Performance Target Difficulty and Fourth-quarter Performance

Prior studies often examine the association between performance and various measures of incentive strength. We argue that target difficulty is another important but often overlooked driver of managerial performance. Using data on earnings targets in annual bonus plans, we construct and validate an empirical measure of beginning-of-year target difficulty and find that it is negatively associated with environmental uncertainty, retention concerns, and CEO entrenchment. We also test and reject the null hypothesis that target difficulty has no effect on fourth-quarter performance. We find that beginning-of-year target difficulty is positively associated with target difficulty at the end of the third quarter which is in turn associated with abnormally strong fourth-quarter performance. We also provide evidence that abnormal performance in the third quarter reverses in the fourth quarter and that this reversal is stronger when targets are moderately challenging (neither too easy nor too difficult to achieve). Finally, we show that much of the reversal in abnormal performance associated with moderately challenging targets can be explained by reductions in fourth-quarter performance following abnormally favorable third-quarter performance