Adopting residual income-based

compensation plans:
Do you get what you pay for?
(Wallace, 1997)

Fernando Siahaan 10599584

Ada Sneekes 5928257
Roy Stift 5870984
Joris Tanke 5947448

Introduction
RQ:
do managers of firms adopting compensation contracts with
residual income-based performance measures take actions
consistent with the incentives from these measures?

Residual income versus earning per share

Residual income = earning before interest cost of
capital
= profit (WACC * invested capital)
Earning per share = net income/number of common shares

Theory
Assumption: Agency problem
objective publicly-traded firms = maximize
shareholder wealth
managers' personal aim = maximize individual
utility = function total compensation
Result: Compensation plans encourages
managers to align firm's objectives and manager's
personal aim

Hypotheses
Investing decisions:

H1a: +

Asset disposition

Residual income-based compensation

H1b: -

Financing decisions:

New investments

H2a: + Share repurchases

Residual income-based compensation

H2b: +

Dividend pay-outs

Hypotheses
Operating decisions:

Asset turnover
H3: +
H3a: +Inventory turnover

Residual income-based compensation

H3b: A
+ccounts receivable turnover
H3c: -

Accounts payable turnover

Hypotheses
Residual income:

H4: +

Residual income-based compensation

Shareholder wealth:
Residual income-based compensation

Residual income

H5: +

Shareholder wealth

Methodology
Sample:
40 firms adopted residual income-based
compensation between 1993-1994; 40 matchpair control group traditional earnings-based
measures in their compensation plans

Interrupted time series design

Pre-adoption period (t1)
-5 years

Post-adoption period (t2)

Year of adoption

+3 years

Methodology
Validity threats time series:
1. history threat (another event)
2. maturation threat (natural changes in a firm)
Solution: matched-pair control

Matching base
1. pre-established
- Four-digit SIC
- Firm size

2. tested t1
- Total assets
- Return on assets
- Leverage

3. tested t1 dependent
- new investment
- dispositions
- repurchases per share
- dividends per share
- asset turnover
- residual income

Methodology
Equation:

Dependent = difference between t1 and

t2
Type of compensation plan
Control variables

Sensitivity analyses and

limitations
Sensitivity analyses
Check results for alternatives explanations
share repurchases
alternate samples
downsizing

Conclusion: results seem robust

Limitations
Earlier use
Other environmental changes
Random sample

Summary
Modest conclusion:
There is a positive relationship
between residual income-based
performance measures and
compensations, which influences
managers decisions, and shareholder
value.

Relationship with other articles or

book
Agency Theory:
Management vs. Owners

Ch. 10 Financial Performance

Measures:
Residual income vs. ROI Measurement