A Summary of the Implications of Executive
Compensation
Chapter 10 – Financial Accounting Theory
Section 10.1 - Overview
Normatively, compensation plans are beneficial to companies as the
inefficiencies of moral hazard are reduced, because shareholders are more likely to
achieve incentive compatibility, thus; implying that managers will be more likely to act
in the best interest of the firm. In order to have an efficient compensation plan the
managers’ efforts must be embedded in the rewards of the compensation plan itself.
Section 10.2 – Are Incentive Contracts Necessary?
Fama’s argument is that incentive contracts are not required because the
managerial labor market controls moral hazard by internal monitoring. The two period
model of internal monitoring by Arya, Fellingham and Glover supports this argument.
Each manager is concerned with achieving their own reservation utility, and
contemplates their marginal utility as well as that of other managers’ when deciding on
their next available move, thereby decreasing moral hazard. Furthermore, managers are
concerned for their own reputation, which decreases the likelihood of them shirking.
On the other hand, a manager’s reputation follows them from job to job;
therefore, the manager has an incentive to keep a good reputation, which may involve
shirking. In addition, managers can control the release of information to the managerial
labor market, implying that the labor market would not reflect underlying manager
value. Investors know and fear this to the point that they reduce the amount they would
be willing to pay for shares.
Overall, internal controls may help to control moral hazard but do not eliminate
it.
Section 10.3 – A Managerial Compensation Plan
The managerial compensation plan of BCE Inc., a large Canadian corporation, is
described below.
Incentive programs are designed to help BCE attain both short-term and longerterm corporate objectives. Short-term awards are based on corporate performance and
an executive’s own initiative. The lower ranked the executive; the less overall
corporate performance is weighted in determining the short-term incentive.
Long-term compensation at BCE consists of stock option and share units, which
are based on market values. This form of compensation is designed to keep the interests
of the executives consistent with those of the shareholders –which is to maximize share
price.
BCE has a mix of short-and long-term incentives in the compensation plan. This
is important for both short-and long-term company goal attainments. Both marketbased and accounting performance measures are used.
Section 10.4 – The Theory of Executive Compensation
The theory of executive compensation implies that there are several aspects to
consider when building a compensation plan, including: efficiency, share price versus
accounting net income, agency costs, decision horizon, and risk.
An efficient compensation plan implies that there is a positive correlation
between managers’ efforts and the reward received from the compensation plan. One
way of measuring manager effort is by using accounting net income. Support for using
net income includes the fact that it is more reliable, as it is based on historical cost, and
it is less volatile with respect to economic events. However, net income is not timely
because executive decisions may produce both short-term and long-term results and
only some of the payoffs may be included in current net income. Given these problems,
share price may be a better measure as it properly reflects publicly available
information, takes into consideration prospective payoffs from current managerial
activities, and fully incorporates the information of net income. However, it also
includes economy-wide factors that are out of manager’s control and is very volatile.
Since share price seems to better reflects long-run payoffs, and net income
reflects short-run payoffs of current manager actions, an alteration of the mix of sharebased and net income based compensation policies allows for setting a managers
decision horizon.
Section 10.5 – The Role of Risk in Executive Compensation
Another component of developing an executive incentive plan is risk, which is
evident because of the inability to predict changes in economical and industry-wide
factors.
The goal of developing the compensation plan is not to eliminate risk, nor is it to
impose as much risk as possible. The reason for the former is consistent with agency
theory, implying that a manager must bear some risks if a compensation plan is to
successfully measure their unobservable efforts. On the other hand, too much risk may
deter a manager from taking on risky projects, which could be in the better interest of
the firm. In addition, causing too much volatility in a manager’s pay to the extent of
imposing risks of personal bankruptcy is inefficient, not to mention unethical.
Therefore, controlling risk by imposing a limit to both downside (bogey, floor) risk and
upside (cap, ceiling) risk somewhat promotes managerial behaviors that are in the best
interests of the firm because there are some restraints as to how much is gained or lost
by the manager.
Holstrom proposed that to decrease the amounts of industry and economic risk,
compensation plans should be based on relative performance evaluation (RPE). This
concept suggests that bonuses should be assessed relative to the average net income
performance of other firms in the industry since this would eliminate the impact of state
realization on the firm, thereby allowing for the net income of the company to be more
highly correlated with the managers’ performance. Empirically, the support for this
method of evaluation is weak because the mix of using share price and accounting net
income as evaluations of management performance decreases the industry and economy
wide risk and also has added perks such as controlling a managers decision horizon that
RPE lacks.
This mix of share price and net income in developing an efficient compensation
contract is affected by the desired time horizon, as well as the precision (reciprocal of
the variance) and sensitivity (the rate at which the expected value of the payoff responds
to manager effort) of the payoffs received. Therefore, if both precision and sensitivity
increase it would be beneficial to increase the proportion of net income to share price in
the compensation contract as the accounting net income would have less noise,
implying more reflectance on manager effort.
Lambert and Larcker’s studies of companies’ return on sales and return on
equity impact on manager’s cash compensations showed that as net income was less
noisy, the return on equity would be a better measure of cash compensation, which is in
line with the above theory. Furthermore, growth firms’ executives had lower
correlations between return on equity and cash compensation than return on shares. LL
also found that when share return and return on equity correlations of firms were low,
the return on equity aspect was weighted more heavily in employee compensation,
reiterates the issue of usefulness of net income, which was also a problem in financial
accounting theory.
Section 10.6 – The Politics of Executive Compensation
Jensen and Murphy conducted studies to determine whether CEO’s were
overpaid and concluded that although not overpaid, the correlation between a CEO’s
performance and compensation was very low. JM’s explanation was that CEO’s did not
have enough risk embedded in their compensation plans in order to motivate their
behaviors.
Overall, managements’ performance is positively correlated with compensation
in the real world, empirical evidence shows that the correlation is very low.
Section 10.7 - Summary
Overall, compensation plans should be efficient, have a proportion of both net
income and share price as a basis to measure management performance and to promote
a certain decision horizon and should involve risk, all while considering the agency
costs involved in making the compensation plan itself.
Chapter 10 Quiz
009.403 – Accounting Theory
Multiple Choice: (8 marks)
1)
According to Holstrom, compensation plans should be based on Relative
Performance Evaluation because:
a) Compensation should be consistent with market valuation of the firm.
b) Evaluating Net Income comparative to that of other firms in the
industry eliminates the impact of state realization.
c) Executives within a firm should be ranked against one another based on
performance.
d) Net Income provides the best information on which to base
compensation plans.
e) Only A and B.
2)
Jensen and Murphy concluded that the correlation between a CEO’s
compensation and their performance is very low. This can be explained by:
a) The fact that CEO’s have the ability to manipulate income figures.
b) External market conditions that the CEO has no control over.
c) CEO’s not having enough risk in their compensation plans to
motivate their behaviour.
d) All of the above.
e) None of the above.
3)
A manager who is more risk-averse would value shares and options given as
compensation _________________ than a less risk-averse manager
a)
b)
c)
d)
4)
Lower
Higher
Neither, they would value them the same.
It depends on whether the compensation is based on Income or the
Market.
Which of the following is not an attribute of a good executive compensation
plan according to the theory of executive compensation?
a) Persuades the manager to have risk tolerances similar to those of
shareholders.
b) Provides incentives to the managers to perform.
c) Impels managers to make decisions given a time horizon.
d) Is based on a carefully calculated balance between Net Income and
Market Value
e) All of the above are attributes of a good executive compensation
plan.
Long Answer: (22 marks)
5)
In the context of manager compensation, explain why it is reasonable to say that
managers are generally risk-averse? (2 marks)
Managers are generally risk-averse because the compensation that they
receive is dependent on only one incentive compensation plan as they only
work for one employer. They cannot diversify their risk by working at 25
different jobs, as this would be unrealistic.
6)
(a) What are some real life implications of eliminating the upside limit of
management compensation plans, while keeping the downside limits? (2 marks)
The manager may take on risky projects all the time because they would
have everything to gain, but nothing to lose.
(b) What are some real life implications of eliminating the downside limit of
management compensation plans, while keeping the upside limits? (2 marks)
Here, the manager would have everything to lose, but nothing to gain. The
manager in this instance would be extremely risk-averse.
(c) What are some real life implications of eliminating both the downside and
upside risk of management compensation? (2 marks)
In the context of diminishing utility, the manager would be very scared to
experience any type of losses, because the losses would be limitless and
could imply personal bankruptcy. Therefore, the manager would probably
be very risk averse because there utility would have a greater decrease for a
decrease in loss than an increase in a gain.
7)
Net Income and Share Price have their own distinct advantages and
disadvantages in the context of being the basis for an Executive Compensation
Plan. List 2 advantages and 2 disadvantages of each, and provide insight as to
how they can work together to provide a better basis on which to measure
executive compensation. (12 marks)
Net Income Advantages:
- More Reliable (based on historic cost)
- Less Volatile to uncontrollable economic
events
- Influences managers to partake in Earnings
Management
Net Income Disadvantages: -
Lacks Timeliness
May not reflect all activities
Can be manipulated
Share Price Advantages:
Takes into consideration prospective
payoffs from current manager activities
Properly reflects publicly available
information
-
Share Price Disadvantages: -
Doesn’t reflect private information
Volatile - is influenced by external factors
- By combining Share Price, which better reflects long-run payoffs, and Net
Income, which better reflects short-run payoffs of current managers
actions to determine a compensation plan, managers are concerned with
both the short-term well being, as well as long-term success of the firm.
- Although Share Price by nature takes Net Income into account, research
has shown that compensation plans are better if both are used when noise
is present in the market.
- Manipulating the proportions of each can change the decision horizon
and risk tolerances to the desired level.