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An Empirical Investigation of the Performance Consequences of Nonnancial Measures

ABSTRACT: Firms are increasingly implementing new performance measurement sys- tems to track
nonnancial metrics such as customer and employee satisfaction,quality, market share, productivity,
and innovation. This study examines the implications of nonnancial performance measures
included in compensation contracts oncurrentand future performance. Contextual factors,
environmental factors, and strategic plans vary across rms and, in turn, adopting appropriate
nonnancial measures determines the performance consequences of such measures. Our ndings
support the contention that rms that employ a combination of nancial and nonnancial
performance mea- sures have signicantly higher mean levels of returns on assets and higher levels
of market returns. Although we nd evidence that the adoption of nonnancial measures improves
rms current and future stock market performance, we nd only partial sup- port for accounting
performance improvements. Overall, the results indicate that the association between the use of
nonnancial measures and rm performance is contin- gent on the rms operational and
competitive characteristics.

INTRODUCTION
the increasing emphasis on the use of a combination of nancial and nonnancial performance
measures has been widely discussed in the accounting literature (e.g., Ittner and Larcker 1998, 2001;
Ittner et al. 1997; Keating 1997; Strives et al. 1998). Competition has compelled rms to implement
management strategies and systems to over- come dissatisfaction with traditional short-term
perspective nancial measurement systems. One of the principal motivations behind the use of
nonnancial measures is the notion that only a collection of conceptually sound nancial and
nonnancial performance measures can properly align the efforts of an enterprise with its strategic
objectives (Kaplan and Norton 1996). Although nonnancial measures have been widely advocated
and adopted, empirical research has provided little evidence on whether these initiatives yield
signicant economic benets. The purpose of this paper is to ll that gap. The objectives of this
study are twofold. First, consistent with recent claims in the performance measurement literature,
we investigate whether the inclusion of nonnancial measures in compensation contracts is
positively associated with contemporaneous and future accounting and stock market performance.
Second, we investigate the related hy- pothesis that the relation between the use of nonnancial
measures and economic perform- ance is a function of the t or match between a rms
operational and competitive circumstances and its choice of performance measures. Using panel
data covering the period 19931998, we compare the performance of a sample of rms that used
both nancial and nonnancial measures (1,441 rm-year obser- vations) to a matched sample of
rms that based their performance measurement solely on nancial measures (1,441 rm-year
observations). Our use of more objective archival data differs from most prior studies that rely on
perceptual measures of the efcacy of perform- ance measurement (Abernethy and Lillis 1995;
Foster and Gupta 1997; Ittner and Larcker 1995, 1998a; Symons and Jacob 1995).1 The triangulation
of this archival study with prior research offers additional insight into the effects of performance
measurement systems that incorporate a wide variety of performance measures (Birnberg et al.
1990; Flick 1992; Hunton et al. 2002; Ittner and Larcker 2001). Our results indicate that nonnancial
measures are signicantly associated with future accounting-based and market-based returns; with
contemporaneous data, the same holds for market-based returns but not accounting-based returns.
The results also indicate that the use of nonnancial measures is signicantly associated with
innovation-oriented strategy, adoption of strategic quality initiatives, length of product
development, industry regulation, and level of nancial distress. Moreover, we nd evidence that
the relation between the use of nonnancial measures and future and current rm performance
depends on the match between use of nonnancial measures and the rms characteristics. The
remainder of the paper is organized as follows. In the second section, we discuss the relevant
literature and develop the testable hypotheses. In the third section, we describe the sample and
empirical tests. The fourth section contains the results of the empirical tests and the sensitivity
analysis, and the fth section includes the summary and conclusion of the study.
HYPOTHESES DEVELOPMENT
Performance Consequences of Nonnancial Measures
Economic theory suggests that performance metrics should include not only nancial performance
measures, but also nonnancial measures that reect different dimensions of managerial actions
(Banker and Datar 1989; Ittner and Larcker 1998b). According to agency theory (Banker and Datar
1989; Feltham and Xie 1994; Holmstrom 1979), nonnancial measures should be included in
management compensation contracts (subject to their costs and the risk imposed on the manager) if
nonnancial measures provide incremental infor- mation about managers actions beyond that
conveyed by nancial measures. The informativeness principle (Banker and Datar 1989; Feltham and
Xie 1994; Holms- trom 1979) underlies a large body of empirical research examining the implications
of agency theory on the trade-off between risk and incentives. Intuitively, the compensation
contract should not exclude a performance measure that provides incremental information about
the dimensions of managerial action that the shareholders wish to encourage (Ittner et al. 1997).
When nonnancial measures are included in the compensation contract, man- agers more closely
align their efforts along the dimensions emphasized by those measures, resulting in improvements
in performance (Banker, Potter, and Srinivisan 2000). Firms seek to enhance their competitiveness
by employing innovative quality-oriented management strategies and utilizing performance
measurement systems that include a broad range of nancial and forward-looking nonnancial
measures (Strives et al. 1998). The potential benets of nonnancial performance measures in
management accounting have been widely cited (Eccles 1991; Johnson and Kaplan 1987; Kaplan and
Atkinson 1989; Lambert 2001; Schiff and Hoffman 1996). This emphasis reects the shift from
treating nancial gures as the foundation for performance measurement to treating them as one
element among a broader set of measures. This perspective contends that nonnancial performance
measures focus attention on the long-term perspective, thus leading to better performance. The
performance measurement literature also assumes that the integration of nonnan- cial measures in
measurement systems allows managers to better understand the relations among various strategic
objectives, to communicate the association between employees actions and strategic goals, and to
allocate resources and set priorities based on those objectives (Kaplan and Norton 1996). Moreover,
focusing on the denition and implemen- tation of strategies and information systems that
emphasize value creation and the under- lying drivers of value can ideally align management
processes and internal goals with external goals (Ittner and Larcker 2001). The t between strategies
and processes promotes congruence between the actions taken by the agent and the actions desired
by the principal, thereby maximizing shareholders value (Banker and Datar 1989; Feltham and Xie
1994; Holmstrom 1979). Incorporating nonnancial measures in a rms performance measurement
system may also provide more direct and timely feedback on managerial effort in some
environments than nancial measures do (Barua et al. 1995). Further, nonnancial measures are
contem- poraneously available for purposes of evaluating the impact of current efforts. This affords
the manager an opportunity to take immediate corrective action (Rees and Sutcliffe 1994). Finally,
nonnancial measures are less subject to manipulation since they are typically less dependent on
managerial judgment than are cost allocations or balance sheet valuations (Rees and Sutcliffe 1994).
Prior studies investigating the relation between nonnancial measures and current per- formance
generally rely on customer satisfaction and total quality management (TQM) as nonnancial
measures. Using cross-sectional data from 77 Swedish rms representing dif- ferent industries,
Anderson et al. (1994, 1997) nd that, after controlling for past returns and time trend,
contemporaneous accounting performance is positively associated with cus- tomer satisfaction.
Perera et al. (1997) nd that the use of nonnancial measures is asso- ciated with enhanced
performance for rms pursuing customer satisfaction through their manufacturing strategy. Ittner
and Larcker (1998a) examine the relation between customer satisfaction and rm performance
using customer-level, business unit, and rm-level data. They nd some evidence that rm-level
customer satisfaction measures are associated with the rms current market value, but not with
contemporaneous accounting measures. Behin and Riley (1999) nd that customer satisfaction is
contemporaneously associated with - nancial performance in the U.S. airline industry. In contrast,
Ittner and Larckers (1998b) survey suggests that many rms do not experience a signicant
association between cus- tomer satisfaction and contemporaneous accounting and market returns.
Prior studies that examine the relation between TQM and rm performance generally provide
evidence consistent with enhanced contemporaneous accounting-based and market- based
performance for those rms implementing TQM. Ittner and Larckers (1995) results suggest that
information and reward systems that place greater emphasis on nonnancial information are
associated with higher accounting returns in organizations making relatively little use of TQM
practices, but not in organizations with extensive TQM programs. Symons and Jacobs (1995) indicate
that TQM-based reward systems are associated with higher performance. Chenhall (1997) concludes
that rms using both TQM and nonnancial man- ufacturing performance measures achieve higher
performance than those using TQM with- out the nonnancial measures. Simons (1987) nds that
return on investment is higher when accounting control systems and business strategy are more
closely linked. Abernethy and Lillis (1995) indicate that greater reliance on nonnancial
manufacturing measures has a more positive effect on performance in exible rms than in
nonexible rms. The results in Hirschey et al. (1998) suggest that nonnancial information on the
quality of patents has consistently positive effects on stock prices. Taken together, the results of
theses studies are consistent with the implications of the impact of nonnancial measure adoption
on current performance. Accordingly, we posit the following hypothesis:
H1: Firms that use a combination of nonnancial and nancial measures perform better
contemporaneously than rms that use nancial measures alone.
Although we predict that the inclusion of nonnancial measures in the rms perform- ance metrics
will improve rm performance, it is crucial to consider the time frame related to performance
evaluation. Since the efcacy of nonnancial measures may take substantial time to be revealed in
performance, we also investigate the relationship between nonnan- cial measures and future rm
performance. Several studies suggest that nonnancial mea- sures are primarily important because
their focus on long-term actions leads to better per- formance (Banker et al. 2000; Hemmer 1996;
Johnson and Kaplan 1987; Kaplan and Norton 1992). Managerial efforts incorporating nonnancial
measures should result in positive outcomes such as innovation and quality, leading to better
performance in the future. Man- agements actions inuence realized values of nonnancial
measures, which, in turn, are indicators of long-term performance (Banker et al. 2000). Although
nancial measures generally reect past performance, nonnancial measures may reect actions
that lead to future performance (Kaplan and Norton 1992). Consistent with these claims, a number
of studies nd that nonnancial measures are leading indicators of nancial performance, even after
controlling for current accounting performance (Banker et al. 2000; Behin and Riley 1999; Foster and
Gupta 1997). In a study of the use of nonnancial measures, Foster and Gupta (1997) used two years
of data from a wholesale beverage distributor to provide evidence on the link between customer
satis- faction and future protability. The results in Ittner and Larcker (1998a), using customer- level,
business unit, and rm-level data, suggest that customer satisfaction is positively related to future
nancial performance. Similarly, Banker et al. (2000) used time-series data covering 72 months for
18 hotels managed by a hospitality rm to provide evidence on the impact of nonnancial measures
on future accounting-based performance. The results of their eld-based study indicate that current
customer satisfaction is signicantly and posi- tively related to future nancial performance. Their
results also suggest that nonnancial measures contain additional information not reected in
nancial measures. Behin and Riley (1999) nd some evidence that customer satisfaction is
associated with future nancial performance in the U.S. airline industry. Finally, Ittner and Larcker
(1996) provide evidence that hedge portfolios based on customer satisfaction measures
outperformed market returns in subsequent periods. In summary, the results of theses studies nd a
positive relation between future rm performance and current use of nonnancial performance
measures. Accordingly, we expect superior future performance from rms that use nonnancial
mea- sures. Therefore we hypothesize that:
H2: Firms that use a combination of nonnancial and nancial measures perform better
prospectively than rms that use nancial measures alone.
The Performance Consequences and the Match of Nonnancial Measures
The previous hypotheses assume that nonnancial measures are efcacious for all rms. The match
or t between nonnancial measures as a management practice and the rms organizational
environment is ignored when examining their performance consequences. Contextual factors,
environmental factors, and strategic plans vary across rms. Contin- gency theories suggest that the
choice of appropriate techniques of managerial accounting depends on circumstances surrounding
the rm (Gordon and Miller 1976; Hayes 1977; Otley 1980). Therefore, the adoption and use of
nonnancial measures is an endogenous choice, with the potential net benet depending on
contextual factors. Since the performance consequences of nonnancial measures may be
contingent on exogenous variables, the ability to draw inferences about the performance
consequences of using those measures might be affected by specication errors. The optimal choice
of performance measures is a function of a variety of factors such as strategic plans, the investment
opportunity set available to the rm, and executive com- pensation (Ittner and Larcker 1998b). Many
managers believe that exclusive emphasis on nancial measures does not adequately fulll these
functions. One research stream examines the relationship between the use of nonnancial
performance measures and related strategic plans, contextual factors, and the organizational
environment. Researchers suggest that var- iables such as strategy, regulation, product life and
development cycles, nancial distress, as well as noise in nancial measures affect performance
consequences (Bushman et al. 1996; Ittner et al. 1997). A rms business strategy is likely to
inuence the relative informativeness of alter- native performance measures (Ittner et al. 1997).
Defender rms follow a cost-leader ori- entation in which they attempt to focus on established
products and markets to extract strategic advantage by minimizing costs through improvements in
operating efciencies. This focus leads defender rms to employ short-term nancial performance
measures to align their performance to the near-term nancial strategy of the rm (Govindarajan
and Fisher 1990; Simons 1987). Conversely, prospector rms seek new products and markets via
initiatives that are unlikely to be immediately evident in the nancial results of operations. As a
result, for prospector rms, short-term nancial measures of performance will be less informative
with regard to management efforts to attain long-term strategic goals. Govindarajan and Gupta
(1985) nd that rms following a prospector strategy are more likely to rely on nonnancial
measures of performance. Based on these arguments, we expect rms that pursue strategic
forward-looking goals to be more likely to place emphasis on nonnancial performance measures
in contracting with their managers. The quality management literature (Daniel and Reitsperger 1991;
Ittner and Larcker 1995; Ittner et al. 1997) advocates the benets of using nonnancial measures to
track the rms quality improvement efforts. Based on these arguments, we expect rms focusing on
a quality strategy to include nonnancial quality metrics to align managers efforts with the strategic
quality objectives of the rm. Ittner et al. (1997) argue that distressed rms are expected to rely
more on short-term nancial measures. Managements desire to avoid bankruptcy and its costly
consequences motivates their reliance on short-term nancial measures. Thus, a distressed rms
choice of short-term nancial measures suggests they will rely less on nonnancial measures com-
pared to a healthy rm. Bushman et al. (1996) argue that greater reliance on individual performance
measures depends on the relative importance of the rms product development and product life
cycles.2 Bushman et al. (1996, 162) predict that a performance measure will only be used if it
provides incremental information over other measures. Supplemental measures of performance
add value to traditional nancial measures with regard to individual perform- ance evaluation,
particularly in those instances where information asymmetry exists between managers and
investors, and when the rm faces longer planning and product development time horizons. The
longer the product development and product life cycles, the less infor- mative nancial measures
may be (Bushman et al. 1996), and the potentially more in- formative nonnancial measures will be.
Specic industry and competitive pressures may impact the choice of the performance
measurement metrics. For instance, Ely (1991) nds that managers accounting choices vary by
industry suggesting that those choices may reect a realization of the potential impact of industry
specics on accounting choices. As discussed in Ittner et al. (1997), nonnancial measures are
extensively used in regulated industries. They argue that in the utility industry, regulators link rate
increases to the achievement of nonnancial goals. Moreover, government intervention in regulated
industries may lead rms in these industries to place greater emphasis on nonnancial measures.
Ittner et al. (1997) and Bushman et al. (1996) provide evidence that regulatory and competitive
pressures lead many utility and telecommunications rms to utilize nonnancial measures in their
executive compensation packages. Therefore, we anticipate that regulated rms will rely more on
nonnancial mea- sures than nonregulated rms. Consistent with agency models, a specic
performance measure is included in a rms set of performance measures if it conveys relative
and/or incremental information over other performance measures (Banker and Datar 1989; Feltham
and Xie 1994; Holmstrom 1979). Because nancial measures imperfectly mitigate the information
asymmetry problem between managers and shareholders (Bushman et al. 1996; Ittner et al. 1997),
nonnancial measures are more likely to be used as the random noise in nancial measures
increases. Consistent with this expectation, Ittner et al. (1997) nd a positive relation between the
noise in nancial measures and the relative importance of the nonnancial measures in bonus
contracts. Thus, we predict that the use of nonnancial measures will increase with the extent of
noise in nancial measures. Ittner et al. (1997) analyze the determinants of the use of nonnancial
performance measures in compensation contracts, nding that the weight placed on nonnancial
mea- sures is positively associated with innovation-oriented strategy, the adoption of strategic
quality initiatives, and negatively related to a number of variables that proxy for poor nancial
performance. Bushman et al. (1996) investigate the use of individual performance evaluation
(including nonnancial measures) in compensation contracts. They nd that in- dividual
performance evaluation, including the use of nonnancial measures, is contingent upon several
factors such as strategic growth opportunity relative to assets in place, the length of both the
product development cycle and the product life cycle, and the noise in nancial measures. The
overall evidence provided by these studies indicates that the use of and weight placed on
nonnancial performance measures are contingent upon several contextual and environmental
factors, as well as on rms strategic plans. In addition, prior research suggests that organizations
that align their performance mea- sures appropriately with contingency factors achieve higher
performance (Govindarajan 1988; Simons 1987). Govindarajan and Gupta (1985) nd that the
benets derived from nonnancial performance criteria are contingent on the business units
strategy. Specically, rms with a build strategy rely more on long-term nonnancial criteria than
those rms with harvest strategies. This suggests that perceived organization performance is higher
when reward systems are matched to business strategy. Although these studies contend that the
optimal weight placed on nonnancial measures in compensation contracts is contingent on a
variety of factors, little evidence exists on the relation between the match between bonus plan
measures and rm characteristics and the performance of rms using the nonnancial measures.
The endogenous nature of the adop- tion of nonnancial measures raises a potential problem in
assessing the performance con- sequences of nonnancial measures. Ignoring the possible
endogeneity between the use of nonnancial measures and rm performance may result in
inappropriate inferences regard- ing the usefulness of nonnancial performance measures. Firms
that adopt nonnancial measures and fail to improve performance may incorrectly estimate the
importance of nonnancial measures. These rms may not enhance their performance because they
fail to match their characteristics and the use of nonnancial performance measures. Conversely,
rms that adopt nonnancial measures and achieve higher performance are believed to have
achieved the proper t between their characteristics and the use of nonnancial measures.
Therefore, we examine the performance differences associated with the degree of mismatch
between the use of nonnancial measures and the contextual factors that reect the rms
characteristics.3 We expect positive performance consequences to be more pronounced in rms
that better match their use of nonnancial measures to their rm characteristics. Hence, we
hypothesize that:
H3: Firms contemporaneous performance is decreasing in the degree of mismatch be- tween their
characteristics and their use of nonnancial measures.
H4: Firms prospective performance is decreasing in the degree of mismatch between their
characteristics and their use of nonnancial measures.
RESEARCH METHODOLOGY The Use of Nonnancial Measures We create a dummy variable (NFM) to
capture the rms reliance on nonnancial measures in its bonus plans. NFM takes on the value of 1
if the rm uses both nancial and nonnancial measures, and 0 if it uses nancial measures alone.4
Following Ittner et al. (1997), we use the proxy text les contained in Lexis/Nexis to develop a
sample of rms that we judge to be using nonnancial measures. We identify the sample by
searching these les using keywords such as non-nancial or nonnancial,customer satisfaction,
employee satisfaction or employee morale or employee motivation, quality, process
improvement,re-engineering or reengineering,new product development,diversity, market
share, productivity or efciency, safety, innovation,operational measure or operational
performance, and strategic objectives.5 We next read the compensation committee report to
conrm that the keyword(s) are used in the appropriate context. The empirical tests compare
performance consequences of rms incorporating both nancial and nonnancial measures versus
rms using only nancial measures. Our sample of rms using nonnancial performance measures
includes all rms for which panel data regarding performance and the use of nonnancial measures
is available for the eight-year period 19921999.6 We delete 422 rm-year observations due to
missing data, mergers and acquisitions, name changes, and bankruptcies. This process results in a
usable sample of 1,441 rm-year observations that use both nancial and nonnancial measures in
their compensation plans. We then create a matching sample of rms that do not use nonnancial
performance measures based on the same two-digit SIC code (1,209 rm-years), total assets within a
70130 percent range (1,365 rm-years), and ROA within a 90110 percent range (1,441 rm-years).
When a rm has no match based on size with the same two-digit SIC code, we use an alternative
matching rule based on size with the same one-digit SIC code (156 rms). Failing that, we use the
rm of closest size and similar performance to the rm in question with the same one-digit SIC code
(76 rm-years). Using rm size assumes that operating performance varies by size (Fama and French
1996). Several studies of operating performance match sample rms to similar-size rms in the same
industry (Denis and Denis 1995; Kaplan 1989). Although Barber and Lyon (1996) conrm the results
of Fama and French (1995), their evidence suggests that in samples of unusually small or large rms,
size-matching is not critical in detecting abnormal operating performance. Matching on past
performance adjusts for underlying economic factors as well as the mean reversion in accounting
data that could be attributed to earnings manipulation (Barber and Lyon 1996). Therefore, we match
our sample based on industry, size, and past performance to capture variations in operating
performance for normal size rms as well as extremely large and small rms.7 Table 1 compares the
distribution of the sample of rms that use both nancial and nonnancial performance measures
versus the matched sample of rms that rely only on nancial measures. Table 1 shows that
approximately 50 percent of the rm-years using nonnancial measures come from the durable-
goods (422 rm-years) and nondurable-goods (302 rm-years) manufacturing industries. In contrast,
only 19 percent of the nonnancial measures observations come from services rms. Overall,
manufacturing rms represent the highest proportion of our sample (49 percent).
Measures of Performance
We use accounting-based and market-based measures to capture economic performance. Our
measure of accounting performance is the return on assets (ROA) reported in Com- pustat. ROA is
dened as earnings before extraordinary items plus interest expense divided by average total assets.
We use ROAit and ROAit1 to examine current and future accounting performance, respectively.
Return on assets has been extensively criticized as being a misleading or inadequate indicator of the
economic rate of return (Fisher and McGowan 1983; Harcourt 1965; Livingstone and Salamon 1970;
Solomon 1966). In particular, return on assets may be distorted by the failure to consider differences
in systematic risk, temporary disequilib- rium effects, tax laws, and accounting procedures (Smirlack
et al. 1984; Wernerfelt and Montgomery 1988). Therefore, we also use market-based measures of
performance to test the effect of nonnancial measures on economic performance. We measure
market-based measures of performance using the annualized market-adjusted stock returns (RET)
from the CRSP database.8 We use RETit and RETit1 to measure the current and future market
performance, respectively. Panel A of Table 2 presents descriptive statistics for the performance
measures of the sample rms. The average ROAit, RETit, ROAit1, and RETit1 for our sample are:
0.034, 0.198, 0.031, and 0.215, respectively. In Table 2, Panel B, we compare accounting-based and
market-based performance between rms using both nancial and nonnancial mea- sures versus
those rms using only nancial measures. For current accounting-based per- formance, mean ROAit
is signicantly higher for rms using nonnancial measures (0.046 versus 0.031). Similarly, mean
current market-based performance (RETit) is signicantly higher for users of nonnancial measures
(0.235 versus 0.139). Regarding future perform- ance, mean ROAit1 is signicantly higher in rms
using nonnancial measures (0.035 versus 0.030). Finally, mean RETit1 is higher for rms using
nonnancial measures (0.284 versus 0.146). We nd similar results using nonparametric tests.
Performance Controls
In testing the performance consequences of using nonnancial measures we later in- troduce
controls for a number of factors. We include lagged performance
(ROAit 1) in the analysis of accounting performance measures to
control for past performance. We also control for the effects of exogenous economic factors by
including a variable reecting industry performance (IROAit and IRETit) for both performance
measures. In addition, we include variables to control for leverage, rm size, growth opportunities,
industry regulation, and volatility. Prior studies have indicated that these variables are potentially
important determinants of rm performance (Fama and French 1992, 1993; Jeter and Chaney 1992;
Lulseged and Christie 2003; Wareld et al. 1995). Leverage (LEV) is measured using the debt-equity
ratio. Firm size (SIZE) is measured as the log of total assets. Growth opportunities (GROWTH) are
measured as the market value of equity plus book value of debt divided by book value of assets at
the beginning of the year. We use a dummy variable to capture the effect of regulation on
rmsperform- ance. The regulation variable (REG) takes on the value of 1 if the rm operates in a
regulated industry (SIC codes 4049), and 0 otherwise. We include accounting return vol- atility
(ACTVOL) in the accounting-based model and stock volatility (SCTVOL) in the market-based model.
ACTVOL is measured as the standard deviation of annual return on assets over the previous ve
years, while SCTVOL is measured as the standard deviation of the annualized daily stock returns over
the previous ve years. We predict positive coefcients for SIZE and GROWTH and a negative
coefcient for LEV. We offer no pre- dictions for REG, ACTVOL, or SCTVOL.
Firm Characteristics and the Match with Nonnancial Measures
We subsequently examine several of the contingency factors that the literature (Bush- man et al.
1996; Ittner et al. 1997) suggests determine the efcacy of relying on individual and nonnancial
measures. These factors include the extent to which the rm follows a prospector strategy (PROS),
the adoption of strategic quality initiatives (QLTY), the length of product development (DCYCLE), the
length of product life cycles (LCYCLE), industry regulation (REG), nancial distress (DIST), and noise in
nancial measures (FN CORR). We use factor analysis to develop a composite measure of business
strategy (PROS) using principal component analysis. We use three indicators for competitive
strategy: (1) the ratio of research and development to sales, (2) the market-to-book ratio, and (3)
the ratio of employees to sales.9 Higher PROS scores reect the prospector end of the strategy
continuum (Ittner et al. 1997). Because prospector rms are involved in more innovative actions,
they should have a higher ratio of research and development to sales than defender rms (Hambrick
1983). Likewise, since prospectors are expected to have higher growth opportunities compared to
defenders, prospectors are expected to have higher market-to- book ratios. The ratio of employees
to sales reects the rms ability to produce and distribute goods and services efciently (Thomas et
al. 1991). As argued by Ittner et al. (1997), defenders should have fewer employees per dollar sales
because of their strategic focus on efciency. Following Ittner et al. (1997), we measure the previous
three variables as the average of the respective yearly ratios over the ve years preceding the proxy
date. Quality (QLTY) is a dummy variable that takes on the value of 1 if the rm has won or been a
nalist in a major quality award competition, and 0 otherwise. The intuition behind this measure is
that the quality award criteria require the rm to demonstrate how quality programs t into the
rms overall business strategy (Ittner et al. 1997). To identify those quality-oriented rms, we use
an extensive keyword search of publications in Dow Jones, Lexis/Nexis, and ABI/INFORM. Following
Bushman et al. (1996), we adopt the classication scheme from the National Academy of
Engineering (1992) to categorize rms into those with shorter versus longer time horizons. We use
the two-digit SIC code and the business description in the rms 10-K reports and Compustat les to
classify our sample according to the adapted National Academy of Engineerings industry group
classications. Table 3 shows the results of the classication process by industry. Using product
development cycles, we classify 744 rm- years as having longer horizons and 1,412 rm-years as
having shorter horizons. Using product life cycle, we classify 1,362 rm-years as having longer
horizons and 794 rm- years as having shorter horizons. We could not classify 726 rm-years based
on the National Academy of Engineering classication scheme, leaving a sample of 2,156 rm-year
obser- vations for rm characteristic analysis. We use a dummy variable for regulated industries
(REG). REG is a dummy variable for regulation that takes on the value of 1 if the rm operates in a
regulated industry (SIC codes 4049), and 0 otherwise. To measure nancial distress (FDIST), we use
a composite factor of three indicators (computed using principal component analysis). These three
var- iables are: (1) the probability of bankruptcy measured based on Ohlsons (1980) Model 3; (2) the
leverage ratio; and (3) the leverage ratio scaled by R&D. Research and development expenditures
proxy for the degree of product specialization (Titman and Wessels 1998).10 Prior research often
uses the variance of accounting returns and stock returns, or their ratio, as a proxy measure for the
unobservable measurement noise in nancial-based mea- sures (Holthausen and Larcker 1991;
Lambert and Larcker 1987). Bushman et al. (1996) use the time-series correlation between
accounting returns and stock returns as a surrogate for the unobservable measurement noise in
nancial-based measures.11 This correlation provides an explicit measure of the managerial
misrepresentation in accounting numbers (Salamon and Smith 1979). We proxy for the noise in
nancial measure (FN CORR) as
Empirical Models
We examine both within-rm and between-rm effects of nonnancial measures on rms economic
performance. We use panel data in our tests in order to study variations within a single rm over
time, as well as variations among rms at a given point in time (Pindyck and Rubinfeld 1998).12 To
test the rst set of hypotheses (H1 and H2), we use the following general model. The model
examines the relationship between rms use of nonnancial measures and their economic
performance:
PERFORMANCE f(USE NFM, PERFORMANCE CONTROLS) (1)
where PERFORMANCE is the rms current (ROAit and RETit) and future (ROAit1 and RETit1)
economic performance; USE NFM reects whether a rm uses nonnancial mea- sures in its
compensation contracts as proxied by NFM; and PERFORMANCE CONTROLS are our control variables
for performance discussed earlier. To test the second set of hypotheses (H3 and H4), we use the
following general models. The combined model investigates the relation between nonnancial
measures and economic performance contingent on the match between the use of nonnancial
measures and rm characteristics:
USE NFM f(FIRM CHARACTERISTICS) (2)
PERFORMANCE f(MISMATCH NFM, PERFORMANCE CONTROLS) (3)
where USE NFM reects whether a rm uses nonnancial measures in its measurement systems as
proxied by NFM; FIRM CHARACTERISTICS are variables that determine the use of nonnancial
measures (PROS, QLTY, DIST, FN CORR, DCYCLE, LCYCLE, REG); PERFORMANCE is the rms current
(ROAit and RETit) and future (ROAit1 and RETit1) economic performance; MISMATCH NFM are the
residuals from equation (2) reecting the extent of mist between the use of nonnancial measures
and rm characteristics; and PERFORMANCE CONTROLS are the covariates for performance
discussed earlier. Following Ittner et al. (2002), we rst predict the choice to use nonnancial
measures using logit regression (model 2). We estimate model 2 using variables that proxy for rm
characteristics and identied in the performance measurement literature as determinants of the use
of nonnancial measures. Next, in model 3, we examine the current and future performance
consequences of the extent of mismatch between the use of nonnancial mea- sures and rm
characteristics. Firm performance should be better (worse) when the rms use of nonnancial
measures does (does not) t the rms particular economic character- istics. The residuals from
model 2 (MISMATCH NFM), the match model, estimate the extent to which the rm has over-
investedor under-investedin nonnancial measures. To allow for potential differences between
rms that have over-invested versus under- invested in nonnancial measures, we estimate two
separate variables for positive and neg- ative residuals (POSNFM and NEGNFM). POSNFM is dened
as the positive residual from the match model (i.e., the rm uses nonnancial measures but the
predicted probability of use is less than 1), and 0 otherwise. NEGNFM is dened as the negative
residual from the match model (i.e., the rm does not use nonnancial measures and the predicted
probability of use is greater than 0), and 0 otherwise. Since positive and negative residuals both
reect a mismatch of the use of nonnancial measures, POSNFM is expected to be negatively
associated with performance and NEGNFM is expected to be positively associated with
performance. The expected sign is negative for POSNFM given that rms over-investing in
nonnancial measures despite having low-predicted probability of use are expected to generate
lower performance. Con- versely, the expected sign is positive for NEGNFM since rms under-
investing in non- nancial measures despite having a high-predicted probability of use is expected to
yield lower performance.
RESULTS
Performance Consequences of Nonnancial Measures
Tables 4 and 5 provide evidence on the current and future performance of rms as a function of
their use of nonnancial measures. Using model 1, we regress rms current and future accounting-
based and market-based performance on a dummy variable for each rms use of nonnancial
measure (NFM) and control variables. Due to complexities in pooled data regressions, we estimate
several regressions to assess the robustness of our performance results.13 The rst estimation is
based on weighted pooled least-squares (OLS) that combines all the cross-section and time-series
data without controlling for any rm- specic effects and autocorrelation. Next, we test for xed
effects and random effects to deal with the cross-section and time-series intercepts and
disturbances difculties. Finally, we performed the Hausman specication test to determine whether
these effects, if any, are xed or random.14 Table 4 reports the estimations of the current
accounting-based and market-based per- formance xed effects models. A test for the null
hypothesis of no xed effects is rejected for the current accounting-based model (F 2.25; p-value
0.001) as well as for the market-based model (F 2.98, p-value 0.001). In addition, the Durbin-h and
the Durbin- Watson statistics indicate no signicant serial correlation (1.643 and 2.043, respectively).
Based on the Hausman specication Chi-square (not reported), the null hypothesis of ran- dom
effects is rejected in favor of the xed effects estimation for the current accounting- based and
market-based models. We used the same model validation procedures with sub- sequent models. In
all cases, the xed effects models provide the best t compared to OLS with the exception of the
market-based model reported in Table 8 and the accounting-based models reported in Table 11.
Table 4 indicates that for the current accounting-based performance using ROAit, the NFM variable
is positive but not signicantly different from 0.15 The insignicant relation- ship between the use of
the nonnancial and current accounting-based measures indicates that the use of nonnancial
measures does not improve the contemporaneous nancial performance, contrary to our
expectations. One alternative explanation is that the return on assets is based on accounting
numbers that are subject to managers manipulation and may not necessarily reect real
improvement in the performance as measured by nonnancial measures. Alternatively, the return
on assets may largely reect short-term performance for which nonnancial performance measures
are less important. Consistent with our expectations, Table 4 shows that NFMit is statistically
signicant with the expected positive sign in the current market-based model. The signicant
positive relation between the use of nonnancial measures and the market-adjusted stock returns is
an indication of the value relevance of nonnancial measures to investors. Therefore, H1 is
supported using market-based performance measures but not using accounting-based measures.
Table 5 reports the results of the estimation of the future accounting-based and market- based
performance models. The null hypothesis of no xed effects is rejected (F 5.34 and 4.09; p-value
0.001) for both models. Accordingly, the following discussion of the future accounting and market
models is based upon the xed effects models. As indicated in Table 5, NFM is signicantly and
positively associated with rmsfuture return on assets, in contrast to the results on the current
return on assets in Table 4. This result suggests that although nonnancial measures appear to be
leading indicators of future accounting-based performance, they do not positively impact the
current accounting performance as measured by return on assets. Also in Table 5, we report the
estimation of the future market-based regression model. Consistent with our expectations, the use
of nonnancial performance measures (NFMit) is statistically signicant with the expected positive
sign. The signicant positive relation between the use of nonnancial measures and the market-
adjusted stock returns provides evidence that nonnancial measures are leading indicators of
market-based performance. Therefore, H2 is supported using both accounting-based and market-
based performance measures. Regarding the control variables in the current performance (Table 4)
and future per- formance (Table 5) models, the coefcients for IROA and lagged ROA are positive
and signicant in the accounting-based models. The negative signicant coefcients of LEV in both
current and future accounting models indicate that rms with higher leverage are less able to
achieve higher accounting-based performance. As expected, the coefcients for SIZE are positive and
signicant, indicating that larger rms achieve higher levels of performance as measured by both
accounting and market performance. As expected, the coefcients on GROWTH in the future
accounting-based model and both current and future market-based model are positive and
signicant. Generally, this result suggests that high-growth rms attain higher levels of performance
both in current and future periods, whether these rms have high or low levels of debt. The positive
and statistically signicant coefcients of REG in both tables indicate that regulated rms perform
better than nonregulated rms as measured by accounting-based and market-based measures.
Finally, except for the future market performance model results, neither ACTVOL nor SCTVOL are
statistically signicant in any of the models.
Endogeneity of Nonnancial Measures
The results of the logit regression prediction for rmsuse of nonnancial performance measures
(model 2) are presented in Table 6. The model appears well specied as indicated by the pseudo R2
and Chi-square statistics. Consistent with prior research (Govindarajan and Gupta 1985; Ittner et al.
1997; Simons 1987), we nd that prospector rms (PROS) rely more heavily on nonnancial
measures than defender rms. Likewise, the use of non- nancial measures is greater in quality-
oriented rms (QLTY), consistent with previous research (Ittner et al. 1997; Ittner and Larcker 1997,
1995; Pfau and Gross 1993). The negative signicant coefcient of DIST indicates that distressed
rms are less likely to use nonnancial measures compared to healthy rms. Consistent with
Bushman et al. (1996), the positive signicant coefcient of DCYCLE indicates that rms with longer
product development cycles are more likely to use nonnancial measures than rms with shorter
product development cycles. Conversely, the results provide no support for rms with longer
product life cycles (LCYCLE) making greater use of nonnancial measures, a result
inconsistent with those of Bushman et al. (1996) on individual measures. The positive coefcient of
REG supports the claim that regulated rms are more likely to use nonnan- cial measures than
nonregulated rms, consistent with Bushman et al. (1996) and Ittner et al. (1997). The results fail to
support a signicant relationship between the use of non- nancial measures and the level of noise
in nancial measures (FN CORR). We use model 3 to test the second set of hypotheses examining
performance conse- quences contingent on the extent of mismatch between the use of nonnancial
measures and rm characteristics. Table 7 reports the results of the association between the
residuals from the logit regression model (model 2) and current accounting-based and market-based
performance using xed effects regressions. While the coefcient signs are as predicted,
the results using current accounting-based measures of performance reect no association between
the performance consequences of using nonnancial measures and the extent of mismatch between
the rms operational characteristics and its use of nonnancial mea- sures. However, corresponding
results using the current market-based measures of perform- ance provide strong evidence that the
association between nonnancial measures and market performance is a function of the match
between the rms operational characteristics and the use of nonnancial measures. The signicant
negative coefcient on POSNFM indicates that when rms over-invest in nonnancial measures
(relative to the prediction of the bench- mark model), these positive deviations are associated with
lower current market-adjusted stock returns. Conversely, the signicant positive coefcient on
NEGNFM indicates that rms that do not use nonnancial measures, when the model predicts they
should, expe- rience lower current market-adjusted stock returns. Although the residuals from
model 2 explain little of the variation in rms current accounting performance, they do have
signicant explanatory power with respect to rms future accounting performance. Table 8 reports
the results of the associations between the residuals from model 2 and future economic
performance (model 3). The signicant neg- ative coefcients on POSNFM in both accounting-based
and market-based models indicate that rms making more extensive use of nonnancial measures
than predicted by model 2 experience lower future accounting and market-adjusted stock returns.
Moreover, the pos- itive coefcients of NEGNFM in both the accounting-based and market-based
models in- dicate that rms that do not use nonnancial measures when the model predicts that
they should also experience lower future accounting and market-adjusted stock returns. The results
in Tables 7 and 8 provide support for H3 and H4. The overall evidence suggests that the association
between performance and the use of nonnancial measures varies with the rms economic
circumstances, and that performance is maximized when the choice of performance measures is
consistent with the companys operational and competitive environment.
Sensitivity Analysis
We conduct additional tests to check the robustness of the results for possible speci- cation errors.
One potential source of error in measuring the use of nonnancial measures is our use of a dummy
variable (NFM), which does not fully capture the actual reliance on, and relative importance of,
nonnancial measures. Among rms using nonnancial measures in evaluating performance, the
weight assigned to the nonnancial measures may vary signicantly across rms and across different
types of nonnancial measures. The preceding analysis uses NFM, a dichotomous variable indicating
the use or nonuse of nonnancial measures. Alternatively, estimating the relative weights assigned
to nonnan- cial measures may provide a better understanding of the impact of the use of
nonnancial measures on rm performance. Therefore, we next replace NFM with the relative
weights assigned to the nonnancial measures (WNFM) in both the accounting-based and market-
based models. It is not possible to estimate relative weights on nonnancial measures for all rms in
our sample.16 However, from the compensation committee report included in the proxy statement
for the sample of rms relying on nonnancial performance measures, we are able to identify a
subsample of 91 rms (324 rm-year observations) that provided the explicit weights placed on
nonnancial measures. We use this subsample for additional analysis. We substitute WNFM in
models 1, 2, and 3 to examine the research hypotheses using the relative weights for the subsample.
The performance effects of using weighted nonnancial performance measures, WNFM (model 1),
are presented in Table 9. Using the weighted measures enhances the explanatory power of the
current and future accounting-based and market-based models slightly (with WNFM: adjusted R2s
are 0.77 and 0.84 for accounting-based models; 0.76 and 0.80 for market-based models, whereas
with NFM: adjusted R2s are 0.73 and 0.80 for accounting- based models; 0.69 and 0.75 for market-
based models). Although the results from our additional analyses (using WNFM) are similar to the
initial analyses (using NFM), the coefcients, signs, signicance levels, and the models explanatory
power are all greater using WNFM. In conclusion, the use of relative weight strengthens the results,
suggesting that the relative weight placed on nonnancial measures has a greater impact on
perform- ance than the mere presence of nonnancial measures in the compensation contract. To
test the robustness of the measurement t or match results, we reexamine this relation using the
weighted nonnancial measure (WNFM) as the dependent variable in the match model (model 2).
Table 10 shows the results of the pooled weighted OLS. The results indicate that the weight placed
on nonnancial measures is greater for rms adopting a prospector strategy, with a quality
management focus, and with rms with longer product development cycle. Moreover, the results
indicate that distressed rms place less weight on nonnancial measures, while regulated rms
place more emphasis on nonnancial mea- sures. The results fail to support signicant relationships
for the noise in nancial measures or product life cycles. Performance results for model 3 using the
residuals from model 2 of the weighted nonnancial measures are presented in Table 11. The
signicant negative coefcients on POSWNFM in both accounting-based and market-based models
indicate that rms placing more weight on nonnancial measures than predicted are associated with
lower current and future accounting and market returns. The positive coefcients on NEGWNFM in
both accounting-based and market-based models indicate that rms that place less weight on
nonnancial measures than predicted are also associated with lower current and future accounting
and market returns. The overall results using the relative weight on nonnancial performance
measures conrms the basic results in our initial analysis (we nd signicant results even for the
current accounting-based model). The results again suggest that the performance conse- quences
associated with the weight placed on nonnancial measures is a function of the rms operational
and competitive environment. In conclusion, with the exception of some of the results for the
current accounting-based models, we nd consistent performance results across all of our models.
Using market-based measures, we nd that nonnancial measures have a signicant impact on the
economic performance of our sample rms.
SUMMARY AND CONCLUSION
The objective of this study is to examine the current and future performance conse- quences of
incorporating nonnancial measures in a set of performance metrics. The em- pirical results indicate
that using nonnancial measures in evaluating performance affects market performance. Although
we nd some evidence for future accounting-based perform- ance, the overall evidence on
nonnancial measures impact on accounting-based per- formance is mixed. Our results are
consistent with results of previous studies, which provide evidence that nonnancial performance
measures are associated with subsequent rm ec- onomic performance (Anderson et al. 1994;
Banker et al. 2000; Foster and Gupta 1997). The results also indicate that nonnancial measure use
is signicantly associated with: (1) an innovation-oriented strategy; (2) a quality-oriented strategy;
(3) the length of the product development cycle; (4) industry regulation; and (5) the level of nancial
distress. More importantly, the association between nonnancial measures and rm performance is
con- tingent on whether the use of nonnancial measures matches the rms characteristics. A
limitation of our study is that we considered the use of nonnancial measures in aggregate terms. It
may be the case that a specic nonnancial measure (e.g., cost control, quality, customer
satisfaction, etc.) affects performance in a different fashion than an alter- nate nonnancial
measure. Ittner and Larcker (2002), for example, nd variation in the specic factors inuencing the
use of different types of nonnancial measures, suggesting that the aggregate performance measure
classication commonly used in compensation research provides somewhat misleading inferences
regarding performance measurement choices. Similarly, the performance implications associated
with the use of different non- nancial measures in different circumstances is also likely to vary. A
further limitation is our exclusive reliance on the use of nonnancial measures in compensation, as
opposed to other potential uses of nonnancial measures, which we do not address here. Further,
we did not consider the potential and likely impact of target setting with regard to both nancial and
nonnancial performance measures Our ndings suggest several fruitful areas of future research.
Research is needed to capture different dimensions of the contextual impact on rm performance. A
host of im- plementation issues concerning the adoption of nonnancial measures has not been ad-
dressed in the literature. Although prior survey research identies several contingent factors, we are
limited to those measures that are publicly available. Future research has the poten- tial to combine
these complementary methodologies, thus drawing from the relative strengths of each method
(Libby et al. 2002). In this way, a combination of survey and archival evidence can potentially provide
a richer understanding of the impact of nonnan- cial measures on rm performance.
APPENDIX
Representative Proxy Statements
Panel A: Weighted Nonnancial Measures Including Specic Description of How the Measures Are
Used
Example: Bausch & Lomb, Inc. (1995).
Under the annual incentive plan, objectives are established at the beginning of each year.
Minimum and maximum performance levels are also dened. An individuals objectives may include
corporate, division, or individual goals or some combination of these. The CEOs goals are based
solely on the overall performance of the Company. Company goals include the following criteria and
weightings: sales growth, 30 percent; earnings growth, 30 percent; return on equity, 30 percent; and
improvement in aggre- gate customer satisfaction ratings from operating divisions, 10 percent.
Panel B: Weighted Nonnancial Measures without Specic Description of How the Measures Are
Used
Example: Atlantic Energy, Inc. (1996).
1996 ANNUAL INCENTIVE PERFORMANCE RESULTS For 1996, the target corporate performance
indicators and relative weights of each indicator at the target level were as follows: Performance
Indicators: 45 percent related to earnings per share of the Companys Common Stock; 10
percent related to ACE lost time accident record; 15 percent related to cash ow per share of the
Companys Common Stock; 10 percent related to ACE customer satisfaction. The annual incentive
portion of the Enterprise Compensation Program provides for incentive opportunities linked to a
combination of AEE business plan goals, the Com- panys performance indicators, and goals specic
to a subsidiarys nancial and oper- ating results. Performance measures and relative weights are
unique to each executive ofcer of AEE based on his respective job accountabilities. In 1996,
bonuses were paid to the executive ofcers of AEE under the Enterprise Compensation Program.
These bonuses ranged from 31 percent to 35 percent of the executive ofcers base salaries.
Panel C: Unweighted Nonnancial Measures without Specic Mention of How They Are Used
Example: Andrew CORP (1995).
Board of Directors also recommends that the MIP be amended to set forth the per- formance-
based criteria which the Compensation Committee of the Board of Directors