2014 chapter 10 · the theory of executive compensation(continued) • congruency of a performance...

Financial Accounting Theory

Seventh Edition

William R. Scott

Chapter 10

Executive Compensation

Chapter 10

Executive Compensation

10.2 Are Incentive Contracts Necessary?

• No: Fama (1980)

– Forces of reputation on managerial labour market enough to motivate

manager to work hard

– Assumes managerial labour market works well

• Yes: Wolfson (1985)

– Forces of reputation help to motivate manager, but incentive contract

still needed

– Suggests that managerial labour markets do not work fully well

– See Supp. slides for details

10.3 The RBC Compensation Plan

• Components of senior management compensation

– Salary

– Short-term incentive bonus

• Cash bonus or deferred share units

– Mid-term incentive plan

• Paid in deferred share units

– Long-term incentive plan

• Paid in ESOs

» Continued

• Changes to compensation plan 2009

– Deferral of bonus payments

– Claw back bonus if fraud or misconduct

– Greater weight on individual non-financial performance measures

– Increased required executive stock holdings

• Effects on manager decision horizon?

• Effects on manager compensation risk?

The RBC Compensation Plan (continued)

10.4 The Theory of Executive Compensation

• Desirable properties of a performance measure

– Sensitivity

– Precision

– Generally, these properties have to be traded off

• Share price

– High in sensitivity, low in precision

• Net income

– Low in sensitivity, high in precision

» Continued

The Theory of Executive Compensation (continued)

• How to increase sensitivity of net income

– Reduce recognition lag

• Net income “waits” until many aspects of manager effort are realized

– R&D, advertising, legal & environmental liabilities

– Capital expenditure programs

• Current value accounting reduces recognition lag

– But decreases precision

» Continued


• How to increase sensitivity of net income (continued)

– Full disclosure

• More difficult for manager to disguise shirking by earnings management

• Enables compensation committee to better evaluate earnings persistence

» Continued


• Controlling length of manager decision horizon

– I.e., control the nature of manager effort

• Short-run effort

• Long-run effort

• Greater proportion of performance based on share price relative to net

income increases long-run effort relative to short-run effort, and vice versa

• Or does it? Effect of ESOs on manager effort leading up to 2007-2008 market

meltdowns

– Effect of RBC proposed 2009 changes to compensation plan on manager decision

horizon?

>> Continued


• Congruency of a performance measure

– If performance measure (e.g., net income) is congruent to payoff, mix

of short-run and long-run effort does not matter to firm owner

(investor)

• Each effort type equally effective in generating payoff

– If net income not congruent to payoff (more likely), effort mix does

matter

• Then, firm owner can control manager’s effort mix (i.e., length of

manager’s decision horizon) through proportion of net income v. share

price-based compensation

» Continued


• The role of risk in executive compensation

– Recall manager must bear some risk to motivate effort

– Risk goes both ways

• Downside risk: Compensation may be less than expected

• Upside risk: Compensation may be more than expected

– Lower performance measure precision → higher risk

» Continued


• The role of risk in executive compensation (continued)

– Too little compensation risk

• Reduces effort incentive

– Too much compensation risk

• Manager avoids risky projects

• Excessive hedging

– Goal is to control compensation risk, not eliminate it

» Continued


• The role of risk in executive compensation (continued)

– Controlling compensation risk

• Relative Performance Evaluation

– Fine in theory, but hard to find in practice

– May depend on firm size (Albuquerque (2009))

• Bogey of compensation plan

– Controls downside risk

• Cap of compensation plan

– Controls upside risk

• Board and compensation committee have role in controlling compensation

risk

• Conditionally conservative accounting also has role in controlling

compensation risk


• Empirical compensation research

– Research suggesting efficient contracting

• Lambert & Larcker (1987)

– Cash compensation (salary + bonus) more highly correlated with ROE than with return

on shares

– Correlation higher as noise in NI lower

– Correlation lower for growth firms

– Higher weight on ROE in compensation plan when correlation between ROE and return

on shares low, and vice versa

• Indjejikian & Nanda (2002)

– Lower firm risk, higher target bonus

Empirical Compensation Research (continued)

• Research suggesting efficient contracting (continued)

– Bushman, Indjejikian & Smith (1996)

• For growth firms, more CEO compensation based on individual performance

measures

– Baber, Kang & Kumar (1999)

• More persistent earnings changes have greater effect on compensation

– Banker, Darrough, Huang, and Plehn-Dujowich (2013)

• Manager bonus negatively related to manager ability

10 - 15

10.6 Politics Of Executive Compensation

• Is executive compensation too high?

– If so, suggests inefficient contracting

• Jensen & Murphy (1990)

– According to authors, not too high, but managers do not bear enough risk--they

need to hold more stock

– Does executive compensation ignore extraordinary losses?

• What about extraordinary gains?

– Gayle & Miller (2009)

• Suggests managers not overpaid

• Suggests increased manager compensation due to increased firm size and

increased compensation risk

>> Continued

Politics Of Executive Compensation (continued )

• Do golden parachutes reduce effort incentive?

– A source of criticism of efficient contracting since may seem to reward poor

performance

– However, Rau & Xu (2012) conclude golden parachutes consistent with

efficient contracting

Politics Of Executive Compensation (continued )

• Value of shares and ESOs to manager less than expense

to firm

– Manager compensation not as high as some believe

• Manager risk averse, cannot diversify share holdings

• Ability to sell shares and ESOs usually restricted

• Therefore, shares and ESOs worth less to manager than their expense

to firm

• Recall ESO expense under IFRS 2 and SFAS 123R based on opportunity

cost to firm (higher than value to manager)

• Difference between ESO value to manager and ESO expense to firm

illustrated by Zions Bankcorp. (Theory in Practice 10.5)

10 - 18

10.7 The Power Theory of Executive

Compensation

• Power theory disputes efficient contracting version of PAT

– Manager uses power in firm opportunistically, to earn more than

reservation utility

• Opportunism limited by “outrage”

• Devices to camouflage excessive compensation and outrage

– Compensation consultants

– Peer groups

– Late timing of ESO awards

The Power Theory of Executive Compensation (continued)

• Controlling excessive manager power over compensation

– Good corporate governance needed

– Corporate governance helped by full disclosure

• Reduces ability of manager to cover up shirking by earnings management

• Helps identify persistent earnings

• Enables compensation committee to better tie pay to performance

• Limits excessive compensation by full disclosure of compensation amounts

to investors


• Controlling excessive manager power over compensation (continued)

– Disclosure regulation

• Compensation discussion and analysis

• Increased disclosures of risk management

• Limit tax deductibility of compensation?

– “Say on pay”

• But usually advisory only


• Despite these controls, power theory seems to

have some validity

• Brown & Lee (2010)

• Negative relationship between excess grants of equity-

based compensation to managers and corporate

governance quality

• Greater cutbacks in manager excess equity-based

compensation post Enron for firms with weak corporate

governance pre-Enron

10 - 22

10.8 The Social Significance of Managerial Labour

Markets that Work Well

• Quality of manager effort important to social welfare

– Motivation of effort requires informative performance measures

• Informative measures encourages efficient tradeoff between sensitivity

and precision

• Full disclosure improves informativeness of performance measures

10.9 Conclusions

• Financial reporting plays two important roles in motivating manager effort

– Provides a performance measure input into compensation contracts

• helps compensation committees tie pay to performance, control manager power, and increase contract efficiency

– Improves working of managerial labour markets

• Full disclosure helps labour market evaluate manager performance and establish reputation

• Role of financial reporting in motivating manager performance and improving the working of managerial labour markets equally important to social welfare as improving operation of capital markets

2014 chapter 10 · the theory of executive compensation(continued) • congruency of a performance...

Documents