Self-Sorting, Incentive Compensation, and Human-Capital Assets

Skilled labour has gained significance as a production factor in the age of information technology, but accounting does not recognize human capital as an asset that contributes to the firm's earning power. This paper suggests a method to develop a latent index to proxy the managerial-skill component of human capital. The proposed labour-skills index depends on the empirical validity of self-sorting theories for managerial tasks and the choice of the type of at-risk (i.e., outcome-contingent) compensation contract. The empirical analysis uses data on compensation of executive members of the Board of Directors, their personal attributes (experience, risk aversion, and wealth), firm-specific variables (profitability growth rates, organizationa1 complexity, and operating risk), and type of industry. The extent to which equity markets value the predicted labour skills shows that investors in the market place recognize human capital even though accounting does not. The valuation coefficient on the variable imputed for human capital is significant for all the years examined. This study contributes to the literature by showing that relative incentive compensation (incentive pay per dollar of fixed salary) is a viable surrogate for human capital defined as the skills embodied in people