Accounting Theory

Session 5
Problem Set 8
Chapter 10
Executive Compensation

Adapted from Scott,

Financial Accounting Theory

Prof. Garen Markarian, PhD 1

 Problem Set 8
Question 1 (1)
1) Agency theory suggests that a way to motivate managers to act in
the best interests of the owners/shareholders is to link managerial
compensation to performance measures, such as net income or
share price. However, such a linkage imposes risk on the manager.

Required (1):
a. Why is it important to control or reduce some of the risk thus imposed on
managers? Explain.
b. Explain two method by which risk imposed on the managers could be
reduced. What happens if too much compensation risk is eliminated?

Prof. Garen Markarian, PhD 2

 Problem Set 8
Question 1 (2)
1) Required (2):
c. Many managerial compensation packages impose restrictions on when
managers can sell stock granted to them as a part of their compensation.
For example, some compensation packages indicate that restricted stock
awards may be forfeited unless the manager continues to work for the firm
for a certain number of years after the granting of the awards. Discuss the
justification behind such restrictions.
d. Inclusion of shares and options in managerial compensation packages has
been attributed to the desire of the owners/shareholders to provide
managers an incentive to undertake policies that benefit the firm’s long-
term rather than short-term interests. If this is true, why not compensate
the manager only on the basis of share return (for example, only by stock
options or restricted stock)? In other words, under these circumstances,
what is the justification for having a cash or bonus element in the
compensation package?
Prof. Garen Markarian, PhD 3
 Problem Set 8
Solution 1
1) Note:
Chapter 7, Note 23 points out that risk goes both ways. That is, the relevant
ex ante compensation risk measure for a manager who trades off risk and
return is a measure of the dispersion of compensation, such as its standard
deviation. Students have a tendency to think primarily of controlling
downside risk in this question. While valid, this view of risk is more of an
ex post concept than an ex ante one. That is, following state realization, the
manager may react negatively to reduced compensation if the realization is
unfavourable, but would be unlikely to react this way if the realization is
favourable. Before state realization, however, a “2- sided” concept of risk is
appropriate. The suggested answers use both ex ante and ex post views of
compensation risk.
Prof. Garen Markarian, PhD 4
 Problem Set 8
Solution 1 a
1) Required:
a. Why is it important to control or reduce some of the risk thus imposed on
managers? Explain.
Reasons why it is important:
• Since managers are likely to be risk averse, they will trade off risk against
expected returns ex ante, and will demand an increase in the expected level of
their compensation as risk increases so as to maintain their reservation level of
utility. This will increase the firm’s average compensation cost.
• Excessive ex ante risk may cause managers to undertake only safe (that is, less
risky) projects whereas shareholders’ interests may be better served by riskier
projects. This is because shareholders can diversify away firm-specific risk.
• Excessive risk may cause the manager to engage in extensive hedging activities.
This is costly to the firm and could possibly lead to the use of derivatives for
speculation rather than risk management.
Prof. Garen Markarian, PhD 5
 Problem Set 8
Solution 1 b (1)
1) Required:
b. Explain two method by which risk imposed on the managers could be
reduced. What happens if too much compensation risk is eliminated?
Different ways of reducing risk are (1):
• The bogey and cap in a bonus plan reduce risk ex ante, because they impose
bounds on the manager’s bonus.
• Existence of stock options in the compensation package reduces downside risk.
If the stock price rises the manager stands to gain but he/she is not adversely
affected if stock prices fall.
Note: If stock price falls substantially, and for an extended period, the exercise price of managers’
stock options may be lowered by the compensation committee of the Board. This possibility further
lowers managers’ risk, but has incentive connotations. See Problems 13 and 15 of the book.

Prof. Garen Markarian, PhD 6

 Problem Set 8
Solution 1 b (2)
1) Required:
b. Explain two method by which risk imposed on the managers could be
reduced. What happens if too much compensation risk is eliminated?
Different ways of reducing risk are (2):
• Use of relative performance evaluation reduces risk because the common risk
faced by all firms in the comparison group is filtered out. Thus a manager may
receive a bonus or stock-based award even if reported results are poor if they are
not as poor as the industry average.
• Existence of a compensation committee to monitor managerial compensation
reduces risk because this committee is likely to consider exceptional or
unexpected circumstances in its deliberations. The committee may award a
bonus even when firm performance is poor if it feels the manager is deserving.
However, compensation committees are often criticized for awarding bonuses
when the manager is not deserving.
Prof. Garen Markarian, PhD 7
 Problem Set 8
Solution 1 b (3)
1) Required:
b. Explain two method by which risk imposed on the managers could be
reduced. What happens if too much compensation risk is eliminated?
Different ways of reducing risk are (3):
• Earnings management, that is, the ability to choose from a set of accounting
policies, reduces risk both ex ante and ex post. Earnings management helps
managers to reduce the effect of unforeseen state realizations on reported net
income. However, the manager may abuse earnings management to cover up
shirking, thereby receiving an undeserved bonus.
If too much compensation risk is eliminated, the manager may shirk.
Agency theory tells us that if effort is to be motivated the manager must
bear some risk. An efficient contract imposes an optimal amount of risk,
not minimal risk.
Prof. Garen Markarian, PhD 8
 Problem Set 8
Solution 1 c (1)
1) Required:
c. Many managerial compensation packages impose restrictions on when
managers can sell stock granted to them as a part of their compensation.
For example, some compensation packages indicate that restricted stock
awards may be forfeited unless the manager continues to work for the firm
for a certain number of years after the granting of the awards. Discuss the
justification behind such restrictions.
Such requirements are imposed so that managers do not reduce their risk by
selling off their firms’ shares (which are subject to firm-specific risk) and
buying diversified portfolios (with little or no firm-specific risk) from the
proceeds of the sale. Requiring managers to bear compensation risk
maintains their incentive to exert effort, thereby controlling moral hazard.

Prof. Garen Markarian, PhD 9

 Problem Set 8
Solution 1 c (2)
1) Required:
c. (…) Discuss the justification behind such restrictions.
However, forcing the manager to hold company stock increases the
manager’s compensation risk. The riskier the compensation, the higher
must be the expected compensation if the manager’s reservation utility is to
be maintained, resulting in higher average compensation cost over time for
the firm. Also, excessive risk may encourage dysfunctional manager
behaviour such as avoidance of risky projects (when these would benefit
diversified investors) and excessive hedging.

Prof. Garen Markarian, PhD 10

 Problem Set 8
Solution 1 d (1)
1) Required:
d. Inclusion of shares and options in managerial compensation packages has
been attributed to the desire of the owners/shareholders to provide
managers an incentive to undertake policies that benefit the firm’s long-
term rather than short-term interests. If this is true, why not compensate
the manager only on the basis of share return (for example, only by stock
options or restricted stock)? In other words, under these circumstances,
what is the justification for having a cash or bonus element in the
compensation package?
It may impose excessive risk on the manager because (1):
• Share price tends to be low in precision. Unless offset by higher sensitivity, the
resulting increase in ex ante risk may require higher expected compensation to
maintain reservation utility.

Prof. Garen Markarian, PhD 11

 Problem Set 8
Solution 1 d (2)
1) Required:
d. (…) why not compensate the manager only on the basis of share return
(for example, only by stock options or restricted stock)? (…)
It may impose excessive risk on the manager because (2):
• Hölmstrom (1979) shows that more than one performance measure can increase
contracting efficiency. This supports the inclusion of net income as a
performance measure in addition to share return.
• Bushman and Indjejikian (1993) show that including both share price-based and
net income-based components in the compensation package can control the
length of the manager’s decision horizon. In some cases, for example if the firm
needs to quickly reduce its costs, the firm may wish to shorten the manager’s
decision horizon. It can do this by increasing the relative proportion of net
income-based compensation since net income will respond quickly to reduced
costs.
Prof. Garen Markarian, PhD 12
 Problem Set 8
Question 2
2) Explain why, for large corporations, a low pay-performance
relationship is to be expected.

Prof. Garen Markarian, PhD 13

 Problem Set 8
Solution 2 (1)
2) Explain why, for large corporations, a low pay-performance
relationship is to be expected.
It is to be expected for the following reasons (1):
• Too much downside risk on a manager reduces compensation contract efficiency
since downside risk may induce dysfunctional behavior such as excessive
avoidance of risky projects and excessive hedging. Downside risk is reduced by
a bogey in the compensation contract, which eliminates the possibility of the
manager paying the firm if losses are incurred. But not requiring the manager to
pay the firm if losses are incurred reduces the pay-performance relationship.
• Many compensation plans impose a cap on compensation.
• For large companies, the amount of increase in value over a year can be
extremely large. Unless compensation is a very small proportion of this value
increase, it would be excessive, even for a manager.

Prof. Garen Markarian, PhD 14

 Problem Set 8
Solution 2 (2)
2) Explain why, for large corporations, a low pay-performance
relationship is to be expected.
It is to be expected for the following reasons (2):
• To the extent that unusual, non-recurring and extraordinary gains and losses are
excluded in determining amounts of compensation awards, a low pay-
performance relationship is generated, since these items then affect net income
but not compensation.
• Managers often receive large amounts of compensation upon leaving the firm
(golden parachutes) even if the reason for leaving is poor performance.
• To the extent the power theory of executive compensation is operative, managers
use their power in the organization to attain excessive compensation, unrelated to
changes in firm value. This reduces the pay-performance relationship both when
compensation is not reduced following poor performance and when a
compensation increase exceeds any increase in performance.
Prof. Garen Markarian, PhD 15
 Problem Set 8
Question 3
3) Firms A and B are roughly the same size, but operate in different
industries. Firm A bases a high proportion of its executive
compensation on net income and a relatively low proportion on
share price performance. For firm B, these proportions are
reversed. Yet, both firms appear to be well managed, consistently
profitable, and growing. Use the concepts of sensitivity and
precision of a performance measure to explain why both firms’
compensation plans are efficient, despite the differing proportions.

Prof. Garen Markarian, PhD 16

 Problem Set 8
Solution 3 (1)
3) (…) Use the concepts of sensitivity and precision of a performance
measure to explain why both firms’ compensation plans are
efficient, despite the differing proportions.
Firm A’s compensation plan suggests that the precision of net income is
high, with reasonable sensitivity of effort relative to share price. An
example of an A-type firm is one with the volatility of net income low
relative to the volatility of share price (e.g.: low financial and operating
leverage), low R&D, and a short-term decision horizon. Then, it is more
efficient for Firm A to base a high proportion of compensation on net
income.

Prof. Garen Markarian, PhD 17

 Problem Set 8
Solution 3 (2)
3) (…) Use the concepts of sensitivity and precision of a performance
measure to explain why both firms’ compensation plans are
efficient, despite the differing proportions.
For Firm B, its compensation plan suggests that the sensitivity of effort
relative to share price is high, with reasonable precision relative to net
income. An example of such a firm is one with the volatility of share price
low relative to the volatility of net income (e.g.: high operating and
financial leverage), with high R&D, and a longer- term decision horizon.
Then, it is more efficient to base a high proportion of compensation on
share price.

Prof. Garen Markarian, PhD 18

 Problem Set 8
Solution 3 (3)
3) (…) Use the concepts of sensitivity and precision of a performance
measure to explain why both firms’ compensation plans are
efficient, despite the differing proportions.
Note that manager compensation is not completely based on net income or
share price, however. This would give the managers an excessively short-
run or long-run horizon, respectively, in operating the firm.
Note: The question implicitly assumes that both firms’ earnings quality is similar.

Prof. Garen Markarian, PhD 19

 Problem Set 8
Question 4
4) In 2002, Toronto-Dominion Bank (TD) announced that it would
voluntarily expense ESOs starting with its 2003 fiscal year
beginning November 1, 2002. Accounting standards in Canada did
not require ESO expensing until fiscal years beginning on or after
January 1, 2004. In the MD&A section of its 2003 annual report, TD
stated that it had charged to expense for 2003 an amount of $9
million for ESOs, using the fair value method.
TD’s reported net income for 2003 was $1.076 billion, compared to
a net loss of $67 million for 2002.
Suggest reasons why TD would voluntarily expense its ESOs.

Prof. Garen Markarian, PhD 20

 Problem Set 8
Solution 4
4) Suggest reasons why TD would voluntarily expense its ESOs.
Reasons why TD would voluntarily expense its ESOs (1):
• To show a commitment to transparency, and high quality reported net income.
This could lower its cost of capital by decreasing investors’ estimation risk.
• TD may not have been a heavy user of ESOs. If so, the impact of expensing on
net income would be moderate, at least relative to its 2003 net income of $1.076
billion.
• TD may have been planning to reduce its use of ESOs in view of the apparent
adverse incentive effects (i.e.: pump and dump, late timing) of ESOs and the
resulting bad publicity surrounding their use.
• TD may have been expecting a period of high earnings, so that net income could
“stand” the charge without creating problems with debt covenants.

Prof. Garen Markarian, PhD 21

 Problem Set 8
Solution 4
4) Suggest reasons why TD would voluntarily expense its ESOs.
Reasons why TD would voluntarily expense its ESOs (2):
• TD may have accepted securities market efficiency, in which case it would
realize that moving ESO cost from the notes to the financial statements proper
would have no direct effect on share price.
• TD, being a large Canadian firm, may have been concerned about the political
cost hypothesis, and wanted to minimize reported net income to avoid charges of
excessive profitability.
• TD may have realized that a new standard requiring ESO expensing was
imminent, so it might as well start now.

Prof. Garen Markarian, PhD 22

 Problem Set 8
Question 5 (1)
5) Ittner, Larcker and Rajan (1997) studied the relative weights placed
on financial and non-financial performance measures in CEO
bonus contracts for a sample of 317 U.S. firms across 48 industries
for 1993-1994. Recall that RBC (Example 10.1) includes attainment
of non-financial performance measures (i.e.: personal goals) as a
criterion for its short-term incentive awards. Non-financial
performance measures in the RBC plan include goals with respect
to risk management, cost management, new revenue initiatives,
financing and development of U.S. operations. Financial
performance measures are net income growth and return on equity.
Ittner, Larcker and Rajan find empirical support for the following
hypotheses about the relative weights on financial and non-financial
performance measures in compensation plans:
Prof. Garen Markarian, PhD 23
 Problem Set 8
Question 5 (2)
5) Hypotheses:
i. Noise. The lower the correlation between manager effort and net income
(measured by the correlation between stock market and accounting-based
return), the less the relative weight on financial performance measures.
ii. Firm strategy. “Prospector firms” (growth and innovation oriented,
identify and adapt quickly to new product/service opportunities) will have
greater relative weight on non-financial performance measures than
“defender” firms (stable set of products/services, emphasis on increasing
efficiency to reduce operating costs).
iii. Product quality. The greater the firm commitment to quality, the greater
the relative weight on non-financial performance measures.
iv. Regulation. Regulated firms will have greater relative weight on non-
financial performance measures than non-regulated firms.

Prof. Garen Markarian, PhD 24

 Problem Set 8
Question 5 (3)
5) Required:
a. Give intuitive arguments to explain these four hypotheses.
b. Which of these four hypotheses might help explain the inclusion by RBC of
non-financial performance measures in its short-term incentive awards?

Prof. Garen Markarian, PhD 25

 Problem Set 8
Solution 5 a (1)
5) Required:
a. Give intuitive arguments to explain these four hypotheses.
(i) Noise:
By definition, the less noise in net income (more specifically, the lower the
variance of the random states of nature which affect net income) the more
precisely net income captures the results of manager effort, other things
equal. While individual non-financial measures may also reflect effort
precisely, the less noise in net income the greater its efficiency relative to
individual performance measures. Since, according to positive accounting
theory, compensation committees want to maximize contract efficiency,
Ittner, Larcker, and Rajan hypothesize that less noisy net income will have
greater relative weight in the compensation plan.
Prof. Garen Markarian, PhD 26
 Problem Set 8
Solution 5 a (2)
5) Required:
a. Give intuitive arguments to explain these four hypotheses.
(ii) Firm Strategy:
For prospector firms, it may take some time for the results of growth and
innovation strategies to show up in net income. Yet to the extent the costs
of such strategies, such as R&D, are written off as incurred under GAAP,
non- financial performance measures are more sensitive to current manager
effort than net income. For defender firms, cost savings and improvements
in efficiency can be measured relatively quickly and accurately, and they
affect net income with little lag. Consequently, net income is more highly
correlated with current manager effort for such firms. Compensation
committees of defender firms react by placing more weight on net income.
Prof. Garen Markarian, PhD 27
 Problem Set 8
Solution 5 a (3)
5) Required:
a. Give intuitive arguments to explain these four hypotheses.
(iii) Product quality:
Can be measured quickly and accurately, for example by analyzing defect
rates, returns, and warranty costs. Thus it provides a precise non-financial
measure of employee effort devoted to quality. However, it may take some
time for the effects of high quality products to show up in net income (it
may take some time for purchasers to realize that quality has improved,
while costs of improving product quality are charged to expense as
incurred). As a result, net income lags the non-financial performance
measures. The greater the firm commitment to quality, the more it will use
non-financial measures of product quality as a quality incentive device.
Prof. Garen Markarian, PhD 28
 Problem Set 8
Solution 5 a (4)
5) Required:
a. Give intuitive arguments to explain these four hypotheses.
(iv) Regulation:
A major reason for regulation is that firms have a monopoly in their
product markets. The profits of regulated firms are limited by the
regulatory process. This reduces sensitivity of net income as a performance
measure. That is, even very high manager effort is constrained in its effect
on the bottom line. However, by maintaining customer satisfaction with
performance, courtesy, responsiveness, etc., the firm can help to sustain its
monopoly position. As a result, non-financial performance measures such
as these will be emphasized more strongly than net income in the
compensation plans of such firms.
Prof. Garen Markarian, PhD 29
 Problem Set 8
Solution 5 b (1)
5) Required:
b. Which of these four hypotheses might help explain the inclusion by RBC of
non-financial performance measures in its short-term incentive awards?
Firm strategy. The personal goals included in the RBC plan seem mostly
strategic in nature (e.g.: development of U.S. operations). Thus RBC seems
to regard itself as a prospector type firm. Since these strategies likely take
some time to show up in net income, personal goal attainment is a more
sensitive performance measure.

Prof. Garen Markarian, PhD 30

 Problem Set 8
Solution 5 b (2)
5) Required:
b. Which of these four hypotheses might help explain the inclusion by RBC of
non-financial performance measures in its short-term incentive awards?
To the extent that executives are directly responsible for product quality,
courtesy, etc., the product quality hypothesis is also an explanation.
Measures of product quality are likely sensitive to manager effort and
measurable with reasonable precision, whereas with so many factors
affecting net income, earnings may not be a precise measure of product
quality performance.

Prof. Garen Markarian, PhD 31