executive remuneration

Question 1

what is the moral hazard problem in executive remuneration

Answer 1

shareholders want managers to work hard, but manager is likely to be effort-adverse (manager shirk)

Question 2

solutions to reducing agency costs

Answer 2

efficient contracting theory: use performance measures to mitigate moral hazard problem (provide incentive with min cost)

Question 3

example of senior mgmt compensation

Answer 3

1. salary
2. short-term incentive bonus: cash bonus, deferred share units (performance targets are ST)
3. mid-term incentive bonus: deferred share units (depending on share price performance over prev 3 years)
4. long-term incentive plan: ESOs, e.g. term of 10yrs, vest at 25% p.a.
5. total compensation positioned relative to the median compensation of a peer grp

Question 4

how to determine quality of performance measures

Answer 4

precision and sensitivity

Question 5

what is sensitivity of performance measure

Answer 5

rate at which expected value of performance measure increases as manager works harder (level of effort)

Question 6

what is the precision of performance measure

Answer 6

precision in predicting the payoff from current manager effort (level of noise)

Question 7

analysing net income as a performance measure (sensitivity)

Answer 7

• historical cost-based net income may result in a recognition lag
• may encourage short-run decision horizon
• may be managed (manipulated)

Question 8

analysing net income as a performance measure (precision)

Answer 8

relatively unaffected by economy-wide and other events that are uninformative about manager effort (not noisy, not subjected to volatility)

Question 9

how to increase sensitivity of net income

Answer 9

1. reduce recognition lag
2. more transparent disclosure -> reduces information asymmetry -> mitigates earnings manipulation

Question 10

analysing share price as a performance measure (sensitivity)

Answer 10

• reflects manager effort “sooner” (little recognition lag)
• may encourage long-run decision horizon
• less ability to manage (manipulate)

Question 11

analysing share price as a performance measure (precision)

Answer 11

more volatile than net income as it is impacted by economy-wide events -> reduce informativeness about manager’s effort

Question 12

how to weigh each of the performance measures

Answer 12

more net income -> shorter horizon,
more share price -> longer horizon
this will control manager’s decision horizon

Question 13

economic consequences of accounting policy

Answer 13

acct policy changes/choices with no direct cash flows matter as they determine contractual payoffs

acct choices have economic consequences as it affects firm value, net income and therefore distribution of wealth in the economy

Question 14

what is an example of economic consequences

Answer 14

employee stock options

Question 15

how managers abuse employee stock option grants

Answer 15

grants on fixed date -> manipulate share price down at scheduled ESO grant dates

grants on various dates -> managers will influence grant dates

Question 16

ways managers abuse employee stock options

Answer 16

pump and dump, spring loading and late timing (backdating)

Question 17

what is option pump and dump

Answer 17

managers will take action to increase share value shortly before exercising options, then sell the shares before share price falls back

Question 18

what is spring loading

Answer 18

managers will pressure compensation committees to grant unscheduled ESOs shortly before good earnings news -> give CEO low exercise price and subsequent benefit because share price rises in response to the good news

Question 19

option backdating

Answer 19

Option backdating sets the ESO grant date to a prior date when the share price was lower than at the actual ESO grant date.