7 - Short-Term Incentives Flashcards
The accounting rules for short-term incentives are simple and straightforward. The cost is an expense and taken as a charge to _______ in the income statement and typically is identified as ______, general and administrative expenses.
Unlike employee benefits and perquisites, taxation is rather simple. The payment is 100% taxable as income to the ________ and 100% tax-deductible to the ______. For those expenses that are paid in subsequent years, an accrual is established to retire a liability charge on the balance sheet since the company cannot take a tax deduction until the executive has taxable income. An exception to this rule is that if payment is made within ___ days of the close of a calendar year, it may be charged to the previous year for tax purposes. This is one reason why companies hurry to ensure they pay year-end ______ within the prescribed window.
- earnings
- selling
- executive
- company
- 75
- bonuses
A short-term incentive plan is typically approved by the board’s compensation committee and then forwarded to the board of directors for approval. if the company is publicly traded, Section ____(m) limits the amount of tax deduction to the company unless the plan is ________-based.
162
performance
Five ways in which employees become eligible for short-term incentives are:
(1) _______. This approach examines each job to determine if it should be included in the incentive plan. Administratively, this has two drawbacks. First, it is possible that two jobs in the same salary grade will be treated differently. Second, it will be necessary to review the list of eligibility on almost an annual basis for appropriate additions and deletions.
(2) ______. Using this to identify eligibility is much simpler, once the appropriate level is identified. However, it must be adjusted annually because short-term incentives are typically expressed as a percentage of it.
(3) _____. The use of this to determine short-term incentive eligibility is probably the most common approach among larger corporations. The rationale is that the value of the job to the organization has already been determined when each job was placed in a job grade. The approach is superior to use of salary in that it relates to the job, not to the person’s earnings.
(4) ______. Eligibility could be determined by this, but the problem with this approach is that the lowest level vice president may have less responsibility than the highest level director. It also raises the issue of organizational comparisons.
(5) ______. Using this to determine eligibility poses the problem of “executive assistants” and “assistants to” who meet the definition but are of less importance than many jobs lower in the organization. For this reason, reporting relationship is rarely the sole criterion for participating in short-term incentive plans.
- Key position
- Salary
- Job grade
- Job title
- Reporting relationship
Because each of the five approaches to eligibility has one or more disadvantages or shortcomings, the best approach may be a combination of two or more definitions. There are no rules about how far down in the organization short-term incentive plans should go. Historically, they include the first several levels of _______. However, over the years, the move has been to include more and more individuals in a short-term incentive plan wherever possible.
management
Award size can be expressed in relation to the amount of incentive needed to be competitive on total annual pay in the marketplace.
The amount of incentive needed to bring the individual’s pay to the competitive level is called the _______.
The difference between the competitive annual level and the person’s salary is the ______, often called the downside risk.
The amount of incentive available above the target amount is called the _______. Typically, this increases at least proportionately with the amount of the risk. Salary-only plans are _____ plans, as are those with some incentive opportunity above salary but only for superior performance.
In addition to determining the appropriate risk-reward relationship, planners need to determine the probability level, in other words, the probability of hitting the target performance level. Some plans set the target performance level at 50-50. There is an equal chance of either achieving or failing to meet the target. Other plans set a stretch target with perhaps a 40% probability of attaining the target and a 60% chance of failing.
target award
risk level
upside opportunity
no-risk
some plans set the two outer limits, which are the ______ and _______, by determining the probability of achieving the award level. some plans strive for this symmetry or reciprocal relationship. others find it too difficult or subjective to determine the probability and simply set the award as a percentage of a normal award, stipulating that they will not pay less than 10% of the normal award nor more than double
threshold
maximum
Following the _______ principle presented in earlier assignments, one would expect the highest short-term incentive both in absolute and relative (to salary) terms to be at the highest job level, typically the CEO level. At that level, the normal award may be 100% of salary with a threshold of 20% and a maximum at ____%.
The performance target relationship can be expressed using a chart. The threshold and maximum could be higher or lower in relation to the target award. No payment is made below threshold performance unless there is either a carry forward from previous years or an allowance for discretionary payments.
progressivity
200%
Certainly the _______ payment form has the greatest impact on the lower-level executive. If the award is all in stock, the recipient may have difficulty paying taxes without selling some of the stock, thereby partially defeating the objective of giving the executive an investment in the future of the organization. Deferred cash, deferred stock and a combination of the two could be the result of voluntary deferral, mandatory deferral or a combination of the two. A combination of current and deferred cash, current and deferred stock, and a combination of current and deferred cash along with current and deferred stock address both current and future income needs. Again, the deferrals could be voluntary, mandatory or a combination of the two.
The individual award must relate to individual performance, especially for the better performer. When the award does not appear to adequately reflect performance, the plan is in trouble. In other words, if a plan gives essentially the same award to both the marginal and the outstanding performer, two things happen. The marginal performer is no longer attentive to requests to ________. The outstanding performer, on the other hand, will either lower future performance to ____________ or be receptive to job offers from other companies.
current cash
improve performance
meet the award level
(short term incentives)
the factors selected for measurement must support the company’s ________. As one drills down into the organization, a clear line of sight must be maintained between performance measurements and business objectives. in addition, performance targets throughout the organization should be of equal stretch or difficulty. the measurements and how they relate to business objectives must be clearly ________ to all bonus candidates and to shareholders
business strategy
communicated
The ________ of the individual significantly affects the determination of what to measure. For example, the CEO and other top corporate officers would be measured on _______ performance and to some extent on individual performance objectives. Moving down to the next organizational level, one would identify appropriate group measurements. However, many will argue that a portion of the award should include company-wide performance, thereby reinforcing an all-for-one team approach. The same rationale applies in moving down to the next organization level. Here the decision may be to not include a company-wide factor as the individual has far less impact. Also, including a company-wide measurement would further dilute the weighting of group, subgroup and individual.
It has often been said that what gets measured gets _______. When measurements set the level of pay, they get a lot of attention. Because of the short time frame, a year or less, and the inclusion of an individual performance component, short-term incentives more than any of the other four pay elements focus the individual on ______. It is, therefore, critical that the measurements be selected carefully and that they support the achievements of the business plan.
organizational level
company-wide
attention
what has to be done
The historical or ________ approach often uses a fixed percentage increase to establish the following year’s target. This has the benefit of simplicity but most assuredly will either be too generous or too conservative depending on the circumstances. Acquisitions and divestitures as well as a change in accounting can affect it. Recalculating both periods on a comparable basis can offset this impact, but the results are artificial. The advantage to this approach is that it focuses on continuous improvement and avoids gamesmanship of managers _______ targets for high payouts. The disadvantage is that it is not sensitive to ______ factors.
look-back
lowballing
outside
The _business plan or _________ approach requires setting targets each year based on an assessment of ______ and _______ to the company. This approach allows individuals to lowball or sandbag, in other words, underestimate realistic targets enabling large incentive awards. Offsetting this risk requires outside assessment of the appropriateness of the considerations and the results. The advantage of this approach is that it permits building in aggressive goals or stretch targets. However, these targets must be _______ or the payout will either be too generous or too low.
look-forward
threats and opportunities
accurate
The peer comparison or _______ approach can stand alone or be a tag-on to performance targets set by historical or business plan approaches. The comparison can be set up using a specific list of companies that in composite rather than individually represent one’s own company. An example of a standalone target would be a plan that paid out X% of excess shareholder value created above the average for the index.
Shareholders like the ______ aspect of the add-on approach, if outperformed by the peer group. However, they do not like paying a substantial award in a year when the company outperformed the peers but had a bad year, although not as bad as its peers. The other downside to this approach is the often difficult job of getting good _____ data.
look-around
penalty
peer
companies need to decide if the plan should be driven from the top down or built from the bottom up. A top-down plan begins with a determination of how much to pay in aggregate and then proceeds to determine ________. A bottom-up plan begins with individual award determinations summing them to an aggregate total.
top-down plans begin with a _____. it may be determined by formula, by judgment or by a combination of the two. A formula-driven fund is typically found in ______ organizations with some history in determining fund size. Discretionary funding is more typical of ______ organizations. Bottom-up plans typically begin with individual performance.
individual awards
fund
larger
smaller
Describe nonfunded plans as:
(a) In ________ individual awards, the CEO looks at the performance of each individual and determines what is believed to be an appropriate bonus. This approach works best with _____ organizations.
(b) _______ individual awards are a very common approach. Here target payouts identified as the normal award are tied to the business plan objective and are structured to vary with degree of target attained. The drop-off in salary percentage below target is greater than the increase above target. Payout is a percentage of salary with a minimum and maximum established and incremental in distribution.
(c) ________ formula and ________ individual awards include a subjective measurement, such as degree of difficulty or other considerations, which typically are used to increase the amount determined by the formula portion of the individual award. The discretionary aspect might also apply to _______ goals. With respect to the issue of stretch targets, the important point is that a greater reward should be given for meeting a stretch goal than a normal goal. Furthermore, stretch goals should have comparable levels of dif culty to ensure a level playing field. A discretionary facet of the individual award determination coupled with an objective portion meets this goal.
discretionary
small
Formula
Combination
discretionary
qualitative
Three types of _*discretionary* funded award plans_ are:
(1) Discretionary individual awards. The discretionary funding decision may be determined before or after individual awards have been calculated and summed. Typically, discretionary funding limits rather than increases the individual award total. This approach works best where the ____ is intimately involved in the individual award determinations, thereby exercising control with no need for a formal _______, using instead the total amount that can be spent as an informal guideline.
(2) Formula individual awards. These are more likely to be established after the sum of the individual awards has been calculated. The discretionary calculation could be used to reduce the total awards, but since they are formula-driven, it is more likely they would be increased because of a belief in the hard work and effort expended. The individual formula could be a percentage of the discretionary fund, a stated dollar amount or some combination of the two.
(3) Combination discretionary and formula individual awards. This means that the discretionary funding decision is made at either the _____ or after the individual awards have been summed to determine if the total is appropriate. A negative discretion formula used by some to comply with tax requirements would be an example. The individual formula sets the maximum that is then reduced by the discretion of the compensation committee to comply with Section 162(m) of the Internal Revenue Code to an amount deemed appropriate. The law states the company is barred from taking more than a $_____ tax deduction for any of the named executives in the proxy unless it is a performance-based plan approved by shareholders.
CEO
fund formula
outset
$1 million
The formula for determining fund size for discretionary individual awards is typically a percentage of ______ and is usually found in ______ companies. Discretionary determination of each individual’s performance is made and summed. If the total exceeds the fund available, the awards are adjusted downward. In formula individual awards, a formula is used to determine the available fund and the fund is allocated by formula to the participants. Possible formulas include the same dollar amount for everyone, a percentage equal to each person’s percent of total salaries of all bonus candidates or a percentage of the fund based on organizational responsibilities. The fund might have been generated by a percentage of net income, the most common being the ______ plan.
profits
smaller
profit-sharing
Discuss deductible vs. nondeductible fund formulas.
One of the main problems in constructing the formula is generating an ________. The deductible formula has a threshold or minimum ______ level that must be reached before generating fund dollars. The nondeductible formula begins generating a _______ with the first dollar of measured performance. The nondeductible formula begins accruing dollars for what many may consider to be poor performance. The deductible formula addresses this issue with its threshold feature, but the result is a steeper trend line than the nondeductible formula and may therefore pay out more than is considered appropriate for outstanding performance. When the formula generates more than is allocated, a decision must be made whether to return to net income or carry over a portion to the next year. The rationale for the carryover provision is to offset ________. The danger is that such an approach may result in paying out almost as much in mediocre years as in outstanding periods.
adequate amount
performance
bonus fund
extraordinary circumstances
Discuss deductible vs. nondeductible fund formulas
Conversely, such deductible formulas cause problems if the company has a _____ year. The issue is not with the bonus that year, for obviously there is no bonus. However, since a loss reduces the company’s _______, it thereby lowers the deductible the following year. Thus, the company pays out a greater than planned portion of earnings during profitable years following loss years.
Some will argue that it is more difficult to show such a turnaround after a loss year. Be that true or not, this type of formula encourages a _______ earnings pattern rather than steady growth. It is certainly to management’s advantage to ensure that all costs that can be taken are taken in a year that earnings will not exceed ____% of shareholder equity. For this reason, the limitation or _____-type formula seems more appropriate.
loss
net worth
cyclical
10%
tandem
One popular deductible formula is the economic profit formula that allows deductions for the use of ______. Economic profit formulas will expose companies that are growing profits in absolute amounts while doing so at an increasing cost of capital and thereby destroying, not creating additional, capital. One could say this results in economic ____ lost. Companies with little capital and high growth rates may not be as interested in economic profit formulas as those with a large infrastructure of buildings, equipment and inventory but more modest growth rates. Stated another way, economic profit formulas may be more appropriate for companies in the ____ stages of the market cycle than those in the _____ stages.
capital
value
later
earlier
Shareholder protection plans are formula-driven plans that assure the shareholder that no monies will be paid to executives until certain financial targets have been met. Many companies adopted these plans years ago and have not modified them. When these formulas are used, they often begin with a percentage of ____ and proceed to make some consideration for shareholders’ equity or provide for a _____ of a minimum amount.
The formula should articulate the basic _______ of the company. Is there a minimum rate to be provided for shareholder return? Is there a minimum increase in earnings before any bonus can be paid? The minimum-increase-in-earnings approach promotes identification with the shareholder but does so at the risk of allowing ______to have a significant impact on the bonus fund.
- profts
- dividend
- objectives
- tax policy
Describe the process for developing a fund formula.
Once the basic objectives have been identified, determining the number of bonus participants and the size of the bonus fund will set formula values. The approximate amount of bonus dollars needed in a good year depends on overall profitability requirements, requirements for capital expenditures and the stability of profits. Formula figures will be lower if profits are high or stable, or if capital requirements are low. As these change negatively, formula percentages will need to rise to allow for an adequate fund.
To quickly estimate the needed amount, multiply the percentage of _______ times the percentage of ______ to be paid in incentives to determine the percentage of payroll. The latter multiplied by payroll indicates approximate dollars.
To build the formula, determine how much bonus should be generated under moderate, successful and very successful nancial conditions. Often these are called threshold, target and maximum. By summing the desired bonus amounts for each candidate under the three conditions, it is possible to determine how much total bonus is needed. Normally, this is adjusted upward by another 10% to 20%
bonus candidates
their salaries
Fund formulas can be structured around a target, but they do not have to be. If a target is established, it normally equates to budgeted ________ performance. This type of plan is sometimes called a target plan. It may also be referred to as a ______-sharing or ____- sharing plan. A target plan may or may not stipulate a maximum payout and a minimum or threshold below which there will be no payout. Target plans are structured a number of different ways. Looking at past performance, looking forward to expected performance and looking around to see what peer companies are doing are three different ways of viewing them. When one includes whether or not the formula will use a threshold, or deductible, more possible _______ are created.
- financial
- performance
- goal
- combinations
Where two factors, for instance growth in earnings per share and return on capital, are prime objectives, building a ______ can help determine payment level at any combination of performance. In addition, formulas that do not take into consideration growth relative to the industry can be either too generous or too conservative. This scenario encourages many companies to adjust the bonus fund relative to the performance of others in the industry. Unfortunately, this approach is cleaner in ______ than in fact simply because of difference in weight of product mix even among companies that are supposedly comparable. Which companies to include and how to weight them are questions sufficiently open to debate in most cases.
matrix
concept
