Information Asymmetry and the Choice of Financial and Non-Financial Performance Targets During an Economic Downturn

Abstract

Prior studies examining how firms use multiple performance measures when evaluating their managers rarely recognize that managers may be privately informed about how well different measures reflect their effort. We extend the standard multi-tasking model to allow performance measures to be affected by the information asymmetry between the firm and its privately informed manager. We show that reducing the information asymmetry component of one measure reduces the corresponding information rent and consequently increases the relative incentive weight on that measure. This result guides our empirical inquiry of performance target setting using survey data on 2,136 entities collected before, during, and after the 2008-2009 recession. We predict that the recession made it more difficult for managers to understand how their effort translates into financial results and thus reduced the information asymmetry affecting financial performance measures. Consistent with our theoretical result, we find using various regression and matching estimators that financial performance targets are substantially more difficult to achieve (afford managers less slack) and at the same time account for a greater part of managerial incentive compensation during the recession than during our control periods.