chapter 10 - executive compensation Flashcards
What is executive compensation contract?
agency contract between firm and manager that attempts to align interests of owners and managers by basing manager’s compensation on one or more measures of manager’s performance
What are most executive compensation contracts based on?
net income and share price
Describe internal monitoring concept
concept that shirking will be detected by managers below, who will want to get ahead and report on superior’s shirking actions
How can it be argued that managerial labour market controls moral hazard?
- manager establishes reputation for creating high payoffs, driving market value up
- PV of future reduced compensation is greater than immediate benefits of shirking –> therefore, will not shirk
- shirking will be deterred if management contemplates downward effects of current shirking on reservation utility of future employment
How to offer more efficient contract?
- exploit the observation ability of each manager
- make payoff a joint effort by linking the effort of one person to the payoff to the other person
- multiperiod contract
Why is executive compensation contracts still necessary?
- managerial labour market not completely effective in controlling moral hazard
- net income not completely informative of performance
- managers can cover up shirking by managing the release of info (opportunistic management)
- market cannot perfectly value manager’s reputation from accounting information
Proportion of measures in evaluating manager performance is based on..?
linear mix of performance measures depends on the product of sensitivity and precision of those measures (eg. level of sensitivity, noise, etc)
How to increase sensitivity of income?
- move to current value accounting to reduce recognition lag (NOTE: this reduces precision)
- full disclosure especially with low persistence items
persistent earnings are a more sensitive measure of current manager’s effort
GAAP reduces scope for opportunistic management and increases sensitivity by decreasing manager’s ability to disguise shirking
Factors that influence the length of manager’s decision horizon
- coexistence of 2 factors (net income and share price)
- decision horizon traded off with sensitivity and precision of performance measures
- performance measure tells more about effort results in more efficient contract
What’s the role of risk in exec comp?
- must bear some compensation risk to motivate effort
- the more risk they bear, the more return is expected
- compensation risk also affects how managers operate firm
ways to control compensation risk
- relative performance evaluation, comparing firm’s net income and share price to the average performance of a peer group of similar firms
- bogey of compensation plan (minimum target achievement) –> downside risk protection
- compensation cap
- conservative accounting to control upside risk by delaying recognition of unrealized gains and discouraging premature revenue recognition
- compensation committee of the board
- share-based compensation
role of conservative accounting in compensation
- promotes contract efficiency because manager has constrained ability to inflate earnings
- little incentive to invest in risky projects (no compensation until realized profits generated)
describe the scope/nature of share-based compensation
- share price quickly reflects investment in long term projects
- ESOs encourage upside risk, with little downside risk
pros and cons of ESOs
- promotes excessive risk taking
- manager effort found to be diverted away from value-increasing projects to opportunistic actions
- the larger the value of CEO’s ESO holdings, the greater the incentive to misstate FS
- also motivate managers to increase firm risk
- encourage managers to undertake risky projects when they’re economically desirable
Empirical research results regarding ROE
- ROE more highly correlated to cash compensation than return on shares
- in growth firms, ROE is less related to cash compensation
- where correlation between ROE and share return is high, there tends to be a higher weight on ROE in the compensation plan (vice versa)
fundamental problem of accounting theory for exec comp
- investor-informing and manager performance-motivating tradeoff
when net income is uninformative to investors…
…it’s also uninformative about manager effort
Characteristics of agency model where manager gets a % of firm’s profits, makes effort decision and investment decision
- when difficult to evaluate investment decision and easy to detect shirking –> reported net income should contain strong stewardship focus
- when easy to evaluate investment decision but hard to detect shirking –> net income should have strong valuation focus
- the less complex the investment decision, the less change the manager will cover up shirking with biased current valuation estimates
Implication of low ROE variability?
- high target bonus relative to base salary
- substitute portion of salary with bonus (move compensation from riskless to risky, less to more incentive)
Growth firm characteristics
- growth firms or firms with long product cycles
- derive a greater proportion of compensation from individual performance measures relative to net income and stock prices
- net income of these firms are uninformative about individual performance
relationship between earning changes and its persistence
positive relationship, as persistence of earnings increases, the effect they have on compensation also increases
what is power theory
states that exec comp is driven by manager opportunism and not efficient contracting and raises questions about efficient contracting
describe power theory
- managers have sufficient power to influence their own compnesation and generate excessive pay at the expense of shareholder value
- managers receive more than their reservation utility
- source of power = ability for managers to influence BOD & comp committee
why doesn’t BOD independence counteract power theory
- if independent director blocks CEO compensation awards and decisions, it leads to anti-management reputation and this is not good
what is poor governance associated with?
- greater excess compensation
- significant portion of CEO compensation is explained by corporate governance variables
how to move compensation practices toward efficiency contracting?
- improve corporate governance
- accounts can assist with governance process by requiring full disclosure
- leads to better identification of earnings component with low persistence and informativeness
