EXECUTIVE
COMPENSATION
Sven-Olof Yrjö Collin
Me: Sven-Olof Yrjö Collin
- Professor in Business Administration with emphasis on
Corporate Governance and Accounting
- Teach in corporate governance, accounting, management
control, corporate finance, strategy, scientific method and
supervise on all levels.
- Research in corporate governance, for example riding
schools, municipal corporations, family firms, but also
executive compensation, accounting choice and auditing,
duty.
E-mail: sven.olof.collin@lnu.se
Homepage: www.svencollin.se
AIM OF LECTURE
TO PRESENT EXECUTIVE COMPENASTION
- AS RELEVANT AS POSSIBLE, i.e., AS AN HUNGARIAN SOUP
AND THEN PRESENT
- ONE ACCOUNTING THEORY VERSION, i.e., THE SIMPLE WATER SOUP
BY POSITIVE ACCOUNTING THEORY
THE COMPENSATION PUZZLE
40%
Size of the firm
Executive Pay
Performance of the firm
5%
5 - 40
IN THE PRINCIPAL - AGENT CONFLICT?
Size: Goal of managers
AGENT
40%
Size of the firm
Executive Pay
Performance of the firm
5%
PRINCIPAL
Profit: Goal of shareholders
INSTITUTIONAL DIFFERENCES
EXECUTIVE COMPENSATION
€
US, UK
Germany
Sweden
Japan
low OWNERSHIP STHRENGT high
high TENDENCY TO USE OPTION SCHEMES low
PRINCIPAL - AGENT RELATIONSHIP
AGENCY
RISK
Competence
Behaviour
PRINCIPAL’S
OBSERVATION
Situation
Situation
Performance
SEPARATING THE PROCESS OF
COMPENSATION
Mechanism
of compensation
Criteria
for compensation
Consequence
WHO TO COMPENSATE
Individual
Group
Figure head
Individual
‘unfair’
Collaboration
Mutual Monitoring
‘back stabbing
MECHANISM OF COMPENSATION
Objectivity
Predictability
Precision
- Contract
- Monitoring
Transparency
Risk
Fairness
CRITERIA FOR COMPENSATION
• Performance
• Behaviour
• Individual characteristics
• Labour market price
• Position
• Peer comparison
PERFORMANCE
MARKET MEASUREMENTS
ACCOUNTING MEASUREMENTS
SUBJECTIVE MEASUREMENTS
•Noise
•Influence
•Informational
•Motivational
- Goal!
- Strategy etc.
STRATEGY
Strategy
Market dominance
Structure
Performance criteria: Sales growth
CEO DISCRETION INFLUENCING PAY
Task programmability
Uncertainty
CEO Discretion
Compensation
WHEN PAY - PERFORMANCE?
uncertainty
BEHAVIOUR CRITERIA
Actions performed by the agent
• subjective
• costly
time
evaluators competence
INDIVIDUAL CHARACTERISTICS
•EDUCATION
•COMPETENCE
•NETWORK
Consultants?
Bidding-up hypothesis
Reservation wage
demand
LABOUR MARKET
Upper bound
Price = Wage
supply
POSITION COMPENSATION
• Figure head (Tournament theory)
• Social recognition
• Hierarchical level
- responsibility
- higher pay on next level
• Information-processing requirements
PEER COMPARISON
REFERENCE POINT
• Peers
• Significant others
WHO DECIDES ABOUT COMPENSATION?
• The Board
• The Chairman of the Board
• The Dominant Owner
• The Remuneration Committee
- consultants...
RELATIONAL CONTRACT
• Exchange create externality
• Experience => mutual expectations
• No time horizon => trust
Tenure => No correlation Pay & Performance
Tenure => Less explicit control
SOCIETY INFLUENCING COMPENSATION
• Media
• Social groups
• Ideology
...more market-dependent decision makers,
more fashionable compensation package
KAUSALITY?
DECIDE ABOUT COMPENSATION IN ORDER TO
- ATTRACT AN INDIVIDUAL TO BECOME A CEO (recruitment)
- MOTIVATE AN INDIVIUDAL TO PROPER PERFORMANCE (incentive)
- ATTRACT INVESTORS TO THE SHARE (client effect, i.e., legitimation)
CONSEQUENCE
Base pay
Variable pay
Employment
Prospects through reputation
Intrinsic rewards
ALIGNING COMPENSATION
Environment
Organisation
Strategy
Individual
WHAT IS RISK?
Return variance: Risk averse (Financial economics)
Probability of loss: Loss averse (Behavioural finance)
Expected value
Bonus today or options for tomorrow
EMPLOYMENT CONSEQUENCES
Downward risk: unemployment
Upward risk: Promotion
Value of reputation
REPUTATION - WAGE
age
INTRINSIC REWARDS
• Job satisfaction
• Prospects of development
• Responsibility
• Power
• Good cause
• Nice atmosphere at the job
• Fun
EXECUTIVE COMPENSATION IN
ACCOUNTING THEORY
From an spicy Hungarian soup to a simple soup of water
(i.e., markets) containg two ingredients, shareholders and
managers, and their risk attitudes and endless needs of
profit.
The strength of simplicity, i.e., abstraction,
The weakness of empirical insignificance and practical
irrelevance
POSITIVE ACCOUNTING THEORY
“…the only accounting theory that will provide a set of
predictions that are consistent with observed phenomena
is one based on self-interest”
(Watts & Zimmerman, 1979:300).
ECONOMIC CONSEQUENCES
ACCOUNTING POLICY CHOICE,
LACKING DIRECT CASH FLOW INFLUENCE,
CAN INFLUENCE THE VALUE OF THE FIRM
BECAUSE
- INEFFICIENT CAPITAL MARKET
- INDIRECT WEALTH EFFECTS
- FOR MANAGEMENT
- FOR THE FIRM
- FOR INVESTORS
- FOR DEBT HOLDERS
- FOR SOCIETY,
-I.E. MOST STAKE HOLDERS
SHIRKING MANAGERS
MANAGERS WITH THEIR OWN GOALS,
… SO WHAT?
MONITORING IS COSTLY
- DIVISION OF LABOUR THROUGH SEPARATION
OF OWNERSHIP AND CONTROL
COMPETENCE TO MONITOR:
INFORMATION – THEORY (EXPERIENCE)
 TO MANAGE THE MANAGER
One mechanisms is executive compensation
ESSENCE OF EXECUTIVE COMPENSATION FOR
POSITIVE ACCOUNTING THEORY
RISK SHARING
INCENTIVE FOR SHAREHOLDER GOAL ATTAINMENT AND
CONGRUENCE
Not fairness, intrinsic rewards, employment etc
PAT PREDICTION I:
THE BONUS HYPOTHESIS
MANAGERS WITH BONUS WILL CHOOSE ACCOUNTING
PROCEDURES THAT SHIFT REPORTED EARNINGS FROM
FUTURE TO CURRENT PERIOD
PAT PREDICTION II:
THE DEBT/EQUITY HYPOTHESIS
MANAGERS IN FIRMS WITH HIGH DEBT/EQUITY
(I.E., LOW SOLIDITY) WILL CHOOSE
ACCOUNTING PROCEDURES THAT SHIFT
REPORTED EARNINGS FROM FUTURE TO
CURRENT PERIOD
HIGH FINANCIAL RISK IS A TREATH TO MANAGERS AUTONOMY IF
THE FIRM HAS CONSTRAINTS ON DEBT LEVELS
PAT PREDICTION III:
THE SIZE HYPOTHESIS
THE LARGER THE FIRM, THE STRONGER INCENTIVE THE MANAGER
HAVE TO DEFER REPORTED EARNINGS FROM CURRENT TO
FUTURE PERIODS
Large firms have higher political costs, media attention, union attention and so
on, that stimulate wage increase, tax changes, more charity and so on.