Financial Accounting Theory Sixth Edition William R.

Scott

Chapter 10
Executive Compensation
10 - 1 Copyright 2012 Pearson Canada Inc

Chapter 10 Executive Compensation

10 - 2 Copyright 2012 Pearson Canada Inc

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 Copyright 2012 Pearson Canada Inc

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

10 - 4 Copyright 2012 Pearson Canada Inc

The RBC Compensation Plan (continued)

Proposed 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 risk?

10 - 5 Copyright 2012 Pearson Canada Inc

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

10 - 6 Copyright 2012 Pearson Canada Inc

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

10 - 7 Copyright 2012 Pearson Canada Inc

The Theory of Executive Compensation (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

10 - 8 Copyright 2012 Pearson Canada Inc

The Theory of Executive Compensation (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

10 - 9 Copyright 2012 Pearson Canada Inc

The Theory of Executive Compensation (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 managers effort mix (i.e., length of managers decision horizon) through proportion of net income v. share price-based compensation

Continued
10 - 10 Copyright 2012 Pearson Canada Inc

The Theory of Executive 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

10 - 11 Copyright 2012 Pearson Canada Inc

The Theory of Executive Compensation (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

10 - 12 Copyright 2012 Pearson Canada Inc

The Theory of Executive Compensation (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

Role of Board, compensation committee Role of conservative accounting

10 - 13 Copyright 2012 Pearson Canada Inc

The Theory of Executive Compensation

(continued)

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) Bushman, Indjejikian & Smith (1996) Baber, Kang & Kumar (1999)

10 - 14 Copyright 2012 Pearson Canada Inc

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

Do golden parachutes excessively reduce risk?

>> Continued
10 - 15 Copyright 2012 Pearson Canada Inc

Politics Of Executive Compensation

(continued )

Value of shares and ESOs to manager less than cost 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 expense to firm based on opportunity cost (higher than value to manager)

10 - 16 Copyright 2012 Pearson Canada Inc

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

10 - 17 Copyright 2012 Pearson Canada Inc

The Power Theory of Executive Compensation (continued)

Controlling excessive manager power over compensation
Good corporate governance needed Corporate governance helped by full disclosure
To reduce ability of manager to cover up shirking by earnings management To help identify persistent earnings To enable compensation committee to better tie pay to performance To limit excessive compensation by full disclosure of compensation amounts

10 - 18 Copyright 2012 Pearson Canada Inc

The Power Theory of Executive Compensation (continued)

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

10 - 19 Copyright 2012 Pearson Canada Inc

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
Encourages efficient tradeoff between sensitivity and precision Encouraged by full disclosure

10 - 20 Copyright 2012 Pearson Canada Inc

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

Motivating manager performance and improving the working of managerial labour market equally important to social welfare as improving operation of capital market
10 - 21 Copyright 2012 Pearson Canada Inc