Chapter 10
Executive
Compensation
Nicole Fitzmaurice,
Eric Poolman, Lisa
Landon, Pang Koh &
Ping Zhou
WHAT IS EXECUTIVE COMPENSATION
 An
executive compensation plan is an agency
contract between the firm and its manager that
attempts to align the interests of owners and manager
by basing the manager’s compensation on one or
more measures of the manager’s performance in
operating the firm
In other words, how does a manager get paid on their
performance.
ARE INCENTIVE CONTRACTS
NECESSARY?
 Fama
(1980) argues that the managerial labour
market controls moral hazard making incentive
contracts unnecessary.
 Managers with a reputation for creating high
payoffs will increase their market value
 Managers with poor reputations will decrease
their market value
 What about managers who hide their shirking
by managing earnings?
WOLFSON (1985)
 Wolfson
examined contracts of oil and gas
limited partnerships in the U.S.
 Contracts between a General partner
(agent) and limited partners (principal)
 General partner privately learns of the
drilling results leading to the “noncompletion incentive problem”
WOLFSON (1985)
 Information
was collected on a sample of
general partners from 1977-1980
 It was found that the higher the reputation, the
more that general partner would receive from
limited partners
 Also found that investors paid much less to
buy into development wells due to the risk of
the non-completion problem
RBC EXECUTIVE OFFICER
COMPENSATION PLAN
 Objective:
attract, motivate and retain
executives


Offer total compensation that is competitive in the market
place
Equitable – compensation reflects responsibilities
 Compensation

Responsible for setting and reviewing compensation plan
 Competitive

Committee
Compensation
Positioned at median of comparator group
EXECUTIVE COMPENSATION PLAN OF
ROYAL BANK OF CANADA
1. Officers are required to hold a significant amount
of RBC shares.
2. Four compensation components:
(a) Salary, paid in cash.
(b) Short-term incentive plan bonus awards paid
in cash or deferred share units.
(c) Mid-term incentive plan, awards paid in
deferred share units.
(d) Long-term incentive plan, awards paid in
stock options
EXECUTIVE COMPENSATION PLAN OF
ROYAL BANK OF CANADA
3. Incentive effects apparent


Short-term and mid-term incentives – focus on
current year’s performance
Long term incentives – focus on share price
4. Mix of short term and long term incentives


Determines Decision Horizon for Management
Trade-off
BASE SALARY
 Established
equitably to reflect the
individual performance and
responsibilities related to that position
 Use
median of comparative group as a
guideline
ANNUAL SHORT TERM INCENTIVE
AWARDS
 Support
achievement of corporate objectives
 Balance
Financial Targets with Strategic
Business Objectives
 Individual
 Target
Contribution to corporate objectives
values used for awards
LONG TERM INCENTIVE PROGRAM
 Major
tool is stock options
 Objectives:
 Compensate
and retain executives
 Link executive officers interests with
shareholders interests
 Encourage executives to pursue value
creating opportunities
STOCK OPTIONS
 RBC
offers executives and key
employees options to buy RBC shares
 On occasion the compensation
committee can approve special grants
of stock options for individual
recognition or further motivation
 Term of an option is normally 10 years
DEFERRED SHARE UNIT PLAN
 Designed
to align the interests of executives with that of
shareholders
 DSUs have the same value as RBC shares and receive
payments that are equal to dividends of RBC shares
 Executives can choose to have 100% of their short term
incentive award paid in DSUs
 DSUs count toward an executives minimum share
requirements
CONCLUSION
 Compensation
Committee believes new
strategy is competitive in the market
 Policy
strongly links compensation awards
with corporate performance measures
 Allows
RBC to attract, motivate, and retain
top executives within the company
10.4 THE THEORY OF EXECUTIVE
COMPENSATION
 Desirable


properties of a performance measure
Sensitivity: rate at which the expected value of the
performance measure responds to manager’s effort
Precision: reciprocal of the variance of the noise in
the performance measure
Manager’s
Effort
Performance
Measure
Sensitivity

Payoff
Precision
Generally, these properties have to be traded off
10.4.1 THE RELATIVE PROPORTIONS OF NET
INCOME AND SHARE PRICE IN EVALUATING
MANAGER PERFORMANCE

Share price


Net income


High in sensitivity, low in precision
Low in sensitivity, high in precision; WHY?
Ways to increase sensitivity of net income
1. Reduce recognition lag
 Net income waits until many aspects of manager
effort are realized

R&D, advertising, capital expenditure programs
 Current
value accounting reduces recognition lag,
but decreases precision.
10.4.1 THE RELATIVE PROPORTIONS OF NET INCOME
AND SHARE PRICE IN EVALUATING MANAGER
PERFORMANCE (CONT’D)
 Ways
to increase sensitivity of net income (cont’d)
2. Full disclosure
 Enables
compensation committee to better evaluate
earnings persistence
3. GAAP
 More difficult for manager to disguise shirking through
earnings management
10.4.1 THE RELATIVE PROPORTIONS OF NET
INCOME AND SHARE PRICE IN EVALUATING
MANAGER PERFORMANCE (CONT’D)
 Controlling

length of manager decision horizon
I.e., control the nature of manager effort
 Long-run
effort (R&D)
 Short-run effort (cost-cutting)
 Greater proportion of compensation based on share
price relative to net income will increase long-run
effort relative to short-run effort, and vice versa

Decision horizon has to be traded off with sensitivity
and precision of performance measure
10.4.2 SHORT-RUN EFFORT AND
LONG-RUN EFFORT

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
Increases in Net Income and Payoffs from Working Hard
Manager's Effort
Short-Run (SR)
Long-Run (LR)
Effort
Effort
Expected Net Income E(NI)
μ1 = $3
μ2 = $3
p1 = 1.5
Expected Payoff E(x)
b1 = $4.5
b2 = $1.5
p2= 1.5
10.4.2 SHORT-RUN EFFORT AND
LONG-RUN EFFORT (CONT’D)

If net income is not congruent to payoff, effort mix
does matter
 Firm
owner can control manager’s effort mix (i.e., length
of manager’s decision horizon) through proportion of net
income vs. share price-based compensation
Increases in Net Income and Payoffs from Working Hard
Manager's Effort
Short-Run (SR)
Long-Run (LR)
Effort
Effort
Expected Net Income E(NI)
μ1 = $3
μ2 = $1
p1 = 1/6
Expected Payoff E(x)
b1 = $0.5
b2 = $5
p2 = 5
THE ROLE OF RISK IN EXECUTIVE
COMPENSATION
 A manager
has some compensation
risk, which becomes the motivator
 There is a trade-off for the manager
between the risk and the return
 The higher the risk means the higher
the expected compensation for the
manager
METHODS TO CONTROL
COMPENSATION RISK
Relative
Bogey
performance evaluation
of the compensation plan
Compensation
committee
EMPIRICAL COMPENSATION RESEARCH
 Compare
return on shares and return on
equity to explain managers’ cash
compensation
 Short term incentive awards are based on
individual achievement and net income
while stock option awards are not.
 Return on equity (ROE) was more related to
cash compensation than a return on shares
EMPIRICAL COMPENSATION
RESEARCH CONT…..
 Managerial
compensation for growth
firm executives had a lower relationship
with return on equity than average
 Firms where the correlation between
share return and return on equity was
low, there tended to be a higher weight
on return on equity in the
compensation plan
10.6 THE POLITICS OF EXECUTIVE
COMPENSATION
 Many
have argued that executives are
overpaid
 Jensen and Murphy argued that CEOs
were not overpaid but that their
compensation was far too unrelated to
performance
 Increased compensation costs are
necessary to overcome the moral hazard
problem between manager and owner
10.7 THE POWER THEORY OF
EXECUTIVE COMPENSATION




The power theory of executive compensation suggests that
compensation in practice is driven by manager
opportunism, not efficient contracting
Bebchuk, Fried and Walker argue that managers have
sufficient power to influence their own compensation
Better corporate governance required to reduce manager
power:
 Sarbanes-Oxley Act and related regulations in Canada
Regulators and accountants are responding to the political
pressures that result when compensation reflects manager
power
10.8 THE SOCIAL SIGNIFICANCE OF MANAGERIAL
LABOUR MARKETS THAT WORK WELL
 Manager
performance contributes to
social welfare via high firm productivity
 More informative performance
measures enable more efficient
compensation contracts
 Results in higher firm productivity and
social welfare
10.9 CONCLUSIONS ON
EXECUTIVE COMPENSATION
 Managerial
labour markets reduce the severity
of moral hazard
 Labour markets are subject to adverse
selection problems such as earnings
management to disguise shirking
 Financial reporting has an important role in
motivating executive performance and
controlling manager power.
HOW ARE EARNINGS MANAGED
BY: NELSON, ELLIOT AND TARPLEY
Earnings Management
“when managers use judgement in financial
reporting and in structuring transactions to alter
financial report to either mislead some
stakeholders about the underling economic
performance of the company or to influence
contractual outcomes that depend on reported
accounting numbers.”
HOW ARE EARNINGS MANAGED
BY: NELSON, ELLIOT AND TARPLEY
 Importance
of understanding how earnings
management occurs
1. Regulators and standard setters identify the
areas most in need of regulatory change
2. Auditors evaluate and report on their clients'
quality of earnings and train novice auditors
about earnings management
3. CEOs, CFOs, audit committees, and
investors focus attention on those areas of
the FS where they should be most skeptical
HOW ARE EARNINGS MANAGED
BY: NELSON, ELLIOT AND TARPLEY
 Importance
of understanding how earnings
management occurs (continued)
4. Managers and audit committees anticipate
the transactions that investors will view most
skeptically
5. Educators teach students about earnings
management
6. Researchers focus their analyses on areas
of high-earnings-management activities.
STUDY FORMAT
1.
Classify attempts according to primary
approach
a)
b)
c)
d)
2.
Expense recognition
Revenue recognition
Issues unique to business combination
Other issues
Sub-classify by particular approaches
GENERAL RESULTS
 Collected
data from 253 auditors based
on 515 earnings management attempts
 53% increased current-year income
 31% decreased current-year income
 16% had no clear current-year
income effects
RESULTS
Expense and other losses
 Attempts include:
 “Recognizing
too much or too little reserves in
current years”
 “Reducing or not reducing previous accruals”
 42%
of time auditors did not require an
adjustment to be made
 Often decreased current-year income
RESULTS
Revenue and Other Gains
 Attempts include:
 “Cut-off
Manipulation”
 “Deferring too much or too little revenue”
 “Timing the recognition of realized or unrealized
gains or losses on investments”
 75%
increased current-period income
 56% required adjustments by auditors
RESULTS
Business Combinations
 Attempts include:
 “Over-or
understating assets, liabilities and
offset with goodwill”
 79% involved overstating liabilities and
goodwill
 “Over- or understating expenses involved in a
period of acquisition”
 Affected income in post-acquisition year
RESULTS
Other Approaches
Attempts include:
 “Income
statement classification
issues:
 “Inappropriate disclosure”
 “Off-balance-sheet items”
 “Accounting for large investments”
RECAP IMPORTANCE OF UNDERSTANDING
EARNINGS MANAGEMENT
1.
2.
3.
Regulators and standard setters identify the
areas most in need of regulatory change
Auditors evaluate and report on their clients'
quality of earnings and train novice auditors
about earnings management
CEOs, CFOs, audit committees, and investors
focus attention on those areas of the FS where
they should be most skeptical
RECAP IMPORTANCE OF UNDERSTANDING
EARNINGS MANAGEMENT
4.
5.
6.
Managers and audit committees
anticipate the transactions that
investors will view most skeptically
Educators teach students about
earnings management and
Researchers focus their analyses on
areas of high-earnings-management
activities.
Chapter 10
Executive
Compensation
QUESTIONS?