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Chapter 10 Executive Compensation
Nish VairavanathanAthavan Thulakanathan
Sally Zhu
http://www.youtube.com/watch?v=vh0U0V8246U
Agenda10.2- Are Incentive Contracts Necessary?10.3- A Managerial Compensation Plan10.4.1- Using Net Income and Share price in
Evaluating Manager Performance10.4.2- Short-Run and Long-Run Effort10.4.3- The Role of Risk in Executive Compensation 10.5- Empirical Compensation Research10.6- The Politics of Executive Compensation10.7- The Power Theory of Executive Compensation10.8- Social Significance of Managerial Labour
Markets That Work well
10.2 Are Incentive Contracts Necessary?Most Of The Research Suggests Incentive
Contracts Are Necessary:Fama:
Incentive Contract’s Aren’t Necessary Because Managerial Labour Markets Control For Moral Hazard
Arya, Fellingham, and Glover (AFG):Incentive Contracts For Lower Level Managers Are Necessary
Wolfson:Found That Market Forces Reduce Moral Hazard Likelihood
But Does Not Eliminate ItBushman, Engel, & Smith
Markets Can’t Value a manager’s reputation perfectly based on accounting information and therefore incentive contracts might be necessary
10.3 A Managerial Compensation PlanMany Managerial Compensation Plans
Require:Holding A Significant Amount Of Company
SharesHolding Three Main Compensation
Components:SalaryAnnual Short-Term Incentive Awards (i.e. Cash
Bonuses, DSUs)Stock Options
10.3 A Managerial Compensation PlanMany Managerial Compensation Plans Require:A Performance Measure Be Reached
Before Incentive Compensation Becomes Payable
o Threshold Level Of Performance Is Called The Bogey
o Upper Limit Of Compensation Is Called Cap
10.3 A Managerial Compensation PlanA Mix of Short And Long-Term Incentive Components Is Important For The Following Reasons:
To Maximize Current Year PerformanceTo Reinforce Longer-Term Considerations
o A High Proportion Of Long-Term Incentive Components Should Produce Longer Manager Decision Horizon
10.3 A Managerial Compensation PlanAlong with Short-Term and Long-Term Incentive Components, A Firm Can Also Create Mid-Term Incentive Components:
Restricted Share Units Are Units Of Stock That Are Awarded When One Or More Targets Are Met
10.3 A Managerial Compensation PlanShort-Run Incentives Like Employment Stock Options (ESOs) Can Create Dysfunctional Behaviour As It Shortens The Decision Horizon
10.3 Real Example of Executive CompensationBarrick Gold CEO: Aaron RegentTOTAL COMPENSATION IN 2010*
Total Annual Cash Compensation$1,544,810
Total Short Term Compensation$1,544,810
Other Long Term Compensation$2,455,578
Total Calculated Compensation$6,959,161
Two Performance Measures:• Share price (High in sensitivity, Low in precision)• Net Income (Low in sensitivity, High in precision)
Banker and Datar (1989); lower the noise in net income and the greater its sensitivity to manager effort, the greater should be the proportion of net income to share price in determining the manager’s overall performance
10.4 The Theory of Executive Compensation
10.4 Theory of Executive Compensation
How To Increase Sensitivity of Net Income?
• Reduce recognition lag e.g. current value accounting reduces recognition lag but tradeoff is precision
• Full disclosure
10.4 Theory of Executive Compensation
Manager effort can be divided into SR & LR:
• Controlling length of manager decision horizon is important because expected net income is more likely to be not congruent to expected payoff [ Example 10.1, pg. 375 ]
• Greater proportion of performance based on share price relative to net income, increases long-run effort to short-run effort, and vice versa
10.4 Theory of Executive Compensation
Compensation risk affects how the manager operates the firm:
• Not enough risk = low manager effort• Too much risk = manger avoids risky
projects
Goal is to control compensation risk, not eliminate it
10.4 Theory of Executive Compensation
Controlling Compensation Risk:
• Relative performance evaluation (Holmstrom,1982), measured by the difference between the firm’s net income and/or share price performance and the average performance of a group of similar firms
• Idea is to eliminate the industry wide risk and allow a net performance that more precisely reflects the manager’s efforts
• However, despite theoretical appeal, there is weak evidence for RPE (Antle and Smith, 1986)
10.4 Theory of Executive Compensation
Controlling compensation risk:
• control downside risk by implementing a ‘bogey’ • placing a cap controls upside risk• role of board e.g. compensation committee• role of conservative accounting
One measure is not better than another, idea is to have a mix of performance measures
A Short Clip http://www.youtube.com/watch?v=8TgcNsaUfrg&feature=relat
ed
10.5 Empirical Compensation ResearchResearch suggesting efficient
compensation contracting• Lambert & Lacker (LL) – (1987)
• ROE was more highly related to cash compensation than return on shares
• Lower the noise in net income, better prediction in payoff
• Lower correlation in compensation and ROE for growth firms• Net income less sensitive to management
effort than average firms• Higher weight in ROE when low correlation
between ROE and return on shares
10.5 Empirical Compensation Research
Summary of LL Research:
• Corr(total comp, NI) >Corr(total comp, share prices): Bonus plans are more popular
• If there is high Corr (total comp, NI)• NI is use for management stewardship
• If there is high Corr(NI, Share price)• NI is use for investment decisions
Corr(total comp, NI) High sensitivity and low precision
Corr(total comp, share prices) Low sensitivity and high precision
10.5 Empirical Compensation Research
Other Research:
• Indjejikian & Kanda (2002) Lower variability of ROE higher the target bonus
relative to base salary
• Bushman, Indjejikian & Smith (1996) Growth firm CEOs derived greater proportion of
compensation from individual performance measure relative to NI and stock-based measures
• Baber, Kang & Kumar (1999) Effect of earnings changes on compensation
increase with persistence of those earnings changes
10.6 The Politics of Executive Compensation
CEO compensation may be less than it seems at first glance
• Jensen and Murphy (JM) 1990: CEOs earn $2.59 increase per $1,000 in
increase in shareholder wealth. Variability (std) of CEO compensation =
variability of compensation of workers Conclusion: CEO did not bear enough risk
to motivate good performance, and recommended larger stock holding by managers
10.6 The Politics of Executive Compensation
Counterarguments to JM:• Low relationship between pay and
performance• Limited downside risks
• Exclude extraordinary loss in bonus rewards and include extraordinary gain
Encourage risky projects Market downturn than bad performance
• Golden Parachutes
10.7 The Power Theory of Executive Compensation
Power theory: executive compensation in practice is driven by manager opportunism, not efficient contracting
• Manager have power to influence own compensation
Influence board of directors and compensation committee’s appointments
• Camouflage excessive compensation Compensation consultants Peer groups Late timing of ESO awards
10.8 Social Significance of Managerial Labour Markets
A Manager Making Good Capital Investment Decisions And Improving Firm Productivity Contributes To Social Welfare
Accountants Can Contribute To Social Welfare by: Full Disclosure Contribute To Informativeness Through An
Appropriate Tradeoff Between Sensitivity And Precision
How Does Chapter 10 Relate To Concepts In Previous Chapters?
Ch. 10 Executive Compensation
Ch1.Moral Hazard & Adverse selection
Ch2. Relevance
& Reliability
Ch3. Expected
Utility Maximizatio
n
Ch4. Manageme
nt’s Discussion & AnalysisCh5.Reaso
ns For Market
Response
Ch8.Positive
Accounting Theory
Ch9. Efficient Contracts &
Agency Theory
Ch6. Auditor’s
Legal liability
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