Accounting based pay for performance

Accounting Based Pay for Performance

In a corporate governance perspective

Master Thesis 2013 Philip Brun Christensen, 280886-XXXX

M.Sc. in Economics & Business Administration

Cand.Merc. ASC

Accounting, Strategy and Control

Danish title:

Regnskabsbaseret performance aflønning

I et corporate governance perspektiv

Institute: Institut for Regnskab og Revision

Supervisor: Christian V. Petersen

Hand in date: 23/09/2013

Characters: 167.529

Total Page: 80

M a s t e r ’ s T h e s i s 2 0 1 3

C O P E N H A G E N B U S I N E S S S C H O O L

Accounting based pay for performance

1. Executive Summary

CBS | Copenhagen Business School | CM.ASC Philip Brun Christensen | 1

1 Executive Summary

The focus of the thesis is accounting based performance pay, used in Danish companies. According to

agency theory there exist a problem since the agent’s interests is not aligned with the principal’s. It is this

problem that bonus contracts are used to solve. Recently there has been an increased debate concerning

stock shares and stock options in relation to the financial crisis. The thesis focuses on accounting based

bonus contracts in order to assess their ability to align management’s interest with the owner’s interest.

The thesis has identified seven bonus criteria that are used to evaluate accounting based bonus contracts.

These seven criteria are; congruency, controllability, simplicity, objectivity, low number of accounting

issues, cost efficient to develop and timeliness. The most important criterion is the congruency, fulfilling

this criterion ensures that company value is created which is in the owner’s interest. These criteria are used

to evaluate the three components of a bonus contracts; performance measure, performance standard and

pay for performance structure.

The recommendation to remuneration boards and shareholders is to use accounting based bonus contracts

that include EVA, as the performance measure, an external peer-group, as the performance standard, and a

linear pay for performance structure. Furthermore the bonus contract should include a bonus bank where a

predetermined share of the bank balance is paid out annually. Thereby ensuring the bonus contract reflects

performance over multiple-periods. The bonus bank also facilitates that poor performance can be

punished. This symmetry between the upside and downside of the performance-based compensation is

recommended by the OECD – Principles on Corporate Governance, as well as the Danish Committee on

Corporate Governance. This combination of performance measure, standard and pay-for-performance

structure is the one according to theory that especially fulfils the congruence, controllability criteria.

The empirical findings do not support the use of the above bonus components. The empirical findings is

characterised by using absolute performance measures, which excludes balance sheets items, budget

standards that which management are able to influence and pay for performance structure that is of the

non-linear type. Evaluating these bonus components with the prior mentioned bonus criteria reveals that

this combination of bonus components has a low congruence with value creation, they are however simple,

cost efficient, since income statement items are already reported and budgets are usually developed

annually.




Table of Contents

1 Executive Summary ........................................................................................................................... 1

Chapter 1. Introduction and Problem Identification ......................................................................................... 4

2 Introduction ....................................................................................................................................... 4

2.1 Problem Statement ....................................................................................................................... 6

2.2 Purpose and focus the thesis ......................................................................................................... 6

2.3 Delimitation ................................................................................................................................... 7

2.4 Disposition of the thesis ................................................................................................................ 8

3 Methodology ..................................................................................................................................... 9

3.1 Research Purpose .......................................................................................................................... 9

3.2 Research approach ........................................................................................................................ 9

3.3 Inductive and deductive methods ............................................................................................... 11

3.4 Literature Review ........................................................................................................................ 11

Chapter 2. Theory on Bonus Compensation.................................................................................................... 13

4 Theoretical frame ............................................................................................................................ 13

5 Corporate Governance and Agency Theory .................................................................................... 13

5.1 Corporate Governance ................................................................................................................ 13

5.2 Disclosure of Bonus Pay Information .......................................................................................... 15

5.3 Agency Theory ............................................................................................................................. 18

6 Compensation .................................................................................................................................. 23

6.1 Characteristics of an effective bonus plan .................................................................................. 23

6.2 Bonus plan components .............................................................................................................. 30

Chapter 3. Empirical Analysis .......................................................................................................................... 55

7 Empirical findings ............................................................................................................................ 55

7.1 Introduction ................................................................................................................................. 55




7.2 Primary data: The quality of public available executive bonus information ............................... 55

7.3 Secondary data: Findings of financial bonuses among Danish executives .................................. 63

7.4 Summary of the findings from the primary and secondary data ................................................ 65

Chapter 4. Guidelines Based on Theoretical and Empirical Findings .............................................................. 67

8 Empirical versus Theoretical Findings ............................................................................................. 67

8.1 Performance Measures ............................................................................................................... 67

8.2 Performance Standards ............................................................................................................... 68

8.3 Performance Structure ................................................................................................................ 69

9 Guidelines for accounting based bonus contract ............................................................................ 71

10 Discussion ........................................................................................................................................ 74

10.1 Critique of the Agency Theory ..................................................................................................... 74

10.2 Quality of available information: ................................................................................................. 75

10.3 Critique of well-designed bonus plans: ....................................................................................... 75

10.4 Criticism of Compensation .......................................................................................................... 76

Chapter 5. Conclusion, Reflection and Further Studies ................................................................................... 77

11 Conclusion ....................................................................................................................................... 77

11.1 Reflection on the development of the thesis .............................................................................. 79

11.2 Further studies............................................................................................................................. 79

12 References ....................................................................................................................................... 81

13 List of Figures ................................................................................................................................... 87

14 List of Tables .................................................................................................................................... 89

15 Appendix (Overview) ....................................................................................................................... 90

15.1 Full Table of Contents .................................................................................................................. 91

15.2 Appendix – Tables and figures ..................................................................................................... 96


2. Introduction


Chapter 1. Introduction and Problem Identification

This chapter introduces the area of bonus compensation and more specifically accounting based bonus

contracts. The introduction will be followed by the problem statement and a section concerning

delimitations that will not be covered in the study.

2 Introduction

After the last couple of years with a financial crisis, the executive remuneration debate has become a hot

topic in the media. Different compensation schemes have been increasingly criticized with regard to

bonuses and stock options. The media have focused a lot on the compensation of executives. Recently,

primarily during the period of the publication of financial statements, where the compensation schemes

have been presented, there have been different examples of ways that the media, companies and

executives have dealt with the compensation question. In the UK and US there have even been examples of

CEO's not accepting their bonuses, as a result of primarily external pressure from the public and

shareholders.

“The recent accounting scandals at Enron, WorldCom, Global Crossing and other companies have been

linked to excessive risk taking and an excessive fixation on stock prices, both allegedly caused by the

escalation in option grant” (Hall et al. 2003, 49-50)

Although stock shares and options are said to align the interest of the executive’s with the interest of the

owner’s, this bonus form has several weaknesses. Hall & Murphy’s (2003) excerpt above shows some

significant problems related to this bonus type (Hall et al. 2003, 49-50). As such the use of stock shares and

stock options has been criticized. The choice of other types of performance measures may be a better

choice. Sloan (1993) argues that market based measures are highly influenced by external factors. For

instance includes share price a significant amount of noise. In contrast to this he mentions accounting

earnings as a better performance measure since it is shielded against external noise (Zakaria 2012, 191).

“It’s Not How Much You Pay, But How” (Jensen et al. 2010, 64)

According to Jensen and Murphy (2010) the real problem with the bonus pay is not that it might be

excessive, but instead how the bonus is paid. Jensen and Murphy (2010) states that the debate should

focus on the components of the executive bonus pay and what incentives is created due to the bonus

contract (Jensen et al. 2010, 64-65).


2. Introduction


A Danish study conducted by Banghøj, Gabrielsen & Plenborg (2010) shows that the link between

performance and pay is weak (Banghøj 2010, 505-506). Another study conducted by Eriksson & Lausten

(2000) shows that the link between CEO compensation and company performance is weak. This result is

similar to other studies of other European countries (Banghøj 2006, 31). In relation to Jensen and Murphy’s

(2010) statement above, this area would appear more beneficial to investigate rather than simply lowering

CEO compensation just due to the fact that they appear excessive (Jensen et al. 2010, 64-65).

“Most research on CEO incentives has been firmly (if not always explicitly) rooted in agency theory:

compensation plans are designed to align the interests of risk-averse self-interested CEOs with those of

shareholders” (Murphy 2013, 233)

This excerpt by Murphy (2013) summarises the idea behind agency theory and thereby bonus

remuneration. This alignment of the executive’s interest with the owner’s interest of creating value is the

main purpose of the bonus contract. However there exists several problems related to performance pay,

which makes it difficult to develop a bonus contract that fully aligns the interest of the executive’s with the

owner’s. This thesis will focus on the area of accounting based bonus contracts in order to analysis to what

extent these can be used to align executive’s interests with the owner’s.

This thesis will primarily be directed towards remuneration boards, shareholders and other stakeholders,

who have interest in knowing pitfall associated with accounting based bonus contracts.


2. Introduction


2.1 Problem Statement

In the above mentioned context, the thesis will have its basis on the following problem statement:

How do you design an accounting based bonus contract that is value creating according to theory and how

does this relate to the accounting based contracts used by the Danish companies?

To answer the main problem statement the following research questions will be answered throughout the

thesis:

What are the bonus criteria that ensure a bonus contract of high quality?

What are the main components in a bonus contract?

What are the characteristics of Danish bonus contracts and how does this relate to the theoretical

view on bonus contracts of high quality?

Which incentives are created when accounting based bonus is used?

2.2 Purpose and focus the thesis

The thesis will examine executive compensation from a board perspective. This will be done in order to

explain how shareholder and stakeholder interests can be aligned. This perspective is chosen based on the

assumption that it is the board that develop and determine executive remuneration contracts and thereby

have the control of this process. This thesis will develop guidelines for developing bonus contracts that is

aimed at providing the board with an increased amount of knowledge of the factors that affects a good

bonus contract. The aim of the thesis is consequently to provide boards with a better foundation for

developing bonus contracts.

Given the specific focus of the thesis, the thesis will mainly be oriented towards groups that have a stake in

the bonus contracts that are developed. This includes boards with the responsibility of developing bonus

contracts, the executives which the specific bonus contract concerns as well as owners who are ultimately

affected by the quality of the bonus contract developed. Furthermore it can be argued that other

stakeholder groups that although they are not directly related to the bonus contract, still has an interest in

regards of the way the company is managed.


2. Introduction


2.3 Delimitation

The interest of this thesis is concentrated on executive compensation this is why the thesis will focus solely

on executive compensation. Furthermore the thesis will not go into depth on how to motivate executives,

but will focus on the compensation of the executives.

The thesis will solely focus on what incentives are created by the use of accounting based bonus contracts,

seen from a logical and economical perspective where the executive strives to maximize his own wealth.

The thesis will therefore not go into depth with the executive’s internal motivation. The thesis will not

include the specific pay to executives, but solely focus on what characterises a bonus contract of high

quality.

The thesis will focus solely on Danish companies in order to develop remuneration guidelines that are

relevant in a Danish context. The primary data will consist of annual reports and company web pages from

the C20 companies in order to gain insights in the use of accounting based bonus contracts. These will be

used as an indicator and not be used to describe all listed firms as a whole. The thesis thereby limits from

seeking primary data from other listed or non-listed companies (Secondary data includes a study of 58

Danish companies).

The data collection will only include information that relates to accounting based bonus contracts. Other

type of bonus contracts will not be included and analysed in the thesis.


2. Introduction


2.4 Disposition of the thesis

Figure 2.1 – Disposition of the thesis (Source: Own creation)


3. Methodology


3 Methodology

The methodology will be further separated in the following sections; research’s purpose, approach,

strategy and will end in a literature review.

3.1 Research Purpose

Research can be classified as descriptive or explanatory (Richey et. Al. 2004, 1101-1103). The descriptive

approach is useful when analysing the problem in relation to existing theories. This approach is based on

gathering a significant amount of information that is used to answer in order to what, when and how

questions (Zikmund, 2012, 159-160). Ritchey & Klein (2004) states that this quantitative approach is used

to provide answers to problems and hypothesis (Richey et. Al. 2004, 1101-1103).

Opposed to the descriptive research the exploratory research is used to gain information within areas

where information is limited. This kind of research is highly used when searching for new insights (Bryman

& Bell, 2007, 67). This research is usually of the qualitative type.

Both the primary and secondary data will be analysed in a quantitative approach. This will be done in order

to provide findings that to some extent best describe the analysed data as a whole. These findings will then

be compared with existing theories on accounting based bonus contracts.

3.2 Research approach

When analysing data, there are two methods to collect data, qualitative and quantitative research

approach. The choice of method depends on the character of the information that is wished to analyse

(Bryman & Bell, 2007, 28).

Qualitative approach is a strategy where the data noted and observed is converted into words and

therefore it does not employ measurements (Bryman & Bell, 2007, 402-403). The characteristics of this kind

of approach are descriptions, smaller studies and an active participation of the researcher. This research

emphasizes on a deductive approach, since its purpose is to test existing theories on empirical findings

(Bryman & Bell, 2007, 403-405).

The quantitative approach is a strategy where the collection and analysis of data is emphasized by

quantification (Bryman & Bell, 2007, 155-156). This approach usually consists of questionnaires, statistics

and other tests. Since this approach entails numerical data collection, it is said to be of a deductive

approach. The approach analyses the empirical information and develops a hypothesis from existing

theories (Bryman & Bell, 2007, 155-158).


3. Methodology


This thesis makes use of the quantitative method, since the quantitative method excludes individuality as is

the case of the qualitative method. Instead the quantitative method focusses on generalizability and

comparability. Predetermined data regarding performance measures, standards and pay for performance

structure, will be collected from company web pages and annual reports in order ensure a comparison

between each company. The generalization of these findings will thereby be describing the companies as a

whole group (Vallgårda & Koch 2011, 51).

The excerpts below from the Committee on Corporate Governance publication of “Recommendations on

corporate governance” (2013) shows that companies is expected to disclose clear and transparent

information regarding remuneration components, the reason why these are chosen, a description of the

criteria that balances these individual components of which the remuneration is based and finally that

these information ought to be disclosed on company websites and/ or in the annual report.

“…that the total remuneration granted to each member of the board of directors and the executive board

by the company and other companies in the group, including information on the most important contents of

retention … … schemes, be disclosed in the annual report and that the linkage with the remuneration policy

be explained (CORG – Committee on Corporate Governance 2013, 24)

Furthermore the committee goes into detail of what ought to be disclosed:

“…that the board of directors prepare a clear and transparent remuneration policy for the … the executive

board, including

• A detailed description of the components of the remuneration for … the executive board,

• The reasons for choosing the individual components of the remuneration, and

• A description of the criteria on which the balance between the individual components of the remuneration

is based.

The remuneration policy should be approved by the general meeting and published on the company’s

website” (CORG – Committee on Corporate Governance 2013, 23)

The Committee on Corporate Governance states that their recommendations are based on best practise

guidelines among companies trading on a regulated market this include the CSE (CORG – Committee on

corporate governance 2013, 3). Furthermore this includes the Comply or explains principle, where the

company that does not fulfil the recommendations is expected to explain why the company deviates and

what the company have chosen to do instead (CORG – Committee on corporate governance 2013, 3).

The recommendation on corporate governance developed by the Committee on corporate governance will

act as the research approach for the thesis. Empirical findings will be collected from company websites and


3. Methodology


their annual reports, since it is assumed that these will provide the relevant executive remuneration

information.

3.3 Inductive and deductive methods

Conducting conclusions of research results is often referred to as two different methods, inductive and

deductive methods.

The inductive method is based on that you make general conclusions from empirical facts and use the

reality as foundation for the conclusions. By using empirical facts as foundation the researcher can obtain

knowledge to prove, reject or develop a theory. It is important to know that the research is based on

empirical facts that do not always include complete information, which makes the conclusion slightly

uncertain (Bryman 2012, 24-26).

The deductive method has its base in existing theories and uses these to describe the results. Thus, the

empirical consequences, derived from these theories are then compared with the actual conditions in

reality (Bryman 2012, 24-26).

The thesis makes use of both the inductive and the deductive method, although the emphasis has been on

the deductive method. The empirical findings both primary findings from annual reports and secondary

findings will be discussed and theories will be used to explain them. By making an empirical study it is

intended to analyse the quality of the different compensations programs, by discussing the strength and

weaknesses and comparing these empirical findings with current theories.

3.4 Literature Review

Throughout the thesis, literature and authors are chosen critically. The thesis strives to use primary

literature. Banghøj (2006) is used as secondary data literature, in order to evaluate the primary data

collected. Other relevant literature is used in order to analyse issues from different angles, or to criticize

existing theories.

Furthermore the thesis have primarily made use of theories that represents a narrow and specific view on

remuneration which is however characterised by containing many different elements and views. As such

the thesis has strived to include both differentiated theories that provide nuanced analysis as well as

opposing and critical views on the selected theories.

Danish literature on executive remuneration is rather limited, this might be because the Danish disclosure

requirements are poor compared to the US and UK. In these countries, companies are required to disclose

detailed information of their executive remuneration. Due to this, a significant amount of the literature and


3. Methodology


theories used throughout the thesis originates from the US or UK and as such is based on country specific

executive compensation. US and UK literature will be used to provide insights to the field of remuneration,

and may be used to understand Danish empirical findings. Whenever possible the thesis will use Danish

literature and theories. These sources are assumed to provide the best description the Danish stetting and

empirical findings.


4. Theoretical frame


Chapter 2. Theory on Bonus Compensation

This chapter will start by describing the concept of corporate governance. This concept will be followed by

different governments and their recommendations on good corporate governance. The Corporate

governance theory will be used as the foundation for analysing why there exists a need for bonus contracts.

This will be explained by the agency theory. Finally the characteristics of a good bonus contract and the

bonus components will be discussed in detail.

4 Theoretical frame

First part of the thesis will review theory and other information that is relevant in order to enable an

analysis of different remuneration methods within the field of accounting based performance measures.

These findings will be used to develop bonus pay guidelines which will be presented in the last part of the

thesis.. This theoretical frame will be used to support the perspective of the thesis, which is to develop

remuneration guidelines that are relevant for boards and remuneration committees that have the

responsibility to develop bonus contracts that are supposed to ensure that the manager’s behaviour are

aligned with the principal’s.

5 Corporate Governance and Agency Theory

In the last decades the company focus of increasing shareholder value has increased incorporating how

governance ensures the fulfilling of the corporate goals (Brickley, Smith, and Zimmerman 2003, 36).

5.1 Corporate Governance

O’Donovan describes the corporate governance concept as:

”an internal system encompassing policies, processes and people, which serves the needs of shareholders

and other stakeholders by directing and controlling management activities with good business savvy,

objectivity and integrity. Sound corporate governance is reliant on external marketplace commitment and

legislation, plus a healthy board culture which safeguards policies and processes.”

(O'Donovan 2003, 13-05-26).

This describes the parties involved in corporate governance; shareholders, stakeholders, management and

board as well as its elements and purpose when used optimally. The corporate governance concept is the

control mechanism that ensures that companies, agents etc. are controlled, directed and held accountable


5. Corporate Governance and Agency Theory


for their actions. The issue of corporate governance exists when there is a separation between ownership

and control.

Seen from a shareholder perspective, the shareholder invests in a company and expects to earn a return

that match similar investments that are bearing the same level of risk. The value of the shareholder’s

investment is equal to the discounted cash flows the investment is going to produce in all future periods

which are also called the net present value (NPV). The manager maximizes shareholder value by increasing

the present value of the discounted cash flows that the company is receiving. The annual earnings

represent the actual year’s cash flows and are therefore not a valid indicator for future cash flows. In

contrast stock price is argued to be a better indicator of company value, since it also reflects future period’s

cash flows and thereby the manager’s performance in regards of maximizing shareholder value (Brickley,

Smith, and Zimmerman 2003, 36). However as mentioned in the introduction stock based performance

measures have been widely criticised and can be manipulated by the manager.

As O’Donovan mentions it is the board’s responsibility to ensure that policies and processes are upheld in

bonus contracts. This in order to select the relevant performance measures as well as reward structures

that provide the agents with incentives to maximize current and future cash flows, and especially ensure

that these have a long-term strategic focus (Brickley, Smith, and Zimmerman 2003, 36).

Corporate governance is only relevant when the agency problem exist. In the case where there exists

perfect information of the agents’ behaviour a simple behaviour contract would align the agents’ actions

with the principals’ interests. If the contract instead was outcome-based i.e. the agent is being rewarded

according to the level of EBIT, and that this bonus component is only partly controllable by the agent, this

will introduce risk related to the agents reward. According to financial theory the agent would therefore

claim a risk-premium to offset the risk of the performance measure (Hart 1995, 678-680).

Hart states that two conditions have to be present in order for corporate governance to be relevant (Hart

1995, 678-680):

1. There exists an agency problem.

2. Transaction costs must be excessive, making a perfect contract too expensive to develop.




Literature states that in order to develop a perfect contract between the principal and agent three costs are

incurred (Hart 1995, 678-689):

1. The cost of identifying all eventualities and their resolution during the lifetime of the contract

2. Negotiation costs – negotiation between the contract parties

3. Development of the actual physical contract – valid document required in the case of disagreement

between the parties

(Hart 1995, 678-689)

When ownership and control has been separated, there is automatically created an agency relationship

where the owner (principal) hires a management (agent) to do the work of the owner. When discussing

agency relationships it also relevant to mention asymmetric information which may lead to moral hazard

and adverse selection problems which is components of the agency problem (Hart 1995, 678-689)

. These specific problems will be discussed further in the following sections.

5.2 Disclosure of Bonus Pay Information

”En virksomheds reviderede årsrapport er den væsentligste og mest troværdige kilde til information om

virksomheden” (PwC - C20 Regnskabsprisen – fokus på en bedre årsrapport, online acces 09-09-13)

Guidelines have been developed with the goal of improving corporate governance in organizations. The

recent economic crisis have increased the emphasis on the value of these guidelines generate.

These guidelines are aimed at limiting such crises as well as they provide economic value. Empirical

research shows that companies that incorporate high corporate governance standards have a higher

market value (OECD 2004, 3).

CSE have their own set of corporate governance guidelines (which is quite common for stock exchanges).

Normally it is expected that listed companies follow these guidelines and if not, they are expected to

explain why this is not the case.

“Lundbeck also deviates from the recommendation regarding disclosure of remuneration paid to individual

members of Executive Management. We do not believe this provides added value to our stakeholders. We

only intend to disclose the total individual remuneration paid to our President and CEO, and the total

remuneration paid to Executive Management.” (Lundbeck annual report 2012, 51)

The above excerpt is an example of how a company explains why they deviate from the recommendation

of corporate governance, and is as such an example of the Comply or explain concept which is used at the

CSE.




The following sections the most important guidelines that are relevant in the context of the thesis will be

covered.

5.2.1 Law on disclosure of enterprise information

”Virksomheden skal angive det samlede vederlag m.v. for regnskabsåret til nuværende og forhenværende

medlemmer af ledelsen for deres funktion fordelt på hvert ledelsesorgan samt … Er der fastsat særlige

incitamentsprogrammer for medlemmer af ledelsen, skal det oplyses, hvilken kategori af

ledelsesmedlemmer programmet gælder for, hvilke ydelser programmet omfatter, og hvad der er

nødvendigt for at kunne vurdere værdien heraf”. (Retsinformation.dk, §98b)

The total remuneration is required to be disclosed on an executive level. During the thesis data collection

process findings show that a significant amount of companies disclose the remuneration on an individual

level, see for example Carlsberg’s annual report:

Figure 5.1 - Executive remuneration (Carlsberg annual report 2011-2012, 78)

5.2.2 OECD Principles of Corporate Governance

The OECD principles of Corporate Governance have been used as a global benchmark used by policy

makers, investors, corporations etc. since the endorsement in 1999. The principles were revised in 2004 in

order to better ensure financial market stability, investment and economic growth (OECD 2004, 3).

“V. Disclosure and Transparency … A. Disclosure should include, but not be limited to, material information

on: … 4. Remuneration policy for members of the board and key executives …” (OECD 2004, 22)

OECD recommends disclosure of remuneration policy of executives. Especially the link between

remuneration and company performance is important to disclose. Furthermore OECD recommends that

shareholders should be able to comment on remuneration policies of board members as well as executives.

(OECD 2004, 22)

“The Principles call for the disclosure of remuneration policy by the board. In particular, it is important for

shareholders to know the specific link between remuneration and company performance...”

(OECD 2004, 22)




Finally OECD also states that one of the important tasks of the remuneration board is to ensure alignment

of executive remuneration and value creation (OECD 2004, 22).

5.2.2.1 OECD Corporate governance and the Financial crisis

The 2010 publication provided lessons learned in relation to the recent financial crisis. A significant factor

that leads to this crisis is flaws in the corporate governance, more specifically flaws in the setup of

executive remuneration, risk management, board practices and the exercise of shareholder rights. OECD

found that the existing principles where sufficient in addressing these flaws, as such OECD stated that there

where a need to implement these principles (OECD 2010, 3).

“It is important for boards to first set the strategic goals of the company and its associated risk appetite.

They are then in a position to establish a compensation structure that meets a small number of performance

metrics based on these goals” (OECD 2010, 3).

The report states that the executive remuneration is a responsibility for the board. According to the excerpt

above bonus contracts should first be develop after strategy and related risk is determined. As such the

bonus contract can be analysed by the risk management department in order to assess if the contract

induces risks (OECD 2010, 3-4). Furthermore the report states mentions challenges concerning: Low

Bargaining position of the board high bargaining position of the CEO, results in failure in the governance of

incentive systems. Remuneration schemes are overly complicated, disguising conditions and consequences.

Asymmetric information with limited downside leads to excessive risk-taking. The use of compensation

consultants, transparency and disclosure is important. For example in order to assess the level of a peer-

group, this could be setup in a way that ensures performing above average (OECD 2010, 8).

“Transparency needs to be improved beyond disclosure. Corporations should be able to explain the main

characteristics of their performance related remuneration programs in concise and non-technical terms.

This should include the total cost of the program; performance criteria and; how the remuneration is

adjusted for related risks” (OECD 2010, 8).

In addition to the above excerpt from the publication, OECD also recommends increased symmetry

between low and high performance-based remuneration (OECD 2010, 8).

5.2.3 Committee on Corporate Governance in Denmark

The recommendation provided by the Committee on Corporate Governance in Denmark has been

discussed in section 3.2. These excerpts depict the Committee on Corporate Governance recommendation

on disclosure of bonus remuneration.




5.2.4 The value relevance of voluntary disclosure in the annual report

Banghøj et. al. has made a study of the value of voluntary disclosing more information in the annual report.

According to their article they state that economic theory suggest that voluntary disclosing information is

beneficial for firms. This voluntary disclosure includes information that is of relevance for investors,

analysts and stakeholder. The study however shows no significant association between current returns and

future earnings. Banghøj et. al. states that this questions whether the voluntary disclosed information are

of value. Another explanation is that investors are unable to make use of the information (Banghøj et. al.

2008, 159-160).

5.3 Agency Theory

In its simplest form agency theory is describing the relationship between a principal and an agent where

the agent acts on behalf of the principal (Lazear, Gibbs 2009, 232-233). Within corporate governance the

agency theory is one of the major theories because it deals with the topic of self-interest, bounded

rationality and risk aversion from both parties (Eisenhardt 1989, 57-74). See appendix 3 for Eisenhardt’s

(1989) overview of the agency theory.

Almost all contractual connections are potential issues to an agency problem. This is characterised as the

situation where one party perform actions on the behalf of a second party. Here the top management

(agent) is action on the behalf of the shareholder's (principal) welfare (Lazear, Gibbs 2009, 232-233).

There exist principal-agent relationships throughout the organisation, i.e. the board (principal) has

delegated power/control to the CEO (agent) as well as the board is the agent in relation to the shareholders

(principal) and that the boards are making decisions on these shareholders. This relationship exists

throughout the company, which all lead back to the shareholders which can be determined as the final

principal. This cascade of principal-agent relationships increases the relevance of aligning top managements

behaviour with the shareholders, since any misalignments on this level will likely be cascaded through the

lower levels in the company (Berle, Means, 1932, 207-208). This underpins the importance of creating

bonus contracts of high quality.

In order to deal with the agency problems, contracts are established providing the agents with incentives

that facilitate agent behaviour that is aligned with the interest of the principal. The cost inquired by such

contracts, the monitoring of the agents activities as well as when the agent does not succeeds in acting in

principals interests are known as agency costs (Jensen & Meckling 1976, 308).




5.3.1 Theory of Principal and Agent

The principal-agent theory is abstract and mathematical, and has a wide focus of general theoretical

implications (Eisenhardt 1989, 60-63). The central research question in the principal-agent theory is; how

should the principal design the agent's reward structure. This focus on the implications of the principal-

agent relationship is used in order to determine the optimal contract between principal and agent, which

differentiates between behaviour and outcome based contracts (Eisenhardt 1989, 57-74).

”The first case, a simple case of complete information, is when the principal knows what the agent has

done. Given that the principal is buying the agent's behaviour, then a contract that is based on behaviour is

most efficient. An outcome-based contract would needlessly transfer risk to the agent, who is assumed to be

more risk averse than the principal. The second case is when the principal does not know exactly what the

agent has done. Given the self-interest of the agent, the agent may or may not have behaved as agreed.”

(Eisenhardt 1989, 6)

According to Eisenhardt the simplest model of the agency theory assumes that there exist a goal conflict

between principal and agent. This conflict is due to the difference in risk-profile, because the principal is

risk neutral and the agent is risk averse. The second case is the reason why the agency problems arise

(Eisenhardt, 1989, 6).

5.3.1.1 Agency Theory Foundations

Most theorists share the acceptance that agency theory is based on the economic model of man (Shapiro

2005, 267). Opposed to this Jensen and Meckling argues that the economic model of man theory is based

on what they call REMM – the Resourceful, Evaluative, Maximizing Model, which to a deeper extent reflects

human behaviour (Jensen & Meckling 1994, 5-6). However, the extent to which these two models are

actually different is questioned by Brunner (1996) who treats them as equals (Brunner 1996, 63-65). In

general agency theory assumes that humans are rational, and thereby will behave opportunistically,

whenever advantageous (Daily et al. 2003, 372). Studies suggest that incentives affect the behaviour, and

as so a change in incentive may result in a change in behaviour in order for the agent to maximize self-

interest (Prendergast 1999, 55).

In this context agency theory addresses the situation of how to ensuring that the self-interested,

opportunistic man are aligned with the owners through the use of incentives.




5.3.2 Agency Problem

A monitoring board of directors is way to monitor the agent and thereby serve as a way to regulate the

agent. However this does not remove the agency problem, but the board of directors decrease the

information advantage of the agent (Jensen & Meckling 1976, 308-310).

The outcome based contract appears to be the solution to agency problem. The alignment of interests

limits the agent’s opportunism and resolves the conflict of interest. Remuneration boards serve to ensure

this alignment and support the principle in monitoring executives (Fama and Jensen 1983, 306-307).

5.3.2.1 Agency cost

As previously mentioned there exists certain costs with relation to the separation of ownership and control

between the principal and agent. These costs are called agency costs. Jensen and Meckling decompose

these costs in three subgroups: 1. Monitoring costs, 2. Bonding costs, 3. Residual loss (Jensen 1976, 308-

310).

+ Maximal principal value creation

- Monitoring costs

- bonding costs

- residual loss

= Realized principal value creation due to the agent

Monitoring costs are defined as the costs that relates to the principals monitoring of the value created due

to the agents work.

Bonding costs are the cost that the agent incurs. These costs can be either related to ensuring the principal

that the agent will not perform actions that harms the principal or that the principal will be compensated if

the agent destroys principal value.

Finally the residual loss is equivalent to the difference between the maximal principal value creation

possible and the actual value creation related to the work of the agent.

This condition between agent and principal reaches a state of uncertainty and asymmetric information. This

state generates two kinds of problems, a moral hazard and adverse selection.




5.3.2.2 Asymmetric information

The principal-agent theory is based on the basis that there exists asymmetric information. According to this

the principal will only have limited knowledge concerning the agent’s actions, and can therefore not assess

whether the agent always act’s in a way that maximizes the principal’s value. The agent has on the contrary

full knowledge of whether or not his actions are in the principal interests or support his own interests. This

creates the asymmetric information where the agent has more knowledge than the principal.

Regarding exchanges where principal delegates work for agents, the agency theory precursors try to

develop methods to solve contractual problems associated with opportunistic agents.

Jensen and Meckling (1976) have studied these situations where there exists asymmetric information

between management and shareholders, and focus on manager’s opportunistic behaviour in these

circumstances (Jensen and Meckling 1976, 308-310). These studies will be further discussed later in the

thesis when bonus structures will be assessed in terms of their strength and weaknesses in regards of

creating a bonus contract of high quality.

The asymmetric information problem can be decomposed in the Moral Hazard Problem and the Adverse

Selection Problem (Eisenhardt 1989, 61).

5.3.2.2.1 Moral Hazard

The moral hazard concept exists when the principal only have limited knowledge of the agents’ behaviour

and that the agent therefore may seek to maximize his own interests rather than the interests of the

principal. Moral hazard may exist when it is either too costly or it is impossible for the agent to monitor the

agents’ behaviour (Eisenhardt 1989, 61) (Padilla, 2002 5-6).

“Moral hazard may be defined as actions of economic agents in maximizing their own utility to the

detriment of others, in situations where they do not bear the full consequences or, equivalently, do not

enjoy the full benefits of their actions due to uncertainty and incomplete or restricted contracts which

prevent the assignment of full damages (benefits) to the agent responsible” (Padilla, 2002:6).

When developing a contract that is set to limit the effects problems of moral hazard agency theory focuses

on the structure of preferences of the parties to contract, the uncertainty issue, and the informational

structure. Agent-principal theory favours a contract that is designed to provide incentives for the agent to

act in the interests of the principal. This is done by aligning interests, risk profiles by rewarding and

punishing the agent according to the amount of creation or destruction of principal value (Eisenhardt 1989,

60-61). Agency literature also focused on another agency problem: adverse selection.




5.3.2.2.2 Adverse Selection

The adverse selection originates from the insurance business, and denotes the situation where there exist a

misrepresentation of information between the agent and principal. This is relevant in the case where the

agent is hired based on specific claimed abilities and the principal are unable to assess whether these

information are correct. This can either be due to lack of knowledge prior to the point of hire or while the

agent is working or due to the complexity of the work and thereby the assessment of the work performed

by the agent (Eisenhardt 1989, 61).


6. Compensation


6 Compensation

6.1 Characteristics of an effective bonus plan

As mentioned earlier the main focus of the bonus plans is to align management interests with the

shareholders. In this context it is relevant to state that there does not exist one general bonus plan that will

be optimal and useful for all companies. But bonus plans of high quality does share a number of criterions,

it is these criterions that will be discussed in the following paragraphs. When developing an effective bonus

plan the following criteria as well as the strength and weaknesses of the bonus components are important

and ought to be revised by the remuneration board when developing a bonus contract in order to ensure

high quality (Petersen, C. V. 2011, Online access 09-09-13)(Merchant 2006, 894):

- Congruence - Low number of accounting issues

- Controllability - Cost efficient

- Simplicity - Timeliness

- Objectivity

The timeliness criterion will be discussed in section 6.1.4. The following model relates bonus components

with the above criteria however the timeliness is not affected by the bonus components (Measure,

standard and structure, see 6.2 Bonus plan components). The timeliness criterion will be further discussed

in a later section when analysing the bonus contract as a whole. The following model includes bonus

criteria that are influenced by the chosen bonus components:

Figure 6.1 – Overview of Bonus components and bonus criteria (Source: Own creation)


6. Compensation


It is however difficult to construct a perfect bonus plan that perfectly aligns the agent behaviour with the

principal’s interests. It is therefore highly relevant for the remuneration board to consider the trade-offs

that exists between the different characteristics. In the following sections the overall characteristics will be

described, and finally an analysis of the most important trade-offs will be conducted.

In following sections each criteria will be discussed briefly in relation why they are relevant when designing

a bonus contract. This discussion is one of the tools that will be used in the analysis of the strengths and

weaknesses of specific accounting based performance measures, this analysis will take place in section

6.2.1.

6.1.1 Congruence

The main focus of the bonus plan is to align the agent’s interests with the principals, in order to maximize

the principal’s value (Petersen, C. V. 2011, Online access 09-09-13).

“For motivational purposes, congruence with the organization’s objectives may be the single most

important measurement quality” (Merchant 2006, 894)

As Merchant states congruence is the single most important criterion since it directly relates the agents

performance with the value created for the principal (Merchant 2006, 894-895). In this way it can be

argued that the congruence criterion set the bar for which level of quality that can be achieved. The

maximum level of congruence is kept if the other criteria are fulfilled to a high degree. For example is the

quality of a bonus contract dependent on all criteria. A bonus contract is of little use if one criterion is not

fulfilled at all. For example a bonus contract that includes a single performance measure which is perfectly

congruent but is beyond the control of the agent is a good example of a bonus contract of very low quality

although it was perfect congruent.

“What is the objective of profit-seeking organizations? Most people, at least those in developed countries,

have come to agree that the primary objective of these organizations is to maximize shareholder (or owner)

value” (Merchant 2006, 895)

“200 years’ worth of work in economics and finance indicate that social welfare is maximized when all firms

in an economy attempt to maximize their own total firm value” (Jensen 2010, 34)

As both merchant and Jensen describes it, congruency in the context of a bonus contract is therefore

directly related maximizing shareholder value. A congruent measure will therefore ensure that

management is rewarded when value is created however management should also be punished when

value is destroyed.


6. Compensation


In this aspect it also important to mention that incongruent measure may provide management with

incentives to destroy value. In this case the other criteria are of little use (Merchant 2006, 895).

It is relevant that the reward is aligned with the value that the agent creates for the principal (Kaplan, &

Atkinson 1998, 673-674). This limits the agents’ rewards size so that it can never be higher than the actual

value that is created for the principal (Petersen, C. V. (2011), Online access 09-09-13). It is also important

that the bonus plan is aligned with the overall corporate strategy of the firm this aspect will be discussed

further in the next section (controllability).

Firms that are not listed on a stock exchange have a challenge with estimating the value created during a

financial year. When making this estimation it is important that this is done in order to ensure a reliable

and accurate signal of value creating. In order to assess the firm value annually, the firm has to have

knowledge of the real present value of all future cash flows. This includes forecasting, timing and

estimating risks for each cash flow which is a time consuming and difficult task, but also has the risk of

being affected by (Petersen, C. V. (2011), Online access 09-09-13):

- Difficulties in estimating cash flows

- Biased accounting based performance metrics (biased recognition of: Earnings, investments, risks)

- Biased by manipulation of the agent

- Distorting accounting policies

In theory this sounds manageable but in reality it is often a more complex operation to achieve unbiased

accounting. For instance accounting regulations may exist and can cause biased accounting, as well as the

agent may have incentive to act against the interest of the principal (Petersen, C. V. (2011), Online access

09-09-13). Some examples might be the difference in how the inventory is being valued, for example fifo

versus average costs. Management can decide to change the accounting policies in order to improve their

reported performance while their unbiased performance remains the same. If bonus are calculated

annually (which most often is the case) in a year with a high risk of bad performance the agent has

incentives to make large write-offs on assets, in order to make it easier to reach next year target. In years

where the agents have a high chance of good performance, the agent might be reluctant to conduct the

necessary investments if they affect the performance measures negatively. This is usually referred to as the

horizon problem (Zimmarman 2011, 140).


6. Compensation


6.1.2 Controllability

The controllability criterion describes to what degree the agent is able to affect the performance measures

that are part of the bonus plan. It is therefore important to consider the performance measures of the

bonus contract and ensure their controllability, hereby only rewarding agent behaviour that is actually

linked with creating value for the shareholders(Petersen, C. V. (2011), Online access 09-09-13).

Merchant (2006) uses the term precision as to what degree the performance measure reflects the agent’s

performance behaviour, and thereby only to a minor extent is affected by externalities (Merchant 2006,

896-897). A good performance measure or standard is characterized by having a high degree of

“informativeness” as defined by Holmstrom (1979) (Murphy 2001, 249).

According to Merchant (2006) a performance measure provides no incentive if the management are not

able to influence the measure in a considerable way (Merchant 2006, 895-896).

Seen from a remuneration board view, the issue is to choose which kinds of events the agent should be

held responsible for. An example for a straight forward performance might be EBIT, which to a large extent

is controllable by the CEO. These kinds of performance measures are quite used in bonus contracts since

they are both highly controllable and congruent with principal value creation. Normally the controllability

criterion would exclude events like terror, earthquakes, change in interest rate etc. since the agent is

unlikely to have control over such events. However it can be relevant that the agent is held responsible for

minimizing the risk and impact that such events might incur and thereby limiting the negative influence on

the principals’ value creation caused by such external factors (Petersen, C. V. (2011), Online access 09-09-

13). This ensures that the agent not solely focuses on generating a high EBIT, but also ensures that

insurance policies etc. are kept up-to-date in order to minimize the impact of externalities (Zimmerman

2011, 183).

There exist certain issues that are relevant for the remuneration board to review and evaluate their

potential risk. The controllability criterion raises the following issues that will be further describe and

analysed throughout the thesis (Petersen, C. V. (2011), Online access 09-09-13):

- Which performance measures are controllable by the agent and to what degree?

- How is it decided which performance measures are controllable?

- Trade-off between controllability and simplicity

o By factoring (according to the degree of their controllability) in all possible performance

measures that fully reflects principal value creation, would in most cases result in a highly

complex bonus contract and thereby offsets the simplicity criteria.


6. Compensation


6.1.2.1 Uncontrollable risk

In this context risk refers to the affect that factors has, on management’s performance measure, factors

that management cannot control. These externalities distort the performance measure in either a positive

or negative way. The performance measure is therefore not a perfect reflection of the actual performance

of the management (Lazear & Gibbs 2009, 239-240).

“Accounting texts often say that a performance measure should include whatever is controllable by the

employee”. (Lazear & Gibbs 2009, 239)

The traditional definition of risk is the variation in performance that is not controllable by the agent. Simple

agency theory support the idea: a performance measure that expose the agent to risk due to

uncontrollable factors with respect to his or her compensation will be more costly for the principal

compared with a measure that do not expose the agent to risk (due to the risk premium).

Figure 6.2 – Factors influencing noise and risk in a bonus contract (Source: Own creation)

6.1.2.2 Incongruence in risk-profile

In addition to earnings management, non-linearity also affects risk-taking behaviour, in particular when the

pay-performance relation is concave. In this case lower performance is penalized more than higher

performance is penalized. Conversely, convex pay-performance relations increase risk-taking incentives.

Financial economists have suggested that boards purposely add convexity to CEO pay contracts to offset

the reluctance of risk-averse CEOs to invest in risky (but profitable) projects. More recently, academics have

alleged that convexities in banking bonuses (where positive performance is rewarded, but negative

performance is not penalized) led to excessive risk-taking that, in turn, facilitated the 2008–2009 financial

crisis. (Murphy 2013, 243)

6.1.3 Simplicity

Simplicity favours performance measures that to a high degree are easy for the principal to communicate,

easy to manage as well as easy to understand for the agent (Petersen, C. V. (2011), Online access 09-09-13).

Merchant defines this criterion as “understanability” which consists of two aspects. The first aspects relates

to Petersen’s concept where the agent needs to understand the measure. The second aspect is that the

agent needs to know how the agent can be influence the measure (Merchant 2006, 897). The Simplicity


6. Compensation


criterion also relates to the amount of performance measures. Keeping a bonus contract simple can have

the benefit of focussing the agent’s efforts on a relatively low number of performance measures, as well as

minimizing the agent’s incentive to manipulate with the performance measure. However a too simple

bonus contract might only capture a small part of the factors that increase shareholder value, causing a

misalignment between the agent and the principal and resulting in a less congruent bonus contract

(Petersen, C. V. (2011), Online access 09-09-13).

6.1.4 Timeliness

“Timely feedback and reward provide greater short-term performance pressure and stronger motivational

reinforcement.” (Merchant 2006, 896)

Merchant uses the timeliness criterion to describe the amount of time between the performed actions and

the measurement/ feedback. Timely feedback is important in order to ensure that the agent is able to link

the action to the reward. If there exists a significant lag between actions and reward then there is a risk

that the motivational incentive is lost (Merchant 2006, 896). Merchant mentions that if the performance

period is longer than the expected tenure of management then it will provide little incentive. As such the

timeliness criterion facilitates a short lag between actions and reward. However value creation is long-term

which make cause timely feedback to induce the horizon problem. The following model shows the feedback

process:

Figure 6.3 - Overview of feedback process (Merchant 2006, 897)

6.1.5 Objectivity

The objectivity concept is one of two concepts that together forms the accuracy term used by Merchant

(Merchant 2006, 896-897). Objectivity is described by Merchant as “freedom from bias”. This means that

the agent should not be able to manipulate the performance measure or influence the setting of the target.

As such performance measures, standards and structures should be verified by independent persons

(Merchant 2006, 896-897).

6.1.6 Measurement Cost - effective to design/produce

This is a quite straight forward criterion. When developing a bonus contract some performance measures,

standards and targets might already be used and are therefore very inexpensive to use in a bonus contract.


6. Compensation


Others like EVA or the performance of a peer-group can be quite expensive to develop (Merchant 2006,

896-897). These will be discussed in the relevant sections concerning either performance measure or

performance standards. The main point concerning this criterion is that the specific firm value created

related to the bonus contract has to be higher or at least the cost of the bonus contract including bonus pay

(Merchant 2006, 897).

6.1.7 Accounting issues

Accounting numbers reflects a wide range of information, and when used for a specific purpose it might be

necessary to eliminate noise that some information might cause. The purpose of accounting numbers when

used in a bonus contract is to provide information on the value that has been created within a specific

period. This information is used to evaluate the performance of the management, since management is

paid on their ability to generate shareholder value. According to Petersen (2011) there exist three areas

that may lead to accounting noise which are: 1. Change in accounting principles. 2. Change in accounting

estimates. 3. Transitory items (Petersen, C. V. (2011), Online access 09-09-13).

Accounting policy and accounting estimates share the some of the same characteristics. For instance it is

possible that the choice of accounting principles as well as accounting estimates affect the performance

measure. Petersen (2011) mentions the effect caused by either recognising revenue according production

criterion or to the invoicing date (Petersen, C. V. (2011), Online access 09-09-13). This leads to different

performance levels although the actual performance in the period is the same. As such management can

decide to change accounting principles and thereby achieve a higher level of earnings. However a change in

accounting principles can also result in a rise in quality of the bonus contract. Petersen (2011) states that it

is relevant for the remuneration board to assess whether the specific change will improve one of the prior

mentioned criteria as well as consider whether the change are value creating and whether management

should be rewarded (Petersen, C. V. (2011), Online access 09-09-13). Furthermore it is also relevant for the

remuneration board to assess whether it is necessary to recalibrate the bonus contract (Petersen, C. V.

(2011), Online access 09-09-13).

Transitory items are special items such as restructuring costs that only rarely occur. Petersen (2011)

mentions the importance of analysing the affect these items have (Petersen, C. V. (2011), Online access 09-

09-13). This is done in order to assess whether or not they should be included in the performance measure,

and if so what amount to be recognised. Petersen (2011) provides two examples that make this distinction:

1. Including the value created (value estimated by the board not the actual sales value) due to the sale of a

poor performing division. 2. Excluding the negative effect that restructuring cost has on the current

period’s performance measure (Petersen, C. V. (2011), Online access 09-09-13). These corrections are


6. Compensation


important in order to ensure the congruence criterion. The first example shows that sales value is not

always equal to the shareholder value generated. The second example deals with the horizon-problem,

which exists when an investments positive NPV is not realized within the period that the performance

measure is recorded. This excludes the negative effect that the restructuring cost would have had on the

performance measure in the current period. However management will benefit from the effect the positive

NPV will have on the performance measure in future periods. The issue, as Petersen (2011) states, is who

decide whether an item is transitory, and when it is decided. One approach is to categorise future items

prior to their existence, however it seems unlikely to be possible to imagine and categorise all of these.

Another approach is to make the distinction for every item (Petersen, C. V. (2011), Online access 09-09-13).

Petersen (2011) states that this procedure is bureaucratic and might offset the simplicity criterion

(Petersen, C. V. (2011), Online access 09-09-13). This reveals that both approaches have their own

strengths and weaknesses.

These criteria and the focus on limiting accounting noise are all relevant factors that are useful for

remuneration boards to have in mind when developing bonus contracts. A bonus contract of high quality is

the one that aligns management’s interest with the interest of the shareholders. The mentioned criteria is

useful to assess to what extent these are fulfilled and thereby determine the quality of the bonus contract.

In the next sections the components of bonus contract will be discussed and their strengths and

weaknesses will be analysed.

6.2 Bonus plan components

As mentioned a one-fits-all bonus model does not exist since most of the problems each company faces are

unique. However the prior mentioned criteria are relevant to when developing a bonus contract. Even

though companies are different they still share elements that can be generalised. As such the congruence

criterion is relevant for all companies of all industries. The following sections can benefit remunerations

committees both as to identify potential pitfalls with existing bonus contracts but also as guidelines when

developing new bonus contracts. Murphy (2001) separates the components of a bonus contract into three

categories: 1. performance measures. 2. Performance standards. 3. Performance structure (Murphy 2001,

250). Petersen (2011) summarizes the main points of these three categories in three separate questions; 1.

What is the most appropriate performance measure? 2. What is an appropriate performance level? 3. How


6. Compensation


should the bonus pay be related to actual performance? (Petersen, C. V. 2011, Online access 09-09-13)

These questions will be further discussed in the following sections.

6.2.1 Performance measures

As mentioned in the section concerning agent theory, the main focus is to ensure the alignment of the

management with the interests of the owners. Performance measures are the means to ensure this

alignment (Zakaria, I. 2012, 191).

Figure 6.4 - Types of performance measures (Source: Own creation)

Sloan (1993) recommends the use of accounting based measures in executive bonus contracts since these

measures are less affected by market noise (Zakaria 2012, 191).

“What you measure is what you get” (Merchant 1006, 893)

It is crucial to select the right performance measures, since you get what you pay for (Merchant 1006, 893).

Choosing the right performance measures will encourage management to choose the decisions that they

are is in the interests of the owners. Performance measures can be divided into absolute and relative

measures. The absolute accounting based performance can vary from net sales to net earnings, whereas

some of the in-betweens like EBITDA or EBIT are some of the more common. The common relative

measures are ROIC, ROE, EVA but also benchmarks against industry, peer group or competitor (Petersen, C.

V. (2011), Online access 09-09-13).

The perfect performance measure reflects the value created in the same period. As such both absolute and

relative performance measures provide insight in last period’s performance. Shareholders have long-term

goals which relates to shareholder value added (SVA), a performance measure that is a multi-period

forecast. This difference in period length and whether it is an ex-post or ex-ante causes problems when a

comparison is made between these. Whether choosing the one or the other performance measure they all

have their strength and weaknesses, which has to be taken into consideration (Petersen, C. V. (2011),

Online access 09-09-13).

“The simple correlation between EVA or earnings and stock returns is a reasonably reliable guide to its value

as an incentive contracting tool.” (Garvey et al. 2000, 210)


6. Compensation


Studies conducted by Garvey et. al. (2000) shows that accounting based figures can be used as components

in incentive contracts (Garvey et al. 2000, 210-212). This view is also supported by other academics

according to Merchant (Merchant 2006, 895).

Single-period performance measures are mostly lag indicators (reflecting prior results) and measure the

value creation of short time intervals (see appendix 4 for an illustration of the difference between single-

and multi-period measures). Whereas the SVA measure is forward-looking and is based on future

discounted cash-flows throughout the entire lifetime of the company, thereby also taken growth and risks

into consideration, which makes it a theoretical superior performance measure compared to single-period

partial backward-looking performance measures such as EBIT, ROIC and EVA (Petersen, C. V. (2011), Online

access 09-09-13). Although SVA might be a superior performance measure it has several shortcomings

which in practice make it less useful. This is backed by empirical studies that shows that companies in

general has a much higher usage of single-period accounting based performance measures

Value creation takes place over multiple-periods, choosing a single-period performance measures provides

the management with incentives to focus on achieving short-term results. This phenomenon is called the

horizon-problem. The problem arises when a short-term project with lower NPV is chosen over a long-term

project with higher NPV, where the latter creates the highest shareholder value. This bias caused by the

short-term focus, can be reduced by increasing the length of the period that the performance is measured

over (Petersen, C. V. (2011), Online access 09-09-13).

“for example, cut research and development investments to boost short-term profits even at the expense of

the long-term” (Merchant 2006, 895)

This is an example of short-term focus where cut downs on R&D costs are assumed to lower the cost more

than revenue will decline, however it is likely that this result in greater destruction of value on the long-

term.

“A perfectly congruent performance measure will induce the first-best direction, but it will not be used to

induce the first-best intensity unless it is noiseless.” (Feltham, Xie, 1994, 447)

When discussing the choice of the optimal number of performance measures it is relevant to assess each

performance measures level of congruency. For example one single performance measure can get accepted

if it has a high congruency with value creation.

“Noisy performance measures create risk, and the agent must be compensated for that risk. The stronger

the incentives used, the larger the risk premium that must be paid. Hence, noise weakens the incentives that

are used. If the basic measure is perfectly congruent, then the primary role for additional performance


6. Compensation


measures is to reduce the risk that must be imposed on the agent. However, the use of non-congruent

performance measures would produce a second-best action that differs from the first-best action in both

direction and intensity.” (Feltham, Xie, 1994, 447)

According to Feltham and Xie (1994) it is recommended to use multiple performance measures in order to

limit risks. Furthermore multiple-performance measures have a higher likelihood of reflecting the

complexity of company’s goal (Feltham, Xie, 1994, 447). Multiple-performance measures are also assumed

to have a higher level of congruence, however by increasing the number of measures the complexity of the

bonus plan increases. A bonus plan with few measures has the advantages of easier evaluation of

management; as well at it is easier for the management to understand how to achieve a higher

performance evaluation (Petersen, C. V. (2011), Online access 09-09-13).

In the following section the strengths of accounting based performance measures will be discussed, after

that there will follow a more specific discussion of the strengths and weaknesses in regards of absolute and

relative performance measures. To assess the strengths of accounting based performance measures the

characteristics of an effective bonus plan presented in section 6.1 will be used as the base of the analyses.

Empirical studies have shown significant usages of accounting based performance measures, which could

be due to some of the strengths of accounting figures (Murphy 2001, 250) (Banghøj 2006, 123-125). First of

all these figures are already generated and easily communicated and widely understood throughout the

company, this fulfils the simplicity criterion. Furthermore these accounting measures are subject to both

internal as well as external audit which to a wide extent fulfils the controllability criterion, as in the

shareholders ability to assess the performance of the management. Within the firm management has the

highest degree of influence on how net earnings are generated, this fulfils the controllability from the

management point of view. Using net earnings as a performance measure will provide the management

with incentives to achieve an increase in this measure. Achieving value creation is dependent on future

cash flows, thereby fulfilling the congruence criterion.

The following sections will go deeper into detail with the strength and weaknesses of the more common

performance measures within both the absolute (revenue, EBIT, net earnings) as well as the relative

performance measures (ROIC, EVA).


6. Compensation


6.2.1.1 Absolute

As well as the strengths just mentioned absolute measures also has some weaknesses that is relevant to

assess before these measures are used.

Overall absolute measures have the following four limitations, which will be explained in more depth in

later examples (Petersen, C. V. (2011), Online access 09-09-13):

1. Single-period vs. multiple-period value growth: Firm value is created throughout the whole

lifetime of its assets, whereas a single-periodic performance measure only presents the results of

the specific period.

2. Capital investments are ignored: There is not a match between the performance measure and the

cash flow achieved in the specific period, because investments in working capital and fixed assets

are not included. The performance measure does not contain the total cost and are therefore not a

congruent measure for value creation.

3. Risk is not taken into consideration: Net earnings can be generated of different projects with big

differences in risk profile due to operational and financial risk’s

4. Easy to manipulate: Manipulation of performance targets can be very easy due to management’s

excessive control of the firm.

These weaknesses question the quality of using these performance measures as objective evaluations of

management performance. In the following sections the most common performance measures i.e.

revenue, EBIT, net earnings and EPS will be introduced and their strengths and weaknesses will be

analysed.

The right performance measure is depending on the strategy of the company. For instance if a company is

entering a new market and the short-term focus of the strategy is to penetrate the market and achieve a

high market share, then revenue might be the optimal performance measure. The Performance measure

completely ignores how cost is recognized, the risk of projects initiated, or the amount of invested capital.

This provides the management with strong incentives to solely focus their energy on finding ways to

increase revenue. In this context it is relevant to mention that the long-term goal still is to generate cash-

flows and thereby generate shareholder value. This example with the specific strategy of entering a new

market shows that certain weaknesses of a performance measure can be ignored under specific conditions.

As the revenue measure only is influenced by sales, some might claim that in this case accounting policies

does not matter, however empirical studies have shown that up 40% of restatements is related to revenue

(Petersen, C. V. (2011), Online access 09-09-13). Given these results it is relevant under which


6. Compensation


circumstances restatements may affect revenue and whether these corrections also should be included

when calculating the performance measure. One examples of this is:

“… if managers are held accountable only for increased sales, they might increase sales in some value-

destroying ways, such as by extending the payment terms beyond what is profitable, by selling to customers

with questionable credit” (Merchant 2006, 895)

The revenue performance measure’s fulfilment of bonus criteria can be summarized as:

Figure 6.5 - Overview of revenue absolute performance measure’s fulfilment of bonus criteria (Source: Own creation)

Another used performance measure is EBIT. This performance measure depicts the performance of the

core business however other costs, like tax and finance, are not included. In order to minimize

manipulation of the EBIT performance it is relevant to discuss how different issues could affect EBIT

(Petersen, C. V. (2011), Online access 09-09-13). For instance; if management want to change the

accounting policy, if changes are made to accounting estimations, should transitory items affect the

measure and expenses such as R&D should they be capitalized or expensed? The latter issue is especially

relevant for R&D heavy firm such as pharmaceutical companies, where continuous development of new

products is required to ensure future cash-flows. One of EBIT’s most significant weaknesses is that it only

partially includes the cost of investments such as amortization and depreciation. For instance it is possible

to achieve a growth in EBIT and at the same time destroying firm value. A way to achieve a higher EBIT can

be to increase the amount of debt and/or invested capital, and invest this extra capital in assets that has a

return that is lower than their cost of capital.


6. Compensation


The EBIT performance measure’s fulfilment of bonus criteria can be summarized as:

Figure 6.6 - Overview of EBIT absolute performance measure’s fulfilment of bonus criteria (Source: Own creation)

In relation to revenue and EBIT the net earnings performance measures has the strength that it consists of

all revenues and costs. Net earnings has the same weaknesses as mentioned in the prior section concerning

EBIT and has specific issues that relates to tax and capital structure (Petersen, C. V. (2011), Online access

09-09-13). In regards of capital structure, net earnings can be increased solely by issuing new stock and

lowering the interest bearing debt. This is achieved since debt interest is recognized in the income

statement whereas the cost of capital to stockholders is not. The tax issue relates to changes in company

tax rate which the management is believed to have no influence on, this does not fulfil the controllability

criterion. In relation to both issues it is relevant to assess whether or not these changes should affect the

bonus pay, and if not how should the bonus contract be designed, while still fulfilling the other criterions

such as congruence, controllable, simplicity and cost-benefit balance.

Murphy (2001) mentions that the ratchet effect might cause problems:

“… division managers at the H.J. Heinz Company received bonuses only if earnings increased from prior year.

The results were predictable and, ultimately, illegal: managers delivered consistent earnings growth by

manipulating the timing of shipments to customers and by fraudulently preparing for services not yet

received”. (Murphy 2001, 273-274)


6. Compensation


The Net earnings performance measure’s fulfilment of bonus criteria can be summarized as:

Figure 6.7 - Overview of net earnings absolute performance measure’s fulfilment of bonus criteria (Source: Own creation)

EPS is another well-known performance measure. An increase in EPS will normally be in the interest of the

shareholders. This ought to be due to a higher increase in earnings than in the number of shares

outstanding, thereby resulting in an increase in stock price (Petersen, C. V. (2011), Online access 09-09-

13)(Petersen 2011, online access). As with some of the other measures EPS has the weaknesses that it

depends on used accounting policies and it does not take risk, investments, time value of money and cost

of capital into consideration. As such EPS is improved as long as the return of the investment is higher than

the interest rate. The prior example was concerning improving the numerator in the ratio. The ratio can

also be improved by reducing the denominator i.e. shares outstanding. Management can achieve a

reduction of the denominator by initiating a share-buy-back program which is funded by increasing interest

bearing debt. The reason for this action might be the fear of a hostile takeover. In that regard it can be

discussed to extent this procedure is value creating. However there might not be a threat of a hostile

takeover which than suggest that management is manipulating the ratio.

As such EPS fulfilments of bonus criteria can be summarised as (see Figure 6.8 ):

Figure 6.8 - Overview of EPS performance measure’s fulfilment of bonus criteria (Source: Own creation)


6. Compensation


6.2.1.2 Relative

Relative performance measures have a higher correlation with value creation. Company value can be

calculated as the book value of current invested capital added the present value of future EVA’s. This shows

that EVA is directly to return and value creation, which fulfils the congruence criterion. ROIC and ROE also

belongs to some of the more common relative performance measures. Compared to the absolute measures

the relative measures also have the advantage that they are self-correcting. For instance if the depreciation

for an asset is extended, this will result in an increased EBIT, but at the same time invested capital will

increase (Petersen, C. V. (2011), Online access 09-09-13). The same is relevant for other accounting issues

that affects the income statement but also affects the balance sheet. The prior example shows how ROIC

has a higher correlation with value creation than the EBIT performance measure, which to a higher degree

fulfils the congruence criterion.

ROIC and ROE both have the strengths that they are relatively easy to understand as mentioned they take

invested capital into consideration which is not the case with the absolute performance measures

(Petersen, C. V. (2011), Online access 09-09-13) . However they do have the specific weakness that they do

not take cost of capital related risk into consideration. ROIC and ROE need to be analysed in comparison to

the WACC in order to determine whether value have been generated or destroyed in the specific period,

which is almost the same as the EVA measure. Another issue is that ROIC and ROE are based on book-

values whereas investors are interested in a return measured at market-value (Petersen, C. V. (2011),

Online access 09-09-13).

ROIC and ROE are also affected by accounting noise that require corrections. Another issue is that for

example the ROIC measure may prevent the management from initiating a project that has a positive NPV

because it will reduce the ROIC performance measures thereby reducing the bonus that will be paid. An

example is where the WACC is 10% the initial ROIC is 15%, the project about to be launched has a ROIC of

12%. If the project is initiated, the overall ROIC will change to 14% and thereby punishing the executive for

making a good decision. Appendix 5 is an example of this situation. (Petersen, C. V. (2011), Online access

09-09-13).


6. Compensation


The ROIC/ ROE performance measure’s fulfilment of bonus criteria can be summarized as:

Figure 6.9 - Overview of ROIC/ ROE performance measure’s fulfilment of bonus criteria (Source: Own creation)

Compared to ROIC the EVA measure also takes cost of equity into consideration. This makes it a more

congruent performance measure since both risk, cost of capital is considered. The strengths of the EVA

measures can according to Petersen (2011) be summarized as, having a high degree of congruency with

value creation, cost of capital is included and is visible to the management. Managers are more likely to

initiate projects which return is higher than the cost of capital (Petersen, C. V. (2011), Online access 09-09-

13). It is objective and measurable ex-post and can be used on company as well as divisional levels. Finally

the EVA performance measure is a rather simple performance measure and is easy to communicate.

EVA can be used to measure company value. Company value equals invested capital and adding the present

value of future EVA’s. EVA is directly related to value creation, and thus fulfils the congruence criterion

(Petersen, C. V. (2011), Online access 09-09-13). In practice the EVA performance measure does have some

weaknesses, for instance is EVA a historical measure and does not reflect future cash flows. There for it is

required to forecast future EVA’s in order to calculate its present value. These forecasts are based on

management’s subjective estimation, and are subject to manipulation. EVA is furthermore affected by

accounting noise. In order for EVA to become as objective and congruent as described in theory, it may be

necessary to make over 150 corrections before EVA can be calculated (Petersen, C. V. (2011), Online access

09-09-13).

However these corrections are only necessary when using the absolute EVA performance measure. If

instead change in EVA is used as the performance measure, then the management is rewarded on actual

performance and not affected by accounting noise (Petersen, C. V. (2011), Online access 09-09-13). For

instance if conservative accounting is applied then this will have a significant effect on the actual level of

EVA. In regards of the change in EVA performance measure this effect will be neutralized since both the


6. Compensation


actual and prior EVA measure will include the change caused by the conservative accounting. As the other

accounting based measures EVA also suffer the weakness of being a single-period measure, this again

relates to the issues of R&D investments as well as restructuring costs both will affect the current years EVA

negatively. This negative effect can be minimized by capitalizing the expenses. However this does not

remove the effect. Furthermore studies conducted by Biddle et Al. (1996) have shown that EVA is not

better at explaining the change in stock price than net earnings (Biddle et Al. 1996, 301).

Another problem related to the single-period relative performance measures is that it is not certain that

return on investment is evenly distributed over the lifetime of the investment (Petersen, C. V. (2011),

Online access 09-09-13). As such it is highly likely that for some years the investments might have a

negative return and other periods have a significantly higher positive return. This problem can be dealt with

by valuing each investment present value of its future cash flows. Although this possibility exists it is based

on a significant amount of uncertainty and manipulation can easily exist due to optimistic management

estimates (Petersen, C. V. (2011), Online access 09-09-13).

The EVA performance measure’s fulfilment of bonus criteria can be summarized as:

Figure 6.10 - Overview EVA performance measure’s fulfilment of bonus criteria (Source: Own creation)

6.2.2 Performance Standards

Murphy (2001) mentions that performance measures ought to have a benchmark, since a specific level of

EBIT or ROIC is not a true indicator of whether or not value has been created either in the short or long run

(Murphy 2001, 246). A performance measure therefore needs a performance standard in order to be

useful.


6. Compensation


“Targets are set at a level that best maximises their motivation potential to elicit the best performance from

the executives.” (Zakaria 2012, 191)

According to Zakaria a high motivation equals a good performance. Setting the standard is highly

subjective. Merchant and Manzoni (1989) defines that a well set standard is “Tight, but achievable”

(Merchant and Manzoni 1989, 539). The level of the standard might also influence the firm in other ways

which has to be taken into consideration. Zakaria mentions that overoptimistic standards might lead to

over-consumption of resources, which may lead to value destruction (Zakaria 2012, 191-192). This might be

the case if the standard is a budget that is also used for resource planning.

Standards are expected performance and can either be prior year performance or can be a comparison

with the performance of a peer-group (Petersen, C. V. (2011), Online access 09-09-13). Murphy (2001)

categorised these standards according to their degree of agent being able to influence the standard. As

such these standards are categorised as either internal (easy to influence) or external standards (hard to

influence)(Murphy 2001, 249). The strength and weaknesses of these two types of standards will be

discussed in the following sections.

6.2.2.1 Internal performance standards

Specific for internal standards is that they are directly related to the management’s performance in the

current or prior years. According to Murphy (2001) the internal standards can be divided into five groups; 1.

Budget standards, performance are measured against expected results. 2. Prior period’s performance,

where the bonus is related to an increase in for example EBIT compared to last period’s performance.

3. Realised earnings compared with cost of capital. This could for example be to compare ROIC with the

WACC. 4. Discretionary standards. These standards are subjective standards where the board might use

prior year’s performance and then assess whether the standard should be higher or lower. 5. Timeless

standards. The timeless standards are given in advance, for instance it could be that the return standard

are set to increase 0,2 % yearly. In the following sections each standards strengths and weaknesses will be

discussed (Murphy 2001, 252).

Before going into detail with specific standards is relevant to keep in mind that internal standards may

include bias i.e. standards may be manipulated by the management. The degree of manipulation is

determined by the standard setting process. Management’s influence on the standard can either be direct

i.e. management is often included in the budget setting process) or less direct for example if the standard is

based on last year’s performance (Murphy 2001, 259-260).


6. Compensation


Budget standards are well used and have the positive side that they can be used with well-known measures

such as revenue and EBIT, which are easy for the management to understand and relate to (Murphy 2001,

252). However since the budget standard is a static measure it is vulnerable to externalities, this might be

unforeseen cyclical changes or industry specific changes, which either makes it too easy or hard for the

management to achieve the standard (Petersen, C. V. (2011), Online access 09-09-13). As mentioned

earlier, externalities are determined as outside factors that management cannot control, these factors

offset the controllable criterion. It is a normal procedure that budget standards are developed by

management and approved by the board. In this situation where adverse selection are based on

management’s higher knowledge, it is likely that they will set conservative standards, given that

shareholders/ the board are not capable of assessing that management does so (Murphy 2001, 274).

Another issue is that if management realizes that it is impossible to reach the budget standard they are

likely to make use of earnings management. This is relevant if next year’s budget standard is likely to be

based on this year’s bad performance and therefore will be more achievable (Murphy 2001, 259-260). This

also relates to the opposite situation where management knows that one year’s extraordinary high result

may cause next year’s standard to be so much higher. In this case management may postpone investments

to future periods if they are assumed to carry a positive result within the specific period. Management also

has the possibility to make larger write-offs on existing assets, thereby lowering the result of the current

periods and decreasing future costs since these are realized in the current year and will therefore not affect

the next years result. This behaviour is also called “big bath accounting”. This example only relates to

performance measures such as EBIT or net earnings that include these costs. The net revenue performance

measure is however not affected by this action. These manipulation opportunities might be an explanation

of why the development of budget standards can be a tedious process (Petersen, C. V. (2011), Online

access 09-09-13).

The budget performance standard’s fulfilment of bonus criteria can be summarized as:

Figure 6.11 - Overview of budget performance standard’s fulfilment of bonus criteria (Source: Own creation)


6. Compensation


The following model shows the fulfilment of the criteria when absolute performance measure is combined

with the budget standard. Note that the choice of performance structure is left out in order to focus on the

effect of applying the performance standard.

Figure 6.12 - Overview of absolute performance measure combined with budget standard and the fulfilment of bonus criteria (Source: Own creation)

Compared to budget standards, the result of prior periods has the advantage that they already exit thereby

does not have to be developed and are not subject to bureaucratic processes as just mentioned in the prior

section. However the performance standard shares several of the same weaknesses. First of all it is also a

static measure making it vulnerable to externalities. A problem with this standard is that it introduces the

ratchet effect i.e. If prior year’s performance is kept as a fixed target until it is achieved then the current

year’s performance will be next year’s standard (Murphy 2001, 259-260). Due to the ratchet effect there

exists a risk that management will make use of earnings management since the current period will be used

as benchmark for the next period. If the management realizes that they cannot achieve a higher level than

last period, thereby not realizing a bonus, they may be inclined to make use of “big bath accounting”.

Applying a cost-benefit-analysis then prior period’s has an advantage compared to the more tedious and

costly process of developing budget standards (Petersen, C. V. (2011), Online access 09-09-13)(Petersen

2011, online access). Another weakness is that managers may act in way that boost revenue but at worst

might be value destroying. The Heinz company example can be used to show the value destruction:

“… division managers at the H.J. Heinz Company received bonuses only if earnings increased from prior year.

The results were predictable and, ultimately, illegal: managers delivered consistent earnings growth by

manipulating the timing of shipments to customers and by fraudulently preparing for services not yet

received”. (Murphy 2001, 273-274).


6. Compensation


The prior year’s result performance standard’s fulfilment of bonus criteria can be summarized as:

Figure 6.13 - Overview of prior year's result performance standard’s fulfilment of bonus criteria (Source: Own creation)

The following model shows the fulfilment of the criteria when net earnings is combined with prior year’s

result. Note that the choice of performance structure is left out in order to focus on the effect of applying

the performance standard.

Figure 6.14 - Overview of absolute performance measure combined with budget standard and the fulfilment of bonus criteria

(Source: Own creation)

The third kind of standard is the one that compare net earnings with cost of capital (Murphy 2001, 252).

This standard has the strength that it is directly related with value creation which fulfils the congruence

criterion. This is in practice done by either comparing ROIC with the WACC or by comparing ROE with the

investors required return. If ROIC is higher than the WACC then value is created, if this is the case then ROE

will also be higher than the required return of the investors. This comparison between ROIC and the WACC

is the same calculation that EVA is based on. The third standard therefore shares the same strengths and

weaknesses as mentioned in the prior section concerning the EVA measure (see section 6.2.1.2). However

since the investors required return is not known it has to be calculated. These calculation are based on


6. Compensation


subjective estimations. This uncertainty is uncontrollable by the management which in theory will then

require a risk-premium since the performance measure and standard are not completely controllable

(Petersen, C. V. (2011), Online access 09-09-13)

The realised earnings compared with cost of capital performance standard’s fulfilment of bonus criteria can

be summarized as:

Figure 6.15 - Overview of realised earnings compared with cost of capital performance standard’s fulfilment of bonus criteria (Source: Own creation)

The following model shows the fulfilment of the criteria when an absolute performance measure is

combined with prior realised earnings compared with cost of capital. Note that the choice of performance

structure is left out in order to focus on the effect of applying the performance standard.

Figure 6.16 - Overview of absolute performance measure combined with realised earnings compared with cost of capital standard and the fulfilment of bonus criteria (Source: Own creation)

Discretionary standards have the strength that they are flexible and can be changed according to for

example changes in strategy due to change in industry or cyclical factors (Murphy 2001, 252). The flexibility

can however also be a weakness which makes it less clear for the management on what parameters they


6. Compensation


are evaluated. Furthermore the a discretionary standard are subjective and are therefore subject to

management trying to influence the board in their process of setting/correcting standards (Petersen, C. V.

(2011), Online access 09-09-13)(Petersen 2011, online access).

Example of subjective evaluation:

The Management Board's remuneration … Cash incentive opportunity … The size of the annual cash

incentive payout will be decided by the Board of Director's Remuneration Committee based on the

achievement against the above-mentioned measures ... constitute an amount corresponding to maximum

50% of the fixed annual fee. (A.P. Møller – Maersk 2013, http://investor.maersk.com/guidelines.cfm)

The choice between objective and subjective evaluation of a performance depends on whether the

measure of performance is best determined by qualitative assessment (subjective) or can be quantified

(objective) (Lazear & Gibbs 2009, 238-239). The objective evaluation is based on a predetermined method

and can supposedly be verified by a third party. Subjective evaluation is on the other hand based on an

individual or a group’s subjective assessment (Lazear & Gibbs 2009, 247-248). Objective evaluation is an ex

ante measure. Management will know how performance is being evaluated prior to the performance

period. In contrast subjective evaluation is evaluated ex post (Hansen 2012, 24). Both forms of evaluations

have their own strengths and weaknesses that depend on the specific situation.

As discretionary standards are set subjectively this provides management with incentive to influence the

board’s subjective process of setting the standard. Prendergast (1999) mentions the following concept as

potential pitfalls when using subjective evaluation “Reneging” – principal avoid what is promised, Personal

bias - Favoritism Leniency bias – reluctance to give poor ratings Hindsight bias – more knowledge at a later

given time Competence bias – principal keeps promoting bias to hide own incompetence (Prendergast

1999, 9-10). This concept will only serve the purpose of providing examples of pitfalls and bias that might

be created when using discretionary evaluation. They will therefore not be explained to a deeper extent.

http://investor.maersk.com/guidelines.cfm


6. Compensation


The discretionary performance standard’s fulfilment of bonus criteria can be summarized as:

Figure 6.17 - Overview of the discretionary performance standard’s fulfilment of bonus criteria (Source: Own creation)

The timeless standard is a fixed standard that is not corrected at a specific time. This standard is based on

one of the prior mentioned standards (Murphy 2001, 252). The strength of this standard is that it limits

management trying to influence the standard. The weakness however is also that this standard does

change according to internal and external factors such as changes in capital structure, company risk profile

or cyclical changes (Petersen, C. V. (2011), Online access 09-09-13).

The timeless performance standard’s fulfilment of bonus criteria can be summarized as:

Figure 6.18 - Overview of the timeless performance standard’s fulfilment of bonus criteria (Source: Own creation)


6. Compensation


6.2.2.2 External performance standards

External standards are benchmark standards that compare company measures with the same measures

among competitors or a chosen peer-group. External standards have the strength of limiting externalities

affecting the performance measure. Management has a positive performance when the company achieves

a better performance than their benchmark, thereby minimizing the externalities that affect the industry or

market as a whole. This minimization of externalities increases the control criterion since it limits

externalities that are considered uncontrollable by management. As opposed to internal standards

management has limited or no influence on external standards such as a peer-group.

A company has the opportunity to compare their own performance measures with competitors or their

industry peer-group. This comparison minimizes externalities such as cyclical events such as a recession,

since it is expected that this will affect the industry more or less equally (Petersen, C. V. (2011), Online

access 09-09-13). By benchmarking against competitors it is possible to determine if the company have

performed better than its peer-group, which the management should be rewarded for even though the

company have experienced a bad year (bad performance). A peer-group also reduces the effect of other

macro and industry externalities such as change in tax rate, industry risk factor which reduces the need for

making calibrations to the bonus plan. However a peer-group comparison might require that corrections

are made so that the accounting policies and risk profile are the same among the peers, which fulfils the

comparison criterion (Petersen, C. V. (2011), Online access 09-09-13). If the corrections that have to be

made in order to ensure the comparison are extensive then this might have the result of degrading the

simplicity criterion. In that case there will be a trade-off between the comparison and the simplicity

criterion.

According to Murphy (2001) this limits bias and thereby manipulation of the standard as well as the

measure. His study has shown no use of earnings management (Murphy 2001, 269). His findings also show

that the incentive zone of the bonus structure is broader and more linear than the ones using internal

performance standards, as well as they are less likely to be capped when external standards are used

(Murphy 2001, 269). The pay for performance structure will be discussed in section 6.2.3 - Structure of

bonus plan.

External benchmarks have several weaknesses that are relevant to discus. For instance a good external

peer-group consists of companies that are not under or over-performing compared to the desired

benchmark industry or market. This is a requirement for the performance standard to fulfil the congruence

criterion. In order to fulfil this criterion it is also necessary to make sure that all companies share the same;

risk profile, accounting principles and the exclusion of transitory items (Petersen, C. V. (2011), Online access


6. Compensation


09-09-13). This is not likely to be the case, and corrections have to be made so that the peer-group can be

used as a benchmark target. This may include a large amount of corrections, where some also might

require subjective estimates. When subjective estimates exist it is relevant to consider whether these can

be manipulated by management. These corrections are expected to lead to a higher degree of congruence,

but this may off-set the simplicity criterion as well as being a rather costly procedure that may require

revalidations from time to time, in order to assure benchmark quality (Murphy 2001, 255-256). As such

achieving one criterion is often is trade-off and reduces another criterion (Petersen, C. V. (2011), Online

access 09-09-13).

Studies conducted by Murphy (2001) shows that external standards (compared to internal standards) are

less subject to manipulation due to management making use of earnings management (Murphy 2001, 252-

254).

The peer-group performance standard’s fulfilment of bonus criteria can be summarized as:

Figure 6.19 - Overview of the peer-group performance standard’s fulfilment of bonus criteria (Source: Own creation)

Internal and external standards both have its significant strengths and weaknesses, and in general one

cannot be said to be superior. However some standards might be more desirable giving company specific

strategy, as well as the industry it operates within.

6.2.3 Structure of bonus plan

This section will cover the aspects of how performance measures are related to the bonus being paid to

management. Petersen (2011) mentions three pay for performance relations; linear, non-linearity and fixed

amount if target is met also called a lump-sum bonus (Petersen, C. V. (2011), Online access 09-09-13).

These three structures will be discussed in the following two sections.


6. Compensation


6.2.3.1 Linearity

Jensen (2003) states the linearity method as superior since the linear is limits the executive of gaming,

furthermore the linear pay for performance structure fulfils the congruence criterion since the more value

is created the more pay management will get (Jensen 2003, 379-380). Healy (1985) supports Jensen (2003)

and adds bonus plans with bounds creates predictable problems (Healy 1985, 106-107). However as there

is no limit to the amount of the bonus pay, this structure has several important pitfalls requirements. For

instance if externalities can affect the performance measure then management will be rewarded/ punished

due to factors that they are not able to control, this offsets the congruence and controllable criterions.

There also exist an issue with having no lower limit. In theory a bad performance should result in a negative

pay.

Jensen (2003) also states that it is relevant to maintain the negative linearity since using a cap provides

management with a reduced risk and thereby may lead to unwanted behaviour to their limited risk (Jensen,

2003, 389-390).

The following figure shows the linear pay for performance structure’s fulfilment of bonus criteria:

Figure 6.20 - Overview of the linear pay for performance structure in relation to bonus criteria (Source: Own creation)

6.2.3.2 Non-linearity

A way to minimize the no upper/lower limit problem is to make use of a cap and floor approach (see

appendix 6). The cap defines at which performance level no excess bonus will be paid and the floor defines

the minimum performance level required to achieve a bonus pay. The interval between the floor and cap

can have any form, as such both linearity and concave forms can be used (Petersen, C. V. (2011), Online

access 09-09-13). Jensen mentions that a bonus structure with “kinks” (for instance where the floor meets

a linear line and again when the line meets the cap), provides management with incentives to make use of


6. Compensation


earnings management (Jensen 2003, 385-386)(see appendix 7 for an graphical overview, and appendix 8-9

for an overview of the steps in the budgeting process and where bias is present according to Jensen).

Research conducted by Healy (1985) supports Jensen’s argument. The research reveals that bonus

structures that make use of cap and floor provide the management with an earnings management

incentive. (Healy 1985, 85-86). Murphy (2013) states that the problem with the cap is that, management

that has reached the maximum available bonus has an incentive either stop being productive or focus on

transferring this period’s results to the next period (Murphy 2013, 242-244).

The following figure shows the non-linear capped pay for performance structure’s fulfilment of bonus

criteria:

Figure 6.21 - Overview of non-linear pay for performance structure in relation to bonus criteria (Source: Own creation)

The lump sum bonus structure is a fixed amount that will be paid to management when a specific

performance target is met (see appendix 11). This structure shares the same strengths and weaknesses as

the non-linearity bonus structure (Petersen, C. V. (2011), Online access 09-09-13)(see appendix 10 for an

graphical presentation of the lump-sum bonus structure). Compared to the cap and floor it can be argued

that it fulfils the simplicity criterion to a higher degree. The lump-sum pay for performance structure is

similar to the non-linear with cap and floor structure (see Figure 6.21).

Each of the previous bonus structures is summarized in this table which shows to what degree they fulfil

each criterion and their strengths and weaknesses.

If the performance measures and standards are of high quality then this would point toward the linear

bonus structures since this will fulfil the congruence criterion to the highest degree. However if the

measures and standards are able to be manipulated and affected by externalities then the congruence

criterion will only be partly fulfilled (Petersen, C. V. (2011), Online access 09-09-13). The linear bonus


6. Compensation


structures will then bear a considerable risk of pay that is not directly related to management’s actual

performance. In the case of lower quality measures and standards it may be argued that it is preferable to

choose either the non-linearity or lump sum bonus structures, this due to the limit of bonus that will be

paid to management. It can be argued that this is more relevant when using internal standards than

external, since it is more likely that internal standards are subject to higher volatility and therefore could

result in a higher pay if the linearity bonus structures is used. This is based on the argument that EBIT

(performance measure) compared with prior year’s performance (internal standard) are subject to high

volatility as well as earnings management whereas the same measure within a peer-group has a lower

volatility due to the bigger size of the peer-group, where the increased numbers of “observations” reduces

the significance of random “misleading” observations, thereby being a better indicator of the true peer-

group performance (Hansen, A. 2012, 29)(Petersen, C. V. (2011), Online access 09-09-13).

Another aspect of aligning the management with the owners is the difference in risk-profile (Murphy 2013,

243-244). Owners are able to diversify their risk, whereas management is highly dependent on their job

performance. Owners are therefore considered less risk-averse than management. This may result in

problems where management might avoid risky investments although they are expected to be value

creating (positive EVA). However management’s personal risk-profile can be influenced by the structure of

the bonus plan (Murphy 2013, 243-244). Murphy (2013) mentions that the use of a concave incentive

curve, which punishes poor performance and rewards high performance (Murphy 2013, 243-244). Such a

bonus structure might affect management behaviour in becoming less risk-averse, resulting in a better

resemblance of the owners risk profile. The convex bonus structure may as such result in a more risk-averse

behaviour. Murphy mentions that this structure may be a good choice in risk-averse governmental

regulated institutions such as the banks (Murphy 2013, 243-244). In both cases it is important that bad

performance is punished. However applying a convex bonus structure and not punishing value destructive

performance may affect the management to be less risk-averse. Murphy (2013) mentions that this setup

facilitated the 2008-2009 financial crisis:

“More recently, some academics (as well as Congress and the popular press) have alleged that convexities

in banking bonuses (where positive performance is rewarded, but negative performance is not penalized)

led to excessive risk-taking that, in turn, facilitated the 2008–2009 financial crisis.” (Murphy 2013, 243)

To limit this behaviour no floor should exist in the bonus structure. This view on symmetry of up- and

downside performance-based bonus is shared by the OECD:

“There should be symmetry between the upside and downside performance-based compensation, although

in practice there are clear practical limits to this” (OECD 2010, 9)


6. Compensation


Value destructive performance may lead to a negative bonus. Petersen (2011) mentions that in practice it

is not likely that management will accept such terms. Petersen suggest the use of a bonus bank will reduce

this problem (Petersen, C. V. (2011), Online access 09-09-13). The use of a bonus bank that defers current

bonus and are used to fund negative bonuses are supported by Stewart (1991) as stated by Murphy (2013):

“The problems with non-linearities are mitigated by eliminating caps on the upside, and finding ways to

implement and enforce “negative” bonuses on the downside While it is difficult to force CEOs to write

checks back to the company after a bad year, negative bonuses can be partially implemented by basing pay

on multi-period cumulative performance (Holmstrom and Milgrom, 1987) or by deferring current

compensation into bonus banks that can be used to fund future negative bonuses (Stewart, 1991)”

(Murphy 2013, 244)

The choice of the Bonus bank set-up will be further discussed in section 6.2.4.

6.2.4 Bonus bank

“The variable component of the remuneration (the incentive pay scheme) should be based on actual

achievements over a period of time with a view to long-term value creation so as not to promote short-term

and risky behaviour.” (CORG – Committee on Corporate Governance 2013, 22)

The problem with negative bonuses can be solved by the use of a bonus bank. Petersen (2011) mentions

that a bonus bank increase management’s horizon making it more long-term (Petersen, C. V. (2011), Online

access 09-09-13).

“The basic idea is that bonuses are not being paid in full unless a satisfactory performance is obtained in

subsequent years” (Petersen, C. V. 2012, 323)

This view is supported by the Danish committee on Corporate Governance

“The variable component of the remuneration (the incentive pay scheme) should be based on actual

achievements over a period of time with a view to long-term value creation so as not to promote short-term

and risky behaviour.” (CORG – Committee on Corporate Governance 2013, 22)

As such bonuses are calculated each year, this provides management with knowledge of their performance.

However the actual paid bonus is calculated in a different way. Petersen (2012) uses an example where a

third of the accumulated bonus will be paid out each year. See appendix 11 for Petersen’s (2012) example.

Petersen (2012) states that a significant opening balance is required, this is to avoid the bank balance to

become negative due to a negative bonus in year one will. This initial cash can either be financed by the

manager or the firm (Petersen, C. V. 2012, 323-324).


6. Compensation


The problem with earnings management is reduced when punishment of bad performance is incorporated

into the bonus contract. This limits the horizon problem from year to year, however the horizon problem is

still relevant to consider when for example the CEO is about to leave the company. A way to deal with this

kind of horizon problem is to incorporate a clause that states that company performance will still affect the

bonus bank balance a period after the CEO has left the company. This set-up reflects to a higher degree the

long-term value creation of projects. However this may also offset the controllability criterion since the CEO

no longer has direct influence. Another issue is that the company performance is now influenced by a new

CEO, which can be seen as an internal externality.

According to Petersen (2012) the main strength of a bonus bank is that it increases the congruence and

thereby alignment of the interest of management and the owners (Petersen, C. V. 2012, 324). The increase

in congruence is explained by two factors:

1. A bonus bank ensures that deferred bonuses to a higher degree reflect long-term value creation.

2. A bonus bank supports the use of a linear pay for performance structure that rewards and punishes

performance equally.

One year’s bad performance will is expected to lead to a lower paid bonus see appendix 12, however

several years bad performance may lead to a negative bank balance. This situation provides the manager

with a certain incentive to leave the company, since he will only receive a bonus when the balance is

positive. If the prior bad performance is due to externalities then it is most likely that the owners/ board

want the manager to stay. Due to this situation it is normal to include discretionary exit clauses that

recalibrate the bonus bank balance (Petersen, C. V. 2012, 325). As prior mentioned the use of discretionary

performance evaluation may lead to several bias and provide the manager with incentive to influence this

discretionary decision (see 6.2.2.1 Internal performance standards).


7. Empirical findings


Chapter 3. Empirical Analysis

This chapter will analyse the use of accounting based performance measures, standards and pay for

performance structure. The next chapter will provide a comparison between empirical and theoretical

findings.

7 Empirical findings

7.1 Introduction

The empirical data consists of both primary and secondary data. The primary data includes annual reports

and information available on company websites and other relevant websites. This choice of primary data

collection method is used as it is the same information that will be available for the investor. The data will

be used to assess the quality of the information available as well as to assess the quality of bonus contracts.

This information of bonus contracts is assumed to be of the interest of the investor when evaluating

whether he is interested in investing in a firm or not. The secondary data will focus on a study conducted by

Banghøj (2001). His study focuses on compensation used in Danish companies. This thesis will focus on his

findings in regards to the use of accounting based performance measures, standards and structure among

58 Danish companies. The similarities and differences among the findings of the primary and secondary

data will be assessed in section 0. The empirical findings will furthermore be discussed in relation to the

theory in section 8.

7.2 Primary data: The quality of public available executive bonus information

The executive remuneration information is gathered from either annual reports or webpages. The 20

Danish companies included in the study are all registered on the Copenhagen Stock Exchange. These 20

companies are all part of C20 which is the most liquid and valuable firms in the CSE.

The 20 selected companies represent 11% of the total 180 companies registered on the CSE. These 180

listed firms will be used as a benchmark in order to assess to what degree the C20 company sample reflects

the population in regards of industry. This will influence the predictability of the findings presented in this

thesis. Out of the C20 companies 67% make use of financial information in their bonus contracts (see Table

7.1).

Participants in the study Sample Total Percentage %

Number of companies 20 180 11%

Makes use of accounting based remuneration 13 20 65%

Does not makes use of accounting based remuneration 7 20 35%

Table 7.1 – Sample size (Source: Own creation)




Most companies state that the uses of bonus contracts are developed in a way that ensures alignment of

the executives with the shareholders. See for example these excerpts from Lundbeck and TDC’s 2012

annual reports:

“We aim to provide talented individuals and key employees with a competitive remuneration. This

remuneration rewards the achievement of both short and long-term objectives in the interest of our

shareholders.” (Lundbeck annual report 2012, 54)

“TDC’s executive remuneration: … is closely linked to company performance and shareholder value creation.

The executive remuneration comprises a mix of base salary and incentive programmes that are measurable,

controllable, well defined and aligned with shareholder interests (TDC annual report 2012, 2013, 84).

The degree of remuneration information in the annual reports and company websites varies, but in general

it is fairly low which makes it a difficult task for the investor to assess the quality of the bonus contract. The

findings that support this argument will be presented in sections concerning each bonus component.

The C20 companies are not a perfect sample of the listed companies on the CSE (see Table 7.2). The sample

does include five of the 11 industries, and includes the top four industries that represent the largest

amount of companies.

Industry Sample Total

Consumer Goods 7% 9%

Consumer services 0% 12%

Financial 14% 34%

Health Care 50% 12%

Industrials 21% 21%

Telecommunications 7% 1%

Technology 0% 8%

Oil & Gas 0% 1%

Basic Materials 0% 2%

Materials 0% 1%

Utilities 0% 1%

Table 7.2 - Sample categorized by industry (Source: Own creation)

In the context of this thesis, the findings will be used to discuss the strengths and weaknesses related to the

specific components being used. The empirical findings will therefore not be used to state that these

findings are what characterises the all listed companies. As already mentioned the focus will be to develop

guidelines that can be used by the remuneration boards etc., and to identify relevant strengths and

weaknesses as well as pitfalls. There following sections will analyse the bonus components that the C20

companies make use of.





Table 7.3 is based on the 13 of the C20 companies that uses accounting measures in their bonus contract

(see Table 7.1). The table shows that eight companies disclose the type of financial performance measure

that is used in bonus contracts. These measures are presented in Table 7.5.

Specified/ unspecified financial performance measures Nr. of respondents Percentage %

Financial performance measure 8 62%

Not specified / unable to determine 5 38%

Table 7.3 - Specified/ unspecified financial performance measures (Source: Own creation)

Although the last five companies stated that they use financial measure in their bonus contract, the

specifics of the measures are not disclosed. Novozymes are one of these five companies that state the use

of financial targets:

Remuneration to Executive Management comprises a base salary, pension, a bonus scheme and stock-

based incentive programs … The variable part of the total remuneration (cash bonus and stock-based

programs) … is dependent on achievement of individual targets and the company’s targets for financial,

social and environmental results. (Novozymes annual report 2012, 74)

Novozymes provide the following statement as their reason to why they choose not to disclose

remuneration information:

Information on the remuneration of Executive Management is provided at an aggregate rather than an

individual level. Novozymes considers this information to be private and confidential, and believes that

information at an individual level is of limited value to shareholders and that the information provided is

adequate to evaluate the compensation of Executive Management. … (Novozymes annual report 2012, 48)

Table 7.4 shows the specific performance measures both as individual measures and categorized as either

absolute or relative.

Type of financial performance measures Nr. of measures Percentage %

Absolute 12 67%

Relative 6 33%

Table 7.4 - Type of financial performance measures (Source: Own creation)




Financial performance measures Nr. of measures Percentage %

Absolute 1 6%

Revenue 2 11%

EBITA 1 6%

EBIT 2 11%

Profit before tax 1 6%

Profit 1 6%

Net profit 1 6%

Free cash flow 1 6%

Cost development 1 6%

Net working capital 1 5%

Ratios 1 5%

Operating profit after tax –WACC 1 5%

Assessment of risk-adjusted return 1 5%

Risk adjusted return on capital at risk 1 5%

Value creation 1 5%

Price to Tangible Book Value 1 5%

Table 7.5 - Financial performance measures (Source: Own creation)

The variety of the financial performance measures being used is quite significant, seen in the light that

these findings only represent eight of the 20 C20 companies (see Table 7.5). The EBIT/profit performance

measure seems to be one of the more frequently used measures. When categorized as either absolute or

relative performance measure it is quite clear that most of the eight companies make use of the absolute

measures.

Nr. of performance measures included in the bonus contract Companies Percentage %

One 6 46%

Two 4 31%

Three 3 23%

Table 7.6 - Nr. of performance measures (Source: Own creation)

Table 7.6 demonstrates that 77% of the C20 companies that include accounting measures only use 1-2

performance measures. Company information also mentions the usage of other performance measures

(see example from TDC below).

“The short-term bonus programmes are based on specific annual targets including personal, financial and

operational targets. These targets are weighted in accordance with specific rules. All targets must support

improved profitability and business development at TDC” (TDC AR 2012, 2013, 84).

These other measures are of a non-financial nature and can either relate to ensuring quality control or

customer satisfaction. As the example shows these non-financial measures relates to value creation. The

actual number of performance measures included in an executive bonus contract is therefore expected to

be higher.




7.2.2 Performance standards


(see Table 7.1). The table shows that eight companies disclose the type of financial performance standards

that are used in bonus contracts. These standards are presented in Table 7.9.

Specified/ unspecified financial performance standards Nr. of respondents Percentage %

Financial performance standard 8 62%


Table 7.7 – Specified/ unspecified financial performance standards (Source: Own creation)

Although the last five companies stated that they use financial measure in their bonus contract, the

specifics of the measures are not disclosed. See example mentioned in section 7.2.1.

Type of financial performance standards Nr. of respondents Percentage %

Internal 9 75%

External 3 25%

Table 7.8 - Type of performance standard (Source: Own creation)

The internal performance standard is the most frequently used standard. This specific study of accounting

based performance standards lacks some relevant information.

Table 7.9 shows the performance standards and their relation to the performance measures mentioned in

the prior section. In about half of the cases the performance standards associated with the performance

measures are not disclosed in the available company information.

Ab

solu

te

Re

ven

ue

EBIT

A

EBIT

Pro

fit

be

fore

ta

x

Pro

fit

Ne

t p

rofi

t

Free

cas

h f

low

Co

st d

eve

lop

-m

en

t

Ne

t w

ork

ing

cap

ital

Rat

ios

Op

era

tin

g

pro

fit

afte

r ta

x -W

AC

C

Ass

ess

me

nt

of

risk

-ad

just

ed

re

turn

R

isk

adju

ste

d

retu

rn o

n

cap

ital

at

risk

Val

ue

cre

atio

n

Pri

ce t

o

Tan

gib

le B

oo

k V

alu

e N

ot

spe

cifi

ed

/

un

able

to

d

ete

rmin

e

Tota

l

Pe

rce

nt

%

Budget 1 1 1 1 1 1 1 1 8 35%

last year 1 1 4%

Peer-group 1 1 1 3 13%

Not specified / unable to determine

1 1 1 1 1 1 1 4 11 48%

Table 7.9 – Number of performance standards in relation to performance measures (Source: Own creation)




Budget is the most frequently used performance standard especially seen in the light that the three peer-

group performance standards are used by one company which can be seen in Table 7.10 shows the

weighted number of performance standards in relation to performance measures. If a company uses two

performance standards then these are each weighted 0.5.

Ab

solu

te

Re

ven

ue

EBIT

A

EBIT

Pro

fit

be

fore

tax

Pro

fit

Ne

t p

rofi

t

Free

cas

h f

low

Co

st d

eve

lop

-

me

nt

Ne

t w

ork

ing

cap

ital

Rat

ios

Op

era

tin

g p

rofi

t af

ter

tax

-WA

CC

A

sse

ssm

en

t o

f ri

sk-a

dju

ste

d

retu

rn

Ris

k ad

just

ed

retu

rn o

n

cap

ital

at

risk

Val

ue

cre

atio

n

Pri

ce t

o

Tan

gib

le B

oo

k V

alu

e N

ot

spe

cifi

ed

/

un

able

to

d

ete

rmin

e

Tota

l

Pe

rce

nt

%

Budget 0,5 0,5 0,5 0,3 0,3 0,5 1,0 0,3 4 31%

last year 1,0 1 8%

Peer-group 0,3 0,3 0,3 1 8%


0,3 0,3 0,5 0,3 0,5 0,5 0,5 4,0 7 54%

Table 7.10 – Weighted relative number of performance standards in relation to performance measures (Source: Own creation)

Five out of eight performance measures are related budget standards. Besides that the relation between

performance standards and measures is quite scattered.

A large number of the companies analysed disclosed that the total executive management remuneration is

evaluated against external benchmarks, see for instance the excerpt from Carlsberg and Novo Nordisk:

While we do not seek to adhere rigidly to market benchmarks, we monitor and take into account pay levels

and incentive opportunities in the principal markets from which we recruit: our European brewing and

spirits peers and the global consumer goods sector as well as companies across industry sectors in the

Nordic region. (Carlsberg AR 2012, 47)

Remuneration of the Board of Directors and Executive Management is assessed on an annual basis against

a benchmark of Nordic companies as well as European pharmaceutical companies that are similar to Novo

Nordisk in size and complexity. (Novo Nordisk AR 2012, 49)

The excerpts from Carlsberg’s and Novo Nordisk’s annual reports demonstrate the use of external

benchmarks. This is however on an aggregated pay level, and can therefore not be directly linked to the

performance standards. The excerpt is used as an indication that remuneration boards evaluate the

remuneration pay level with external benchmarks such as peer-groups. This can be useful when assessing

whether the level of pay is too high or low compared to the peer-group, which can be an indicator of

externalities affecting the performance measure. This relates to the pay for performance structure which is

the focus of the next section.




7.2.3 Performance structure


(see Table 7.1). The table shows that 12 companies disclose the type of financial performance standards

that are used in bonus contracts. These structures and their relation to performance measures and

standards are presented in Table 7.12 and Table 7.14.

Specified/ unspecified financial performance structure Nr. of respondents Percentage %

Financial performance structure 12 92%


Table 7.11 - Specified/ unspecified financial performance structure (Source: Own creation)

Although the last company stated that they use financial measure in their bonus contract, the specifics of

the structure are not disclosed. See example mentioned in section 7.2.1.

Table 7.12 shows the performance structure and their performance measure relation.

Ab

solu

te

Re

ven

ue

EBIT

A

EBIT

Pro

fit

be

fore

ta

x

Pro

fit

Ne

t p

rofi

t

Free

cas

h

flo

w

Co

st

de

velo

pm

en

t

Ne

t w

ork

ing

cap

ital

Rat

ios

Op

era

tin

g p

rofi

t af

ter

tax

- W

AC

C

Ass

ess

me

nt

o

f ri

sk-

adju

ste

d

retu

rn

Ris

k ad

just

ed

retu

rn o

n

cap

ital

at

risk

Val

ue

cre

atio

n

Pri

ce t

o

Tan

gib

le

Bo

ok

Val

ue

No

t sp

eci

fie

d

/ u

nab

le t

o

de

term

ine

Tota

l

Pe

rce

nt

%

Cap 1 1 1 1 1 1 1 1 1 1 4 14 61%

Linear with cap and floor

2 1 1 1 5 22%

Cap, and hurdle bonus

1 1 1 3 13%


1 1 4%

Table 7.12 – Number of performance structures in relation to performance measures (Source: Own creation)

12 of the companies disclose that executive bonus pay is caped. The information detail concerning the used

bonus structure is rather limited an example of this can be the excerpt from A.P. Møller – Maersk (2013):

The Management Board's remuneration … Cash incentive opportunity … The size of the annual cash

incentive payout will be decided by the Board of Director's Remuneration Committee based on the

achievement against the above-mentioned measures ... constitute an amount corresponding to maximum

50% of the fixed annual fee. (A.P. Møller – Maersk 2013, http://investor.maersk.com/guidelines.cfm)

http://investor.maersk.com/guidelines.cfm




Nine companies do describe the use of a linear pay for performance relation and that cap and floor is used

(see Table 7.13).

Ab

solu

te

Re

ven

ue

EBIT

A

EBIT

Pro

fit

be

fore

tax

Pro

fit

Ne

t p

rofi

t

Free

cas

h

flo

w

Co

st

d

eve

lop

me

nt

Ne

t w

ork

ing

cap

ital

Rat

ios

Op

era

tin

g

pro

fit

afte

r

tax

- W

AC

C

Ass

ess

me

nt

of

risk

-ad

just

ed

retu

rn

Ris

k ad

just

ed

re

turn

on

cap

ital

at

risk

Val

ue

cr

eat

ion

P

rice

to

Ta

ngi

ble

Bo

ok

Val

ue

No

t sp

eci

fie

d

/ u

nab

le t

o

de

term

ine

Tota

l

Pe

rce

nt

%

Cap 1 0,3 1 0,3 1 1 0,3 0,5 0,5 0,5 4 9 69%


1 1 0,3 0,3 2 15%


0,3 0,3 0,3 1 8%


1 1 8%

Table 7.13 – Weighted relative number of performance structures in relation to performance measures (Source: Own creation)

Table 7.14 shows that cap and linear with cap and floor performance structures are mostly related to

budget standards. The peer-group is the only performance measure that is related to the Cap, and hurdle

bonus performance structure.

Bu

dge

t

last

ye

ar

Pe

er-g

rou

p

No

t sp

eci

fie

d

/ u

nab

le t

o

de

term

ine

Tota

l

Pe

rce

nta

ge

%

Cap 6 1 7 14 61%


2 3 5 22%


3 3 13%


1 1 4%

Table 7.14 - Performance structure in relation to performance standards (Source: Own creation)

The following section will analyse Banghøjs studies with focus on bonus components. The findings from

Banghøjs study will be compared with the findings within the public available information, which will be

presented in a later section.




7.3 Secondary data: Findings of financial bonuses among Danish executives

Banghøj has made a large study of the usage of bonus among CEO’s and management board members. The

study includes 58 Danish companies and 77 respondents and fulfils the diversity criterion in regards of

industry and geographic conditions. As such Banghøj’s study is a good indicator for the Danish market in

general (Banghøj 2006, 119-121). His research results will be used to provide insight into what are the

characteristics performance measures, performance standards and bonus structures used in Danish bonus

contracts, which will be discussed in the following sections. The empirical findings will be discussed in

comparison with the theoretical view on bonus contracts of high quality.


Banghøj’s results concerning performance measures both include financial and non-financial measures

(Banghøj 2006, 124-125). The table is based on the result concerning the financial measures and are

furthermore categorised as either absolute or relative measure (see Table 7.15).

Type of financial performance measures Nr. of respondents Percentage %

Absolute 35 81%

Relative 8 19%

Table 7.15 – Type of performance measures (Source: Own creation based on Banghøj’s study)

Financial performance measures Nr. of respondents Percentage %

Turnover 5 12%

Gross profit 1 2%

Profit on ordinary activities before tax 10 23%

Profit on ordinary activities after tax 1 2%

Earnings before interest, tax, amortization and depreciation - EBITDA 1 2%

Earnings before interest and tax 4 9%

Earnings before interest and tax - EBIT 3 7%

Net result 4 9%

Cost reductions 1 2%

Cash flow 5 12%

Cash flow return on investment - CFROI 1 2%

Profit ratio 2 5%

Return on invested capital – ROIC 1 2%

Return on Equity – ROE 1 2%

Econimic value added – EVA 3 7%

Table 7.16 – Performance measures (Source: Own creation based on Banghøj’s study)

Table 7.15 shows that 81 % of the respondents make use of absolute performance measures (Banghøj

2006, 124-125). Among these the most used performance measures are on the earnings level where the

main part is excluding taxes (See Table 7.16). Within this group a large number of respondent’s uses profit

on ordinary activities thereby excluding special items. A reason for the high number of absolute

performance measures could be due to the fact that these are already being reported. The relative group is

mostly characterised of performance measures that to some extent includes risk and the cost of capital.





EBIT

PB

T

EVA

CFO

Gro

ss p

rofi

t

Pro

fit

on

ord

inar

y ac

tivi

tie

s

Pro

fit

rati

o

Cas

h f

low

Earn

ings

be

fore

inte

rest

an

d t

ax

Turn

ove

r

Co

st r

ed

uct

ion

CFR

OI

EBIT

EBIT

DA

Tota

l

Pe

rce

nta

ge

%

Budget 1 1 3 1 1 7 2 4 2 5 1 1 4 1 34 94%

Earlier years 1 1 3%

Peer group 0 0%

Cost of capital 0 0%

Discreationary 1 1 3%

Table 7.17 – Performance standards (Source: Own creation based on Banghøj’s study)

The single most used performance standard is the budget (see Table 7.17) which 94% of the respondents

make use of (Banghøj 2006, 126). As with the absolute performance measures, the high use of budgets as

the bonus standard could be explained that budgets are already being used. Studies conducted in the US by

Murphy (2013) reveals the same high use of budget standards (Murphy 2013, 244-245).


The population of Banghøj’s study of performance structure is fairly low since it is answered by 24 out of

the 41 respondents that stated that they received a non-discretionary bonus. The findings will therefore be

used as indicator of what might characterize the Danish industry. The study shows that the most used

performance structure is the lump-sum, stepwise and linear bonus with cap and floor is also quite common,

however the fully linear bonus structure is only rarely used (Banghøj 2006, 125-126).




7.4 Summary of the findings from the primary and secondary data


Table 7.18 depicts the findings of the primary and secondary data.

Banghøj study Company information

Type of financial performance measures Nr. of

respondents Percentage

% Nr. of


%

Absolute 35 81% 8 62%

Relative 8 19% 5 38%

Financial performance measures Nr. of


% Nr. of


%

Absolute 1 6%

Revenue 2 11%

Turnover 5 12%

Gross profit 1 2%

Profit on ordinary activities before tax 10 23%

Profit on ordinary activities after tax 1 2%

Earnings before interest, tax, amortization and depreciation - EBITDA 1 2%

EBITA 1 6%

Earnings before interest and tax 4 9%

Earnings before interest and tax - EBIT 3 7% 2 11%

Profit before tax 1 6%

Profit 1 6%

Net profit 1 6%

Net result 4 9%

Cost development 1 6%

Cost reductions 1 2%

Net working capital 1 6%

Free cash flow 1 6%

Cash flow 5 12%

Ratios 1 6%

Cash flow return on investment - CFROI 1 2%

Profit ratio 2 5%

Assessment of risk-adjusted return 1 6%

Risk adjusted return on capital at risk 1 6%

Return on invested capital - ROIC 1 2%

Operating profit after tax - WACC 1 6%

Return on Equity - ROE 1 2%

Econimic value added - EVA 3 7%

Value creation 1 6%

Price to Tangible Book Value 1 6%

Sum 43 18

Number of different performance measures 15 17

Table 7.18 - Performance measures primary and secondary data (Source: Own creation based own findings and on Banghøj’s study)

Similarities: In both cases the absolute performance measure is the most significantly used measure type,

this is although most significant in Banghøj’s findings. EBIT is one of the more frequently used performance

measures

Differences: Although Banghøj’s study includes a larger sample, the amount of different performance

measures compared to the public available information is relatively lower. The explanation to this could

probably be that companies name performance measures slightly different - for example could net profit




and profit be classified as the same (see Table 7.18), whereas Banghøj’s survey included 15 predefined

performance measures.


Similarities: In both cases the budget standard is the frequently used measure type.

Differences: In Banghøj’s study none of the respondents where using peer-group as a performance

standard. As it is only one out of 20 C20 companies that today state that they make use of this performance

standard, it is not possible to state whether this is a new trend that has started since Banghøj’s study took

place seven years ago.


Similarities: In both studies the use of cap and also floors in the bonus structure is quite significant.

Banghøj’s study is however more detailed in the actual relation between performance and received bonus

pay. This is probably due to the fact that the survey used includes figures of the most common kinds of

bonus structures. The primary data such as annual reports mostly describes the bonus structure in brief

sentences (see example in section

Performance structure).

Differences: Banghøj’s study reveals that a few respondents make use of a fully linear pay for performance

structure. In contrast the primary data shows that those who disclose this information all make use of the

cap to limit the amount of bonus pay.


8. Empirical versus Theoretical Findings


Chapter 4. Guidelines Based on Theoretical and Empirical Findings

This chapter will provide a comparison between empirical and theoretical findings, which will be used to

establish guidelines for bonus structures. The chapter will end in a discussion of these findings as well as

the foundation of the theories applied in the study.

8 Empirical versus Theoretical Findings

The comparison will both be conducted on the specific component but it will also be analysed in an

aggregated setting. I.e. the fulfilment of the bonus criteria will be evaluated on the combination of

performance measure standard and structure.

8.1 Performance Measures

The absolute performance measure type is the most used which is shown both in the primary and

secondary findings. This measure is most often based on income statement items before interest and tax.

This type of measure excludes balance sheet items and therefore does not include cost of capital. This

measure is easy to understand, communicate and is already being reported. As such the absolute

performance measure fulfils the simplicity and cost efficient criteria. According to theory the optimal

performance measure would be of the relative type, preferably the EVA performance measure as this

includes invested capital and cost of capital. As such EVA is a better indicator for value creation, which is

not the case for the absolute performance measures. As prior mentioned, theory recognises the

congruence criterion as the single most important criterion. However the development of the EVA measure

can be costly and complex both to communicate and develop which might offset the simplicity and the cost

efficient criteria. Both the absolute measure and EVA have a significant amount of accounting issues.

The use of the absolute performance measure’s fulfilment of bonus criteria can be summarized as:

Figure 8.1 - Overview of absolute performance measure’s fulfilment of bonus criteria (Source: Own creation)




8.2 Performance Standards

Both the primary and secondary findings show that the most used performance standard is the budget

standard. This performance standard is easy to understand, communicate and develop, thereby fulfilling

the simplicity and cost efficient criteria, as was the case with the absolute measure. Earlier studies

conducted by Murphy (2001) show similar results concerning the high use of budgets as performance

standard (Murphy 2001, 252). The high use of budgets does not come as a surprise, since most companies

use budgets as part of their management systems, and are therefore already developed.

Another explanation to the significant use of budget standards could be explained by the absence of best-

practice or as described by Zakaria (2012):

“This is attributed to the phenomenon of mimetic isomorphism, where the absence of clear guidelines

results in firms mimicking the practice of others.” (Zakaria 2012, 201)

Seen from a theoretical perspective the budget standard has the weakness of being influenced by the

management which has an incentive to set low targets that are easy to achieve. When combining the

absolute performance measure and the budget standard the simplicity and cost-efficient criteria is fulfilled

to a high degree. The congruence criterion is not improved by combining the absolute performance

measure and the budget standard. According to theory the optimal choice would be the external peer-

group standard, as this limits the influence by the management, and limits the distorting effect of

externalities. However this standard can be difficult to develop.

The following model provides an overview of the fulfilment of the bonus criteria when as absolute

performance measures is combined with the budget standard:

Figure 8.2 - Overview of absolute performance measure combined with budget standard and the fulfilment of bonus criteria (Source: Own creation)




8.3 Performance Structure

The primary findings show that the most common pay for performance structure is the use of non-linear

type. Most of which are linear with a cap and floor and others are of the lump-sum type. The secondary

findings share the same characteristics as the non-linearity is the most common type of measure, yet in this

case the lump-sum is the most used structure, and the linear with cap and floor are also used to some

extent. In both cases the linear pay for performance structure is rarely used. According to theory the non-

linearity pay for performance structure, provides management with an incentive to “gaming”, which could

be done by making use of earnings management. According to Jensen (2003) the preferred choice of bonus

structure ought to be the linear bonus structure. This is due to the gaming problems that are established

when there exist kinks (See kink A and B in appendix 13) in the bonus structure (Jensen 2003, 385-389).

According to theory the optimal choice is the linear structure, since it is expected to be the structure that is

congruent with value creation. However the choice of pay for performance structure has to be analysed in

the relation with the performance measure and standard. Besides the risk of management manipulation of

the absolute measure and the budget there exist another significant weakness which is the distorting effect

that externalities has on the measure. As prior mentioned achieving the budget standard does not equal

that value is generated. In relation to the absolute measure and the budget standard, the non-linear with

cap and floor pay for performance structure, has the strength of setting a limit the bonus pay. As such this

structure reduces the effect that the externalities, management manipulation and management influencing

the standard setting, as these are not value creating. This structure limits the up and down side of the

performance pay, which could be argued is the best choice of performance structure if the absolute

performance measure and the budget standard is chosen.




The following model provides an overview of the fulfilment of the bonus criteria by combining an absolute

performance measures, budget standard and a non-linear pay for performance structure:

Figure 8.3 - Overview of combining absolute performance measure, budget standard, non-linearity with cap and floor and the fulfilment of bonus criteria (Source: Own creation)

This combination of the absolute performance measure, the budget standard and the non-linearity pay for

performance standard has a low congruence with value creation. These findings are supported by Eriksson

& Lausten (2000) studies conducted among Danish firms. These studies show that the performance-pay has

a weak relation with company performance (Banghøj 2006, 31).


9. Guidelines for accounting based bonus contract


9 Guidelines for accounting based bonus contract

Based on the theoretical and empirical findings this section will provide guidelines that include factors that

are relevant to consider when developing or evaluating existing accounting based bonus contracts.

“…criteria that are useful in evaluating any measure” (Merchant 2006, 894)

According to Merchant (2006) the use of criteria are useful when evaluating measures. As such the thesis

has used seven criteria in order to evaluate a accounting based bonus contract according

The seven criteria the is relevant to consider an accounting based bonus contract is, congruency,

controllability, simplicity, objectivity, number of accounting issues and cost efficiency. The most important

criterion is that the bonus contract is value creating, which makes congruency the single most important

criterion. However it is important to notice that fulfilling all criteria not likely. The trade-off between the

criteria is described by Merchant (2006):

“Not surprisingly, none of the measurement alternatives provides a perfect solution. All fail to satisfy one or

more of the criteria, although some are better than others in specific situations.” (Merchant 2006, 894)

When developing a bonus contract it is important to consider that the purpose of the contract is to align

management with the owners. As such one should consider the present strategy as well as company

specific characteristics when developing the bonus contract.

The following model shows an overview of the bonus components and bonus criteria.

Figure 9.1 – Overview of bonus components and bonus criteria (Source: Own creation)




The following sections will discuss the optimal bonus contract which is based on the assumption that the

company strategy is to generate shareholder value, and that no company specific characteristics need to be

taken into consideration.

According to theory the optimal design of a bonus contract includes a combination of performance

measure, standard and structure that has a high congruence with value creation. Theory proposes that the

EVA is chosen as the performance measure, a peer-group as the external standard and a linear pay for

performance structure. The EVA measure is congruent with value creation especially if it is multiple period

thereby limiting the horizon-problem. EVA is also to limit management manipulation especially if change in

EVA is used as the performance measure. The number of accounting issues is also limited if change in EVA is

used, which is quite significant for the absolute EVA performance measure. The external peer-group is

expected to better reflect true company performance since externalities affecting on an industry and global

level is expected to influence the group equally. The external peer-group is furthermore expected to limit

management influence on the standard. Combining EVA measure and the peer-group standard the

congruence, controllability, accounting issues and objectivity criteria is fulfilled to a significant level.

However this is achieved by lowering the fulfilment of the simplicity and cost efficient criteria.

The following model provides an overview of the fulfilment of the bonus criteria by combining the EVA

performance measure, the External peer-group standard and the linear pay for performance structure:

Figure 9.2 - Overview of the combination of the EVA performance measure, external peer-group standard, linear pay for

performance structure and the fulfilment of bonus criteria (Source: Own creation)

This combination of EVA performance measure, external peer-group standard and linear pay for

performance standard has several weaknesses that are relevant to consider. A few of these will be




presented. For instance is EVA not perfect congruent with value creation. The EVA of a project can be

positive (negative) in some years although the NPV of the project is negative (positive). The peer-group

might not share the same characteristics with the company. If the peer-group on average achieves a lower

(higher) performance this result in a higher (lower) evaluation of management performance which is not

due to their actual performance, this results in a higher (lower) pay that does not reflect the actual

performance. A problem with the linear pay for performance relation is that there exists a risk that

accounting issues is not dealt with correctly. This distorts the measure and result in a too high or low pay

for performance. As prior mentioned the use of a bonus bank is advisable when including a pay for

performance structure that punishes bad performance.

The following section will provide an example of how a specific strategy and company characteristics

affects the choice of bonus components and their fulfilment of bonus criteria.

As such the optimal short-term bonus structure is used to support the strategy focus on generating a

positive EVA or is used to support the strategy of achieving a high market share in a new market. In the first

case the use of EVA as performance measure would appear as the optimal choice, in the second case the

use of revenue performance measure might be a better choice. The relevance of the bonus criteria also

depends on company characteristics, an example is the pharmaceutical industry in this case it is expected

that externalities have a limited to effect, and both absolute and relative measure have are highly

controllable. Another industry example is the bank sector. Seen in the light of the recent economic crisis it

might be advisable to reduce risk by limiting management manipulation of the performance measure, their

influence on the setting of the performance standard and including punishment of poor performance. As

the lack of punishment for poor performance change their risk profile into becoming more risk-seeking.

This combination of performance measure, performance standard and pay for performance is relevant to

consider, as it according to theory provides the best fulfilment of the bonus criteria. However remuneration

boards, shareholders, stakeholder etc. should still include company specific strategy as well as company

characteristics.


10. Discussion


10 Discussion

The following section will discuss the findings as well as relevant theories used in the thesis.

10.1 Critique of the Agency Theory

The following sections include different critiques both on a general level and on a specific level in relation

to corporate governance in Denmark.

“Other scholars remove the economists' blinders that cause them to focus only on the self-interest and

opportunism of agents and the difficulties of regulating them. Perrow (1986), for example, accuses the

economics paradigm of being incapable of keeping its eye on both sides of the principal-agent relationship

and of recognizing that agency problems on the agent side of the relationship are often mirrored on the

principal side.” (Shapiro 2006, 268)

The problem with agency theory as Shapiro states is the strong focus on the opportunistic and self-interest

agent, and how they are best regulated. According to Shapiro agency theory can be criticised for not

focussing equally on the principal. As the principal is expected to be as opportunistic and focussed on self-

interest as the agent. The principal is therefore expected to have as much incentive to manipulate and

influence performance measure and standard setting (Shapiro 2006, 268).

Furthermore it can be discussed to what extent that the American based agency theory can explain the

European and Danish corporate governance. Agency theory builds on basis that there exist a separation of

ownership and control within the company. However studies by Rajan & Zingales (2003) challenges agency

theory as their studies show that as this is not necessarily the case in European corporate governance

systems (Banghøj 2006, 183). Furthermore a study performed by Gabrielsen, Gramlich and Plenborg (2002)

indicate that information from financial accounting systems is distorted when managerial ownership

increase. Banghøj states that this indicates that the corporate governance in Denmark is based on

relationships (Banghøj 2006, 183). According to Banghøj the relationship type of corporate governance

makes use of other communication means then the official channels. This could be one explanation of the

relative limited information available regarding executive remuneration in company annual reports and

webpages.

Kunz and Pfaff (2002) provide another issue with the agency theory. The agency theory is one of the more

simple theories that are used to understand performance measurement systems and incentives. Kunz and

Pfaff (2002) criticize the agency theory for its behavioural assumptions, i.e. the assumption that pay-for-


10. Discussion


performance increases the agent’s productivity. However psychological theories and intrinsic motivation

seem to challenge this assumption. (Kunz et. al. 2002, 275-295)

10.2 Quality of available information:

Based on the publicly available annual reports from 2009 the Danish Committee on Corporate Governance

conclude that:

“It is prevalent that information regarding remuneration generally speaking is insufficient” (Committee on

corporate governance in Denmark, 2011).

The gathering of primary empirical data has been a difficult task. Some data have required more work than

just looking in the company’s annual report or searched for bonus remuneration on the company web site.

This might support the Danish relationship-based corporate governance theory, since it would be expected

that majority shareholders would require these information, as such there might exist an asymmetry in the

available company information.

During the data collection another issue appeared, which is the complexity if the bonus contracts. In

general the annual reports show complex structure bonus structure. This made it difficult to extract the

information that only related to accounting based compensation. A study performed by PwC support this

view that executive bonus contracts have become too complex:

”Incitamentsaflønning er blevet så kompleks og volatil, at den ikke altid motiverer de ledere, den er rettet

imod. Globale topchefer foretrækker mindre bonus, hvis blot kompleksiteten og risici i lønpakken mindskes.”

(PwC - Globale ledere: Kompleksiteten i lønpakkerne er blevet for stor, accessed 09-09-13)

10.3 Critique of well-designed bonus plans:

The development of a bonus contract requires a significant amount of work. Banghøj et al. (2010) have

conducted studies of different bonus contracts and their degree of design quality. This study shows that

there does not exist a significant strong pay-for-performance relation in the case of the bonus contracts

that are better designed.

“Contrary to our expectations we do not find a stronger pay-to-performance relation in firms with better

designed bonus plans.” (Banghøj et al. 2010, 506)

Another issue is the significant difference between the theoretically right combination of the bonus

components which achieves a high congruence with value creation, whereas empirical findings show a low

congruence.


10. Discussion


“Di Maggio and Powell (1983) argue that in the absence of clear or absolute directions as to what is best

practice, guidelines and common practices are often institutionalised as best practices, thus resulting in

both a best practice benchmark and a legitimising instrument (Deephouse, 1996)” (Zakaria 2012, 191).

The above excerpt might be one explanation why the combination of absolutes measures with budget

standards is used by quite a significant amount of the C20 companies. If common practises are in fact being

institutionalised as best practices then this might be an indicator that the corporate governance guidelines

might need to be more clear or should ensure a better communication and adaptation of these corporate

governance guidelines as is the conclusion reached by the OECD Steering group proclaim in their report on

the financial crisis (OECD 2010, 3).

10.4 Criticism of Compensation

Executive performance pay is criticised by Bebchuk & Fried’s (2004). Performance pay is assumed that the

board negotiates at an arm’s length arrangement, which Bebchuk & Fried state that is not the case due to

moral hazard and adverse selection (Bebchuk et al. 2004, 23-24)

Bebchuk and Fried (2004) suggest that improvements are made to the payment design, that transparency

of the performance pay and that the shareholder’s should approve the bonus contracts. This is not far from

OECD (2004) current principles of corporate governance.

Bebchuk and Fried’s (2004) codes on performance pay assume that they can work if the performance pay is

designed and governed better. Their recommendation includes; the role of the independent non-executive

directors, remuneration policy is included as a shareholder vote, that remuneration consultants are

independent and that individual executive pay is disclosed (Bebchuk et al. 2004, 23-26). Murphy shares the

view that remuneration consultants are not objective and independent.

“Critics of perceived abuses in executive pay have increasingly accused the consultants as being complicit in

the alleged excesses in compensation” (Murphy 2010, 248)


11. Conclusion


Chapter 5. Conclusion, Reflection and Further Studies

This chapter will sum up the findings covered during the previous chapters and will discuss future research

areas.

11 Conclusion

The conclusion is a result of the thesis’ analysis and discussion. The following sections will summarize

central elements of the study in order to provide answers to the problem statement and research

questions (cf. 2.1).

The thesis provides insights to the use of accounting based bonus characteristics based on primary data

including the Danish C20 companies as well as secondary data based on a broader study conducted by

Banghøj (2006) which includes data from 58 companies (Banghøj 2006, 121). The primary data collection is

based on annual reports and company webpages as these are expected to contain the relevant information

according to the committee on corporate governance (CORG - Committee on corporate governance 2013,

23-24).

The thesis has covered seven bonus criteria that ensure that an accounting based bonus contract are of a

high quality. These criteria are; congruency, controllability, simplicity, objectivity, low number of accounting

issues, cost efficient to develop and timeliness. The single most important criterion is the congruency

criterion. The congruency criterion covers the relation between pay for performance and company value

created. According to agency theory this alignment of the agent’s interest with the principal interest of

creating company value is the main focus of the theory. The first six are relevant when considering the

bonus components of an accounting based bonus contract, since these bonus components affects the

fulfilment of these accounting based bonus criteria. The seventh criterion the timeliness states that the

agent/ executive should receive feedback on its actions in a timely manner in order to ensure that the

agent/ executive can relate actions with the reward.

According to theory (Murphy 2001)(Petersen, C. V. (2011), Online access 09-09-13) a bonus contract

includes three main components, which are performance measure, standard and pay for performance

structure. The Performance measure is used to measure the executive’s performance. The performance

standard is used to evaluate the performance of the executive. The pay for performance structure

determines how the achieved performance evaluation is related to bonus paid to the executive. The

following sections describe these components in further details as well as the empirical and theoretical

findings related to these components.


11. Conclusion


Primary and secondary findings show that the most common performance measure is based on income

statement items before interest and tax. This excludes balance sheet items and therefore does not include

cost of capital. Seen from a theoretical point of view this makes little sense, since those absolute

performance measures are a bad indicator of value creation. According to theory these absolute measures

only fulfils the congruence criterion is only fulfilled to a low degree, which is the single most important

criterion.

The second finding is that the budget standard is the most used performance standard. This as well as the

absolute performance measure is easy to understand, communicate and develop thereby fulfilling the

simplicity and cost efficient criteria. Seen from a theoretical perspective the budget standard has the

weakness of being influenced by the management which has an incentive to set low targets that are easy to

achieve. When combining the absolute performance measure and the budget standard the simplicity and

cost-efficient criteria is fulfilled to a high degree however the congruence criterion is not.

In regards of the pay for performance structure the most used is the non-linear with cap and floor.

According to theory this pay for performance structure is less congruent with value creation. The linear pay

for performance structure is considered as being perfect congruent with value creation. This is because that

pay for performance is directly related to value creation. Besides the risk of management manipulation of

the absolute measure and the budget there exist another significant weakness which is the distorting effect

that externalities has on the measure.

As prior mentioned achieving the budget standard does not equal that value is generated. In relation to

the absolute measure and the budget standard, the non-linear structure with cap and floor pay for

performance has the strength of setting a limit to the effect that these externalities, management

manipulation of the measure and influence on the standard. This structure limits the up and down side of

the performance pay, which could be argued is the best choice of performance structure if the absolute

performance measure and the budget standard is chosen. These findings are supported by studies

conducted among Danish firms. These studies show that the performance-pay and company performance

is not related. However this might be due to imperfect bonus contracts.

According to theory the optimal combination of performance measure, standard and structure is the

combination that has a high congruence with value creation. As such the optimal choice would be EVA as

the performance measure, a peer-group as the external standard and a linear pay for performance

structure. Since the EVA measure, to a high degree is congruent with value creation and management

manipulation is limited especially if change in EVA is used as the performance measure. The use of change

in EVA also limits the accounting issues that exist if absolute EVA is used. The external peer-group is


11. Conclusion


expected to better reflect true company performance since externalities affecting on an industry and global

level is expected to influence the group equally. Since the peer-group is external it is expected that

management influence on this standard is limited. Combining EVA measure and the peer-group standard

the congruence, controllability, low number of accounting issues and objectivity criteria are fulfilled to a

significant level. However this is achieved by lowering the fulfilment of the simplicity and cost efficient

criteria.

The theoretical findings state that the design of the bonus contract should include a combination of

performance measures, standards and pay for performance structure that ensure a high fulfilment of the

bonus criteria, most important is the congruence criterion since it equals value creation. As such appear the

relative EVA measure, the external peer-group standard and the linear pay for performance structure as

the being the superior choice. However the bonus contract should support the company strategy and

consider company specific information, which might affect the optimal choice of bonus components. As

such there does not exist a one fits all bonus contract, which is why it is relevant for remuneration boards,

shareholders, stakeholders etc. to take in mind these factors when evaluating and designing accounting

based bonus contracts.

11.1 Reflection on the development of the thesis

I have continuously been focused on ensuring that the thesis findings and conclusion is valid and reliable. I

have strived to collect data that is both satisfactory and relevant for the analysis. I have used different

theories and literature that has different/opposing views on the analysed areas. This is done in order to

ensure an objective analysis of executive remuneration thereby minimizing my own pre-understanding of

the topic.

During the development of the thesis, I experienced a change of my view on the interaction between the

elements of the thesis. I experienced that these are to a much greater deal dynamically interactive, which

requires the writer to be continuously open-minded and keeping an overview of the process as well as the

development and direction the thesis is developing. This can be a difficult task as the final product is not

known. Finally I experienced the great value of being able to discuss difficulties with a sparring partner as

well as being able to brainstorm on thesis directions with my supervisor. This might be of even more value

when you are writing your thesis on a single person basis, and not having a thesis partner.

11.2 Further studies

The thesis reveals new areas that could be worth studying in greater detail. These are presented in the

following sections.


11. Conclusion


11.2.1 Improved information quality

The level of available information is quite limited and often aggregated, which makes it difficult to analyse

bonus contracts. The trend however is that the disclosure of information of the executive remuneration is

increasing. The increased transparency that will follow if this trend continues will facilitate more

information which would be expected to provide a better reflection of the whole population.

11.2.2 A deeper understanding of the Danish corporate governance system

As discussed the agency theory might not be a perfect fit to the Danish corporate governance system. The

relationship based model might be better at describing the Danish setting. A deeper study within this area

could reveal whether this is the case. Furthermore this study could reveal if information is indeed shared

through relationships, thereby inducing information asymmetry amongst investors, as minority investors

are less likely to have the same information as large shareholders such as funds etc. Banghøj also indicates

this area as an opportunity for further studies (Banghøj 2006, 184). Furthermore he suggests that increased

regulation of accounting information might be a solution, as is the case in US and UK.

Banghøj mentions other areas of further research which is not limited to accounting based bonus contracts

as is the case for this thesis (Banghøj 2006, 184-185).

11.2.3 Further analysis of what can explain the incongruence between empirical findings and theory

Since the gap is quite significant between the theoretical optimal accounting based bonus contract and the

empirical findings, it could be interesting to go into more depth of understanding why this is the case.

These studies could explain what the remuneration board takes into consideration when developing bonus

contracts. It would also be relevant to gain insight into their knowledge of the use of accounting based

bonus contracts in order to determine whether they are familiar with the theoretical optimal accounting

based bonus contract. These findings are assumed to provide better insights which factors influence the

process of development of bonus contracts.

11.2.4 Multiple performance measures

The criteria model develop throughout the thesis includes performance measure, standard and pay for

performance structure. However it would be relevant to extent the model to include multiple performance

measures, standards used in the same contract.


12. References


12 References

Articles:

- Banghøj, J., & Plenborg, T. (2008). Value relevance of voluntary disclosure in the annual report.

Accounting & Finance, 48(2), 159-180.

- Banghøj, Jesper, Gorm Gabrielsen, Christian Petersen, and Thomas Plenborg. 2010. "Determinants

of Executive Compensation in Privately Held Firms." Accounting & Finance 50 (3): 481-510.

- Biddle, G. Bowen, R. M., Wallace, J.S. (1996). Evidence on the relation and incremental information

content of EVA, residual income, Earnings and operating cash flow, Working paper, University of

Washington, Seattle, WA.

- Brickley, James A., Clifford W. Smith, and Jerold L. Zimmerman. 2003. "CORPORATE GOVERNANCE,

ETHICS, AND ORGANIZATIONAL ARCHITECTURE." Journal of Applied Corporate Finance 15 (3): 34-

45.

- Brunner, K., 1996, Economic analysis & political ideology: the selected essays of Karl Brunner

Volume 1, Edward Elgar Publishing, Cheltenham, UK

- Daily, C., Dalton, D. & Cannella Jr., A., 2003, 'Corporate Governance: Decades Of Dialogue & Data',

Academy of Management Review, 28, 3, pp. 371-382

- Eisenhardt, Kathleen M. 1989. "Agency Theory: An Assessment and Review." The Academy of

Management Review 14 (1): 57-74.

- Eriksson, T. and Lausten, M. 2000: “Managerial pay and firm performance – Danish Evidence,”

Scandinavian Journal of Management 16: 269-286

- Feltha, G.A. And J. Xie (1994), Performance measure congruity and diversity in multi-task

principal/agent relations, Accounting Review, 69.

- Gabrielsen, G., Gramlich, J. D., Plenborg, T. 2002. "Managerial Ownership, Information Content of

Earnings, and Discretionary Accruals in a Non-US Setting."

- Garvey, G.T. and Milbourn, T.T. (2000), “EVA versus earnings: does it matter which is more highly

correlated with stock returns?”, Journal of Accounting Research, Vol. 38, pp. 209-45.

- Hall, Brian J. and Kevin J. Murphy. 2003. "The Trouble with Stock Options." The Journal of Economic

Perspectives 17 (3): 49-70.

- Hansen, A. (2012): Performance evaluation systems: Design criteria and design choices in a

transaction Costs perspective, Working paper, CBS.


12. References


- Hart, Oliver. 1995. "Corporate Governance: Some Theory and Implications." The Economic Journal

105 (430): 678-689.

- Healy, P. (1985). The effect of bonus schemes on accounting decisions. Journal of Accounting and

Economics 7, 85-107.

- Holmstrom, B., & Milgrom, P. (1987). Aggregation and linearity in the provision of intertemporal

incentives. Econometrica, 55, 303–328.

- Jensen 2003. "Paying People to Lie: The Truth about the Budgeting Process." European Financial

Management 9 (3): 379-406.

- Jensen, M., Meckling, W. 1994, 'The Nature of Man'. Journal of Applied Corporate Finance, 7, 2, pp.

4-19

- Jensen, M.C. (2010), “Value maximization, stakeholder theory, and the corporate objective

function”, Journal of Applied Corporate Finance, Vol. 2 No. 1, pp. 34-42.

- Jensen, Michael C. 2003. "Paying People to Lie: The Truth about the Budgeting Process." European

Financial Management 9 (3): 379-406.

- Jensen, Michael C. and Kevin J. Murphy. 2010. "CEO Incentives— it's Not how Much You Pay, but

how *." Journal of Applied Corporate Finance 22 (1): 64-76.

- Jensen, Michael C. Meckling,William H. 1976. "Theory of the Firm: Managerial Behavior, Agency

Costs and Ownership Structure." Journal of Financial Economics 3 (4): 305-360.

- Kunz, A.H. & Pfaff, D. 2002. “Agency theory, performance evaluation, and the hypothetical

construct of intrinsic motivation”. Accounting, Organizations and Society, 27, 275‐295

- Lazear Edward, P. 2009. "Personnel Economics in Practice." In , edited by Gibbs Michael, 232-233.

Hoboken, N.J.

- Merchant, K. A. 2006, "Measuring general managers' performances", Accounting, Auditing and

Accountability Journal, vol. 19, no. 6, pp. 893-917.

- Merchant, K., & Manzoni, J. (1989). The achievability of budget targets in profit centers: a field

study. The Accounting Review, 64, 539–558.

- Murphy, Kevin J. 2001. "Performance Standards in Incentive Contracts." Journal of Accounting and

Economics 30 (3): 245-278.

- Murphy, Kevin J. 2013. "Chapter 4 - Executive Compensation: Where we are, and how we Got

There." In Handbook of the Economics of Finance. Vol. Volume 2, Part A, 211-356: Elsevier.

- O'Donovan, G. 2003. "Change Management – “A Board Culture of Corporate Governance”." (A

Mondaq Business Briefing.): 13-05-26.


12. References


- Prendergast, C. 1999, The Provision of Incentives in Firms‘, Journal of Economic Literature, 37, 1,

pp. 7-63

- Rajan M, V and Zingales, L 2003: “Banks and Markets: The Changing Nature of European Finance”

- Richey, Rita C., James D. Klein, and Wayne A. Nelson 2004, "Developmental research: Studies of

instructional design and development." Handbook of research for educational communications and

technology 2 : 1099-130.

- Shapiro, S., 2005, ‗Agency Theory‘, Annual Review of Sociology, 31, 1, pp. 263-284

- Sloan, R. G. (1993). Accounting earnings and top executive compensation. Journal od Accounting

and Economics, 16, 55–100.

- Stewart, G. B. (1991). The quest for value: A guide for senior managers. New York: Harper Business.

- Vallgårda, S. og Koch, L. (2011): Forskningsmetoder i folkesundhedsvidenskab. 4. udg., Munksgaard

Denmark: Copenhagen.

- Zakaria, Idlan. 2012. "Performance Measures, Benchmarks and Targets in Executive Remuneration

Contracts of UK Firms." The British Accounting Review 44 (3): 189-203.

- Zimmerman, J. 1997. ‘EVA and performance measurement: capturing synergies and other issues.’

Journal of Applied Corporate Finance, p. 98-109.

Books:

- Banghøj Jesper. 2006. "Financial Accounting Information and Compensation in Danish Companies."

In , edited by Copenhagen Business School. CBS The Ph.D. School in Economics and Business

Administration, 1-205. København: Copenhagen Business School. CBS ; The Ph.D. School in

Economics and Business Administration;.

- Bebchuk, L. A.; Fried, J. M. (2004): Pay without Performance: The Unfulfilled Promise of Executive

Compensation. London: Harvard University Press.

- Bryman, A., & Bell, E. (2007). Business research methods. Oxford university press.

- Bryman, Alan. 2012. Social research methods. Oxford university press.

- Kaplan, R.S. & Atkinson, A.A. (1998): Advanced Management Accounting. 3. ed. London: Prentice

Hall Int., 1998

- Lazear, E.P. & Gibbs, M. (2009): Personnel Economics in Practice. Danvers, John Wiley & Sons.

- Petersen, Christian, V. & Plenborg T. 2012. Financial Statement Analysis, Valuation, Credit Analysis,

Executive Compensation,. Harlow:.

- Zikmund, W. G., Carr, J. C., & Griffin, M. (2012). Business research methods. CengageBrain. com.


12. References


Online:

- Petersen, C. V. (2011). "5.2 Regnskabsbaseret Bonusaflønning, Hvad Ledelsen Bør Vide Om Design

Af Regnskabsbaserede Bonusaftaler." Chap. 5.2, In Børsen Ledelseshåndbøger [Økonomistyrring],

edited by Steen Hildebrandt Nikolaj Bukh. http://ledelseshandboger.borsen.dk.esc-

web.lib.cbs.dk/article/view/511/regnskabsbaseret_bonusafloenning.html: Børsen Forum A/S.

Online access 09-09-13

- PwC - C20 Regnskabsprisen – fokus på en bedre årsrapport. Online access 09-09-

13http://www.pwc.dk/da/nyt/finance/regnskab/c20-regnskabsprisen.jhtml

- PwC - Globale ledere: Kompleksiteten i lønpakkerne er blevet for stor. Online access 09-09-13

http://www.pwc.dk/da/presse/meddelelser/incitamentsafloenning.jhtml

Investor Pages

- A.P. Møller-Maersk A/S - http://www.maersk.com/pages/default.aspx

- Carlsberg A/S - http://www.carlsberggroup.com/investor/Pages/default.aspx

- Chr. Hansen Holding A/S - http://investor.chr-hansen.com/

- Coloplast A/S - http://www.coloplast.com/Investor-Relations/Dansk-information/

- Danske Bank A/S - http://www.danskebank.com/en-uk/ir/Pages/investor-relations.aspx

- DSV A/S - http://investor.dsv.com/

- FLSmidth & Co - http://www.flsmidth.com/en-US/Investor+Relations

- GN Store Nord A/S - http://www.gn.com/Investor

- H.Lundbeck A/S - http://investor.lundbeck.com/

- Jyske Bank A/S - http://www.jyskebank.dk/wps/portal/jfo/ir

- Nordea Bank AB DKK - http://www.nordea.com/Investor+Relations/50892.html

- Novo-Nordisk A/S - http://www.novonordisk.com/investors/

- Novozymes - http://www.novozymes.com/en/investor/Pages/default.aspx

- Pandora A/S - http://investor.en.pandora.net/

- SAS AB DKK - http://www.sasgroup.net/SASGROUP_IR/CMSContent/Home.htm

- TDC A/S - http://investor.tdc.dk/

- Topdanmark - http://inv.topdanmark.com/

- Tryg A/S - http://tryg.com/dk/investor/index.html

- Vestas Wind Systems A/S - http://www.vestas.com/da/investor.aspx

- William Demant Holding A/S - http://www.demant.com/investor.cfm

http://ledelseshandboger.borsen.dk.esc-web.lib.cbs.dk/article/view/511/regnskabsbaseret_bonusafloenning.html

http://ledelseshandboger.borsen.dk.esc-web.lib.cbs.dk/article/view/511/regnskabsbaseret_bonusafloenning.html

http://www.pwc.dk/da/nyt/finance/regnskab/c20-regnskabsprisen.jhtmlOnline%20access%2009-09-13

http://www.pwc.dk/da/presse/meddelelser/incitamentsafloenning.jhtml

http://www.maersk.com/pages/default.aspx

http://www.carlsberggroup.com/investor/Pages/default.aspx

http://investor.chr-hansen.com/

http://www.coloplast.com/Investor-Relations/Dansk-information/

http://www.danskebank.com/en-uk/ir/Pages/investor-relations.aspx

http://investor.dsv.com/

http://www.flsmidth.com/en-US/Investor+Relations

http://www.gn.com/Investor

http://investor.lundbeck.com/

http://www.jyskebank.dk/wps/portal/jfo/ir

http://www.nordea.com/Investor+Relations/50892.html

http://www.novonordisk.com/investors/

http://www.novozymes.com/en/investor/Pages/default.aspx

http://investor.en.pandora.net/

http://www.sasgroup.net/SASGROUP_IR/CMSContent/Home.htm

http://investor.tdc.dk/

http://inv.topdanmark.com/

http://tryg.com/dk/investor/index.html

http://www.vestas.com/da/investor.aspx

http://www.demant.com/investor.cfm


12. References


Publications:

- Committee on Corporate Governance 2013, “Recommendation on Corporate Governance”

http://corporategovernance.dk/file/371640/commitee_on_corporate_governance_recommendati

ons_on_corporate_governance.pdf accessed 17-09-13

- Danish Act on Commercial Enterprises’ Presentation of Financial Statements, etc. (the Danish

Financial Statements Act https://www.retsinformation.dk/Forms/r0710.aspx?id=136726, accessed

17-09-13

2011 UK edition:

http://www.fsr.dk/Faglige_informationer/Regnskaber/Love%20og%20bekendtgoerelser/Aarsregns

kabsloven/engelsk%20version%20af%20loven, accessed 17-09-13

- OECD 2004, “Principles of Corporate Governance”: accessed 17-09-13

http://www.oecd.org/corporate/ca/corporategovernanceprinciples/31557724.pdf

- OECD 2010, “Corporate governance and the financial crisis”:

http://www.oecd.org/daf/ca/corporategovernanceprinciples/44679170.pdf accessed 17-09-13

Annual reports

- A.P. Møller-Maersk - Annual report 2011/2012

- Carlsberg A/S - Annual report 2011/2012

- Chr. Hansen Holding A/S - Annual report 2011/2012

- Coloplast A/S - Annual report 2011/2012

- Danske Bank A/S - Annual report 2011/2012

- DSV A/S - Annual report 2011/2012

- FLSmidth & Co - Annual report 2011/2012

- GN Store Nord A/S - Annual report 2011/2012

- H.Lundbeck A/S - Annual report 2011/2012

- Jyske Bank A/S - Annual report 2011/2012

- Nordea Bank AB DKK - Annual report 2011/2012

- Novo-Nordisk A/S - Annual report 2011/2012

- Novozymes - Annual report 2011/2012

- Pandora A/S - Annual report 2011/2012

- SAS AB DKK - Annual report 2011/2012

- TDC A/S - Annual report 2011/2012

- Topdanmark - Annual report 2011/2012

http://corporategovernance.dk/file/371640/commitee_on_corporate_governance_recommendations_on_corporate_governance.pdf

http://corporategovernance.dk/file/371640/commitee_on_corporate_governance_recommendations_on_corporate_governance.pdf

https://www.retsinformation.dk/Forms/r0710.aspx?id=136726

http://www.fsr.dk/Faglige_informationer/Regnskaber/Love%20og%20bekendtgoerelser/Aarsregnskabsloven/engelsk%20version%20af%20loven

http://www.fsr.dk/Faglige_informationer/Regnskaber/Love%20og%20bekendtgoerelser/Aarsregnskabsloven/engelsk%20version%20af%20loven

http://www.oecd.org/corporate/ca/corporategovernanceprinciples/31557724.pdf%20accessed%2017-09-13

http://www.oecd.org/daf/ca/corporategovernanceprinciples/44679170.pdf


12. References


- Tryg A/S - Annual report 2011/2012

- Vestas Wind Systems A/S - Annual report 2011/2012

- William Demant Holding A/S - Annual report 2011/2012


13. List of Figures


13 List of Figures

Figure 2.1 – Disposition of the thesis (Source: Own creation) .......................................................................... 8

Figure 5.1 - Executive remuneration (Carlsberg annual report 2011-2012, 78) ............................................. 16

Figure 6.1 – Overview of Bonus components and bonus criteria (Source: Own creation) ............................. 23

Figure 6.2 – Factors influencing noise and risk in a bonus contract (Source: Own creation) ......................... 27

Figure 6.3 - Overview of feedback process (Merchant 2006, 897) ................................................................. 28

Figure 6.4 - Types of performance measures (Source: Own creation) ............................................................ 31

Figure 6.5 - Overview of revenue absolute performance measure’s fulfilment of bonus criteria (Source: Own

creation) .......................................................................................................................................................... 35

Figure 6.6 - Overview of EBIT absolute performance measure’s fulfilment of bonus criteria (Source: Own

creation) .......................................................................................................................................................... 36

Figure 6.7 - Overview of net earnings absolute performance measure’s fulfilment of bonus criteria (Source:

Own creation) .................................................................................................................................................. 37

Figure 6.8 - Overview of EPS performance measure’s fulfilment of bonus criteria (Source: Own creation) .. 37

Figure 6.9 - Overview of ROIC/ ROE performance measure’s fulfilment of bonus criteria (Source: Own

creation) .......................................................................................................................................................... 39

Figure 6.10 - Overview EVA performance measure’s fulfilment of bonus criteria (Source: Own creation) ... 40

Figure 6.11 - Overview of budget performance standard’s fulfilment of bonus criteria (Source: Own

creation) .......................................................................................................................................................... 42

Figure 6.12 - Overview of absolute performance measure combined with budget standard and the

fulfilment of bonus criteria (Source: Own creation) ....................................................................................... 43

Figure 6.13 - Overview of prior year's result performance standard’s fulfilment of bonus criteria (Source:

Own creation) .................................................................................................................................................. 44

Figure 6.14 - Overview of absolute performance measure combined with budget standard and the

fulfilment of bonus criteria (Source: Own creation) ....................................................................................... 44

Figure 6.15 - Overview of realised earnings compared with cost of capital performance standard’s fulfilment

of bonus criteria (Source: Own creation) ........................................................................................................ 45


13. List of Figures


Figure 6.16 - Overview of absolute performance measure combined with realised earnings compared with

cost of capital standard and the fulfilment of bonus criteria (Source: Own creation) ................................... 45

Figure 6.17 - Overview of the discretionary performance standard’s fulfilment of bonus criteria (Source:

Own creation) .................................................................................................................................................. 47

Figure 6.18 - Overview of the timeless performance standard’s fulfilment of bonus criteria (Source: Own

creation) .......................................................................................................................................................... 47

Figure 6.19 - Overview of the peer-group performance standard’s fulfilment of bonus criteria (Source: Own

creation) .......................................................................................................................................................... 49

Figure 6.20 - Overview of the linear pay for performance structure in relation to bonus criteria (Source:

Own creation) .................................................................................................................................................. 50

Figure 6.21 - Overview of non-linear pay for performance structure in relation to bonus criteria (Source:

Own creation) .................................................................................................................................................. 51

Figure 8.1 - Overview of absolute performance measure’s fulfilment of bonus criteria (Source: Own

creation) .......................................................................................................................................................... 67

Figure 8.2 - Overview of absolute performance measure combined with budget standard and the fulfilment

of bonus criteria (Source: Own creation) ........................................................................................................ 68

Figure 8.3 - Overview of combining absolute performance measure, budget standard, non-linearity with cap

and floor and the fulfilment of bonus criteria (Source: Own creation) .......................................................... 70

Figure 9.1 – Overview of bonus components and bonus criteria (Source: Own creation) ............................. 71

Figure 9.2 - Overview of the combination of the EVA performance measure, external peer-group standard,

linear pay for performance structure and the fulfilment of bonus criteria (Source: Own creation) .............. 72


14. List of Tables


14 List of Tables

Table 7.1 – Sample size (Source: Own creation) ............................................................................................. 55

Table 7.2 - Sample categorized by industry (Source: Own creation) .............................................................. 56

Table 7.3 - Specified/ unspecified financial performance measures (Source: Own creation) ........................ 57

Table 7.4 - Type of financial performance measures (Source: Own creation) ................................................ 57

Table 7.5 - Financial performance measures (Source: Own creation) ............................................................ 58

Table 7.6 - Nr. of performance measures (Source: Own creation) ................................................................. 58

Table 7.7 – Specified/ unspecified financial performance standards (Source: Own creation) ....................... 59

Table 7.8 - Type of performance standard (Source: Own creation) ................................................................ 59

Table 7.9 – Number of performance standards in relation to performance measures (Source: Own creation)

......................................................................................................................................................................... 59

Table 7.10 – Weighted relative number of performance standards in relation to performance measures

(Source: Own creation) .................................................................................................................................... 60

Table 7.11 - Specified/ unspecified financial performance structure (Source: Own creation) ....................... 61

Table 7.12 – Number of performance structures in relation to performance measures (Source: Own

creation) .......................................................................................................................................................... 61

Table 7.13 – Weighted relative number of performance structures in relation to performance measures

(Source: Own creation) .................................................................................................................................... 62

Table 7.14 - Performance structure in relation to performance standards (Source: Own creation).............. 62

Table 7.15 – Type of performance measures (Source: Own creation based on Banghøj’s study) ................. 63

Table 7.16 – Performance measures (Source: Own creation based on Banghøj’s study)............................... 63

Table 7.17 – Performance standards (Source: Own creation based on Banghøj’s study) .............................. 64

Table 7.18 - Performance measures primary and secondary data (Source: Own creation based own findings

and on Banghøj’s study) .................................................................................................................................. 65


15. Appendix (Overview)


15 Appendix (Overview)

Appendix 1: Full Table of contents ................................................................................................................. 91

Appendix 2: Abbreviation list ......................................................................................................................... 95

Appendix 3: Agency Theory Overview ........................................................................................................... 96

Appendix 4: Single-period versus multiple-period performance measure .................................................. 96

Appendix 5: Effect that different projects has on ROIC ................................................................................ 97

Appendix 6: Non-linear with cap and floor pay for performance structure ................................................. 97

Appendix 7: Jensen: Non-linear with cap and floor pay for performance structure ................................... 98

Appendix 8: Jensen: Steps in budgeting process: Combining de-central and central knowledge ............... 99

Appendix 9: Jensen: Implication for initiation and implementation .......................................................... 100

Appendix 10: Different types of non-linear pay for performance structures ............................................ 101

Appendix 11: Example of Bonus bank .......................................................................................................... 101

Appendix 12: Bonus bank: Different scenarios ............................................................................................ 102




15.1 Full Table of Contents

Appendix 1: Full Table of contents

1 Executive Summary ........................................................................................................................... 1

Chapter 1. Introduction and Problem Identification ......................................................................................... 4

2 Introduction ....................................................................................................................................... 4

2.1 Problem Statement ....................................................................................................................... 6

2.2 Purpose and focus the thesis ......................................................................................................... 6

2.3 Delimitation ................................................................................................................................... 7

2.4 Disposition of the thesis ................................................................................................................ 8

3 Methodology ..................................................................................................................................... 9

3.1 Research Purpose .......................................................................................................................... 9

3.2 Research approach ........................................................................................................................ 9

3.3 Inductive and deductive methods ............................................................................................... 11

3.4 Literature Review ........................................................................................................................ 11

Chapter 2. Theory on Bonus Compensation.................................................................................................... 13

4 Theoretical frame ............................................................................................................................ 13

5 Corporate Governance and Agency Theory .................................................................................... 13

5.1 Corporate Governance ................................................................................................................ 13

5.2 Disclosure of Bonus Pay Information .......................................................................................... 15

5.2.1 Law on disclosure of enterprise information ...................................................................... 16

5.2.2 OECD Principles of Corporate Governance ......................................................................... 16

5.2.2.1 OECD Corporate governance and the Financial crisis ..................................................... 17

5.2.3 Committee on Corporate Governance in Denmark ............................................................ 17

5.2.4 The value relevance of voluntary disclosure in the annual report ...................................... 18

5.3 Agency Theory ............................................................................................................................. 18




5.3.1 Theory of Principal and Agent ............................................................................................. 19

5.3.1.1 Agency Theory Foundations ............................................................................................ 19

5.3.2 Agency Problem ................................................................................................................... 20

5.3.2.1 Agency cost ...................................................................................................................... 20

5.3.2.2 Asymmetric information .................................................................................................. 21

5.3.2.2.1 Moral Hazard ............................................................................................................. 21

5.3.2.2.2 Adverse Selection ...................................................................................................... 22

6 Compensation .................................................................................................................................. 23

6.1 Characteristics of an effective bonus plan .................................................................................. 23

6.1.1 Congruence .......................................................................................................................... 24

6.1.2 Controllability ...................................................................................................................... 26

6.1.2.1 Uncontrollable risk .......................................................................................................... 27

6.1.2.2 Incongruence in risk-profile ............................................................................................. 27

6.1.3 Simplicity ............................................................................................................................. 27

6.1.4 Timeliness ............................................................................................................................ 28

6.1.5 Objectivity ............................................................................................................................ 28

6.1.6 Measurement Cost - effective to design/produce .............................................................. 28

6.1.7 Accounting issues ................................................................................................................ 29

6.2 Bonus plan components .............................................................................................................. 30

6.2.1 Performance measures........................................................................................................ 31

6.2.1.1 Absolute ........................................................................................................................... 34

6.2.1.2 Relative ............................................................................................................................ 38

6.2.2 Performance Standards ....................................................................................................... 40

6.2.2.1 Internal performance standards ...................................................................................... 41

6.2.2.2 External performance standards ..................................................................................... 48

6.2.3 Structure of bonus plan ....................................................................................................... 49




6.2.3.1 Linearity ........................................................................................................................... 50

6.2.3.2 Non-linearity .................................................................................................................... 50

6.2.4 Bonus bank .......................................................................................................................... 53

Chapter 3. Empirical Analysis .......................................................................................................................... 55

7 Empirical findings ............................................................................................................................ 55

7.1 Introduction ................................................................................................................................. 55

7.2 Primary data: The quality of public available executive bonus information ............................... 55


7.2.2 Performance standards ....................................................................................................... 59

7.2.3 Performance structure ........................................................................................................ 61

7.3 Secondary data: Findings of financial bonuses among Danish executives .................................. 63




7.4 Summary of the findings from the primary and secondary data ................................................ 65




Chapter 4. Guidelines Based on Theoretical and Empirical Findings .............................................................. 67

8 Empirical versus Theoretical Findings ............................................................................................. 67

8.1 Performance Measures ............................................................................................................... 67

8.2 Performance Standards ............................................................................................................... 68

8.3 Performance Structure ................................................................................................................ 69

9 Guidelines for accounting based bonus contract ............................................................................ 71

10 Discussion ........................................................................................................................................ 74

10.1 Critique of the Agency Theory ..................................................................................................... 74




10.2 Quality of available information: ................................................................................................. 75

10.3 Critique of well-designed bonus plans: ....................................................................................... 75

10.4 Criticism of Compensation .......................................................................................................... 76

Chapter 5. Conclusion, Reflection and Further Studies ................................................................................... 77

11 Conclusion ....................................................................................................................................... 77

11.1 Reflection on the development of the thesis .............................................................................. 79

11.2 Further studies............................................................................................................................. 79

11.2.1 Improved information quality ............................................................................................. 80

11.2.2 A deeper understanding of the Danish corporate governance system .............................. 80

11.2.3 Further analysis of what can explain the incongruence between empirical findings and

theory 80

11.2.4 Multiple performance measures ......................................................................................... 80

12 References ....................................................................................................................................... 81

13 List of Figures ................................................................................................................................... 87

14 List of Tables .................................................................................................................................... 89

15 Appendix (Overview) ....................................................................................................................... 90

15.1 Full Table of Contents .................................................................................................................. 91

15.2 Appendix – Tables and figures ..................................................................................................... 96




Abbreviation list

Appendix 2: Abbreviation list

CEO – Chief executive officer

COC – Cost Of Capital

CORG – Committee on Corporate Governance

CSE – Copenhagen stock Exchange

E – Earnings

EBIT – Earnings Before Interest and Tax

EBITDA - Earnings Before Interest Tax Depreciation and Amortisation

EPS – Earnings per share

EVA – Economic Value Added

EVA – Economic Value Added

NOPAT – Net Operating Profit After Tax

NPV – Net Present Value

P/E – Price-to-earnings ratio

ROI – Return on Investment

ROIC – Return on Invested Capital

SVA – Shareholder Value Added

WACC – Weighted average cost of capital

Throughout the thesis the following will be used interchangeably (specific for each bullet point):

Pay, remuneration, compensation

Management, managers, executives (members of the management board in a company)




15.2 Appendix – Tables and figures

Appendix 3: Agency Theory Overview

Agency Theory Overview (Eisenhardt 1989, 59)

Appendix 4: Single-period versus multiple-period performance measure

Single-period versus multiple-period performance measure (Petersen, C. V. (2011), Online access 09-09-13)




Appendix 5: Effect that different projects has on ROIC

Effect that different projects has on ROIC (Petersen, C. V. (2011), Online access 09-09-13)

Appendix 6: Non-linear with cap and floor pay for performance structure

Non-linear with cap and floor pay for performance structure (Petersen et al. 2012, 320)




Appendix 7: Jensen: Non-linear with cap and floor pay for performance structure

Paying People to Lie: the Truth about the Budgeting Process (Jensen 2003, 386)




Appendix 8: Jensen: Steps in budgeting process: Combining de-central and central

knowledge

Steps in budgeting process: Combining de-central and central knowledge (Slide from Accounting and control – Lesson 10)




Appendix 9: Jensen: Implication for initiation and implementation

Implication for initiation and implementation (Slide from Accounting and control – Lesson 10)




Appendix 10: Different types of non-linear pay for performance structures

slides from PMI course lesson 5 slide 22

Appendix 11: Example of Bonus bank

Example of Bonus Bank (Petersen 2012, 323)




Appendix 12: Bonus bank: Different scenarios

Bonus Bank: Different scenarios (Petersen 2012, 324)

Documents

Accounting based pay for performance