H2 to the extent that

accounting systems are more susceptible to misreporting in the period surrounding CEO

turnover. Finally, we find that the incentive weight on financial performance measures is

positively associated with size as measured by the number of employees (p<.001) and higher by

about 14% (18%) in public corporate (BU) entities than in private corporate entities.

A limitation of FINBON06 is that it measures incentive strength ex post and thus may

reflect variation in performance rather than the ex ante incentive strength. To partially address

this limitation, column 2 presents the results after controlling for 2006 performance relative to

budget (see question 7 in Appendix B). We do not interpret the coefficients estimates directly

(given potential biases arising from including an endogenous variable as a regressor), except for

noting that that the results in column 1 are largely robust to controlling for performance.

We use FINBON07 as a more direct way to proxy for the ex ante incentive strength. It

measures the percentage of CFO salary that will be earned if all 2007 financial targets are met.

We find that this percentage is positively associated with industry-level importance of long-term

debt (p=.066) which is our proxy for the importance of CFO value-enhancing effort. Also,

22
consistent with the results in column 1, we find that FINBON07 increases with CFO tenure

(p=.025) and is lower when there is a new CEO (p=.057). The incentive weight is also higher in

public companies and positively associated with size. In contrast to column 1, rapidly growing

entities and BUs of public companies do not have a significantly higher expected percentage of

CFO salary contingent on meeting 2007 financial targets. One explanation for this latter result is

that these entities enjoy more budgetary slack and consistently beat their financial performance

targets (Indjejikian and Matějka 2007; Indjejikian and Nanda 2002). This is because financial

performance targets that are easy to achieve (relative to other targets) often result in large

bonuses for financial performance and thus make the ex post weight on financial targets

(FINBON06) systematically greater than the ex ante weight (FINBON07).

In summary, we find support for H1 in that the incentive weight on financial performance

measures in CFO bonuses increases with growth, industry importance of long-term debt, and

CFO tenure, all of which are likely to be associated with greater marginal product of CFO value-

enhancing effort. We also find that the incentive weight on financial performance measures in

CFO bonuses is lower when a new CEO has been appointed in the last two years. This finding is

consistent with H2 to the extent that the period surrounding CEO turnover is characterized by a

greater need to take write-offs, book large accruals, etc. which may increase the susceptibility of

accounting systems to misreporting (Murphy and Zimmerman 1993; Pourciau 1993).

4.3. Changes since 2002

We test H3 by examining whether firms have changed the weights on financial performance

measures in CFO bonuses between 2003 and 2007. We view the 2003 weights (set in 2002 or

earlier) as reflecting the pre-SOX environment and compare them with the ex ante weights on

financial performance measures in 2007. Assuming public firms face greater penalties for

23
misreporting in the post-SOX environment (Engel et al. 2007; Zhang 2007), H3 implies that

public entities have decreased the incentive weight on financial performance measures in CFO

bonuses.

Empirically, the dependent variable in our OLS model is the difference between 2007 and

2003 weights on financial performance measures in CFO bonuses. We denote this difference

FIN07-03 and calculate it as FIN07_CFO minus FIN03_CFO (we lack data on CFO bonuses

paid in 2003 and thus cannot calculate the 2003 equivalent of FINBON07). Our explanatory

variables are similar to those included in the regressions from Table 6. We omit industry level

variables (LDEBT, INREC) because, by construction, they are constant across time and thus drop

out of our changes model. Instead, we include a proxy for past performance (our most distant

proxy being 2004 performance relative to budget) in an attempt to control for 2003 ex post

incentive weights to be high or low due to random fluctuations in performance unrelated to the

ex ante incentive strength.

Table 7 presents the results of our estimations in three different samples. In column 1,

we use a sample of all 533 observations for which we have available data (after excluding

entities with CFO tenure of 3 years or less to assure that the change captured by FIN07-03

applies to the same CFO). In column 2, we use a sample of 456 observation obtained by

excluding CFOs who earn $50,000 or more in equity compensations. Column 3 further excludes

entities where CFO bonus size is relatively low (30% of their salaries or less). We use the latter

two restricted samples to demonstrate that our results get stronger as we focus on CFOs for

whom bonuses are the primary source of relatively large incentive compensation (an implicit

assumption of our model).

24
Consistent with H3, we find that BUs of public companies have reduced the weights on

financial performance measures in CFO bonuses. Relative to private companies, BUs of public

companies have reduced the weights on average by 7% (p=.007; the estimates are 6%, p=.040,

and 12%, p=.003, in column 2 and 3, respectively). A comparable estimate specific to public

companies is not significantly different from zero in column 1. However, our estimates in the

restricted samples are comparable to those for public BUs. For example, we find that public

companies where bonuses are the primary source of CFO incentive compensation have reduced

the weights on financial performance measures on average by 13% (p=.003 in column 3) as

compared to private companies.

Further, we find that good performance in 2004 is associated with a decrease in the

weights on financial performance measures in CFO bonuses (p<.01 in all three estimations).

Thus, to the extent that performance in 2003 and 2004 are correlated, PERF04 captures some of

the variation in 2003 weights on financial performance measures due to good or bad

performance. The lack of other significant results is likely due to the fact that the remaining

regressors are relatively constant across time.

In summary, we find that relative to private entities public companies and BUs have

reduced the emphasis on financial performance measures in annual bonus plans of their CFOs in

the post-SOX environment. For example, we calculate based on our estimates in column 3

(including only CFOs with bonuses greater than 30% of their salaries and little or no equity

compensation) that a private company with median sample characteristics has increased the

weight on financial performance measures in CFO bonus plans between 2003 and 2007 by about

5%; similarly, the median BU of a private companies has increased the weight by 3%. These

changes contrast sharply with those in public entities—both public companies and BUs have

25
reduced the weight by about 8%. This is consistent with H3 and more generally with our theory

suggesting that as the cost of misreporting borne by the firm increase, the CFO should reallocate

effort towards compliance activities and prevention of misreporting so that, in equilibrium, the

new environment is characterized by weaker incentives and less misreporting.

5. Discussion and Conclusions

In this paper, we use survey evidence of CFO compensation practices to examine how firms

provide incentives and measure performance of their chief financial officers. Based on a

principal-agent characterization of the firm-CFO relationship, we predict that firms’ reliance on

financial performance measures in evaluating CFOs will reflect a tradeoff between CFOs’

decision-making responsibilities and their fiduciary duties to oversee the financial reporting

process. In particular, we predict that firms will rely more heavily on financial performance

measures in settings where CFOs’ decision-making responsibilities are important, but

deemphasize such measures when motivating CFOs’ fiduciary responsibilities becomes

relatively more important.

Our empirical findings are broadly consistent with our theoretical predictions. First, we

find that the incentive weight on financial performance measures in CFO bonus plans is

positively associated with sales growth, industry importance of long-term debt, and CFO tenure

all of which proxy for the importance of CFO decision-making responsibilities rather than the

importance of CFO fiduciary responsibilities. Conversely, we find that the incentive weight on

financial performance measures in CFO bonus plans is lower in the period surrounding CEO

turnover when accounting systems are more susceptible to misreporting and thus when CFO

fiduciary responsibilities are relatively more important.

26
Second, we show that changes in the emphasis on financial performance measures in

CFO bonuses since the enactment of SOX legislation are markedly different for public and

private entities. Relative to private entities, public firms have reduced significantly the weight on

financial performance measures in CFO bonus plans. This is consistent with our theory given

that the post-SOX environment has made public entities more sensitive to compliance and

control issues, to costs of misreporting, and thus to the importance of CFO fiduciary

responsibilities.

Finally, our paper provides additional descriptive evidence that is broadly consistent with

our theory. For example, the emphasis on financial performance measures in CFO bonus plans is

lower than the emphasis in CEO bonus plans. In a principal-agent framework, this difference

would naturally arise if fiduciary responsibilities (relative to other decision-making duties) are

more important for CFOs than for CEOs. Further, we find that CFO bonus plans of public

companies are more likely to include some explicit control- and compliance-related non-

financial targets than the CFO bonus plans of private companies. Also, board of directors in

public companies are more likely to get closely involved in awarding subjective bonuses to

CFOs than boards in private companies.

Our conclusion that fiduciary responsibilities affect CFO incentive design is subject to a

number of limitations. First, we are unable to augment or validate our survey measures with

additional public data since the identity of participating firms is unknown. Second, by the very

nature of survey data, we rely on our respondents to communicate accurately sensitive

information about their own and other executives’ compensation. Although this may have

introduced some measurement error, it is unlikely to be the cause of a systematic bias. Despite

27
these limitations, our study provides new and unique evidence on CFO evaluation and

compensation practices which hopefully stimulate future research in this area.

28
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30
Table 1—Descriptive Statistics

N Mean St. Dev. 25th Pct. Median 75th Pct.

PRIVATE 1,353 0.69 0.46 0.00 1.00 1.00
PUBLIC 1,353 0.09 0.28 0.00 0.00 0.00
PUBLIC_BU 1,353 0.13 0.33 0.00 0.00 0.00
PRIVATE_BU 1,353 0.10 0.30 0.00 0.00 0.00
SIZE 1,338 1,610 8,397 85.0 200 675
SALARY_CFO 1,225 166,422 95,431 105,000 142,000 200,000
BONUS_CFO 1,107 75,209 180,167 12,000 32,000 80,000
GROWTH 1,161 15.20 24.79 4.00 10.0 20.0
LDEBT 1,086 0.15 0.11 0.06 0.14 0.20
INREC 1,086 0.32 0.21 0.16 0.27 0.41
TENURE 1,345 7.31 6.15 3.00 6.00 10.0
NEWCEO 1,353 0.16 0.36 0.00 0.00 0.00

PRIVATE—privately-owned companies (corporate level), PUBLIC—publicly listed companies (corporate level), PUBLIC_BU—business units of
publicly listed companies, PRIVATE_BU—business units of privately-owned companies, SIZE—the log of the number of employees in a company or
BU, SALARY_CFO—annual CFO salary in 2006, BONUS_CFO—annual CFO bonus earned in 2006, GROWTH—percentage increase in annual sales
in 2006, LDEBT—average long-term debt over total assets during 2001–2005 (SIC-2 industry median); INREC—average of inventory plus receivables
over total assets (SIC-2 industry median), TENURE—number of years CFO has been on the job, NEWCEO—equals one if a new CEO has been
appointed in the last two years.

31
Table 2—Percentage of CFO and CEO Bonus Contingent on Different Types of Performance Measures

N Mean St. Dev. 25th Pct. Median 75th Pct.

Panel A: Corporate level

FIN06_CFO 843 50.1 40.5 0.00 50.0 100
FIN06_CEO 731 56.0 41.5 0.00 65.2 100
NFIN06_CEO 843 13.5 23.3 0.00 0.00 25.0
NFIN06_CFO 731 11.9 22.2 0.00 0.00 20.0
SUB06_CFO 843 34.0 41.2 0.00 10.0 80.0
SUB06_CEO 731 28.2 39.9 0.00 0.00 50.0

Panel B: Business unit level

FIN06_CFO 220 45.6 37.8 0.00 49.0 80.0
FIN06_CEO 187 54.3 36.9 25.0 50.0 90.0
HLF06_CFO 220 15.6 26.3 0.00 0.00 25.0
HLF06_CEO 187 16.4 25.5 0.00 0.00 25.0
NFIN06_CEO 220 15.2 24.8 0.00 0.00 25.0
NFIN06_CFO 187 13.5 22.3 0.00 0.00 25.0
SUB06_CFO 220 20.4 32.1 0.00 0.00 27.5
SUB06_CEO 187 13.1 26.1 0.00 0.00 20.0

FIN06_CFO—percentage of CFO bonus in 2006 earned for meeting financial performance targets, NFIN06_CFO—percentage of CFO bonus in 2006
earned for meeting non-financial performance targets, SUB06_CFO—percentage of CFO bonus in 2006 awarded subjectively, HLF06_CFO— percentage
of CFO bonus in 2006 earned for meeting higher-level financial performance targets (applies to BU level entities only). Same definitions apply to CEOs.

32
Table 3—Frequency of Different Types of Non-Financial Performance Measures in
CFO Bonus Plans (n=278)

I) General management targets 59.0%

Operations 24.1%
People management 16.5%
Strategic management 14.0%
Customer orientation 14.0%

II) Reporting targets 35.3%

Compliance & control 13.3%
Efficiency of reporting 13.3%
IT & systems 10.8%
Support of internal decision making 5.4%

III) Financing targets 19.1%

Short-term financial management 7.2%
Mergers & acquisitions 6.8%
Obtaining capital 5.8%

IV) Communication & teamwork 6.8%
The above categories include the following examples:
I) General management: Operations—efficiency, quality, safety, process improvement, or cost control;
People management—employee turnover, staff development, recruiting, contribution to performance
evaluations, or corporate culture; Strategic management—market share, business development
milestones, business growth, R&D goals, implementation of profitability strategies, restructuring,
organizational structure, or design of incentives; Customer orientation—customer satisfaction, on-time
delivery, community involvement, supplier relations, or PR initiatives.
II) Reporting targets: Compliance & control—clean audit, no restatements, external/tax reporting, SOX
compliance, documentation of procedures, risk management, or regulatory reporting; Efficiency of
reporting—timeliness, accuracy, lean accounting, reporting in new acquisitions, or accounting
department efficiency; IT & systems—ERP implementation, software upgrades, or IT projects; Support of
internal decision-making—working on projects for BUs, useful information for management,
management satisfaction, or setting BU performance targets.
III) Financing targets: Short-term financial management—collections, cash-flow, working capital, financial
condition, debt covenants, or forecasting; Mergers & acquisitions—divestitures, deals, or capital
investment evaluations; Obtaining capital—banking/investor relations, communication with analysts, or
IPO.
IV) Communication & teamwork—leadership, interpersonal skills, interaction with managers or board
members, loyalty, or work ethics.

33
Table 4—Frequency of Compliance & Control Targets in CFO Bonus Plans in
Different Types of Entities

N Frequency

PRIVATE 167 8.4%
PRIVATE_BU 31 19.4%
PUBLIC 39 25.6%
PUBLIC_BU 41 17.1%

Total 278 13.3%

Frequency refers to the percentage of CFO bonus plans that include one of the compliance & control
targets (see Table 3).

34
Table 5—Higher-Level Involvement in Awarding Discretionary Bonuses to CFOs

N Mean St. Dev. Median Freq.

PRIVATE 734 1.94 1.09 2.00 29.8%
PRIVATE_BU 93 3.11 1.54 3.00 65.6%
PUBLIC 117 2.80 1.07 3.00 60.7%
PUBLIC_BU 120 2.78 1.58 3.00 50.8%

Total 1,064 2.23 1.27 2.00 61.3%

Value of 1 implies that subjective bonuses to CFO are awarded by the CEO (there is little or no
consulting of the board of directors). Value of 5 implies that subjective bonuses to CFO are awarded
by the board of directors (there is little or no consulting of the CEO). See Question 8 in Appendix A
for the exact wording and scale. Freq. refers to the percentage of entities where the board of directors
or higher-level executives are closely involved in the decision to award a discretionary bonus to a CFO
(i.e., values of 3 or larger).

35
Table 6—Tobit Models of the Incentive Weight on Financial Performance Measures
in 2006 and 2007

Expected Column 1 Column 2 Column 3
Variables Sign FINBON06 FINBON06 FINBON07

Intercept -0.845 -1.068 -0.577
(0.000) (0.000) (0.000)
GROWTH + 0.002 0.001 0.001
(0.011) (0.203) (0.182)
LDEBT + 0.394 0.550 0.701
(0.187) (0.058) (0.066)
INREC + -0.001 0.028 -0.041
(0.996) (0.842) (0.809)
TENURE + 0.070 0.052 0.067
(0.002) (0.021) (0.025)
NEWCEO - -0.099 -0.086 -0.075
(0.015) (0.028) (0.057)
PUBLIC 0.120 0.133 0.155
(0.024) (0.008) (0.016)
PUBLIC_BU 0.168 0.137 -0.019
(0.000) (0.002) (0.666)
PRIVATE_BU 0.034 0.022 -0.044
(0.557) (0.698) (0.550)
SIZE 0.094 0.087 0.066
(0.000) (0.000) (0.000)
PERF06 0.084
(0.000)

Pseudo R2 0.132 0.171 0.106
ˆ 0.401 0.389 0.407
N 885 857 563
Two-sided p-values in brackets (based on White heteroskedasticity-adjusted standard errors). SIC-2 industry
indicator variables included but not reported.
FINBON06—CFO 2006 bonus based on financial performance measures as a percentage of CFO salary in
2006; FINBON07—CFO 2007 bonus based on financial performance measures as a percentage of CFO
salary in 2006 (as expected if all targets are met); PERF06—2006 performance relative to budget. Other
variables defined in Table 1.

36
Table 7—OLS Regressions of Changes in Weights on Financial Performance
Measures between 2007 and 2003

Expected Column 1 Column 2 Column 3
Variables Sign FIN07-03 FIN07-03 FIN07-03

Intercept 12.722 16.079 21.246
(0.076) (0.039) (0.050)
GROWTH -0.011 -0.029 -0.049
(0.696) (0.501) (0.508)
TENURE 0.890 -0.529 -0.614
(0.645) (0.779) (0.811)
NEWCEO - -4.666 -3.506 -2.357
(0.151) (0.383) (0.633)
PUBLIC - 0.287 -8.298 -12.894
(0.931) (0.019) (0.013)
PUBLIC_BU - -7.182 -5.918 -12.462
(0.007) (0.040) (0.003)
PRIVATE_BU 0.789 0.876 -1.163
(0.840) (0.825) (0.773)
SIZE -0.064 -0.085 -0.224
(0.915) (0.900) (0.797)
PERF04 -3.320 -3.433 -4.641
(0.003) (0.005) (0.008)

Adjusted R2 0.033 0.035 0.100
N 533 456 222

Two-sided p-values in brackets (based on White heteroskedasticity-adjusted standard errors). SIC-2
industry indicator variables included in a stepwise estimation procedure (SIC 65—Real estate retained as
the only significant effect; not reported above).
Column 1 includes all sample observations where CFO tenure is greater than 3 years. Column 2 excludes
observations where CFOs earn $50,000 or more in equity compensation from the sample in Column 1.
Column 3 excludes observations where CFOs’ bonuses are equal or less than 30% of their salaries from the
sample in Column 2.
FIN07-03—2007 weight on financial performance measures in CFO bonus minus the weight in 2003.
PERF04—2004 performance relative to budget. Other variables defined in Table 1.

37
Appendix A
Proofs

A risk-neutral principal hires a risk-averse agent to provide effort e (unobservable by the

principal) where e shifts the distribution of firm profitability x [ x, x ] to the right in the sense

of first-order stochastic dominance, i.e., Fe ( x, e)  0 . We assume the agent privately observes x

after providing e but that x is not publicly observable. Instead, the accounting system generates

a profitability report R( x, g )  x  kg where k  0 is a known constant and g represents

potential distortions (unobservable by the principal). We assume that prior to the release of R

the agent has an opportunity to alleviate misreporting by reducing g if it’s in his best interest to

do so.

We assume reported firm profit R( x, g ) is the only variable available for contracting and

write the compensation contract as S (R) . Furthermore, we assume the agent’s utility for

compensation, productive effort e and reporting distortions g is given by u ( S ( R)  c( g ))  h(e)

where u (.)  0 , u (.)  0 , c( g )  1 cg 2 is the cost of misreporting borne by the agent ( c  0 is
2

a known constant) and h(e)  1 he 2 is the (separable) disutility for performing e ( h  0 is a
2

known constant). Finally, we assume that if g  0 , then the principal also bears a cost of

L( g )  1 Lg 2 where L  0 is a known constant.
2

We begin with the reporting stage where, having already performed e and observed x

(and thus resolved all uncertainty about his performance), the agent decides on a level of g to

maximize u ( S ( R)  c( g ))  h(e) . The first order condition is given by

 dS ( R) 
u (.) k  cg   0 (A2)
 dR 

38
dS ( R) k
so that g *  . (A2)
dR c

c
The second-order condition for incentive compatibility requires   0 or
dR / dx

dR dg * k 2 d  dR 
dS
 1 k  1  0 . This condition is verified after we solve for the optimal
dx dx c dx

contract. Note that if the agent is rewarded with a fixed wage ( dSdRR )  0 ), then the agent
(

discharges his fiduciary responsibilities to its fullest and sets g *  0 . If dS ( R )
dR  0 , then the agent

benefits from some misreporting and tolerates g *  0 .

If we let u ( x)  u ( S ( R( x, g * ))  c( g * )) , then anticipating u (x ) at the reporting stage, the

agent selects e in the earlier stage to maximize E[u( x)  h(e)] . We have

x
Max
e  x
[u ( x)  h(e)] f ( x; e)dx (A3)

which implies a first-order condition of

x
 he  x
u ( x) f e ( x; e)dx  0 . (A4)

x
The agent’s second order condition requires that  h  
x
u ( x) f ee ( x; e)dx  0 . To ensure the

validity of the first-order approach, we assume f ( x; e) and h(e) are such that the second-order

condition (with respect to e ) is always met.

At the contracting stage, the principal maximization problem is as follows:

x
Max
S ( R ),e  x
[ x  S ( R)  L( g * )] f ( x; e)dx (A5)

subject to:

x
(1) 
x
[u ( x)  h(e)] f ( x; e)dx  U

39
x
(2)  he  x
u ( x) f e ( x; e)dx  0

where u ( x)  u ( S ( R( x, g * ))  c( g * )) and g * is given by A2. The Lagrangean for A5 is:

[ x  S ( R)  L( g * )] f ( x; e)dx +    [u ( x)  h(e)] f ( x; e)dx  U 
x x
Max
S ( R ),e 
x
 x



(A6)

    he  u ( x) f e ( x; e)dx  .
x

 x



Pointwise optimization with respect to S (R) gives the first-order condition

 dg *  du ( x) du ( x)
H   1  Lg *  f ( x; e)   f ( x; e)   f e ( x; e)  0 . (A7)
 dS  dS dS

dg * dg * / dx
Since g * solves A2, we have  . Also, since u ( x)  u ( S ( R( x, g * ))  c( g * )) , we
dS dS / dx

have

 ds  R R dg *  dg * 
u (.)      cg *
 
du ( x) du ( x) / dx
   dR  x g dx  dx 
(A8)
dS dS / dx dS / dx

which, given A2 and R( x, g )  x  kg , simplifies to

 ds 
du ( x)  
 u (.) dR  . (A9)
dS  ds 
 
 dx 

Hence A7 can be stated as:

 ds dg * 
 L g * 
1  dx dx      f e ( x; e) . (A10)
u (.)  ds  f ( x; e)
 
 dR 

ds ds  dg *  dS ( R) k
Moreover, since  1  k
  and g * 
 , A10 simplifies to
dx dR  dx  dR c

40
k 2  L  d  dR 
dS
1  1  
c  c  dx f ( x; e)
 e . (A11)
u (.) f ( x; e)

Note that if k  0 so that the profit report is known to be immune from misreporting, then

ds ds
R( x, g )  x , g *  0 ,  , and A11 reverts to the standard characterization of the optimal
dR dx

contract as in Holmstrom (1979). The principal’s second-order condition requires

 k2 d  dR 

dS 2

dH 1  L  dx2 
  1   dS  u(.)     f e ( x; e)    0 .
 (A12)
dS  dR / dx   c  c  dR  f ( x; e)  
 

Finally, to ensure that incentive compatibility with respect to agent’s choice of g is met, we

require

dR k 2 d  dR 
dS
 f ( x; e)  k 2 L d  dR 
dS
 1  u (.)    e
   0. (A13)
dx c dx  f ( x; e)  (c) 2 dx


OBSERVATIONS:

L    d  dS  
2

 dS  d  dR   H
dS

2k 
1    dR 
d  
  c   c    dx 
1) 
dR    0
 dx   dk  
dk dS  H  dS  H 
dx  dS
 
  
dx  dS 

 k   d  dR  
2

 dS  d    H 
2 dS
dS
d 
dR
    

 dR   dx   dL      c    dx   0
2)  
dL  dS  H  dS  H 

dx  dS 
  
dx  dS 

 2 L    d  dR  
2

 dS  d  dR   H   k 
2 dS
dS
d    1  
 c    dx 
 dR   dx   dc     c      0
3)  
dc  dS  H  dS  H 

dx  dS 
  
dx  dS 

41
 H 
 dS  dS 
d  dR   d   f e   d  dS  
d   u (.)  dR 
  
4) 
dR 
 dx    f   dx   0
 fe  dS  H  dS  H 
d      
 f  dx  dS  dx  dS 
 
 

Parametric example:

To be completed.

42
Appendix B
Questionnaire Items

1a. What percentage of the 2006 annual bonus incentive component did you earn based on
the achievement of
1b. If performance exactly meets targets on all measures, what percentage of your 2007
annual bonus do you expect to be based on the achievement of
1c. What percentage of the 2003 annual bonus did you earn based on the achievement of

Financial performance targets of the division

Financial performance targets of higher levels
(e.g., the firm, business group)

Non-financial performance targets

Achievements evaluated subjectively
(i.e., without pre-set targets)

Other, please specify below

2. How much did you earn through the following incentive components in 2006?
(Fill in zero if an incentive opportunity was offered but did not pay out.)
(Leave blank if no such incentive opportunity offered.)

Annual bonus

Long-term cash compensation plan

Equity-based compensation

Other, please specify below

3. Your annual salary in 2006 was

4. If performance exactly meets targets on all measures, your 2007 annual bonus should
be about

5. Last year's annual sales growth was about %

6. Please describe your industry.
(For example: manufacturing—components for the auto industry; wholesale—industrial
packaging products; management, IT, and strategy consulting)

43
7. How well did the firm perform in the last three years relative to the budget?

2006 performance
2005 performance
2004 performance

Scale:
Far below budget
Below budget
About the same as budget
Above budget
Far above budget
N/A

8. Who decides the following aspects of your incentives?11

Selection of performance measures

Discretionary bonus

(CEO decision = The CEO decides with little or no consulting of the board of directors.
Board decision = The board of directors decides with little or no consulting of the CEO.)

Scale:
1 CEO decision
2 Largely CEO
3 Joint decision
4 Largely the Board
5 Board decision
N/A

(Division manager = The general manager at the division decides with little or no consulting
of the higher-level CFO/controller.
Higher-level CFO = Higher-level CFO/controller decides with little or no consulting of the
general manager at the division.)

Scale:
1 Division manager
2 Largely division manager
3 Joint decision
4 Largely higher-level CFO
5 Higher-level CFO
N/A

11
The former scale applies to respondents at the corporate level, the latter one to those at the BU level.

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