Acct Theory- Mod 8 Flashcards
What are the advantages and disadvantages of incentive based compensation contracts?
ADVANTAGE:
Promotes good work ethic because people work better when there is an incentive
DISADVANTAGE:
If the manager is good, other companies will try to steal him
If the manager shirking, then no one will want to hire him and you are stuck with him (or there is no temptation for him to leave)
What are the 3 main incentive components found in management/executive contracts?
Short Term
Mid Term
Long Term
What are the three main ways that we can increase the sensitivity of Net Income?
- Reduce revenue recognition lag
- Separate out unusual or no-recurring items (this will ensure full disclosure from management because they will have no reason to hide things)
- Reduce earnings management
Why is share price a less precise measure of management performance?
-Other factors such as the economy effect share price
Why should we use both net income and share price to measure management performance?
- Combined they make the decision horizon longer term
- Provides an opportunity for both bonuses and stock options
- Mix of performance measures is always desirable
- Net income alone is too susceptible to management manipulation
How can we address managerial risk in a contract?
- More than one performance measure
- Minimum thresholds to guarantee a minimum salary and incentives for performance above the benchmark
- Review and approval by compensation committees
- Exclusion of low persistence items
- Limitations on some management activities
- Comparison to peer groups
- Individual performance indicators
What is restricted stock?
Stock that requires management to hold it for a certain period of time. (Including after they have been terminated)
What is power theory?
Managers will use their power to secure more than their reservation utility, at the expense of shareholder value.
What is earnings management?
The use of accounting policies by a manager in order to achieve some specific objective (likely for their own personal gain)
What role do analysts play in earnings management?
Missing the predictions of analysts can harm the stock price so sometimes managers make decisions simply to meet analyst expectations
What are the 4 patterns of earnings management? Describe each
Taking a bath:
If incurring a loss, go all in and have a big loss
Income Minimization:
Minimizing income to reduce income taxes or to get government assistance. Or if their is a cap on bonuses.
Income Maximization:
Net income becomes high enough to trigger bonuses but low enough not to reach the cap
Income Smoothing:
Managers attempt to show consistent returns (or consistent growth) over a long period of time
What are the 4 main motivations that lead to earnings management?
Maximize managerial compensation
Meet investor expectations
Prevent violation of debt covenants
Present optimistic information prior to an IPO
What are the 3 common methods to engage in earnings management?
Bias in accruals
Selection of policies
Bias in estimations
What are some arguments in favour of earnings management?
It helps management communicate company information discreetly
It allows managers the flexibility to adopt changes in GAAP without a detrimental effect on the company
What are some arguments against earnings management?
Hides violations of debt covenants
Company potential is overstated during IPO
Trying to meet forecasts and expectations can lead to falsifying results
Greed can motivate managers to maximize personal wealth at the expense of the investors
