Chapter 10

AK0040
ACCOUNTING THEORY
Executive Compensation
ACCOUNTING PROGRAM
Contents
• Overview
• Are Incentive Contracts Necessary?
• A Managerial Compensation Plan
• The Theory of Executive Compensation
• Emphirical Compensation Research
• The Politics of Executive Compensation
• The Power of Executive Conpensation
• The Social Significance of Managerial Labour
Markets That Work Well
Overview
• An executive compensation plan is agency contract
between the firm and its manager that attempts to
align the interests of owners and manager by basing
the mangers’s compensation on one or more measures
of the manager’s performance in operating the firm.
• Many compensation plans are based on two
performance measures: net income and share price.
• The is, the amounts of cash bonus, shares, options, and
other components of executive pay that are awarded in
a particular year depend on both net income and share
price performance.
Overview
• The role of net income in motivating manager
performance is equally as important as its role in
informing investors.
• This is because motivating responsible manager
performance and improving the operation of
managerial labour markets are desirable social
goals.
• These goals are as important as the enabling of
good invesment decisions and securities market
operation.
Overview
• Consequently, an understanding of the properties
that net income needs on order to measure
manager performance is important for
accountants.
• Unless net income had desirable qualities of
sensitivity and precision, it will not be infermative
about manager effort.
• That is, it will not measure performance efficiently
and will enable the market to properly value the
manager’s worth. It will also be “squeezed out” of
efficient compensation plans.
Are Incentive Contracts Necessary?
• Fama (1980)
Fama made the case that incentive contracts of
the type studied are not necessary because the
managerial labour market controls moral
hazard. If a manager can establish a reputation
for creating high payoffs for owners, that
manager’s market value will increase.
Conversely, a manager who shrink, thus
reporting lower payoffs on average, will suffer a
decline in market value.
• Fama (1980) (...continued)
As a manager who is tempted to shirk looks ahead
to future periods, the present value of reduced
future compensation, Fama argued, will be equal to
or greater than the immediate benefits of shirking.
Thus, the manager will not shirk. This argument, of
course, assumes an efficient managerial labour
market that properly values the the manager’s
reputation.
Analogous to the case of a capital market, the
operation of a managerial labour market is
enhanced by full diclosure of the manager’s
performance.
• We conclude that while internal and market forces
may help control managers’ tendencies to shrink,
they do not eliminate them.
• It seems that effort incentives based on some
measure of the payoff are desirable for efficient
contracting.
• We now turn to an examination of an actual
managerial compensation contract of a large
corporation. As will see, incentives loom large.
A Managerial Compensation Plan
• To attain proper alignment, incentive plans usually
feature a combination of salary, bonus, equity-
based compensation such as restricted stock and
options, and golden parachutes.
• This components of compensation are usually
based on several performance measures-individual
achievement, net income, and share price.
• We can think of these as noisy measures of the
future payoff from current-period manager effort.
The Theory of Executive Compensation
The Relative Proportion of Net Income and Share Price in
Evaluating Manager Performance
• Much of the theory of executive compensation drives form
the agency models, despite their single-period orientation.
• There are a number of ways that accountants can increase
the sensitivity of net income. One posibility is to reduced
recognition lag by moving to current value accounting.
• Reduced recognition lag increases sensitivity since more of
the future payoff show up in current net income.
• However, current value accounting is a double-edged
sword in this regard, since it tends to reduce pecision.
• Reduced recognition lag increases sensitivity since more of
the future payoff form manager effort show up in current
net income.
The Relative Proportion of Net Income and Share Price
in Evaluating Manager Performance
• Another approach to increasing sensitivity is through
full disclosure, particularly of low-presistence items.
• Full diclosure increases sensitivity by enabling the
compensations committee to better evaluate manager
effort and ability, and thus to evaluate earnings
persistence.
• Persistent earnings are a more sensitive measure of
current manager effort than transitory of price-
irrelevant earnings, which may arise independently of
effort.
The Relative Proportion of Net Income and Share Price
in Evaluating Manager Performance
• With respect to share price, a major reason for its
relatively low precision derives from the effects of
economy-wide factors.
• For example, if interest rates increase, the expected
effects on future firm performance will quickly show
up in share price. This effects may say relatively little
about current manager effort, however. As a result,
they mainly add volatility to shate price.
• The sensitivity of share price is sufficiently great that it
will always reveal additional payoff information
beyond that contained in net income. Thus, we may
ecpecte both measures to coexist.
Short-Run Effort and Long-Run Effort

• To enable us to better understand executive
compensation, we now extend the agency model to
regard effort as multi-dimensional.
• Specially, we persue the assumption in the previous
section that effort consists of short-run (SR) and
long-run (LR) effort.
Short-Run Effort and Long-Run Effort
• SR is effort devoted to activities such as cost control,
maintenance, employee morale, advertising, and other
day-to day activities such as long-range income mainly in
the current period.
• LR is effort devoted to activities such as longprange
planning, R&D, and aquisitions.
• While LR effort may generate to activities some net
income in the the current perion, most of the payoffs
from these activities extend into future periods.
• Recognition of effort as a set of activities introduces a
new concept – the congruency of a performance
measure.
The Role of Risk in Executive Compensation
• We can also consider the managers’ effort from a risk
perspective since, in the presence of moral hazard, the
manager must bear some compensation risk if effort is
to be motivated.
• Since managers, like other rational, risk-averse
individuals, trade off risk and return, the more risk
managers bear, the higher must be their expected
compensation if reservation utility is to be attained.
• Thus, to motivate the manager at the lowest cost,
designers of efficient incentive compensation plams try
to get the most motivation for given amount of risk
imposed or, equivalently , the least risk for given level of
motivation.
• It is important to realize that compensation risk
affects how the manager operates the firm.
• If enough risk is imposed, the firms suffers from low
manager effort.
• If too much risk imposed, the manager may
underinvest in risky project even though such
projects would benefit diversified shareholders.
• The are several ways to control compensation risk,
perhaps the most inportant of these from theoretical
perspective is relative performance evaluation (RPE).
• The theory developed by Baiman and Demski (1980) and
Holmstrom (1982).
• Here, instead of measuring performance by ner income
and/or share price, performance is measured by the
difference between the firm’s net income and/or share
price performance and the average performance of a
peer group of similar firms, such as other firms in the
same economy or industry.
• Another way to control risk is through the bogey of the
compensation plan. Under such a risky contract, the average
level of compensation needed for the manager to attain
reservation utility would be prohibitive.
• In other words, fear of personal bankruptcy is probabli not
tje best way to motivate a manager to work hard.
• For this reason, compensation plans usually impose a
bogey. That is, incentive compensation dose not kick in until
some level of financial performance – 10% return on equity,
for example – is reached.
• The effect is that if the bogey is not attained, the contract
does not award any incentive compensation. However, an
ancillary effect is that the manager dose not have to pay the
firm if thers is a loss.
• If downside risk is limited, it seems reasonable for
upside risk to be limited too; otherwise, the manager
would have everything to gain and little to lose, which
could encourage excessive risk taking.
• As a result, many plans impose a cap, whereby
incentice compensation ceases beyond a certain level.
• For example, no bonus may be awarded for return on
equity exceeding, say, 25%.
• Conservative accounting also controls upside risk by
delaying recognition of unrealized gains and
discouragingp premature revenue recognition.
• However, basing compensation on censervative
earnings gives the manager little incentive to invest in
risky project.No compensation will be received unless
and until a project starts to generate realized profit.
• This create a role for share-based compensation.
• The manager can also shed risk by excessive hedging.
Not only is hedging costly, but effort incentive will
suffer if the manager works out from under risk this
way.
Empirical Compensation Research
• The above empirical result suggest that
compensation committees, like investors, are on
average quite sophisticated in their use of
accounting and share price information.
• Just as full disclosure of value-relevant financial
accounting information will increase investors’ use
of this information, full disclosure of “effort
informative” stewardship information will increase
its usage by compensation committees, thereby
maintainingand increasingthe role of net income in
motivating responsible manager performance.
The Politics of Executive Compensation
• In 1990, Jensen and Murphy (JM) published a

controversial article about top manager
compensation.
• They argued thes CEO’s were not overpaid but that
their compensation was far too unrelated to
performance, where performance was measured as
the change in the firm’s market value.
• However, some counterarguments can be made to
Jensen and Murphy’s article.
Jensen and Murphy counterarguments cosist of:
1. We would expect the relationship between pay and
performance to be low for large firms, simply
because of a size effect. An increase of even a small
proportion of this amount the CEO’s remuneration
would likely attract media attention.
2. For large corporation at least, it is difficult to put
much downside risk on an executive. An executive
whose pay is highly related to performance would
have so much to lose from even a small decline in
firm value that this would probably lead to excessive
avoidance of risk projects. (...continued)
Jensen and Murphy counterarguments cosist of:

2. (...continued) As a result, the compensation
committee may, for example, exclude low-
persistence losses when declining on bonus
awards, particularly if the loss is relatively
uninformative about manager effort.
Such as losses do, however, lower company value
and net income. Consequently, such exclusions
lower the pay-performance relationship.
If, in addition, upside risk is limited, the
relationship is further lowered.
• Executive compensation is surround by political
controversy.
• Much of this controversy results from CEOs who exploit
their powerm using it to generate excessive to
shareholders nad others, on the assumption that they
will take action to eliminate inefficient plans, or the
managers and firms that have them.
• There is some evidence that expanded information is
having the desired effect. However, politicians, media
and shareholders should realize that utility of risky
compensation to risk-averse managers may be less that
it seems at first glance.
The Power Theory of Executive
Compensation
• The power theory of executive compensation
suggest that executive compensation in practice is
driven by manager opportunism, not efficient
contracting.
• The power theory was set forth by Bebchuck, Fried,
and Walker (BFW;2002). They argued that
managers have sufficient power to influence their
own compensation, and that they use this power to
generate excessive pay, at the expense of
shareholder value.
Compensation
• We conclude that financial reporting has an
important role in motivating executive performance
and controlling manager power.
• This role includes full disclosure, so that
compensation committees and investors can better
relate pay to performance.
• It also includes expensing stock option awards to
help control their abuse and encourage more
efficient compensation vehicles.
Compensation
• As a result, responsible manager performance is
motivated and the extent to which manager
reputation is based on incomplete or biased
information is reduced.
• This improves the operation of the managerial
labour market, a goal equally important to society
as promoting good investor decisions and
improving the operation of securities markets.
The Social Significance of Managerial
Labour Markets That Work Well
• In a capitalist economy, manager performance
contributes to social welfare. Welfare is increased
to the extent managers “work hard”- that is, make
good capital invesment decisions and bring about
high firm productivity.
• Attainment of these desirable social goals is
hampered to the extent that measures of manager
performance are not fully informative.
The Social Significance of Managerial
Labour Markets That Work Well
• More informative performance measures enable
more efficient compensation contracts, better
reporting on stewardship, and better operation of
the managerial labour market, resulting in higher
firm producitvity and social welfare.
• Accountants can contribute to informativeness
both by an appropriate tradeoff between sensitivity
and precision of net income and by full disclosure.
Questions and Answers

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AK0040

Short-Run Effort and Long-Run Effort

• In 1990, Jensen and Murphy (JM) published a

Jensen and Murphy counterarguments cosist of:

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