Financial Accounting Theory

Sixth 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
 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?
 10.4 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
 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
 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
 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 manager’s effort mix (i.e., length of
manager’s decision horizon) through proportion of net income v. share
price-based compensation

» Continued
 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
 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
 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
 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)
 10.6 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
 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)
 10.7 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
• 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
 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”
 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
 10.9 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