Ittner, Larcker, and Rajan (1997) studied the relative weights placed on financial and nonfinancial performance measures in CEO bonus contracts for a sample of 317 U.S. firms across 48 industries for 1993-1994. Recall that BCE Inc. (Section10.3) has both types of performance measures in its short-term incentive awards. Non-financial performance measures in the BCE plan are based on individual creativity and initiative, succession planning, and Management development. Financial performance measures include earnings per share, revenue growth, earnings growth capital intensity, free cash flow, and return on invested capital.

Ittner, Larcker, and Rajan find oneal support for the following hypotheses about the relative weights : on financial and non-financial performance measures in compensation plans:

i. Noise. The lower the correlation between ‘manager effort and net income (measured by the correlation between stock market and accounting-based returns), the less the relative weight on financial performance measures.

ii. Firm strategy. ” ‘Prospector firms” (growth and innovation oriented, identify and adapt quickly to new product/service opportunities) will have greater relative weight on nonfinancial performance measures than “defender” firms (stable set of products/services, emphasis on increasing efficiency to reduce operating costs).
iii. Product quality. The greater the firm commitment to quality, the greater the relative weight on non-financial performance measures.
iv. Regulation. Regulated firms will have greater relative weight on non-financial performance measures than non- regulate firms.
Required

a. Give intuitive arguments to explain these four hypotheses.

b. Which of these four hypotheses might explain the inclusion by BCE Inc. of non-financial performance measures in its short-term incentive awards?