Smeal College of Business Managerial Accounting: ACCTG 404 Pennsylvania State University Professor Huddart 1. Types of Compensation Managers compensation takes various forms, including: salary, bonus, deferred compensation (like stock appreciation rights and phantom stock), participating unit plans, stock options, and non-pecuniary rewards. Below we describe some features of these compensation components. Salary This is the most common form of compensation. Higher level managers have higher salaries and promotion to higher salary levels depends on performance. That is, salaries in the long run depend upon performance. Cash Bonus Most bonus schemes are either linear or piece-wise linear in the respective performance measure. One example is a sales commission. Often, a bonus pool is decided on the basis of a company s annual profit. Usually this pool is a fixed proportion of after-tax profits which exceed some target level T, where T is expressed as a fraction of the total capital stock of the company. [For example, recently Goodyear Tire Company offered 10% of its after-tax net income above T, where T was 5% of capital stock. General Motors Corporation offered 8% of income above 7% of capital stock, until income was 15% of capital stock, and then it offered 5% thereafter.] A bonus pool is typically divided among top managers, usually in proportion to their salaries, and the achievement of some pre-specified goals. Bonuses may be paid in cash or in the form of company shares. Based on notes by Nahum Melumad and Stefan Reichelstein. c Steven Huddart, 1995 2011. All rights reserved. www.personal.psu.edu/sjh11
ACCTG 404 Deferred Compensation This type of compensation takes many forms: (a) Deferred Bonuses are based on performance of the company for the last 3 5 years, and are paid only if the manager does not leave the company. Alternatively, bonuses are paid after retirement, based on lifetime performance. One common form of deferred compensation is a pension plan. Some of these plans are introduced for tax reasons. (b) Performance Shares are similar to deferred bonuses, except that they are based on cumulative growth in earnings-per-share (EPS) for the last 4 6 years. The award is made in terms of a number of company shares. (c) Stock Appreciation Rights (SAR s), Phantom Stock are similar to deferred bonuses, except that they are based on increases in stock price in the recent past. Participating Unit Plans These are awards based on performance evaluation of managers by the Board of Directors, or of divisional managers by the general managers. Included in the performance evaluation are: returns on investment, comparison of targets and forecasts with actual performance (e.g., of revenues, or costs, or productivity), comparison with other companies in the same industry, achievement of other company goals such as establishment of training and welfare schemes for workers, employment of women and minorities, etc. Page 2
ACCTG 404 Stock Options In this arrangement the manager is given the right to purchase shares at some future date at a fixed price. A manager, for instance, can be offered the option to buy his employer s shares in ten years at the price of $120 per share. This is valuable to the manager only if the market price of shares in ten years exceeds $120 per share. Suppose, for example, the price is $140 per share, and the manager holds 1,000 stock options; then he can earn $20,000 by obtaining these shares at $120 and selling them on the market at $140. Such an arrangement may encourage managers to undertake projects likely to increase the price of the firm s stock. Non-pecuniary rewards One final component of compensation is non-cash perks such as the prestige and special rights that attach to an office. A high percentage of American companies offer perks: first-class air travel (52%), a company airplane (46%), a company car (73%), chauffeur service (33%), country club memberships (67%), financial planning (60%), an executive dining room (23%), home security (13%), and communications equipment (31%). 1 1 Source: The American Advantage, The Wall Street Journal April 17, 1991. Page 3
ACCTG 404 2. Strength of the Pay for Performance Relationship M.C. Jensen and K.J. Murphy, Performance Pay and Top-Management Incentives Journal of Political Economy 98 (1990) 225 264. Data: Regression: There are 2,213 CEOs listed in Forbes Surveys 1974 1986, about 7,000 observations. (CEO wealth) t = a + b (shareholder wealth) t a = $31,700; b = $3.25 1,000 = 0.00325. Implication: An annual return on shares that is two standard deviations below the mean costs CEOs $5,400, on average. Agency hypotheses that may explain Jensen and Murphy s findings Executives are risk averse. High pay-performance contracts are not feasible. Firm value changes are imperfect measures of the CEO s choice of actions. Relative performance evaluation is widely employed. Accounting measures of performance dominate stock price returns. Unobservable (to the researcher) measures of performance exist that dominate stock price returns. Non-pecuniary rewards constitute a large component of performance pay. The market for takeovers or the managerial labor market are the principal sources of managerial discipline. Implicit regulation or political costs preclude the pay for performance contracts suggested by agency theory. Page 4
ACCTG 404 3. Earnings Management P.M. Healy (1985) The Effect of Bonus Schemes on Accounting Decisions Journal of Accounting and Economics 7 85 107. The test results suggest that (1) accrual policies of managers are related to income-reporting incentives of their bonus contracts, and (2) changes in accounting procedures by managers are associated with adoption or modification of their bonus plan. In light of Healy s findings, the following characteristics of an accounting measure (e.g., earnings) determine its usefulness in an incentive contract. A quantitative, verifiable measure is less likely to be manipulated by the executive. Comparability and predictability are desirable to assure that performance in the current period can be meaningfully related to past performance and to the performance of executives in other parts of the organization or in other companies. Measures that are both sensitive and precise are most informative of the executive s efforts and should therefore be weighted most heavily in the compensation contract. Where (i) the timing of the recognition of an expense or revenue is controlled by the executive under the terms of the compensation contract and (ii) the bonus is not a linear function of the accounting measure, then the compensation contract creates incentives for income smoothing. 4. Performance Evaluation for Investment Centers 4.1 Overview For cost and profit centers there are natural performance measures: cost and divisional profit. An organizational subunit is called an investment center if it operates like a profit center and, in addition, its manager is given authority to make investment choices. There is no obvious way of evaluating the performance of an investment center. Performance evaluation pursues two distinct goals: Page 5
ACCTG 404 Assess the economic viability of the business segment, Evaluate the effectiveness of the center s management. Both of these goals require the choice of a performance measure which is usually based on accounting numbers. There are alternative ways of computing such performance indices. 4.2 Accounting Measures for Investment Center Evaluation Any reasonable performance measure for an investment center must relate invested capital to profits obtained. The most widely used measures are: Return on Investment: ROI = Net Income/Investment Residual Income: RI = Net Income r (Investment), where r is the required rate of return (cost of capital) for the particular investment center. Incremental ROI = Change in Income/Change in Investment The use of ROI as a performance measure may result in situations where the divisions reject projects that, from the viewpoint of the organization, should be accepted since they promise an ROI in excess of the minimum desired rate of return. 5. Choosing an investment base 5.1 Which assets should be included? Survey Results (Reece-Cool, 1978): The following table indicates the percentage of companies (in a sample of 459) including the following assets in their asset base. Page 6
ACCTG 404 Asset Category Cash 63% Receivables 94 Inventories 95 Other current assets 76 Land and buildings (used only by investment center) 94 Land and building (prorated, when used by more than one investment center 45 Equipment (used only by investment center) 83 Equipment (prorated, when used by more than one investment center 41 Common (corporate) assets prorated 16 5.2 What dollar value should be assigned to those assets? Net book value Gross book value Replacement cost (entry value) Net realizable value (exit value) Book value adjusted for inflation To compare the performances of subunits as economic entities, it is desirable to have a uniform basis for measuring assets. Using historical cost of assets would usually involve different acquisition dates and therefore would not provide an appropriate common denominator. This problem pertains to book value measures. When historical cost is used to measure asset values, some companies prefer gross book value because it facilitates comparisons among divisions. Others prefer net book value because it is consistent with conventional external reporting of assets and net income. Some companies use historical cost adjusted for inflation. Page 7