What Firms do to Mitigate Adverse Incentive-Driven Behaviour
On Wednesday, 22 September 2021, Professor Emerita Anne Lillis, Department of Accounting, University of Melbourne presented the 82nd CPA Australia–University of Melbourne Annual Research Lecture, the oldest continuous lecture series in the University’s Calendar and the world’s longest-running annual lecture in the accounting discipline. For the second year running, COVID-19 restrictions meant that the lecture was delivered online via Zoom.
The formalities commenced with the chair for the evening, departmental head, Associate-Professor Brad Potter, calling on the department’s Professor Emerita, Maggie Abernethy to introduce Professor Lillis, her long-time colleague and collaborator. In her introduction Professor Abernethy referred to the “crossover” nature of the lecture – being directed at both academics and practitioners – as well as to Professor Lillis’s important research contributions and teaching innovations.
The theme of the lecture was the “the thorny problem of performance measurement and incentives”, the nub of the problem being the potential for performance measures to be “gamed” to produce dysfunctional rather than beneficial results to enterprises (and society more generally).
While performance-based pay is ubiquitous, it is also associated with notorious examples of dysfunctional behaviour such as teachers “teaching to the test” to boost students’ exam scores, police testing themselves at roadside alcohol testing stations to meet test-volume targets and, as revealed by Australia’s recent Royal Commission into Misconduct in the Banking, Superannuation and Financial Services Industry, financial-sector employees creating bogus accounts and selling inappropriate products to customers to meet income-enhancing performance targets
The bulk of the lecture then focused on how firms sought to avoid these dysfunctional behaviours while retaining performance-based incentives in employment contracts. To this end, Professor Lillis outlined the findings of a major study she had undertaken, together with collaborators Mary Malina and Julia Mundy, into how subjectivity in performance measurement and reward systems is used to mitigate incentive contracting risk. The investigation focused on 38 supervisory and subordinate managers in four large firms with international operations, two of which were manufacturers, with the remaining pair being, engaged respectively in investment-management and professional-services.
All four firms adopted performance measurement and reward systems that focused on objective measures of performance, or, in the case of “soft” attributes like leadership and teamwork, framed as objectively as possible. The bonus schemes adopted by these firms were represented as relatively formulaic, involving multiple measures and weightings.
However, overlaying these objective measures were many layers of subjective assessments impacting on all elements of formulae and weightings other than firm performance (which effectively set the overall bonus potential). In particular, while managers needed to meet hard targets, it mattered, not only from the standpoint of their bonuses, but also retention and promotion prospects, “how” targets were achieved. The “how” was generally considered to take more than 50 per cent weight in ratings that determined pay and prospects.
The importance of these subjective elements influencing bonus determination, meant that the relevant employment performance agreements were what economists label “relational” contracts: agreements containing many implicit or unwritten terms. However, given their unwritten character, it was important that those bound by such contracts trusted how they would be administered and considered them to be both “clear” and “credible”. In the four firms investigated it emerged that trust was present and it was general understood that subjective performance measurement was underpinned by clear and credible processes.
Another finding of the investigation, supporting the results of other research, is that the bureaucratic processes required to implement well-informed subjective performance measurement are costly activities, with some firms questioning their cost-effectiveness.
Professor Lillis concluded with the observation that jointly, both accountants and HR human resources professionals potentially over-value the notion of “hard” targets and objective measures and undervalue the notion of well-informed subjectivity. Managerial work is rarely captured adequately in a set of hard metrics. Who gets rewarded and promoted will signal what is valued to firms. If firms do not have the systems in place to distinguish those employees that genuinely contribute value from those that do not, then they will continue to reward what they can count rather than what counts.
Following the presentation, Associate-Professor Brad Potter was the conduit for a lively Q&A session. In closing proceedings, Ms Jacquetta Griggs, President of the Victorian Division of CPA Australia, emphasised the rich tradition of the lecture as well as complimenting the speaker on the presentation.
To view the full catalogue of past CPA Australia - University of Melbourne Annual Research Lectures, click here.