The Impact of Performance Measure Discriminability on Ratee Incentives

Abstract

ABSTRACT: The literature addresses optimal contract design issues that the principal must address to provide proper incentives to the agent. However, there has been limited empirical assessment of how agents actually respond to the performance-evaluation schemes in the contracts offered them. Moreover, the literature overlooks factors, other than those from the pay-for-performance context, that may impact the effectiveness of incentive provisions. This study considers the effect of discriminability on agent performance. We find that (1) agent performance improvement is positively associated with the degree of discriminability, (2) subjective measures are inferior to objective measures in providing incentives to the agent because of the lack of discriminability, and (3) the inferiority of subjective measures for incentive purposes is exacerbated in circumstances in which the discriminability gap between objective and subjective measures is significant. Our findings suggest that, in order to have subjective measures effectively complement objective measures, the accounting profession must develop sound performance measurement systems that define and measure subjective performance with sufficient discriminability.

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