Would Shareholders in Firms with Japanese Governance Mechanisms Benefit from the Use of Annual Incentive Plans?

Abstract

This paper studies the economic consequences of choosing two different types of executive compensation contracts. The analysis is based on a two-period agency model in which compensation contracts are subject to renegotiation; compensation is paid based on the agent’s earnings report (e.g., a performance-based contract) or a non-verifiable measure within the firm (e.g., a conventional implicit contract). According to the analysis, conventional implicit contracts can dominate performance-based contracts if the nonverifiable measure is sufficiently informative so that the agent’s earnings report is not significantly considered during renegotiation. However, if the agent has strong bargaining power, the performance-based contract is optimal. The theoretical findings have implications for empirical compensation research. First, the firms’ compensation policy may not serve as a useful test for identifying profitable firms. Second, the combination of the compensation policy and the ownership structure is likely to be associated with the level of executive compensation.