Subjective Adjustments to Objective Performance Measures in Executive Annual Bonus Contracts

We examine boards of directors' subjective adjustments to objective performance measures in executive incentive contracts. Using a unique hand-collected sample of adjusted earnings per share measures used to determine executives' annual bonuses, we provide large-sample evidence that subjective adjustments are related to uncontrollable noise, firms' demand for congruity improvement, and the need to meet CEOs' participation constraints. We also find that managers are more likely to meet or beat their performance targets when boards adjust their realized earnings. Finally, we find that the ex ante option to adjust mitigates managerial short-term focus more effectively than ex post adjustments. Overall, our findings suggest that boards use subjective adjustments to alleviate the limitations of formula-based incentive contracts