2 - Performance Measurements and Deferred Compensation

Question 1

Generally accepted accounting principles (GAAP) and statements by the Financial Accounting Standards Board (FASB) form the basis for ______ records. _______ records reflect the Internal Revenue Code (IRC) and proclamations by the Internal Revenue Service. A reconciliation of the two is called _______, which appears on the accounting balance sheet. The dual set of records is legal and consistent with the needs of the company.

Answer 1

accounting

Tax

deferred taxes

Question 2

_______ accounting recognizes a sale immediately upon the sale and shipment of the product or when a service is performed, whereas under _______ accounting, it is recognized when the payment is received.

Similarly, under accrual accounting when a company purchases items or services, they are recognized when ordered, and under cash accounting, they are recognized only when paid.

Answer 2

Accrual

cash

Question 3

An income statement, also called an earnings statement or a profit and loss statement, reflects a company’s income and expenses for a prescribed period of time.

1. (a) ________ (revenue) are sales less any returns, discounts and allowances. Typically appear on the _____ line of an income statement. Any additional business income normally appears on a separate line directly under net sales.
2. (b) ___________ is the cost to make or buy the product. This gure is subtracted from net sales resulting in the gross margin for the firm.
3. (c) _______ or the amount left over from the subtraction of cost of goods sold from net sales is a useful measurement for calculating manufacturing and retailing pay plans.
4. (d) Earnings before interest and taxes (EBIT) is sometimes called _______. If a company believes that key executives shouldn’t be rewarded or penalized for changes in tax rates, it may use EBIT in its incentive plan calculations. It should be noted that this gives the executives the added bene t of having the calculation being made before interest expense charges.
5. (e) Income from _________ is a figure usually of high interest to financial analysts and investors. Subtracting the effect of discontinued operations net of tax leaves net income—sometimes called net earnings, net profit or “the bottom line.” (Many argue that this gure should be used for incentive calculations at the corporate level as it includes all the costs.)

Answer 3

1. Net sales
   
   • first
2. Cost of goods sold
3. Gross margin
4. operating income
5. continuing operations

Question 4

Because income is not synonymous with cash, a _______ statement is used as a supplement to the income statement to show the source and amount of cash receipts and payments. Few customers pay cash at the time of the sale so there is a time lag between the time the sale is made and the time the company receives the cash. Also, a company may have investing and financing activities. This statement is thus a report of the cash received and spent during the business year.

Answer 4

cash-flow

Question 5

The _________, which consists of assets, liabilities and shareholders’ equity, is a financial snapshot of the organization at a point in time. Like an income statement, it is prepared _______ and usually issued to shareholders on a quarterly or year-end basis. It is called a ________ because total assets equal the combination of total liabilities plus shareholders’ equity.

Answer 5

balance sheet

monthly

balance sheet

Question 6

Assets are sometimes described as _______ or short term, and ______ or long term.

• (short-term) assets are cash and assets that can be converted into cash within a 12-month period. They include cash and cash equivalents, short-term investments, short-term loan receivables, accounts receivable, inventories consisting of nished goods plus work in process plus raw materials and supplies and prepaid expenses.
• (long-term) assets include items with values and uses extending beyond a year. Noncurrent or long-term assets include long-term investments, long-term loan receivables, land, buildings and equipment (net of depreciation), goodwill (net of amortization), along with other longer term, prepaid expenses and other assets.

Answer 6

current

noncurrent

Question 7

To combat the undertaking of “creative accounting” by unscrupulous ceos and cfos, many industry followers believe that the best financial statement to use is the __________. many agree that the most important section of this statement is _______ provided by operating activities, namely, running the business, not investment or nancing activities

Answer 7

cash-flow statement

net cash

Question 8

many believe that the best financial statement to use for pay programs based on financial measurements is the cashflow statement. Whereas the income statement measures performance on an accrual basis, the cash flow statement ignores future financial _______. Accrual accounting requires _______, some of which can lead to “creative accounting.”

Answer 8

obligations

judgments

Question 9

Key non financial measurements include:

1. (a) _______—embodies the values and beliefs of the workforce on how work is to be done. Attitude surveys and behavioral tests are common measurement techniques used to measure a company’s culture. Measuring a company culture is especially important when companies are attempting to change it.
2. (b) __________ innovation—New product development can be examined at the corporate as well as at the divisional level.
3. (c) ________ —The collective and interactive skills of an organization’s workforce at all levels of the company are the major factors in determining its creativity, productivity and customer satisfaction.
4. (d) ________ —Questions to ask include how strong are the copyrights and patents of the company? When do they expire? What is the likely impact on the revenue and earnings of the company?
5. (e) _______ —This covers a wide range of possibilities ranging from business strategies that might include organizational restructuring and planning issues to culture which de nes how work is done and how people are treated.
6. (f) ________ — can be measured at all levels of the organization. If output is defined as volume times cost, then increases can come from (1) increasing volume with no increase in cost, (2) decreasing cost with no decrease in volume or (3) increasing volume and decreasing cost.
7. (g) _______— is defined in terms of nearness to perfection at any level of the company. The standard selected should be consistent with the requirement, especially if the product is delivered at higher cost. Otherwise, the lower cost would be the obvious choice of the buyer.
8. (h) _______—This is volume, or the number of units produced or sold at any level of the company. It excludes cost and price. It is useful in netting out price changes in measuring productivity.

Answer 9

1. Culture
2. Product/service
3. Intellectual capital
4. Intellectual property
5. Organizational objectives
6. Productivity
7. Quality
8. Quantity

Question 10

Four non nancial key measurements outside the company are:

• (1) ________ Because satisfied customers will buy a product again and dissatis ed customers will not, and because both will tell others about their experience with a product, customer satisfaction is an indication of company and/or divisionwide future sales potential
• (2) _________—This is a measurement of the percentage of customers who come back to buy again. The shorter the interval between their return and the longer the period of continually coming back, the more impressive the indicator.
• (3) ________—This is a measurement of how well the company is performing in terms of air and water pollution, how well it is complying with regulatory requirements, and what the likely nancial exposure of noncompliance is.
• (4) ________—The ratio of CEO pay to a stated financial measurement can be compared to ratios of comparator companies. The lower the ratio, the more expensive the cost of management.

Answer 10

1. Customer satisfaction
2. Customer retention
3. Environmental compliance
4. Management cost ratio

Question 11

Typically, the measurement of a chief executive officer is set by the Board of directors with shareholder input. normally, targets are set in relation to:

(1) ______ performance,
(2) ______ expectations and
(3) performance of ________

Answer 11

1. past
2. future
3. comparable companies.

Question 12

If more than one measurement is used, the question is what weight should be given to each? If each is of equal importance, then each is of equal weight. This is the first step in the weighting process. If they are of equal weight, there is no need to do anything else. If they are not, attempts need to be made to determine the rough order of magnitude of their importance.

Individuals should know what is being measured and how before the beginning of the measurement period. They should also receive ________ during the period on progress in relation to the identified target. If these two steps are not performed, how can one expect to motivate performance? People need to know the basis for measuring performance, especially as it relates to pay. It is important during the _________ phases to show how the individual performance is aligned with the identi ed objectives. This is the _______ alignment. Furthermore, the specific link between performance and pay needs to be clearly described.

Answer 12

regular reports

communication

line of sight

Question 13

The __________ is the variation from the arithmetic mean. One of these would include all data plus or minus 68.26% from the mean. Two standard deviations would be 95.46% and three standard deviations would be 99.73% of all values.

The degree of _________ is the relationship of the data to a trend line. If every plot point were on the trend line, the correlation would be perfect or _____. Variations from the line of regression are described in terms of _______ of estimate, as opposed to the standard deviation. One would include data plus or minus 68.26% from the line mean. Two standard errors of estimate would be 95.46%, and three standard errors of estimate would be 99.73% of all values plotted. Another way to express ________ is in terms of percentiles, quartiles and deciles. A percentile is 1/100th, the quartile is 1/25th and the decile is 1/10th.

Answer 13

• standard deviation
• correlation
• 1.0
• standard error
• dispersion

Question 14

The more subjective the measurement, the more likely the rating will be subject to rater errors, resulting in an evaluation that is either too positive or too negative. Some of the more common rater error problems include:

(1) _______ influenced—A particular event is used as a generalization of overall performance. This could result in a halo to horns effect—Everything is good or everything is bad.
(2) ______ influenced—Appearance, personality and potential are used as performance measurements.
(3) _______ influenced—Undue emphasis is given to either prior history or most recent event rather than performance over the entire measurement period.

Answer 14

Event

Person

Time

Question 15

deferred compensation plan

(a) A funded plan is one in which rights to firm assets secure the benefits promised by the employer. A funded plan can be either formally or informally and indirectly funded. In a formally funded plan, the funding of the liability is direct, and payment to employees is made from the ______ set aside. In an informally or indirectly funded plan, the employer sets up a ______, takes out an insurance contract or invests in a mutual stock fund to accrue the amount of the liability, but retains sole control over its application.
(b) An unfunded plan is simply backed by the promise of the employer to pay. This promise does not trigger any income tax liability to the recipient as long as it does not include _______ funds that would put the recipient ahead of general creditors of the company according to Revenue Ruling 70-435 by the Internal Revenue Service.

Answer 15

property

reserve

earmarked

Question 16

Under a qualified plan an employer receives a tax deduction on the amount of contributions to the plan and the employee’s tax liability is deferred until benefits are _________. (Amounts in the quali ed plan may be rolled over into another quali ed plan or an individual retirement account thereby deferring taxation to a still later date. To qualify for these tax advantages under the Internal Revenue Code (IRC), plans must meet prescribed eligibility, nondiscrimination, vesting, funding, fiduciary and other requirements prescribed by the Employee Retirement Income Security Act (ERISA)).

Answer 16

distributed

Question 17

A nonqualified plan is one exempted from the requirements of ______ and therefore not having the favorable tax treatment of qualified plans under the IRC. There is no employer tax deduction until benefits are distributed and the employee receives _______, and the individual must pay taxes on the distribution.

Answer 17

ERISA

taxable income

Question 18

A _______ benefit is one in which an executive is completely and immediately 100% vested.

A _______ benefit is one that the executive must earn, typically over a period of time. this time period would either be a stated number of years or upon retirement. in addition, some plans will require that the employee not engage in any activity that could be viewed by the company as being in competition with its lines of business.

Answer 18

nonforfeitable

forfeitable

Question 19

The doctrine of _________ states: Income, although not actually reduced to a taxpayer’s possession, is constructively received by a taxpayer in the taxable year during which it is credited to his or her account, set apart for him or her, or otherwise made available so that he or she may draw upon it at any time, or so that one could have drawn upon it during the taxable year if notice of intention to withdraw had been given. However, income is not constructively received if the taxpayer’s control of its receipt is subject to substantial limitations or restrictions.

• What this means is that if an executive could reach out and take the money (regardless of whether or not he or she did), it is considered taxable income. This could lead to the disastrous situation where a person is taxed on income _________.
• The chance of such an interpretation being made is minimized if the individual makes a ______ before the amount is earned. Some interpret this as before January 1 of the year in which the bonus is calculated, not simply a couple of months before the calculation is made. They cite the Revenue Ruling that indicates that a decision by December 31 is required in connection with compensation to be earned during the following year. This is called the ________ principle. It is further reinforced by Section 409A of the Internal Revenue Code. (See question 21.) Section 409A requires the election to be made prior to the end of the preceding taxable year, except for new eligibles and performance-based plans.

Answer 19

constructive receipt

not yet received

determination

year-before-the-year

Question 20

A tax principle closely allied with the doctrine of constructive receipt is the theory of ________. Here irs interprets an action by the employer as resulting in something of value being bestowed upon an employee. for example, the mere promise by the company to pay in the future rather than currently has no economic value even though the trust is irrevocable and not accessible to present or future management. this is the earlier identified ______ trust. A variation is a dry _____ trust, which becomes funded at the time of a change of control, typically to protect the executive and, therefore, is subject to taxation.

Another variation was a ______ trust with a call provision that permitted the recipient to require early payment by the grantor. this typically would have been because the executive feared pending company ______ and therefore an inability by the company to make full payment. section 409A does not permit this preemptive action; however, payment upon time of change in ownership or effective control is permitted.

similarly, if the employer sets up a trust to which the employee has nonforfeitable rights, then the amount of annual contribution will be construed to be an economic benefit, and the employee will be taxed that year on the value of that contribution. this is a ________ trust.

Answer 20

• economic benefit
• rabbi
• rabbi
• grantor
• bankruptcy
• secular

Question 21

As used here, ________ means shares of employer stock given to an employee under a deferred compensation plan with a restriction on when the stock can be sold. For example, an executive might be given 1,000 shares of company stock (then selling at $100 a share) with restrictions that lapse at the rate of 100 shares a year for the next ten years.

Answer 21

restricted property

Question 22

TRA ’69 provided that in order to delay recognition of income at the time of a stock grant, the restrictions must include a ____________ which it defines as being conditioned upon the future performance of substantial services.

TRA ’69 also allows the recipient of the restricted stock to make a Section 83(b) election not later than ____ days after the grant of the restricted stock. If the Section 83(b) election is made, the recipient of the restricted stock grant will include in gross income for that taxable year the fair market value of the property over any amount paid by the taxpayer for the property. Essentially the taxpayer pays the tax on the lower value at grant rather than the higher value when the restrictions lapse. An executive making a Section 83(b) election is betting that the restricted stock will appreciate in value and be worth more when it vests and that he or she will remain in service and meet the vesting requirements. If the stock is forfeited, no deduction is permitted for the tax paid on the unvested stock. The executive may only deduct any amount paid to the company to purchase the restricted stock. Thus, the executive is taking a _____ by making a Section 83(b) election. However, the executive having been taxed on the amounts set aside will not be subject to taxation when received. This is the _______ rule—namely, amounts once taxed plus any future earnings on such values will not be subject to taxation when received.

The risk of forfeiture also comes into play in determining when to subject the monies to FICA (Social Security) and HI (Medicare) taxation. The rule is that individuals covered by a nonquali ed plan will be subject to taxation when the amount can be reasonably determined. That is, it will be taxed when actually or constructively received unless it is not subject to forfeiture in which case it is taxed at that time.

Regardless of whether or not an 83(b) election has been made, a grant of restricted property generally will not constitute a deferral of compensation for purposes of Section 409A.

Answer 22

substantial risk of forfeiture

30

risk

nonduplication

Question 23

section 409A of the internal revenue code regulates nonqualified deferred compensation arrangements. the penalties for noncompliance are substantial and they include a ____% tax penalty plus an underpayment interest rate penalty. describe the compliance requirements for (a) elections; (b) distributions; and (c) changes in time and form of distribution.

(a) Elections

The initial deferral elections must be made by the employee before the beginning of the ______ in which the services are performed or within 30 days after first becoming eligible (applies when the employee originally becomes eligible to participate in the plan) or within the ___-month period prior to the end of a performance-based compensation plan of at least 12 months.

(b) Distributions

Distributions must be made on a fixed schedule with payments made only on fixed dates. _________ are permitted in the event of separation from service (special rules apply to key employees of public companies), disability, death, a change in control of the employer corporation, an unforeseeable emergency, or termination and liquidation of the plan.

(c) Changes in time and form of distribution

Once the time and form of payment is specified, payments may be deferred only if the election to defer is made at least ___ months in advance of the original payment date and is not effective for at least 12 months after it is made, and the additional deferral period is at least ____ years.

Answer 23

• 20
• tax year
• six
• Early distributions
• 12
• five

Question 24

describe the tax and accounting treatment of a company and an individual in the case of a deferred compensation plan.

The company is expected to take an annual charge to earnings equal to that period’s obligation to future payment. A reserve on the balance sheet reflects the accumulated liability. Since the number of shares of stock and their price is known at the time the restrictions go into effect, then the fair market value of the stock at that time will be expensed over the period of restriction, without regard to changes in the _______. However, the company will not receive a tax deduction on the full value of the stock until the time the restrictions lapse. If ______ were paid during the period of restriction, they were tax deductible at that time.

If the deferral is in the form of cash, that amount is expensed over the period of restriction. In this regard, the cash plus interest will require a greater charge to ______ than the restricted stock, whose price is locked in at the time of deferral.

The executive has no accounting issue, only one of ______. If the individual made a Section 83(b) election choosing to be taxed at the time of award rather than payment, the gain on the stock price if any would receive the long-term, capital gains tax treatment when sold. If no election was made, the full value of the stock received would be taxed as _________, just as if it were cash.

Answer 24

• stock price
• dividends
• earnings
• taxation
• ordinary income

Question 25

There are a number of advantages to deferring compensation including:

(a) Nonqualified deferred agreements can be set up on a highly discriminatory, pick and choose basis. Many companies limit this group to less than 5% of their workforce.
(b) If the amount earned is paid interest or otherwise invested, potentially the individual does not experience a loss in value caused by inflation, and the amount is allowed to grow at a tax-free compound rate until time of payment, when all dollars are subject to income tax.
(c) Deferrals can increase retirement _______ and thereby offset pension plan weaknesses, especially for executives.
(d) Deferred salary and incentives may be included as earnings for nonqualified pension plans in the year earned, thereby protecting the pension.
(e) It would appear that the employer can fund the deferred compensation obligation through ______ contracts without triggering an income tax liability to the employee if the company owns all policy rights, including designation of bene ciary.
(f) The marginal tax rate may be less at a subsequent date.
(g) A nonqualified plan is not subject to ERISA _____ requirements.
(h) Generally, _______ benefits are not affected by the amount of deferred payments received.
(i) If amounts deferred are under risk of forfeiture for executives who leave the company for reasons other than death, disability or retirement, the individual’s inclination to join another company may be retarded. However, many plans will permit a “hardship” withdrawal.
(j) A large portion of the deferred income can be passed on to an executive’s beneficiaries through properly designed trusts and supplemental insurance coverage provided by the employer.
(k) Short-term deferrals significantly reduce year-to-year uctuations to incentive payments and smooth out the taxable earnings of the executive.
(l) Nonfunded, deferred compensation plans enable a company to preserve capital by withholding a portion of compensation to a future date and thereby increase current _____.
(m) The company benefits to the extent it recaptures forfeited payments since these would have been lost if paid when earned. In addition, it will bene t to the extent it credits the deferral with a value less than the cost of borrowed capital.
(n) It is advantageous to the company for an executive to defer until retirement that portion of pay which otherwise would be nondeductible under Section 162(m) of the IRC which places limits on deductible compensation in excess of $1 million.
(o) Nondiscounted, nondeferred stock options and stock appreciation rights, whether paid in cash or in stock, are excluded from Section 409A.

Answer 25

income

life insurance

funding

Social Security

cashflow

Question 26

What are some disadvantages to deferring compensation? (pp. 103-105)

Some disadvantages of deferring compensation include:

(a) Unless the amount deferred is protected against ______, it will have signi cantly less value when received than when earned, even under the most favorable tax circumstances.
(b) The buildup in deferred compensation resulting from an interest rate or other in ation factor is currently considered compensation when received. This increase, if excessive, might be ruled unreasonable compensation and not be deductible by the corporation.
(c) The tax situation must be thoroughly reviewed on a state as well as federal basis to ensure it results in lower taxes.
(d) An unfunded plan makes the executive a general creditor of the company, and therefore the executive risks ______.
(e) Deferred compensation plans increase the ______ requirements of the company.
(f) The Sarbanes-Oxley Act prohibits the trading of company stock by directors and executive of cers during the blackout period of company bene t plans.
(g) The Sarbanes-Oxley Act requires the forfeiture of CEO and CFO bonuses, incentive compensation and stock gains during the 12-month period following the restatement of nancial statements because of ______, thereby affecting any such payments deferred.
(h) The deferred compensation plan, especially if funded, may come under the de nition of a security as de ned by the Securities Acts of 1933 and 1934.
(i) Bene ts received are subject to FICA tax either when actually or constructively paid or earned and not subject to risk of forfeiture.
(j) Since the amount deferred proportionately reduces current total compensation, the executive may be more vulnerable to other offers of employment at slightly more than the current total package but with no deferral requirements.
(k) Conversely, executives may demand more current compensation.
(l) Because of the partial payment over a number of years of service, it may be dif cult for an executive to see the impact of performance on the bonus.
(m) Deferred compensation cannot be considered _____ during the period of deferral for purposes of determining bene ts under quali ed pension and pro t-sharing plans.
(n) Payment beginning at the time of retirement from the company can create another problem, namely, when the individual is retiring from Company A to join Company B. The earnings from the new employer will signi cantly reduce, if not totally eliminate, any tax advantage the executive hoped to receive on the deferred payments.
(o) Some committees allow the executive to state preferences of current and deferred compensation only in percentages. This approach does not recognize that the individual’s needs are absolute, not relative.
(p) If the deferred payments are designed to continue after the death of the employee, such payments will probably be included in the deceased’s estate in accordance with Section 2039 of the IRC.
(q) While deferred compensation plans are often described as golden handcuffs locking the executive to the corporation, often only marginal performers are really shackled to the company.

Answer 26

inflation

nonpayment

administrative

misconduct

pay