Chapter 10 Executive Compensation

Nish VairavanathanAthavan Thulakanathan

Sally Zhu

http://www.youtube.com/watch?v=vh0U0V8246U

Agenda10.2- Are Incentive Contracts Necessary?10.3- A Managerial Compensation Plan10.4.1- Using Net Income and Share price in

Evaluating Manager Performance10.4.2- Short-Run and Long-Run Effort10.4.3- The Role of Risk in Executive Compensation 10.5- Empirical Compensation Research10.6- The Politics of Executive Compensation10.7- The Power Theory of Executive Compensation10.8- Social Significance of Managerial Labour

Markets That Work well

10.2 Are Incentive Contracts Necessary?Most Of The Research Suggests Incentive

Contracts Are Necessary:Fama:

Incentive Contract’s Aren’t Necessary Because Managerial Labour Markets Control For Moral Hazard

Arya, Fellingham, and Glover (AFG):Incentive Contracts For Lower Level Managers Are Necessary

Wolfson:Found That Market Forces Reduce Moral Hazard Likelihood

But Does Not Eliminate ItBushman, Engel, & Smith

Markets Can’t Value a manager’s reputation perfectly based on accounting information and therefore incentive contracts might be necessary

10.3 A Managerial Compensation PlanMany Managerial Compensation Plans

Require:Holding A Significant Amount Of Company

SharesHolding Three Main Compensation

Components:SalaryAnnual Short-Term Incentive Awards (i.e. Cash

Bonuses, DSUs)Stock Options

10.3 A Managerial Compensation PlanMany Managerial Compensation Plans Require:A Performance Measure Be Reached

Before Incentive Compensation Becomes Payable

o Threshold Level Of Performance Is Called The Bogey

o Upper Limit Of Compensation Is Called Cap

10.3 A Managerial Compensation PlanA Mix of Short And Long-Term Incentive Components Is Important For The Following Reasons:

To Maximize Current Year PerformanceTo Reinforce Longer-Term Considerations

o A High Proportion Of Long-Term Incentive Components Should Produce Longer Manager Decision Horizon

10.3 A Managerial Compensation PlanAlong with Short-Term and Long-Term Incentive Components, A Firm Can Also Create Mid-Term Incentive Components:

Restricted Share Units Are Units Of Stock That Are Awarded When One Or More Targets Are Met

10.3 A Managerial Compensation PlanShort-Run Incentives Like Employment Stock Options (ESOs) Can Create Dysfunctional Behaviour As It Shortens The Decision Horizon

10.3 Real Example of Executive CompensationBarrick Gold CEO: Aaron RegentTOTAL COMPENSATION IN 2010*

Total Annual Cash Compensation$1,544,810

Total Short Term Compensation$1,544,810

Other Long Term Compensation$2,455,578

Total Calculated Compensation$6,959,161

Two Performance Measures:• Share price (High in sensitivity, Low in precision)• Net Income (Low in sensitivity, High in precision)

Banker and Datar (1989); lower the noise in net income and the greater its sensitivity to manager effort, the greater should be the proportion of net income to share price in determining the manager’s overall performance

10.4 The Theory of Executive Compensation

10.4 Theory of Executive Compensation

How To Increase Sensitivity of Net Income?

• Reduce recognition lag e.g. current value accounting reduces recognition lag but tradeoff is precision

• Full disclosure

10.4 Theory of Executive Compensation

Manager effort can be divided into SR & LR:

• Controlling length of manager decision horizon is important because expected net income is more likely to be not congruent to expected payoff [ Example 10.1, pg. 375 ]

• Greater proportion of performance based on share price relative to net income, increases long-run effort to short-run effort, and vice versa

10.4 Theory of Executive Compensation

Compensation risk affects how the manager operates the firm:

• Not enough risk = low manager effort• Too much risk = manger avoids risky

projects

Goal is to control compensation risk, not eliminate it

10.4 Theory of Executive Compensation

Controlling Compensation Risk:

• Relative performance evaluation (Holmstrom,1982), measured by the difference between the firm’s net income and/or share price performance and the average performance of a group of similar firms

• Idea is to eliminate the industry wide risk and allow a net performance that more precisely reflects the manager’s efforts

• However, despite theoretical appeal, there is weak evidence for RPE (Antle and Smith, 1986)

10.4 Theory of Executive Compensation

Controlling compensation risk:

• control downside risk by implementing a ‘bogey’ • placing a cap controls upside risk• role of board e.g. compensation committee• role of conservative accounting

One measure is not better than another, idea is to have a mix of performance measures

A Short Clip http://www.youtube.com/watch?v=8TgcNsaUfrg&feature=relat

ed

10.5 Empirical Compensation ResearchResearch suggesting efficient

compensation contracting• Lambert & Lacker (LL) – (1987)

• ROE was more highly related to cash compensation than return on shares

• Lower the noise in net income, better prediction in payoff

• Lower correlation in compensation and ROE for growth firms• Net income less sensitive to management

effort than average firms• Higher weight in ROE when low correlation

between ROE and return on shares

10.5 Empirical Compensation Research

Summary of LL Research:

• Corr(total comp, NI) >Corr(total comp, share prices): Bonus plans are more popular

• If there is high Corr (total comp, NI)• NI is use for management stewardship

• If there is high Corr(NI, Share price)• NI is use for investment decisions

Corr(total comp, NI) High sensitivity and low precision

Corr(total comp, share prices) Low sensitivity and high precision

10.5 Empirical Compensation Research

Other Research:

• Indjejikian & Kanda (2002) Lower variability of ROE higher the target bonus

relative to base salary

• Bushman, Indjejikian & Smith (1996) Growth firm CEOs derived greater proportion of

compensation from individual performance measure relative to NI and stock-based measures

• Baber, Kang & Kumar (1999) Effect of earnings changes on compensation

increase with persistence of those earnings changes

10.6 The Politics of Executive Compensation

CEO compensation may be less than it seems at first glance

• Jensen and Murphy (JM) 1990: CEOs earn $2.59 increase per $1,000 in

increase in shareholder wealth. Variability (std) of CEO compensation =

variability of compensation of workers Conclusion: CEO did not bear enough risk

to motivate good performance, and recommended larger stock holding by managers

10.6 The Politics of Executive Compensation

Counterarguments to JM:• Low relationship between pay and

performance• Limited downside risks

• Exclude extraordinary loss in bonus rewards and include extraordinary gain

Encourage risky projects Market downturn than bad performance

• Golden Parachutes

10.7 The Power Theory of Executive Compensation

Power theory: executive compensation in practice is driven by manager opportunism, not efficient contracting

• Manager have power to influence own compensation

Influence board of directors and compensation committee’s appointments

• Camouflage excessive compensation Compensation consultants Peer groups Late timing of ESO awards

10.8 Social Significance of Managerial Labour Markets

A Manager Making Good Capital Investment Decisions And Improving Firm Productivity Contributes To Social Welfare

Accountants Can Contribute To Social Welfare by: Full Disclosure Contribute To Informativeness Through An

Appropriate Tradeoff Between Sensitivity And Precision

How Does Chapter 10 Relate To Concepts In Previous Chapters?

Ch. 10 Executive Compensation

Ch1.Moral Hazard & Adverse selection

Ch2. Relevance

& Reliability

Ch3. Expected

Utility Maximizatio

n

Ch4. Manageme

nt’s Discussion & AnalysisCh5.Reaso

ns For Market

Response

Ch8.Positive

Accounting Theory

Ch9. Efficient Contracts &

Agency Theory

Ch6. Auditor’s

Legal liability