Ittner, Larcker, and Rajan ( ILR; 1997) studied the relative weights placed on financial and non- financial performance measures in CEO bonus contracts for a sample of 317 U. S. firms across 48 industries for 1993– 1994. Recall that RBC ( Example 10.1) includes attainment of non- financial performance measures ( i. e., personal goals) as a criterion for its short- term incentive awards. Non- financial performance measures in the RBC plan include goals with respect to risk management, cost management, new revenue initia-tives, financing, and development of U. S. operations. Financial performance measures are net income growth and return on equity.

ILR found empirical support for the following hypotheses about the relative weights on financial and non- financial performance measures in compensation plans:

i. Noise in net income. The lower the correlation between manager effort and net income (measured by the correlation between stock market and accounting- based returns), the less the relative weight on financial performance measures.

ii. Firm strategy. “ Prospector firms” ( growth and innovation oriented, identify and adapt quickly to new product/ service opportunities) will have greater relative weight on non-financial performance measures than “ defender” firms ( stable set of products/ services, emphasis on increasing efficiency to reduce operating costs).

iii. Product quality. The greater the firm commitment to quality, the greater the relative weight on non- financial performance measures.

iv. Regulation. Regulated firms will have greater relative weight on non- financial performance measures than non- regulated firms.

Required

a. Give intuitive arguments to explain these four hypotheses.

b. Which of these four hypotheses might help explain the inclusion by RBC of non-financial performance measures in its short- term incentive awards?