Relative performance evaluation and peer-performance summarization errors

Relative performance evaluation and peer-performance summarization errors In tests of the relative performance evaluation (RPE) hypothesis, empiricists rarely aggregate peer performance in the same way as a firm’s board of directors. Framed as a standard errors-in-variables problem, a commonly held view is that such aggregation errors attenuate the regression coefficient on systematic firm performance towards zero, which creates a bias in favor of the strong-form RPE hypothesis. In contrast, we analytically demonstrate that aggregation differences generate more complicated summarization errors, which create a bias against finding support for strong-form RPE (potentially inducing a Type-II error). Using simulation methods, we demonstrate the sensitivity of empirical inferences to the bias by showing how an empiricist can conclude erroneously that boards, on average, do not apply RPE, simply by selecting more, fewer, or different peers than the board does. We also show that when the board does not apply RPE, empiricists will not find support for RPE (that is, precluding a Type-I error). http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Review of Accounting Studies Springer Journals

Relative performance evaluation and peer-performance summarization errors

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Publisher
Springer Journals
Copyright
Copyright © 2012 by Springer Science+Business Media, LLC
Subject
Economics / Management Science; Accounting/Auditing; Finance/Investment/Banking; Public Finance & Economics
ISSN
1380-6653
eISSN
1573-7136
D.O.I.
10.1007/s11142-012-9212-9
Publisher site
See Article on Publisher Site

Abstract

In tests of the relative performance evaluation (RPE) hypothesis, empiricists rarely aggregate peer performance in the same way as a firm’s board of directors. Framed as a standard errors-in-variables problem, a commonly held view is that such aggregation errors attenuate the regression coefficient on systematic firm performance towards zero, which creates a bias in favor of the strong-form RPE hypothesis. In contrast, we analytically demonstrate that aggregation differences generate more complicated summarization errors, which create a bias against finding support for strong-form RPE (potentially inducing a Type-II error). Using simulation methods, we demonstrate the sensitivity of empirical inferences to the bias by showing how an empiricist can conclude erroneously that boards, on average, do not apply RPE, simply by selecting more, fewer, or different peers than the board does. We also show that when the board does not apply RPE, empiricists will not find support for RPE (that is, precluding a Type-I error).

Journal

Review of Accounting StudiesSpringer Journals

Published: Oct 6, 2012

References

  • Peer firms in relative performance evaluation
    Albuquerque, A
  • Tests for relative performance evaluation based on assumptions derived from proxy statement disclosures
    Bannister, J; Newman, H; Weintrop, J
  • Does the use of peer groups contribute to higher pay and less efficient compensation?
    Bizjak, J; Lemmon, M; Naveen, L
  • Empirical research on CEO turnover and firm-performance: A discussion
    Brickley, JA
  • Relative performance evaluation in CEO pay contracts: Evidence from the commercial banking industry
    Crawford, AJ
  • The effect of competition on CEO turnover
    DeFond, ML; Park, CW

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