Relative Performance Evaluation and Earnings Management*

Conventional agency theory suggests that firms should benchmark CEO compensation to absorb systemic risk and more efficiently incentivize executives work hard. Yet, empirical research has found only a modest use of benchmarking in contracts. In this paper, I highlight one weakness relative performance evaluation (RPE). When earnings management is possible, creates stronger incentives for misreporting measures compared benchmark-independent pay. The optimal contract will depend less on correlated (e.g. stock market index) if it easier the manager misreport performance. Thus, model predicts with weak internal controls bad auditors are likely RPE, offering theoretical explanation empirically observed lack RPE use.