A Contracting-Agency Analysis of the Association Between Firm Risk, Incentives and Firm Performance: An Australian Perspective

Tosi and Gomez-Mejia, (1989) suggest that the challenge of corporate governance is to set up supervisory and incentive alignment mechanisms that alter the risk and effort orientation of agents to align them with the interests of principals. The research problem is to discern the conditions that align the goals of the agent with those of the principal. These conditions will promote maximum effort in achieving the organisational goal thus maximizing shareholder wealth. Therefore, the objective of this study is to determine the efficiency of incentive contracts given certain characteristics of the firm. That is, the study sets out to determine whether risk firms with higher levels of incentives are associated with higher firm performance. In this study, data was collected from 40 of the top 500 Australian publicly listed companies. Information on incentives and firm characteristics was acquired from company annual and financial reports, a mailed questionnaire and the Australian graduate school of management risk measurement service of the University of New South Wales. The results of this study demonstrated how the relationship between firm risk and performance is associated with the incentive contracts used by these firms. In particular, the results of this study showed that the negative relationship between firm risk and firm performance is weakened by higher levels of share options in executives’ compensation contracts. In addition the results demonstrated that the relationship between firm performance and share ownership is dependent on the level of firm risk. The results of this study are expected to improve our understanding of how and why firms adopt different types of incentives in an effort to reduce agency costs. Rarely has prior research examined whether the effectiveness of the incentive contract in eliminating agency costs is associated with the environmental characteristics of the organisation (Bloom & Milkovich, 1998).