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 BCE Compensation Plan

• Components of senior management compensation– Salary– Short-term incentive awards

• Cash bonus or deferred share units, based on attainment of financial targets (e.g., EPS ) & new business development,

• Individual contribution (based on a third performance measure: creativity & initiative)

– More suitable for less senior managers?

• Compensation components, cont’d.– Stock options, based on share price

performance– Executives required to hold BCE shares

• All compensation components except salary increase alignment– Since investors and managers both want

firm to do well

10.3 The BCE Compensation Plan (continued)

• Revisions to compensation plan 2004– Mid-term incentive plan (2 year)– Reduced stock option awards

• Restricted share units instead

– Reasons for revisions• To shorten manager decision horizon, but

not too short• Improve BCE corporate governance

credibility

10.3 The BCE Compensation Plan (continued)

10.4 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

10.4 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

10.4 Theory of Executive Compensation (continued)

• How to increase sensitivity of net income, cont’d.– Full disclosure

• More difficult for manager to disguise shirking by earnings management

• Enables compensation committee to better evaluate earnings persistence

10.4 Theory of Executive Compensation (continued)

• Two types of manager effort– Short-run– Long-run

• If net income congruent to payoff, mix of short-run and long-run effort does not matter to investor– Each effort type equally effective in

generating payoff

10.4 Theory of Executive Compensation (continued)

• If net income not congruent to payoff (more likely), effort mix does matter– Firm owner may wish to control manager’s

effort mix (i.e., length of manager’s decision horizon)

10.4 Theory of Executive Compensation (continued)

• Controlling length of manager decision horizon– Greater proportion of performance based

on share price relative to net income increases long-run effort relative to short-run effort, and vice versa

– Recall BCE 2004 compensation plan revisions

• Why did BCE want to shorten decision horizon?

10.4.3 The Role of Risk in Executive Compensation

• Risk goes both ways– Downside risk: Compensation may be less

than expected– Upside risk: Compensation may be more

than expected• Source of compensation risk

– Lower performance measure precision → higher risk

• Manager must bear some risk to motivate effort

10.4.3 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

10.4.3 The Role of Risk in Executive Compensation

(continued)• Controlling compensation risk– Relative Performance Evaluation

• Fine in theory, but hard to find in practice

– Bogey of compensation plan• Controls downside risk

– Cap of compensation plan• Controls upside risk

– Role of Board, compensation committee– Role of conservative accounting– Golden parachutes

• Eliminate too much risk?

10.5 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?• Ignoring losses and including gains increases

compensation

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

10.7 The Power Theory• 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– Compensation consultants– Peer groups

The Power Theory in Action• Late timing of ESO awards

– Another way to camouflage excessive compensation

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

Two Roles for Financial Reporting for Executive

Compensation• To provide a performance measure for compensation contracts– But must compete with share price

• To inform the managerial labour market about manager performance and value– Reputation at least partially motivates effort

• Recall Fama/Wolfson arguments

– Reputation determines manager’s reservation utility

• Both roles can be accomplished simultaneously

10.8 Social Significance of Well-Working Managerial Labour

Markets• Full disclosure helps the managerial labour market to work well– Manager’s reservation utility (i.e.,

manager’s market value) will then better reflect his/her ability and effort

• Well-working managerial labour markets encourage productivity and social welfare

10.9 Conclusions• Financial accounting-based performance measures

are an important input into compensation contracts– Full disclosure helps compensation committees tie

pay to performance, control manager power, and increase contract efficiency

• Financial accounting-based performance measures can improve the operation of managerial labour markets – Full disclosure improves working of managerial

labour market • But not to point where need for an incentive

contract is eliminated

Chapter 10 Supplement

Wolfson (1985) Study of Oil and Gas Limited Partnerships

10.2 Empirical Evidence of Incentive Problems and

Their Mitigation in Oil and Gas Tax Shelter Programs

Mark A. Wolfson (1985)An application of agency theory

The Question to be Addressed

• In a multi-period context, can market forces (i.e., reputation effects) eliminate shirking?– If so, no need to motivate managers

by means of incentive contracts

Tax-Advantaged Limited Partnerships to Drill for Oil

and Gas (U.S.)• Principal: the limited partner, who

invests and receives advantageous tax treatment

• Agent: the general partner/manager– Conducts drilling and on basis of drilling

results decides whether or not to complete the well

Two Types of Drilling • Exploratory

– Riskiest (low probability of high payoff)

• Developmental– Least risky (high probability of low payoff)

An Incentive Contract

• A common sharing rule (contract) – Tangible drilling costs: must be capitalized for

tax purposes– Intangible drilling costs: immediately tax

deductible– Agent (manager) pays tangible costs– Principal (limited partner, investor) pays

intangible costs– Let revenue from well be R– Manager gets, e.g., .40R – Investor gets .60R

Information Asymmetry

• Manager knows expected R, investor does not

• This leads to incentive problems of moral hazard and possible shirking by manager– Noncompletion problem (manager shirks

by not completing well)

The Noncompletion Problem

(Well is Drilled But Not Yet Completed)• A model of revenue from well:

– E(R) = K(D + C)• D: drilling costs. Paid by investor• C: completion costs. To be paid by

manager• K: manager’s skill (e.g., K = 2)

– Manager generates $2 in revenue for each dollar spent

• Manager knows E(R) and C, investor does not

The Noncompletion Problem (continued)

• From standpoint of society (and investor)– Complete well if R ≥ KC, since D is sunk

• From standpoint of manager– Complete well if .40R > KC

• Thus manager may not complete well (i.e., may shirk) when completion is in best interests of principal and society

• NB: Noncompletion problem greater for development wells

Controlling the Noncompletion Problem

• Direct monitoring of manager drilling effort and results (too costly)

• Manager establishes a reputation (multi-period) to convince principal that he/she will not shirk

Testing For Reputation Effects• For each general partner (manager) in the sample

of limited partnerships:– Expected return rating (ERR)

• A measure of a manager’s reputation, based on past performance

• Analogous to past income statements– Net return rating (NRR)

• Expected oil and gas finding rate. A measure of the cost to “buy in” to the manager’s partnership. Lower NRR implies higher cost to buy in, since limited partners (investors) then get lower expected return

• NRR analogous to a managerial labour market (i.e., measures the manager’s worth)

Testing For Reputation Effects (continued)

• Is higher reputation associated with higher cost to buy in?– Yes: Wolfson reports statistically significant

evidence that higher reputation (higher ERR) associated with higher cost to buy in (lower NRR)

– It appears investors are willing to accept a lower expected return the higher the manager’s reputation

• Conclude: reputation reduces the non-completion problem of manager shirking

Testing For Reputation Effects (continued)

• Does reputation eliminate the noncompletion problem?– No: Wolfson reports higher NRR for development

wells– Development wells

• Average NRR for his sample = 2.695– Exploratory wells

• Average NRR for his sample = 2.357

• Thus lower price to buy into development wells

Testing For Reputation Effects (continued)

• Wells more subject to the noncompletion problem (development wells) are priced lower by investors than wells less subject to the noncompletion problem (exploratory wells)

• If reputation completely eliminated the noncompletion problem, the prices would be the same

Conclusion to Testing For Reputation Effects

• Conclude: reputation effects do not completely eliminate the need for an incentive contract

• Managerial labour market works, but not fully well

Implications for Accountants

• 2 roles for accounting information– Market forces of reputation reduce but do not

eliminate manager shirking • Thus compensation contracts and performance

measures such as net income still needed– Net income should be informative about manager

effort• i.e., the ability of market forces to motivate effort

is improved as accountants reduce ability of managers to shirk through higher quality reporting

– Both roles benefit society

The End

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