43

Using Sales Revenue as a Performance Measure

Abstract

• The study provides a systematic examination of the compensation contracting relevance of sales revenue.
• There is an increasing temporal trend in the explicit use of sales revenue as a performance measure in CEO annual bonus contracts.
• This mirrors a similar increase in the relative pay-sensitivity of revenues versus earnings over time.
• Sales revenue is more likely to be used as an explicit performance measure in annual bonus contracts when:
  • Sales revenue is relatively more informative about firm value than accounting earnings.
  • Firms follow a growth-focused organizational strategy.
• The pay-sensitivity of revenue is significantly more positive for firms that explicitly reward revenue performance.
• Earnings pay-sensitivity is not significantly different from zero for these firms.
• This paper extends our current understanding of the selection of performance measures in compensation contract design.
• It also raises new questions about the validity of the traditional implicit tests in examining questions related to executive pay.
• Keywords: Performance measures, executive compensation, sales revenue, pay-sensitivity
• JEL Classifications: M40, M41, M46, J33

I. INTRODUCTION

• This study examines the use of sales revenue as a performance measure in CEO compensation contracts.
• Prior research documents that sales revenue plays a significant role in equity pricing:
  • (Swaminathan and Weintrop 1991; Anthony and Ramesh 1992; Ertimur, Livnat, and Martikainen 2003; Penman 2004; Jegadeesh and Livnat 2006; Chandra and Ro 2008; Srivastava 2014).
  • Particularly when accounting earnings is less informative about firm value.
• Examples:
  • Anthony and Ramesh (1992) and Ertimur et al. (2003) find that investors react more strongly to revenue surprises when firms are in their early growth stages.
  • Chandra and Ro (2008) and Callen, Robb, and Segal (2008) document that the market places greater valuation weight on the sales revenue of technology and loss firms.
• The ability of revenue to substitute for accounting earnings as a measure of firm performance appears to be a function of its:
  • Relatively greater persistence (Armstrong, Davila, Foster, and Hand 2011; Dichev and Tang 2008; Jegadeesh and Livnat 2006).
  • Greater difficulty in managing revenues than costs (Ghosh, Gu, and Jain 2005; Ertimur et al. 2003).
  • The view that revenue is more readily understood by financial statement users than accounting earnings (Wagenhofer 2014).
• We extend this line of inquiry to examine the use of sales revenue as a performance measure in compensation contracting.
• A vast literature has previously examined the usefulness of accounting earnings in setting executive pay.
• Accounting profits have become progressively less important in evaluating top executives over the last three decades as firms have shifted toward the use of alternative performance measures (Bushman and Smith 2001).
• Recent survey evidence shows that sales revenue has recently become the most frequently used explicit performance measure in executive annual incentive plans (see Towers Watson 2001, 2005, 2010).

Trends in Using Sales Revenue

• A Towers Watson survey conducted in 2001 documents that sales revenue is the second most frequently used performance measure, with 25% of survey respondents reporting the use of revenue as a performance measure.
• The surveys conducted in the 2005 and 2010 show that sales revenue has become the most frequently used performance measure, with 31% and 34%, respectively, of the responding firms employing revenue as a performance measure.
• Despite these trends, however, extant research has not yet explored the compensation contracting relevance of sales revenue.

Research Design

• We address this void in the literature using two complementary research design approaches:
  • First, we employ an explicit contract approach to empirically examine the factors that influence firms’ decisions to contract on sales revenue performance.
  • Second, we build on insights generated in the prior theoretical and empirical literatures on performance evaluation (Holmstrom 1979; Banker and Datar 1989; Lambert and Larcker 1987; Sloan 1993; Bushman, Indjejikian, and Smith 1996; Ittner, Larcker, and Rajan 1997; Hayes and Schaefer 2000).
• We predict that firms are more likely to supplement accounting earnings with sales revenue as an additional performance measure in compensation contracts when sales revenue (accounting earnings) is relatively more (less) informative about firm value.
• We proxy for the informativeness of sales revenue and accounting earnings in reflecting firm value using numerous empirical measures from prior literature.
• We hand-collect the performance measures employed in executive bonus contracts for S&P 500 firms, as listed in their proxy statements filed with the Securities and Exchange Commission (SEC), over 1993-2007.
• Consistent with our expectations, we find that firms are significantly more likely to explicitly employ sales revenue as a supplemental performance measure in CEO bonus contracts when:
  • Sales value relevance is higher.
  • When sales variability is lower.
  • When special items are reported more frequently.
  • Accrual management and earnings variability are greater relative to other firms.

Sample Period

• We begin our sample period in 1993 because this date coincides with Internal Reserve Service regulations (Section 162(m)) that limit the deductibility of cash compensation paid to firms’ five highest paid executives unless the compensation qualifies as “performance-based.”
• We end the sample period in 2007 to avoid any confounding effects associated with the financial crisis of 2008.

Organizational Strategy

• We also hypothesize that firms’ organizational strategy will influence the compensation contracting relevance of sales revenue.
• In particular, we predict that firms are more likely to explicitly reward revenue performance when following a “prospector” business strategy (Miles and Snow 1978; Porter 1980).
• “Prospectors” attempt to be first-to-market through new product development, technology innovation, and gaining market share, as opposed to “defenders” who attempt to keep current market share by emphasizing operating efficiencies and reducing costs (Ittner et al. 1997).
• Following Bentley, Omer, and Sharp (2013), we construct a discrete STRATEGY composite measure to proxy for firms’ organizational strategy but also examine additional firm characteristics that reflect adoption of the “prospector” strategy, including R&D and intangible asset intensity, firm age, firm size, and degree of merger and acquisition (M&A) activity.
• Consistent with our expectations, we find the composite STRATEGY measure is positively associated with the use of sales revenue as a performance measure, as are R&D, intangible intensity, M&A activity, and industry competitiveness, while firm size and firm age are negatively associated with the contracting relevance of sales revenue.

Pay-Sensitivity of Sales Revenue

• Next, we empirically examine the pay-sensitivity of sales revenue following the methodology developed in the implicit contract literature -- i.e., regressing changes in CEO cash compensation on changes in sales revenue, earnings, and stock return performance -- using two separate samples.
• First, using all available data on ExecuComp, we demonstrate that the average pay-sensitivity for sales revenue performance is significantly positive after controlling for earnings and returns.
• We further find that while the pay-sensitivity of earnings is declining over time, the pay-sensitivity of revenue remains constant over our sample period.
• In addition, the relative pay-sensitivity of revenues to earnings is significantly increasing over time, indicating that revenue performance plays an increasingly important role in determining CEO pay.
• This finding is consistent with our descriptive data showing that the explicit use of sales revenue as a performance measure is also increasing during our sample period.

Implicit Contract Approach

• We also employ the implicit contract approach using our sample of S&P 500 firms, but extend the analysis using our hand-collected explicit performance measures.
• Consistent with prior work, we find that the pay-sensitivities of earnings and stock return performance in determining CEO pay are significantly positive for the average firm; we further document that the average pay-sensitivity for sales revenue performance is significantly positive.
• However, when we condition our analyses on the explicit use of revenue as a performance metric, our inferences change.
• Consistent with our expectations, we find that revenue pay-sensitivity is significantly higher for firms that explicitly reward revenue performance, and while we anticipated a lower earnings pay-sensitivity for this group of firms, we find that earnings has no significant explanatory power in predicting CEO cash compensation after controlling for sales performance and stock returns.
• That is, the pay-sensitivity of earnings is not significantly different from zero for firms that explicitly reward revenue performance.
• This finding contradicts the basic assumption underlying the use of the implicit contract approach in the executive compensation literature – namely, that earnings performance is a universal determinant of bonus compensation – and demonstrates how omitted variable bias inherent in the implicit contract approach may lead to incorrect inferences.

Analogous Findings

• This finding is analogous to that of Chandra and Ro (2008), who document that the value relevance of earnings drops significantly over the 1973-2003 period but the value relevance of revenues is not diminished.
• Similarly, Dichev and Tang (2008) report that earnings volatility has increased significantly over 1967-2003 but that revenue volatility over the same time period has either remained unchanged or decreased slightly, depending upon the length of the reporting period.

Contributions to Literature

• We contribute to the existing literature by providing the first systematic examination of the contracting relevance of sales revenue.
• We document a significant increase in the frequency with which sales revenue is used as an explicit performance measure over time, which is mirrored by a similar increase in the relative pay-sensitivity of sales revenues to earnings.
• We further find that the explicit use of revenue as a performance measure is significantly positively (negatively) associated with the informativeness of revenue (earnings) as a measure of firm value, consistent with prior literature on the informativeness principle (Holmstrom 1979).
• Revenue is also more likely to be employed as an explicit performance measure in annual bonus contracts in firms that follow a “prospector” organizational strategy, which extends the prior literature linking compensation policies to strategic objectives (Balkin and Gomez-Mejia 1990; Ittner et al. 1997; Sanders and Carpenter 1998).
• These findings augment our current understanding of compensation contract design in general and contribute to the emerging literature on the use of explicit performance measures in compensation contracting (e.g., Gong, Li, and Shin 2011; Chen, Matsumura, Shin, and Wu 2015) in particular.
• We also contribute to the existing literature by providing new evidence on the validity of the implicit contract approach typically used in executive compensation research.
• Contrary to the widespread assumption in the implicit contracting literature that earnings is always relevant in setting executive pay, we document that the accounting earnings is not a significant determinant of compensation for firms that explicitly reward revenue performance.
• This finding complements Gong et al. (2011), who find that the explicit and implicit contract approaches yield varying inferences regarding firms’ use of relative performance evaluation in compensation contracts.
• These findings suggest that assumptions underlying the implicit contract approach may result in measurement error and erroneous inferences, consistent with arguments offered by Bushman and Smith (2001), and provide support for the superiority of the explicit contract approach to examining compensation contracting questions.
• The remainder of the paper is structured as follows:
  • In section 2, we discuss prior research and develop our hypotheses.
  • We present the sample and data in section 3.
  • We discuss empirical tests and results in section 4.
  • We conclude in section 5.

II. LITERATURE REVIEW AND HYPOTHESIS DEVELOPMENT

• Top line sales revenue is one of the largest and most value-relevant items in firms’ financial statements and considered a key value driver of shareholder value (FASB 2000; Zhang 2005; Ghosh et al. 2005; Penman 2004; Srivastava 2014).
• Prior research documents that the stock market reaction on the earnings announcement date is significantly related to contemporaneous and past revenue surprises (Jegadeesh and Livnat 2006) and the market awards a distinct equity premium to firms meeting revenue forecasts (Rees and Sivaramakrishan 2007).
• Due to its importance, managers often voluntarily disclose projected revenue performance along with earnings guidance (e.g., Han and Wild 1991; Wasley and Wu 2006).
• The frequency of issuing analysts revenue forecasts has also increased dramatically over time (Ertimur, Mayew, and Stubben 2011; Jegadeesh and Livnat 2006).
• In some cases investors even place a higher valuation weight on sales than on earnings.
• For instance, Rees and Sivaramakrishan (2007) find that the equity premium to firms meeting earnings forecasts disappears when revenue forecasts are not met.
• For Internet firms with losses or negative cash flows, the market views revenues and revenue growth as highly important and analysts tend to follow the price-to-sales ratio (Hand 2000; Trueman et al. 2000, 2001; Bagnoli, Penno, and Watts 2001; Demers and Lev 2001; Davis 2002; Bowen, Davis, and Rajgopal 2002; Callen et al. 2008).
• Furthermore, Srivastava (2014) documents that for software companies the value-relevant information contained in earnings has declined while the value relevance of revenue has increased post-SOP 97-2 implementation.
• Using a broader sample of firms, Chandra and Ro (2008) document a similar decline in the value-relevance of earnings over time but no diminishment in the value-relevance of revenue.
• This latter finding is attributed to revenue’s greater persistence relative to earnings and the greater difficulty in managing revenues than expenses (Ertimur et al. 2003; Marquardt and Wiedman 2004; Ghosh et al. 2005).
• Despite the importance of sales revenue in firm valuation, the use of sales revenue as a performance measure in compensation contracting has been largely ignored.
• Existing research on executive compensation has mainly focused on the role of earnings as the primary accounting performance measure.
• However, statistical evidence shows that the usefulness of accounting earnings in evaluating top executives has declined over the last three decades, with firms shifting toward the use of alternative performance measures (Bushman and Smith 2001).
• In contrast, recent survey evidence reveals that the explicit use of sales revenue has significantly increased over time, switching from the second most frequently used performance measure to the most frequently used performance measure in executive compensation contracts (see Towers Watson 2001, 2005, 2010).
• However, prior research has not explored even the most fundamental questions regarding the relevance of sales revenue in compensation contracting.
• Much of the existing research on executive compensation employs the “implicit contract” approach, in which measures of executive pay are regressed on accounting-based and stock price-based performance measures to estimate pay-for-performance sensitivities (Bushman and Smith 2001).
• However, it should be noted that in studies employing the implicit contract approach, the actual performance measures used in determining compensation are unknown.
• Assuming or guessing the performance measures used in contracts creates potential for serious errors-in-variables and omitted variables problems (Bushman and Smith 2001; Demski and Sappington 1999; Murphy 1999).
• In addition, the implicit approach makes it difficult for researchers to investigate the factors determining the choices of various performance measures used in executive compensation contracts (Ittner and Larcker 2002).
• In contrast, in the explicit contract approach, the researcher has detailed information on actual performance measures used.
• Not only does this approach reduce the likelihood of serious econometric problems but, more importantly, it allows researchers to understand the signals the board communicates to shareholders and other stakeholders about the firm’s activities and executives’ actions (Murphy and Jensen 2011; Armstrong, Guay, and Weber 2010).
• Despite its advantages, however, the academic literature has only recently begun to exploit the use of specific performance measures.
• For example, Chen et al. (2015) relate the use of customer satisfaction measures in executives’ annual bonus contracts, obtained from firms’ proxy statement filings, to competition intensity and type.
• Gong et al. (2011) examine the explicit use of relative performance evaluation (RPE) in executive compensation contracts and demonstrate the difficulty in detecting RPE use as an incentive mechanism under the traditional implicit contract approach.
• Following the innovative example of these two recent studies, we adopt the explicit contract approach to explore the determinants of the compensation contract- relevance of sales revenue.
• Agency theory suggests that a performance measure is useful in contracting only if it provides incremental information regarding the agent’s unobserved actions (Holmstrom 1979; Banker and Datar 1989; Feltham and Xie 1994).
• An extensive empirical literature documents that the use of earnings in compensation contracts is consistent with the informativeness principle (Lambert and Larcker 1987; Ely 1991; Sloan 1993; Bushman, Indjejikian, and Smith 1996; Ittner, Larcker, and Rajan 1997, Hayes and Schaefer 2000); more recent work reports similar findings for the use of cash flows (Banker, Huang, and Natarajan2009; Nwaeze, Yang, and Yin 2006).
• We extend this line of inquiry to predict that firms are more likely to explicitly contract on sales revenue when sales revenue (accounting earnings) is relatively more (less) informative about firm value.

First Hypothesis

• H1: Firms are more likely to explicitly reward revenue performance in bonus compensation contracts when revenue (earnings) is relatively more (less) informative about firm value.

Second Hypothesis

• Our second hypothesis links the contract-relevance of sales revenue to corporate strategy.
• Performance measures should be closely tied to corporate strategies to ensure that managerial incentives are properly aligned (Ittner et al. 1997).
• Previous studies show that corporate strategy is often a determinant of executive compensation design (e.g., Balkin and Gomez-Mejia 1990; Dow and Raposo 2005; Gomez-Mejia 1992; Ittner et al. 1997; Sanders and Carpenter 1998).
• For example, Sanders and Carpenter (1998) study the relationship between globalization strategy and executive compensation and show that firms engaging a global diversification strategy adopt CEO compensation contacts that are high level and long-term oriented.
• Ittner et al. (1997) find that firms pursing innovation- and quality-oriented strategy place more weight on non-financial metrics, suggesting that firms link compensation policies to strategic objectives to ensure that managerial incentives and corporate objectives are aligned.
• We thus consider how the use of revenue as performance metric might be linked to corporate strategy.
• We utilize the Miles-Snow (1978) typology to characterize firms as following either a “prospector” or a “defender” strategy.
• Each type of firms implements a substantially different set of value chain activities (Porter 1985).
  • Prospectors are firms that search for new markets, seek out new opportunities, and emphasize firm growth.
  • They invest heavily in scientific research, new product development, brand building, marketing and advertisement, employee training, quality control, and/or fast delivery (Porter 1980; White 1986; Ward and Duray 2000).
  • In contrast, defenders focus on defined markets and emphasize operating efficiencies to lower costs.
  • They rely on cost control activities such as standardized product design, procurement of inexpensive labor, full utilization of capacity resources, and tight budgetary control of overhead costs, R&D expenses, advertising, and selling expenses (Porter 1980; White 1986: Zahra and Covin 1993: Ward and Duray 2000).
• We expect that firms following a prospector business strategy are more likely to place greater importance on revenue growth than firms following a defender strategy and will therefore explicitly reward sales revenue performance in compensation contracts.

Second Hypothesis Formal

• H2: Firms following a “prospector” corporate strategy are more likely to explicitly reward sales revenue performance in CEO annual bonus contracts than other firms.

Additional Explorations

• We also explore the compensation contracting relevance of sales revenue by estimating the pay-sensitivities using the traditional implicit approach.
• We expect sales revenue to be relevant in determining the magnitude of bonus compensation after controlling for earnings and stock return performance because of its greater persistence relative to earnings (Armstrong et al. 2011; Dichev and Tang 2008; Jegadeesh and Livnat 2006) and the relatively greater difficulty in managing revenues than costs (Ghosh et al. 2005; Marquardt and Wiedman 2004; Ertimur et al. 2003).

Third Hypothesis

• H3: The pay-sensitivity of sales revenue is positive for the average firm.

Decreasing Pay-Sensitivity of Accounting Earnings

• Prior research has documented that the pay-sensitivity of accounting earnings has been decreasing over time (Bushman and Smith 2001).
• This circumstances mirrors the temporal decline in the value relevance of earnings that has been well-established within the accounting literature (Collins, Maydew, and Weiss 1997; Francis and Schipper 1999; Lev and Zarowin 1999; Dichev and Tang 2008; Donelson, Jennings, and McInnis 2011), consistent with Bushman et al.’s (2006) finding that the stewardship and valuation roles of earnings are positively correlated.
• In contrast, the value relevance of sales revenue has not suffered the same decline as that of accounting earnings.
• Chandra and Ro (2008) report that the value relevance of sales revenue has remained constant over their sample period of 1973-2003.
• Relatedly, Dichev and Tang (2008) report that the volatility in sales revenue has either remained constant or declined slightly over 1967-2003, depending upon the length of the financial reporting period, while earnings volatility has increased significantly over the same time period.
• Assuming that the correspondence between stewardship and valuation roles of performance measures extends to sales revenue, we expect that the ratio of the pay-sensitivity of sales revenue to the pay-sensitivity of earnings, which captures the relative mix of performance measures used in setting executive pay, is increasing over time.

Fourth Hypothesis

• H4: The relative pay-sensitivity of sales revenue to earnings is increasing over time.
• Finally, we combine the explicit and implicit contract approaches to examine the pay-sensitivity of sales revenue, conditioning on the explicit use of revenue as a performance metric.
• If firms explicitly contracting on sales revenue indeed place a higher weight on sales revenue performance, we expect that the pay-sensitivity of sales revenue (earnings) is significantly higher (lower) for firms that explicitly reward revenue performance.
• In contrast, if firms employ sales revenue in conjunction with many performance measures and do not view it as an incrementally informative performance measure, we do not expect a significant weight on sales revenue.

Fifth Hypothesis

• H5: Revenue (earnings) pay-sensitivity is significantly higher (lower) for firms that explicitly reward revenue performance compared with firms that do not explicitly reward revenue performance.

III. SAMPLE DESCRIPTION

• To identify firms in which CEO bonus compensation contracts are explicitly based on revenue, we hand-collect performance measure data from firms’ proxy statements filed with U.S. Securities and Exchange Commission (SEC) over the years 1993 to 2007.
• Hand-collecting data necessarily limits our sample size; we therefore focus on firms in the Standard & Poor (S&P) 500, as identified using the Compustat S&P Index Constituent Identifier.
• Firms included in the sample fulfill the following requirements:
  • (1) The firm is identified as an S&P 500 firm in December of any year over the period 1993-2007.
  • (2) the firm’s proxy statement is available on the SEC website.
  • (3) the firm has an annual bonus plan.
  • (4) executive bonus compensation is explicitly based on at least one performance measure.
  • (5) the firm discloses the explicit performance measures employed in the bonus plan.
• We exclude financial firms (SIC codes 6000-6999) and utilities (SIC codes 4900-4999) as the executive compensation design and earnings properties of regulated industries typically differ substantially from other firms.

Sample Data Sources

• We obtain financial data from Compustat and stock price information from CRSP to estimate the determinants of employing sales revenue as a performance measure in CEO bonus compensation contracts.
• Our sample is reduced by the data required for the estimation, resulting in a total of 3,909 firm-years in the probit estimation of the decision to explicitly contract on sales revenue performance (H1 and H2).
• To test H3, H4, and H5, we obtain CEO compensation data from ExecuComp database.
• We use all the ExecuComp data available to estimate the pay-sensitivities of sales revenues to test H3 and H4 (N = 18,246 firm-years) and use ExecuComp data for only S&P 500 firms to test H5 (N = 4,358 firm-years).
• We first compile descriptive data on the variety of performance measures used in CEO annual bonus contracts over our sample period.

Performance Measures

• EPS is the most commonly used measure (38%).
• Sales revenue is the second-most popular performance measure used in CEO annual incentive compensation contracts, with 1,194 (31%) of firms explicitly mentioning its use.
• In order of frequency, the other financial performance measures mentioned include:
  • Operating income/pretax income/EBITDA (26%).
  • Net income (21%).
  • Accounting returns (18%).
  • Cash flow/free cash flow (17%).
  • Return on shareholders’ equity (9%).
  • Economic profits (9%).
  • Stock returns (7%).
  • Operating margin (6%).
  • Cost controls (3%).
• In addition, firms often employ more than one performance measures: the mean (median) number of measures used is 2.79 (2.00).
• Firms that use revenue as a performance measure are significantly more likely to also adopt EPS, operating income/pretax income/EBITDA, cash flow/free cash flow, or operating margin than other firms, but are significantly less likely to use accounting return measures, ROE or EVA/Economic profit.
• Firms that adopt sales revenue as a performance measure also tend to use significantly more performance measures than other firms.
• The yearly distribution shows a clear increasing temporal trend in the frequency of firms using sales as a performance measure.
• In 1993, the percentage is only 17.44% while it peaks at 41.05% in 2006.
• This is consistent with survey evidence (Towers Watson 2001, 2005, and 2010) that shows that sales revenue has become an increasingly important performance measure over time.
• High-tech industries exhibit high frequencies of firms using sales as a performance measure.
• For example, Business Services, Computers, Pharmaceuticals, Medical Equipment, and Electronic Equipment are the five industries with the highest percentages of firms contracting on sales, with frequencies ranging from 52.30% to 68.68%.
• In contrast, manufacturing industries generally have low frequencies of firms contracting on sales.
• For example, Petroleum and Natural Gas has a frequency of only 0.84%, and no sample firm in the Tobacco Products, Fabricated Products, or Non-Metallic and Metal Mining employs revenue as a performance measure.
• The industry distribution provides preliminary evidence that prospector firms operating in growth industries tend to contract on sales more frequently than defender firms operating in mature industries, consistent with our expectations.

IV. EMPIRICAL TESTS

Determinants of explicit use of sales revenue

• To empirically test H1 and H2, we estimate the following probit model of the decision to employ sales revenue as an explicit performance metric in CEO annual incentive contracts:
  $P(SALES)<em>{i,t}= \beta</em>0 + \beta<em>1 SALESVR</em>{i,t-1} + \beta<em>2 SALESNOISE</em>{i,t-1} + \beta<em>3 EARNINGSVR</em>{i,t-1} + \beta<em>4 EARNINGSNOISE</em>{i,t} + \beta<em>5 DDICHEV</em>{i,t-1} + \beta<em>6 SIFREQ</em>{i,t-1} + \beta<em>7 LOSSFREQ</em>{i,t-1} + \beta<em>8 STRATEGY</em>{i,t-1} + \beta<em>9 R\&D</em>{i,t-1} + \beta<em>{10} INTANGIBLE</em>{i,t-1} + \beta<em>{11} AGE</em>{i,t-1} + \beta<em>{12} LOGTA</em>{i,t-1} + \beta<em>{13} M\&A</em>{i,t-1} + \beta<em>{14} HHI</em>{j,t-1} + \beta<em>{15} HITECH</em>{i,t-1} + \delta_{i,t}$
• In equation (1), SALES is an indicator variable that equals one when CEOs’ annual bonus contracts are explicitly tied to sales revenue performance, and zero otherwise.
• In H1, we hypothesize that firms are more likely to explicitly reward revenue performance in bonus compensation contracts when revenue (earnings) is relatively more (less) informative about firm value.
• We use a number of informativeness measures to test H1.
• First, prior studies find that higher compensation weights are placed on performance measures that are more value relevant to investors (e.g., Bushman et al. 2006; Banker et al. 2009).
• Therefore, we include SALESVR in equation (1) to proxy for value relevance of revenue.
• We obtain the proxy by using an 8-quarter rolling window estimation of the following model:
  $CAR<em>{i,q} = \alpha</em>0 + \alpha<em>1 \Delta RPS</em>{i,q} + \alpha<em>2 \Delta EPS</em>{i,q} + \epsilon_{i,q}$
• CAR is the raw stock return minus the CRSP value-weighted market portfolio return for firm i in quarter q.
• ΔRPS (ΔEPS) is changes in revenue per share (changes in earnings per share) from the same quarter of the prior year, deflated by beginning-of-quarter stock price.
• The estimated coefficient on ΔRPS (ΔEPS) is used as a proxy for the incremental value relevance of revenue (earnings).
• A significantly positive coefficient on SALESVR will be consistent with our expectation that firms are more likely to explicitly reward revenue performance in bonus compensation contracts when revenue (earnings) is relatively more (less) informative about firm value.
• The second informativeness measure is performance measure volatility.
• Prior studies document that the compensation weights on a performance measure is decreasing in its volatility (e.g., Banker and Datar 1989; Natarajan 1996).
• We therefore include SALESNOISE, which is measured by estimating the firm’s standard deviation of sales revenue deflated by common shares outstanding over previous eight quarters.
• We expect the coefficient on SALESNOISE to be negative and significant.
• Since, as shown in Table 1, firms tend to use sales performance in tandem with some form of profit measure when setting managerial pay, we include the value relevance of earnings (EARNINGSVR), estimated in equation (2) as α2, and earnings noise (EARNINGSNOISE), defined as standard deviation of return on assets over previous eight quarters, in equation (1).
• The third set of informativeness measure relates to earnings quality.
• Lower quality of earnings creates a demand for additional performance measure for both valuation and contracting purposes (e.g., Lougee and Marquardt 2004; Nwaeze et al. 2006).
• We use the Dechow and Dichev (2002) measure of accruals quality as our first proxy for earnings quality (DDICHEV), obtained by estimating the following model:
  $\Delta WC<em>t = r</em>0 + r<em>1 CFO</em>{t-1} + r<em>2 CFO</em>t + r<em>3 CFO</em>{t+1} + r<em>4 \Delta REV</em>t + r<em>5 PPE</em>t + \epsilon_t$
• ΔWC is the change in working capital, measured by change in current assets minus change in current liabilities, minus change in cash and short-term investment, and plus change in debt in current liabilities.
• CFO is cash flow from operations.
• ΔREV is change in revenue, and PPE is growth value of property, plant, and equipment.
• All variables are deflated by average total assets.
• Model (3) is estimated cross-sectionally by year within each of the 48 Fama and French (1997) industry classifications.
• DDICHEV is the standard deviation of firm-level residuals.
• Firms are more likely to supplement accounting earnings with sales revenue as an additional performance measure in compensation contracts when earnings quality is low.
• Since a bigger standard deviation of residuals indicates lower quality of earnings, we expect the coefficient on DDICHEV is positive and significant.
• Special items include nonrecurring items, which are related to low-quality earnings (Donelson et al. 2011; Dechow and Ge 2006).
• Therefore, we use the frequency of reported special items as our second proxy for earnings quality.
• Special item frequency (SIFREQ) is measured by the percentage of special items in previous eight quarters.
• Similarly, prior studies show that accounting losses do not prolong; therefore, they are less informative about firm value (Hayn 1995; Collins et al. 1997).
• We therefore include the incidence of losses (LOSSFREQ), defined as the percentage of accounting losses, i.e., earnings before extraordinary items, in previous eight quarters, as another proxy for earnings quality.
• We expect both the coefficient on SIFREQ and LOSSFREQ are positive and significant, suggesting that firms are more likely to supplement accounting earnings with sales as an additional performance measure when earnings quality is low.
• In H2, we hypothesize that firms following a “prospector” corporate strategy are more likely to use sales revenue as a performance measure.
• To test H2, similar to Bentley et al. (2