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Discretion and the complexity of simple incentive contracts
Felix Hoppe, Maastricht University
Frank Moers, Maastricht University
ABSTRACT. In this paper, we argue that discretion can improve incentive contracting by addressing two important considerations: (1) risk reduction and (2) congruity improvement. We distinguish between discretion being applied in incentive contracts solely based on earnings and contracts based on multiple measures. In an earnings-based contract, the benefit of discretion is its ability to reduce risk, while in a multi-measure contract, the benefit of discretion is its ability to reduce noncongruity. We expect that, conditional on the use of only accounting information (accounting and nonaccounting information), the choice of implicit contracts is a positive function of accounting noise (environmental uncertainty). Finally, we expect that the ability to exploit the benefits of discretion depends on the monitoring quality of the board. The empirical results based on incentive contract data for 424 CEOs of U.S. public firms are consistent with our expectations.
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