Overview Executive plans Necessity of incentive plans Look at theories RBC example http://www.youtube.com/watch?v=kHdq8XbG7v4&fe ature=youtu.be http://www.youtube.com/watch?v=kHdq8XbG7v4&fe ature=youtu.be
Theory of Executive Compensation Efficiency of a compensation plan can be increased if it is based on two or more performance measures Mix of share price and net income in determining manager performance depends upon the product of sensitivity and precision of those measures
The lower the noise in net income and the greater its sensitivity to manager efforts, the greater should be the proportion of net income to share price in determining manager’s overall performance. Share price cannot be replaced as a performance measure as long as it contains additional effort information.
Manager effort can be classified as short-run and long- run efforts Length of managers decision horizon can be influenced by mix of share price and net income based compensation Study by Datar, Kulp and Lambert (2001) suggests that decision horizon must be traded off with sensitivity and precision as performance measures
Risk in Executive Compensation The more risk managers bear, the higher their expected return Several ways to control compensation risk-perhaps most important is relative performance evaluation (RPE) RPE- performance is measured by the difference between the firm’s NI/Share Price performance and average performance of peer firms
This measure removes systematic risks Despite RPE’s theoretical appeal, there is strong evidence that managers aren’t compensated this way Compensation Plans usually impose a bogey – incentive compensation does not kick in until some level of financial performance is reached Many plans also include caps-whereby incentives cease beyond a certain level
Empirical Compensation Research Study by Lambert and Larker (1987) (LL) investigated the relative ability of return on shares and ROE to explain managers’ cash compensation When net income is relatively uninformative to investors, that same NI is relatively informative about manager effort Full disclosure of ‘effort informative’ stewardship information will increase its usage by compensation committees
The Politics of Executive Compensation The question of manager compensation has been a longstanding one in the United States and Canada. Many have argued that top mangers are overpaid. http://www.youtube.com/watch?v=aAQ-QluvS3U
The Politics of Executive Compensation http://www.youtube.com/watch?v=o8DKfQME2o0 http://www.youtube.com/watch?v=W7mpFMpbKGg Sensitivity of shareholder, media, and politicians to perceived excessive compensation continues, reinforced by reaction to management abuses leading p to the 2007-2008 market meltdowns.
The Politics of Executive Compensation Episodes such as this led to various forms of government interference. 1. Bonus controls for bailed-out companies 2. Prohibitions of bonuses and dividends for financial institutions whose legal capital falls below threshold 3. 50% surtax paid by the company on bonuses exceeding specified limits (for U.K. & France)
The Politics of Executive Compensation However; Jensen and Murphy(JM) published a controversial article about top manager compensation.(In 1990) They argued that CEOs were not overpaid but that their compensation was far too unrelated to performance, where performance was measured as the change in the firm’s market value.
The Politics of Executive Compensation In 2009, some more support for an argument that mangers are not overpaid is provided by Gayle and Miller.
The Politics of Executive Compensation These findings imply that the large increase in average executive compensation over time was not driven by mangers securing higher compensation at the expense of the average wage-earner, it is driven by a dramatic increase in the costs of overcoming moral hazard in compensation contracts.
The Politics of Executive Compensation Despite the high absolute amounts of executive compensation, there is evidence that, on average, manager are not overpaid relative to shareholder value created or to increase in per capita income over time. The value of risky compensation received by the manager is less than the cost of this compensation to the firm.
The Power Theory of Executive Compensation What is Power Theory? ( BFW; 2002) The executive compensation in practice is driven by manger opportunism not efficient contracting The managers have sufficient power to influence their own compensation They might use this power to generate excessive pay, at the expense of shareholder value
The Power Theory of Executive Compensation The theory acknowledges that there are limits to the manger’s power over compensation. If compensation awards become too high, they attract negative publicity and at some point the board will have to step in to excessive its responsibility.
How can manager compensation practice be moved towards more efficient contracting? To improve corporate governance Accountants can also assist the governance process Full disclosure enables better identification of earnings components with low persistence and informativeness.
The Social Significance of Managerial Labour Markets that Work Well Manager performance contributes to social welfare. Welfare is increased to the extent managers “work hard”, that is, make good capital investment decisions and bring about high firm productivity.
The Social Significance of Managerial Labour Markets that Work Well More informative performance measures enable more efficient compensation contracts, better reporting on stewardship, and better operation of the managerial labour market, resulting in higher firm productivity and social welfare. Accountants can contribute to informativeness both by an appropriate trade off between sensitivity and precision of net income and by full disclosure.
Conclusions on Executive Compensation Incentive Contracts are still necessary even if managers’ reputations on managerial labour markets fully reflect publicly available information Financial reporting has an important role in motivation executive performance and controlling manager powers.
How Are Earnings Managed? Overview of article What is earnings management? 532 auditors were asked and 253 responded Most likely areas to attempt earnings management?
Most common attempts For expenses they alter reserves For revenues they conduct “Cut-off manipulation” For business combination they over value goodwill.