Abstract
Following the optimal contracting hypothesis, this study investigates the issue of whether the board of director's ex ante choice to incorporate individual performance evaluation (IPE) measures into the CEO bonus plan rewards managerial decisions not reflected in measures of the firm's current financial performance. Empirical results provide evidence that the use of IPE in the CEO bonus plan is an increasing function of the proportion of outsider directors on the board and a decreasing function of the informativeness of financial performance measures. This study also demonstrates how the use of IPE in incentive contracting can explain CEO cash compensation that is not explained by the firm's current performance and governance variables. Finally, the CEO incentive cash compensation not explained by observable performance measures or governance structure is positively associated with firm future performance one year after its award. Overall, results support the optimal contracting hypothesis. IPE appears to be used to increase the informativeness of CEO actions and determine the level of current CEO cash incentive compensation.
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