

Department of Social Systems and Management
Discussion Paper Series

No.1306

Are the shareholders in Japanese governancemechanisms getting a benefit from the use of annual
incentive plans?
byMichiko OGAKU

May 2013

UNIVERSITY OF TSUKUBA
Tsukuba, Ibaraki 305-8573
JAPAN

Are the shareholders in Japanese governance mechanisms
getting a benefit from the use of annual incentive plans?
Michiko Ogaku, Ph.D. student
Graduate School of Systems and Information Engineering, University of Tsukuba, 1-1-1 Tennodai,
Tsukuba, Ibaraki 305-8573, Japan; ohgaku@sk.tsukuba.ac.jp

August 28, 2013

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 performancebased contracts if the non-verifiable measure is sufficiently informative so that theagent’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 profitablefirms. Second, the combination of the compensation policy and the ownership structure is likely to be associated with the level of executive compensation.
Keywords: executive compensation; agency theory; performance evaluation.

Are the shareholders in Japanese governance mechanisms getting abenefit from the use of annual incentive plans?1
The recent dismissal of the British chief executive of Olympus has once again drawn theattention of European media to peculiarities in corporate governance in Japan. Accounting
practices and lack of transparency have aroused particular concern. (Cortazzi 2011, 15)

1. Introduction
This paper studies the economic consequences of the choice of two different types of executive compensation contracts and examines whether shareholders in firms with Japanese governance mechanisms would benefit from the use of annual incentive plans. Japanese governancemechanisms are usually characterized as bank- and relationship-oriented, while Anglo-Saxon
governance mechanisms are perceived as market-oriented. There are pros and cons of Japanese
governance mechanisms. According to some observers, Japanese governance mechanisms giveinternal management autonomy, and management’s degree of freedom from bank control has aclose positive correlation with the level of corporate profit (e.g., Aoki 1990). In contrast, others
view the lack of transparency as one of the major obstacles to investment (e.g., Schulz 2004;
Jones 2011). Obviously, the internal management autonomy is a double-edged blade. As Jones(2012, 12) comments,...[it may result in] corporate decisions that are incomprehensible to outsiders. This tendency can sometimes manifest itself in a course of systematic lying to outside shareholders
through falsified accounts or other deliberate misinformation. ...Corporate scandals like
Olympus are thus seized upon as yet another example of bad “Japanese-style” management systems.
Implementation of performance-based compensation contracts is expected to provide a major
improvement in transparency. Currently, performance-based compensation is exempted fromJapanese corporate taxation by Corporate Tax Act No. 34. Until this act was passed, the1

The author is very grateful for the support and constructive advice from Shyam Sunder (instructor in topics on
accounting research course at Keio University 2011), Ella Mae Matsumura (editor), Susumu Ueno (editor), twoanonymous referees and seminar participants at Keio University, Osaka University, University of Tsukuba andthe 7th APMAA Conference 2011. The author is solely responsible for all remaining errors.

1

Japanese executive compensation system was starkly different from those of western counterparts. Even a reasonable allowance for salaries, which is tax deductible under Section 162 of the
U.S. Internal Revenue Code, for instance, was not allowed as a deduction under Japanese corporate tax law. The amendment made the Japanese executive compensation system more easily
understandable to people in western countries and allowed tax deductibility of performancebased compensation, regular period compensation (e.g., salary), and pre-determined compensation.2 It is fair to say that performance-based compensation is exempted from corporate
taxation in order to encourage firms to change their discretionary bonus contract practice to a
performance-based one that appears more market-oriented.
Somewhat ironically, discretionary bonuses continued to be used considerably after the introduction of the current terms of Corporate Tax Act No. 34. According to the Tokyo Stock
Exchange (TSE), 87.1% of TSE-listed companies responded that they have initiatives to offer
incentives (Tokyo Stock Exchange 2011). Performance-based compensation was introduced
in 19.7% of the TSE-listed companies, and stock option plans and “others” were introduced
in 31.4% and 45.2% of the TSE-listed companies, respectively. Out of 1,038 companies that
selected “others”, 50.4% referred to either “remuneration” or “bonus” in their supplementary
explanation of initiatives. This suggests that each year, several firms revised the salary component of their executive compensation on the basis of the performance of the previous period,
although some of the salary component may be regarded as a discretionary bonus.
Several Japanese firms continue using an opaque bonus contract practice, contrary to what
authorities might have expected. However, Japanese firms have typically used rank hierarchy
as a primary incentive device (Aoki 1990). Therefore, rewards might not be paid on the basisof performance measures, but instead are paid on the basis of rank (Shirai and Inoue 2010).
Thus, it is not obvious that a performance-based contract improves Japanese executives’ work
incentives. In other words, it is not known whether a performance-based contract reduces moral
hazard problems in Japanese governance mechanisms because these mechanisms may alreadymotivate executives to work hard.
2

Extra compensation qualifies as performance-based or pre-determined compensation if it was paid on the basisof performance measures that appear in a firm’s financial reporting or if it was declared to the tax office before
the execution of a contract.

2

The empirical evidence on the impact of the firms’ choice of executive compensation contract
is ambiguous. Kaplan (1994) studies top executive compensation and its relationship withfirm performance in the largest Japanese and U.S. companies, and finds that the relationshipbetween executive compensation and performance in Japan and the U.S. are statistically similar,
although the corporate governance mechanisms in those countries are considered significantly
different from each other. These results are supported by Kato (1997) and Basu et al. (2007).
They identify that CEOs of keiretsu earn less than those of independent firms, and keiretsu
could play a role as an effective Japanese governance mechanism. On the other hand, Core et al.
(1999) find that U.S. firms with weaker governance mechanisms had greater agency problems.
Finally, Basu et al. (2007) find that Japanese firms with weaker governance mechanisms, inparticular firms with higher insider ownership, have greater agency problems.
Motivated by the mixed empirical findings, this paper theoretically studies the consequencesof the choice of two different types of executive compensation contracts. The analysis is basedon a career concerns model in which compensation contracts are subject to renegotiation; compensation is paid on the basis of 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). Career concerns were first formalized by Holmström (1999). Gibbons and Murphy (1992) and Meyer andVickers (1997) develop dynamic models with explicit contracts based on the career concerns
model of Holmström (1999) and enable analyses of the interplay between implicit dynamic incentives and explicit incentives. Kaarbøe and Olsen (2008) extend the work of Meyer and Vickers (1997) by adding distorted performance measures based on the multi-task agency model ofFeltham and Xie (1994). Kaarbøe and Olsen (2008) come closest to this paper’s models; however, this paper takes a different approach when modeling distorted performance measures.
Instead of using the weights given to a performance measure as a degree of distortion, thispaper uses biases that the agent can introduce into his earnings report in order to inflate his
performance evaluation. This paper follows the work of Fischer and Verrecchia (2000) whenmodeling the agent’s biased reporting.
This paper also relates to the literature on relational contracts (e.g., Bull 1987; Baker et al.
1994; Levin 2003; MacLeod 2007). For example, Baker et al. (1994) consider subjective

3

performance measures in implicit contracts and their model is similar in spirit to the one inthis paper; however, the contract they consider is one in which a worker anticipates that theemployer could renege on a promise if their contract is implicit, and they focus on the roleof trust in enforcing implicit contracts. This paper assumes that Japanese firms’ discretionary
bonus contracts are driven by career concerns as compared to trust.
In the first of two main results, this paper shows that the conventional implicit contract candominate the performance-based contract if the agent’s bargaining power is moderate and thenon-verifiable measure within the firm is sufficiently informative, making it unlikely that theagent’s earnings report will trigger renegotiation for the second-period compensation contract.
On the other hand, the second result shows that the performance-based contract is optimal
if the non-verifiable measure is not sufficiently informative and the agent’s bargaining power
is considerably strong. One interpretation of these results complements Aoki’s (1990, 12)following description of the way in which rank hierarchy works as an incentive:
The existence of a credible threat of discharge when the employee does not meet the criteria
for continual promotion plays an important role in enabling the rank hierarchy to operate
as an effective incentive to curb shirking. A discharge in mid-career may point to some
negative attributes of the discharged so that he or she may not be able to gain equivalentrank outside, when information about him or her is not perfect.
In these terms, the main results show that explicit contracts are not required when executives
have concerns that they may not be able to gain equivalent rank outside and when information
about them is not verifiable outside.
The remainder of this paper is organized as follows: Section 2 explains the model assumptions and derives the optimal contract in equilibrium. Section 3 theoretically addresses whether
the shareholders in Japanese firms would benefit from the use of annual incentive plans. Section
4 provides the conclusion.

42. Model
2.1

Model Assumptions

Consider a two-period agency model with a risk neutral board of directors (the principal) anda risk neutral and effort averse manager (the agent), who run the business on behalf of theshareholders (the owner). Although shareholders are not active players, the paper assumes
their presence. This is in order to emphasize the fact that non-verifiable measures, which play
an important role in this analysis, are observed only by the contracting parties.
The key feature of this analysis is the consideration of two types of executive compensation
contracts: conventional implicit contracts and performance-based contracts. At t = 0, theprincipal selects one of these two types of contracts and provides a take-it-or-leave-it offer. The
initial contract commits both parties to stay in the relationship for two periods, but does notpreclude the possibility that the principal may reset the terms of the contract, and in turn, theagent may terminate the employment relationship in the case of a breakdown in renegotiation
for the second period contract.However, to ease exposition, once selected (and accepted by
the agent), it is assumed that the form of contract is not allowed to change for two periods.
However, the parameters may change.
Figure 1 presents the timeline. At t = 0, a compensation contract is signed between theprincipal and the agent. During the first period, the agent’s effort a1 generates stochastic cash
flow v1 . The realized value of the cash flow is not directly observable to anybody except
the agent. After observing v1 , the agent provides his earnings report r1 , which is potentiallydistorted by his bias b1 . In addition to the agent’s earnings report, the contracting parties (butnot the shareholders) may observe the non-verifiable measure s1 , which is useful for subjective
assessments of the agent’s contribution to the value of the cash flow. At t = 1 the principal andthe agent renegotiate the second-period contract w2 . The sequence of events is repeated in thesecond period except that at the end of period two, no further contract negotiation takes place.
At that point, shareholders consume the residual income.

5

FIGURE 1
Timeline



 












 

 



 






In the conventional implicit contract, compensation w̄t is assumed to consist of only fixed
payments, and the agent is motivated to work hard by career concerns. The principal uses
information about the agent’s current performance xt = (rt , st )! to update her beliefs about
the agent’s ability, where xt is a column vector composed of the earnings report rt and thenon-verifiable measure st . st is the realization of the random variable s̃t which is given bys̃t = at + η̃ + ζ̃t ,where at ∈ R denotes the agent’s effort in period t. The agent’s effort is not observable by
the principal (and shareholders). η̃ and ζ̃t are two independent normally distributed randomvariables. It is assumed that η̃ has mean E[η̃] > 0 and variance ση2 and ζ̃t has mean zeroand variance σζ2 . η̃ represents a manager’s unknown ability, which is related to the agent’s
contribution. ζ̃t represents errors in the assessment of the agent’s contribution. The realized
st is common knowledge to the contracting parties, but not verifiable to a third party. This
assumption corresponds closely with the Japanese firms’ discretionary bonus contract practicein which the salary component in executive compensation is revised on the basis of a subjective
assessment (from shareholders’ perspective) in the previous period. On the other hand, in theperformance-based contract, compensation wtper is assumed to be composed of fixed payments
and variable (earnings-report-based) payments.
wtper = ᾱt + βt rt ,(1)

where ᾱt ≥ 0 is the fixed payment for period t and βt > 0 is an incentive coefficient forperiod t. This assumption corresponds exactly with performance-based compensation in Cor-6

porate Tax Act No. 34. It is assumed that the non-verifiable measure is not available when theperformance-based contract is selected, and information available for the principal to update
her beliefs is xt = rt .
The firm’s cash flow in each period results from the agent’s effort and ability and a random
factor. The firm’s cash flow in period t is given by the following expression:vt = at + η + εt ,where η is the agent’s actual, unknown ability, εt is the realization of a normally distributed
random variable ε̃t with mean zero and variance σε2 . ε̃t denotes the impact of uncontrollable
events on a firm’s cash flow. Let ε̃t be independent of η̃ and of ζ̃t . The realization of the cash
flow in each period vt is not directly observable to anybody except the agent until the end of thesecond period; however, the functional form of ṽt and the distributions of noise and the agent’s
ability are common knowledge.
Observing the realization of the cash flow, the agent provides an earnings report to the principal (and shareholders). The earnings report for period t is potentially biased, as follows:r t = vt + bt ,where bt ∈ R represents the bias introduced by the agent into the earnings report. bt is notdirectly observed by the principal (and shareholders).
The agent is risk neutral and effort averse. It is assumed that exerting effort (both constructive
and destructive, i.e., at and bt ) causes the agent to incur a private cost of c(at , bt ). The costfunction is given byc(at , bt ) =a2tc · b2t+.
2
2

c is a known positive parameter and denotes the marginal impact of effort for providing a biased
report on the agent’s private cost. To reduce the number of parameters, the marginal impact of
productive effort at is assumed to be 1. When period t compensation is offered as wt , the7

agent’s objective function is given as

CE = E[w̃1 + w̃2 ] − c(a1 , b1 ) − c(a2 , b2 ).

(2)Compensation wt may be a random variable when it depends on performance measures that
include random variables. The principal is risk-neutral, and her objective function can be statedasE[ṽ1 + ṽ2 ] − E[w̃1 + w̃2 ].

(3)

In order to make a contract, the principal considers two types of constraints. The first typeconsists of the incentive constraints: the agent will choose at and bt to maximize his expectedutility. The second type consists of participation constraints: the principal must offer the agent
expected utility at least as high as the agent’s reservation wage. Following Meyer and Vickers (1997), the agent’s reservation wage depends on the total expected surplus. Let the total
expected surplus at the start of the contract be Π:Π = E[ṽ1 + ṽ2 ] − c(a1 , b1 ) − c(a2 , b2 ).

(4)

If the agent’s bargaining power is B ∈ (0, 1), his reservation wage is BΠ and the first-period
participation constraint is given byCE ≥ BΠ.

(5)

Throughout the paper it is assumed that the principal commits to satisfying the agent’s participation constraints not only at the initial contract but also at the time of renegotiation.3
3

As Meyer and Vickers (1997) pointed out in their footnote 9, if one develops a model along the lines of careerconcerns literatures with a participation constraint of this form, one would need to recognize the possibility that(i) if the agent’s expected productivity after the first period were extremely low, it would be an efficient choice
ex post for him to change firms, and (ii) if the agent initially planned to leave after the end of the first period(take-the-money-and-run strategy). However, the possibility would be negligible as long as the gap between his
ex ante expected outputs at the first-period firm and at other firms were large enough, or the agent is to receive a
sufficiently large lump-sum payment in the second period for remaining with his first-period firm, for example
the first-period fixed payment may be paid at the beginning of the second period.

8

Setting the participation constraint in (5) as an equality4 , the principal’s objective function in(3) can be simplified as follows:E[ṽ1 + ṽ2 ] − c(a1 , b1 ) − c(a2 , b2 ) − BΠ = (1 − B)Π.

(6)

Note that (1 − B) is always positive.
2.2

Conventional Implicit Contracts

This section presents the model’s solution assuming that the conventional implicit contract isselected. The modeling is based on the career concerns model of Holmström (1999). First, theoptimal contract in the second period is characterized.
At the start of the second period the principal maximizes her share of the total amount of
second-period expected surplus:!
"(1 − B)Π2 = (1 − B) E[ṽ2 |x1 ] − c(â2 , b̂2 ) ,(7)

subject to the following two constraints:
a2 , b2 ∈ arg max{E[w̃2 |x1 ] − c(a!2 , b!2 )},! !
a2 ,b2E[w̃2 |x1 ] − c(a2 , b2 ) ≥ BΠ2 ,

(8)
(9)

where ât and b̂t are the principal’s belief about the equilibrium amount of effort and bias,
respectively. The constraint in (8) is the incentive constraint and the constraint in (9) is theagent’s participation constraint.
From the principal’s perspective, the total surplus Π2 can be rewritten as
Πcon= E[ṽ2 ] + ρdr1 (r1 − E[r̃1 |â1 , b̂1 ]) + ρs1 (s1 − E[s̃1 |â1 ]) − c(â2 , b̂2 ).
2
4

(10)

The equality is satisfied under the optimal contract. Because the principal initiates a negotiation, she will set
compensation wt at the lowest level at which the agent is willing to accept the contract, i.e., CE = BΠ. On theother hand, when CE = BΠ is satisfied, the participation constraints and the agent’s outside opportunities give
him the same level of expected utility. Because it is a take-it-or-leave-it offer and this paper supposes that theagent will not choose outside opportunities that give the same expected utility as the principal’s offer, the agent
will accept the principal’s offer.

9ρdr1 reflects the marginal impact of the first-period earnings report r1 on the principal’s belief
about the second-period cash flow. Similarly, ρs1 reflects the marginal impact of the first-period
non-verifiable measure s1 on the principal’s belief about the second-period cash flow. The exact
expressions for the regression coefficients ρdr1 and ρs1 are contained in Appendix A. It is notedthat ρdr1 , ρs1 ∈ (0, 1) and ρdr1 + ρs1 < 1.
To determine the agent’s optimal effort choice, recall that compensation w̃2 in (8) is defined
as a fixed payment. Because the agent’s efforts do not impact compensation, his optimal effort
choice is a2 = b2 = 0.
Considering the agent’s bargaining power, the principal offers a contract to satisfy the participation constraint. Setting (9) as an equality and substituting a2 = b2 = 0, w̄2 is givenbyw̄2con (x1 ) = BE[ṽ2 |x1 ].

(11)

The symbol “con” is used to denote that it is satisfied in the optimal conventional implicit
contract. Note that the second-period contract w̄2con (x1 ) in (11) depends on x1 = (r1 , s1 )! .
This comes from the fact that the principal updates her belief about the agent’s ability η̃ byobserving x1 . Thus, w̄2con (x1 ) gives an implicit incentive to the agent in the first period, i.e.,
career concerns are present in the first period. Recall that w̄2con (x1 ) does not give any incentive
to the agent in the second period, i.e., a2 = b2 = 0. Thus, both the earnings report and thenon-verifiable measure are used to provide only implicit incentives in the conventional implicit
contract.
The first-period problem is solved in a similar manner. The principal’s problem at t = 0 is
to maximize her objective function in (6) subject to the participation constraint in (5) and the
incentive constraint

a1 , b1 ∈ arg max
{CE}.
! !
a1 ,b1(12)

Because the second-period compensation w̄2con (x1 ) in (11) depends on x1 = (r1 , s1 )! , the agent
has an incentive to exert effort in the first period to increase w̄2con (x1 ). Thus, the agent’s incen-

10

tive constraint can be rewritten as
a1 , b1 ∈ arg max{w̄2con (x1 ) − c(a!1 , b!1 )},! !
a1 ,b1for which the solution isacon= B(ρdr1 + ρs1 ),
1
bcon
=
1

1 d
Bρ .
c r1

(13)
(14)

Setting (5) as an equality, w̄1 is given by
con conw̄1con = B (acon
1 + E[η]) + (1 − B)c(a1 , b1 ).

(15)

Substituting compensations in (11) and (15) and the agent’s induced efforts, the total expectedsurplus for the conventional implicit contract Πcon is given by

Π

con

#
$
1
1 d 2
d
2
= − (ρr1 + ρs1 ) + (ρr1 ) B 2 + (ρdr1 + ρs1 )B + 2E[η̃].
2cΠcon is used in Section 3 when the principal compares her share of the total expected surplus
for each type of contract.
2.3

Performance-based contracts

In this section, the optimal contract for the performance-based contract is derived. The modeling is based on dynamic models with explicit contracts developed by prior literature (e.g.,
Baker et al. 1994; Meyer and Vickers 1997; Kaarbøe and Olsen 2008). Similar to the aforementioned conventional implicit contract, the principal maximizes her objective function in (7)subject to constraints in (8) and (9) at t = 1. From (7) and the fact that the information available
for the principal is now x1 = r1 , the total expected surplus Π2 from principal’s perspective canbe written asΠper= E[ṽ2 ] + ρr1 (r1 − E[r̃1 |â1 , b̂1 ]) − c(â2 , b̂2 ).
2
11

(16)

The symbol “per” is used to denote that it is satisfied in the optimal performance-based contract.
ρr1 reflects the marginal impact of the first-period earnings report on the principal’ belief about
the second-period cash flow. Note that the regression coefficient ρr1 is different from ρdr1 which
was given in the aforementioned conventional implicit contract. For the principal the firstperiod earnings report in the performance-based contract is the sole source of information about
the agent’s efforts and ability. In contrast, in the conventional implicit contract the principal
can use not only the first-period earnings report, but also the first-period non-verifiable measure.
Thus, the impacts of the first-period earnings report ρr1 in the performance-based contract arebigger than ρdr1 in the conventional implicit contract for the principal. The exact expression iscontained in Appendix A.
For determining the agent’s optimal effort choice, first consider the expectation of his compensation at t = 1. For the contract defined in (1), it is given byE[w̃2 |x1 ] = ᾱ2 + β2 {E[ṽ2 |x1 ] + b2 } − c(a2 , b2 ).

(17)

Substituting (17) in the constraint in (8), the agent’s optimal effort choice is given byaper= β2 ,
2

(18)

1
β2 .
c

(19)

bper
=
2

Maximizing (7) with respect to β2 and considering the agent’s induced efforts in (18) and (19),the incentive weight of the optimal contract at t = 1 is given by
β2∗ =

c
.
c+1

(20)

The fixed component of the agent’s compensation α¯2 is determined in a manner that satisfies
the constraint in (9). This is given by1ᾱ2∗ (x1 ) = (B − β2∗ )E[ṽ2 |x1 ] − (β2∗ )2 + (1 − B)
c

12

#

$
1 ∗ 2
1 ∗ 2
(β ) + (β2 ) .
2 2
2cTherefore, the second-period wage contract offered to the agent is
w2per (x1 ) = ᾱ2∗ (x1 ) + β2∗ r2 .

(21)

Note that the second-period fixed payment ᾱ2∗ (x1 ) in (21) depends on the first-period earnings
report r1 . However, the optimal second-period incentive payment β2∗ r2 in (21) does not depend
on r1 , because it is an explicit contract based on the second-period earnings report r2 .
Next, consider the first-period problem. The principal’s problem at t = 0 is to maximize her
objective function (6) subject to the constraints in (12) and (5). Recall that the agent’s secondperiod fixed payment ᾱ2∗ (x1 ) in (21) depends on his first-period earnings report r1 . Thus, theincentive constraint in (12) can be written as
a1 , b1 ∈ arg max{E[β1 r̃1 ] + E[ᾱ2∗ (x1 )] − c(a!1 , b!1 )},! !
a1 ,b1(22)

for which the solution isaper= β1 + µr1 ,
1
bper
=
1

1
(β1 + µr1 ) ,
c

(23)
(24)

where µr1 = (B − β2∗ )ρr1 is the implicit incentive to increase the second-period fixed payment.
cc
The sign of µr1 is ambiguous. It is positive when B > 1+c
and negative when B < 1+c.

Considering the agent’s optimal effort choice and maximizing (6) with respect to β̌1 , β̌1 =
β1 + µr1 , the incentive weight of the optimal contract at t = 0 is given byβ̌1∗ =





c
1+c

B < BF , µr1 B > BF ,

(25)

r1 )
where BF = c(1+ρ. Note that the incentive weight of the performance-based contract in (1)(1+c)ρr1

is defined as positive, i.e., β1 > 0. Perhaps when β̌1∗ = µr1 is satisfied, the contract can be
defined as a semi-performance-based contract because it provides a direct incentive only in thesecond period. Thus, BF is the threshold above which the semi-performance-based contract13

has to be offered instead of the performance-based contract.
Setting (5) as an equality and considering the agent’s optimal action choice and the optimal
incentive weights, the first-period fixed payment is given by11ᾱ1∗ = (B − β̌1∗ )E[ṽ1 ] + (1 − B)c(β̌1∗ , β̌1∗ ) − β1 ( β̌1∗ ) − µr1 E[r̃1 ].
c
c

(26)

Note that a long-term linear contract in which the fixed payment is α1 + (α2 − µr1 r1 ) and thecincentive coefficient for rt is always 1+cwould be a renegotiation-proof contract.

The total expected surplus for the performance-based contract Πper and that for the semiperformance-based contract Πper
F are given byc+ 2E[η̃],
1+c )
,
*
+2
1+c
c
c
= −
+ µ2r1 ++ µr1 + 2E[η̃].
2c
1+c
1+c

Πper =
ΠperF

Note that Πper ≥ Πper
F is satisfied (and the equation is satisfied when B = BF ). Recall thatΠper is computed to be the optimal total surplus.
Figure 2 shows the agent’s induced actions in equilibrium. For example, PER (CON) effort
indicates the sum of the first- and the second- period effort of the performance-based contract(the conventional implicit contract). The x-axis measures the bargaining power scale. When cis larger than one, the agent’s cost of introducing bias is higher than that of exerting productive
effort. Thus, the line of induced effort is always above the line of induced bias in each contract.
In this case, the effort exerted in the performance-based contract is always higher than that in
the conventional contract.
On the other hand, when c is less than ρr1 and ρs1 is sufficiently large, i.e., the non-verifiablemeasure is sufficiently informative, the agent’s preference for effort and bias is completely
opposite in each contract. Importantly, when c is less than ρr1 and ρs1 is sufficiently large, thebias of the performance-based contract is always higher than that of the conventional implicit
contract, and in some interval, the effort of the conventional implicit contract is higher than thatof performance-based contract.

14

FIGURE 2
Agent’s induced actions   
























3. Choice of the Type of Contracts
In this section, the optimal choice of the type of contract is derived. At the start of period 1,
the principal compares her share of the total expected surplus for each type. The following
proposition summarizes the results.
Proposition 1: Suppose σζ2 = kσε2 , k > 0.
( i ) For c ≥ 1, the performance-based contract is optimal.
(ii) For c < 1, k con (c) exists such that k con (c) is a decreasing function inc and• For k > k con (c), the performance-based contract is optimal overB ∈ (0, 1) if c > ρr1 , and over B ∈ (0, BF ) if c < ρr1 ;• For k < k con (c), ccon ∈ (0, 1), B con and B exp , 0 < B con < B exp ,exists such that for c < ccon the conventional implicit contract is

15

optimal over B ∈ (B con , B exp ) if B exp ≤ min(BF , 1), and overB ∈ (B con , min(B exp , 1)) if B exp > min(BF , 1).
All proofs are in Appendix B.
The intuition behind these results is straightforward. When the private cost of introducing
bias into an earnings report is higher than that of exerting productive effort for the agent, i.e.,c ≥ 1, the performance-based contract in which the performance measure serves as an incentive
to work hard dominates the conventional implicit contract. Furthermore, even though introducing bias into an earnings report is an easier choice for the agent, i.e., c < 1, when the nonverifiable measure is not informative enough, i.e., k > k con , the performance-based contract isstill the optimal choice for the principal. On the other hand, when reporting with bias is not aneasier choice for the agent, i.e., c < 1, and the non-verifiable measure is sufficiently informative
so that the agent’s earnings report does not consider renegotiation for the next compensation
contract, i.e., k < k con (c), the conventional implicit contract could dominate its counterpart.
Note that the coefficient k in σζ2 = kσε2 could be a measure of relative informativeness. A lower
coefficient k reflects a superior non-verifiable measure’s relative informativeness to the earnings report. Recall that the shareholders observe only the agent’s earnings report. It can be said
that when the non-verifiable measure works well the agent works hard despite the fact that his
contribution is assessed with an opaque decision process from the shareholders’ perspective,
which is often observed in Japanese management mechanisms. These results correspond to theempirical evidence provided by Kaplan (1994) , Kato (1997), and Basu et al. (2007). Thesestudies report that a relationship-oriented governance mechanism works as well as a marketoriented governance mechanism. Arguably, non-verifiable measures in relationship-oriented
governance mechanisms are sufficiently informative because they provide common consent,
which can be interpreted as that in which a non-verifiable measure would play an importantrole in relationship-oriented mechanisms.
However, it is not the case if the agent’s bargaining power B is in the range (0, B con ] ∪(B exp , min(BF , 1)). In particular, when the agent’s bargaining power is considerably strong,i.e., B ∈ (B exp , min(BF , 1)), the conventional implicit contract allows the agent to provide
a biased earnings report and get excess compensation as compared to the performance-based

16

contract. The following corollary shows that inequality B exp < min(BF , 1) is satisfied and a
non-empty set (B exp , min(BF , 1)), in which the performance-based contract is optimal, exists.
Corollary 1: Suppose c < ρr1 and k < k con . If k is sufficiently close to k con (c), ρexp ∈(0, 1] exists such that for ρr1 < ρexp , B exp < B F < 1 is satisfied and theperformance-based contract is optimal over B ∈ (B exp , BF ).
In other words, when the non-verifiable measure in the conventional implicit contract is relatively uninformative and when the marginal impact of the earnings report in the performancebased contract ρr1 is weaker, i.e., ρr1 < ρexp , the performance-based contract can dominate theconventional implicit contract depending on the strength of the agent’s bargaining power. The
results imply a scenario: the conventional implicit contract may be chosen by managers who
have strong bargaining power as compared to the board of directors, although a performancebased contract could be optimal for their firms. This scenario is consistent with Basu et al.
(2007), who find that top Japanese executives earn more in firms with higher insider ownership.
Figure 3 characterizes the case where the assumptions of Corollary 1 and c < ccon are satisfied.

FIGURE 3


Difference of the total surplus






17

3.1

Empirical Implications

On the basis of the aforementioned results, implications for empirical compensation research
can be discussed. First, the firms’ executive compensation policy (e.g., how directors are paid)
is may not serve as a useful test in identifying profitable firms. A change in the pay policy
from discretionary to performance-based bonus contract practice is not expected to have a positive relationship with firm performance. This prediction is consistent with Kubo (2005), whoanalyzes whether a firm’s method of paying its directors matters, although the current study
does not agree with his conclusion that executive compensation is not designed to motivate executives to work towards increasing shareholder value. Second, the combination of the firms’
executive compensation policy and ownership structure is likely to be associated with the levelof executive compensation. If firms with higher insider ownership continue to use a conventional contract, they may experience higher agency costs.

4. Conclusion
This paper studies the consequences of the choice of two 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 on the basis of 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). The analysis shows that assessment of the agent’s contribution based on an earnings report creates incentives for providing a biased report; these incentives could significantly distort the structure of the optimal-compensation contract. The
effect makes the conventional implicit contract optimal if the non-verifiable measure within thefirm is sufficiently informative and the agent’s bargaining power is moderate. In contrast, if
the non-verifiable measure is not sufficiently informative and the agent has strong bargaining
power, the conventional implicit contract motivates the agent to provide a biased report and theperformance-based contract becomes optimal.
These results imply two different scenarios. First, Japanese firms use the conventional implicit contract because top executives in those firms are motivated to work hard by subjective

18

assessments of their contribution to firm value, though it can be seen as an opaque decision process by shareholders. Second, the conventional implicit contract is chosen by top executives
who have strong bargaining power as compared to the board of directors, although their nonverifiable measures are relatively uninformative and so a performance-based contract could be
optimal for their firms. Therefore, the shareholders in firm with Japanese governance mechanisms would not always benefit from the use of annual incentive plans.
As long as the Japanese governance mechanisms are working well, implementation of aperformance-based compensation contract may give excessive rewards to executives who are
already motivated to work hard. A performance-based compensation contract would not be
what improves firms’ transparency but it seems to work well in firms that already have a transparent governance mechanism.
Although this paper has applied classic agency theory, which is built upon the assumption that
there is a conflict of interest between a principal and an agent, it is easy to imagine analyses
relaxing the assumption. For example, further insights on performance-based measures undervarious control mechanisms can be generated by introducing a goal congruent agent.5

APPENDIX A
Regression Coefficients
The covariance matrix (ṽ2 , r̃1 , s̃1 ) is22
 ση + σε






5

ση2

ση2

ση2

ση2 + σε2

ση2

ση2

ση2

ση2 + σζ2





.



For example, this kind of analysis is conducted by Banker et al. (2010). They integrate agency theory andorganizational control theory and study three types of control: outcome based control; behavior-based control;and clan control.

19

By applying well-known formulas for multivariate normal distributions (e.g., DeGroot 2004),
ρdr1 =ση2 σζ2,ση2 σζ2 + σε2 ση2 + σε2 σζ2ρs1 =ση2 σε2,ση2 σζ2 + σε2 ση2 + σε2 σζ2

ρr1 =

ση2
.
ση2 + σε2

APPENDIX B
Proof of Proposition 1
Let ∆Π = Πcon − Πper and ∆ΠF = Πcon − Πper
F . Recall that (1 − B) is positive. Hence(1 − B)∆Π and ∆Π have the same sign, and (1 − B)∆ΠF and ∆ΠF also have the same sign,∆Π and ∆ΠF can be taken as the principal’s measure of the optimal type of contract. To
examine the sign of ∆Π, the discriminant of ∆Π is evaluated. From σζ2 = kσε2 , ρdr1 can be
written as ρdr1 = kρs1 . Substituting the expression, ∆Π can be rewritten as#$1
1 2 2 2c2∆Π = − (1 + k) + k ρs1 B + (1 + k)ρs1 B −
.
2
c
1+c
The discriminant of ∆Π is given byD=4
ρ2s1 3(1 − c)(1 + k)2 − 2k 2 .
1+c( i ) For c ≥ 1. Because the discriminant of ∆Π is negative, i.e., D < 0, ∆Π has no real roots.
Because the coefficient of B 2 in ∆Π is negative, ∆Π is the parabola that opens downwards.
Thus, the sign of ∆Π is negative for all B. Further, for c > 1, BF > 1 over all ρr1 ∈ (0, 1).
Therefore, the performance-based contract is optimal over all B ∈ (0, 1).

(ii) For c < 1. To determine the sign of the discriminant of ∆Π, denote ψ(k) = (1 − c)(1 +k)2 − 2k 2 . The discriminant of ψ(k) is given by 8(1 − c) > 0. Thus, ψ(k) has two real roots.

Because the coefficient of k 2 in ψ(k) is negative, ψ(k) is the parabola that opens downwards.
The roots are given by5
5
1 − c − 2(1 − c)
1 − c + 2(1 − c), and,
.
1+c
1+c

20

Let kcon√√

1−c+ 2(1−c)
1−c− 2(1−c)=. Note that k con is a decreasing in c. Because the sign of
1+c
1+c

is negative and that of k con is positive, ψ(k) > 0 for k ∈ [0, k con ) and ψ(k) < 0 for k > k con
is known.
For k > k con . The discriminant of ∆Π is negative, i.e., D < 0. Thus, ∆Π < 0 over all
B ∈ (0, 1). Taking account of the fact that if c < ρr1 the performance-based contract is
unfeasible over B ∈ [BF , 1), it can be said that the performance-based contract is optimal,
over B ∈ (0, 1) if c > ρr1 , and over B ∈ (0, BF ) if c < ρr1 .

For k < k con . Because the discriminant of ∆Π is positive, ∆Π has two real roots. These roots
are given by
6
6
1
1(1 + k) − 1+c[(1 − c)(1 + k)2 − 2k 2 ](1 + k) + 1+c[(1 − c)(1 + k)2 − 2k 2 ]
3
4
3
4
,
and,
.
(1 + k)2 + 1c k 2 ρs1(1 + k)2 + 1c k 2 ρs1

Let B con =(1+k)−√ 1

2
2
1+c [(1−c)(1+k) −2k ]1 22(1+k) + c k ρs1[]

and B exp =(1+k)+√ 1

2
2
1+c [(1−c)(1+k) −2k ]1 22(1+k) + c k ρs1[]. One knows that∆Π > 0 over B ∈ (B con , B exp ). The fact that ∆Π(0) is negative implies that B con > 0 and
B exp > 0. Because the limit of B con as c approaches zero is zero, ccon ∈ (0, 1) exists suchthat for c < ccon , B con < 1 is satisfied. Recall that ∆ΠF ≥ ∆Π for all B. If B exp > BF
and ∆Π > 0 over B ∈ (B con , B exp ), ∆ΠF > 0 is satisfied over B ∈ (BF , B exp ). Thus,
the conventional implicit contract is optimal, over B ∈ (B con , B exp ) if B exp ≤ min(BF , 1),
and over B ∈ (B con , min(B exp , 1)) if B exp > min(BF , 1) . This completes the proof of
Proposition 1.
Proof of corollary 1
Let the vertex of ∆Π be (Bv , ∆Π(Bv )). Because ∆Π(k) is continuous, the roots of ∆Π canbe made to be as close to Bv as desired by making k sufficiently close to k con . Thus, when
Bv < BF is satisfied, inequality Bv < B exp < BF can be derived by making k sufficiently
close to k con . Consider now when inequality Bv < BF is satisfied. Inequality Bv < BF can3478
be rewritten as (1 + 1c )Bv − 1 < ρ1r1 . Denote ψ(c, k) = 1 + 1c Bv − 1. When k = k con ,ψ(c, k con ) > 0 is satisfied. Suppose c is fixed somewhere in (0, ρr1 ). Because ψ(c, k) is
a continuous function, for any number ε > 0, some number δ > 0 exists such that for allk, |k − k con | < δ ⇒ |ψ(c, k) − ψ(c, k con )| < ε. Thus, ψ(c, k) > 0 in the neighbourhood21

1
U = {(c, k)||k − k con | < δ, c ∈ (0, ρr1 )}. Let ρexp = min{ ψ(c,k), 1}, (c, k) ∈ U . If ρr1 < ρexp ,1
ψ(c, k) < ρexp
< ρ1r1 . This indicates that Bv < BF is satisfied over (c, k) ∈ U . From the proofof Proposition 1, ∆Π < 0 over B ∈ (B exp , BF ]. Therefore, the performance-based contract is
optimal over B ∈ (B exp , BF ). This completes the proof of Corollary 1.

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