1. Chapter 10 Executive Compensation
Nish Vairavanathan
Athavan Thulakanathan
Sally Zhu

2. Agenda 10.2- Are Incentive Contracts Necessary?
10.3- A Managerial Compensation Plan
Using Net Income and Share price in Evaluating Manager Performance
Short-Run and Long-Run Effort
The Role of Risk in Executive Compensation
10.5- Empirical Compensation Research
10.6- The Politics of Executive Compensation
10.7- The Power Theory of Executive Compensation
10.8- Social Significance of Managerial Labour Markets That Work well

3. 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 It
Bushman, Engel, & Smith
Markets Can’t Value a manager’s reputation perfectly based on accounting information and therefore incentive contracts might be necessary
Fama’s:
argument assumes an efficient managerial labour market that properly values the manager’s reputation.
Arya, Fellingham and Glover: Designed a two period model where two managers can observe each other’s efforts and their payoffs are based on a joint effort. So if one manager shirks in one period than the other will threaten to shirk in the next period which results in both manager’s monitoring each other and ensuring an efficient contract.
Bushman, Engel & Smith: They analyzed a large sample of firms over

4. 10.3 A Managerial Compensation Plan
Many Managerial Compensation Plans Require:
Holding A Significant Amount Of Company Shares
Holding Three Main Compensation Components:
Salary
Annual Short-Term Incentive Awards (i.e. Cash Bonuses, DSUs)
Stock Options
DSU’s-the holders of the shares may not redeem them as long as they are in the employ of the company
Refer to chapter 3 and portfolio diversification and how it’s not in a manager’s best interest to have his income and a large part of his portfolio coming from the same source
Ask them about whether this is contributes to a diversified portfolio?

5. 10.3 A Managerial Compensation Plan
Many Managerial Compensation Plans Require:
A Performance Measure Be Reached Before Incentive Compensation Becomes Payable
Threshold Level Of Performance Is Called The Bogey
Upper Limit Of Compensation Is Called Cap

6. 10.3 A Managerial Compensation Plan
A Mix of Short And Long-Term Incentive Components Is Important For The Following Reasons:
To Maximize Current Year Performance
To Reinforce Longer-Term Considerations
A High Proportion Of Long-Term Incentive Components Should Produce Longer Manager Decision Horizon

7. 10.3 A Managerial Compensation Plan
Along 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

8. 10.3 A Managerial Compensation Plan
Short-Run Incentives Like Employment Stock Options (ESOs) Can Create Dysfunctional Behaviour As It Shortens The Decision Horizon
ESO- employee stock options- gives them the right to buy stock over some period of time

9. 10.3 Real Example of Executive Compensation
Barrick Gold CEO: Aaron Regent
TOTAL COMPENSATION IN 2010*
Total Annual Cash Compensation
$1,544,810
Total Short Term Compensation
Other Long Term Compensation
$2,455,578
Total Calculated Compensation
$6,959,161

10. 10.4 The Theory of Executive Compensation
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
Sensitivity: : rate at which the expected value of the measure responds to manager effort
Precision : reciprocal of the variance of the noise in the measure, also depends on effects on economy-wide factors
TRADEOFF BETWEEN SENSITIVTY AND PRECISION

11. 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

12. 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

13. 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
Managers are risk averse individuals, and trade off risk and return.
Thus, to motivate the manager at the lowest cost, designers of efficient incentive compensation plans try to get the most motivation for a given amount of risk imposed
Or, equivalently, the least risk for a given level of motivation.

14. 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)
Under RPE, if industry has low performance and company does well, you should see higher bonuses
if industry has high performance and company does well, you should see lower bonuses

15. 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
– Downside risk: Compensation may be less than expected, worst case 0 compensation
– Upside risk: Compensation may be more than expected, best case is the capped amount

16. A Short Clip

17. 10.5 Empirical Compensation Research
Research 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

18. 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

19. 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

20. 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

21. 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

22. 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

23. 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
Due to the extensive interaction between accountants and managers, reporting on manager performance is equally important to society as reporting to investors.

24. How Does Chapter 10 Relate To Concepts In Previous Chapters?
Ch1.Moral Hazard & Adverse selection
Ch2. Relevance & Reliability
Ch3. Expected Utility Maximization
Ch9. Efficient Contracts & Agency Theory
Ch. 10 Executive Compensation
Ch4. Management’s Discussion & Analysis
Ch3. Expected Utility Maximization- In chapter 10 it’s where the manager is trying to maximizing his expected utility by working hard in the short run and long run
Ch6. Auditor’s legal liability- Ensuring CEO’s are using conservative accounting practices and using the measurement approach(involves greater usage of current values in the financial statements)- Making sure that Managers are working within international financial reporting standards.
Ch8. Having an incentive contract that doesn’t align the interests of the executive and the firm is an inefficient contract in the sense that the executives decision are going to only consider the factors that will maximize their remuneration that may not be in the best-interests of the firm.
Ie. Managers choosing accounting policies that shift reported earnings from future periods to the current period because their remuneration is heavily based on net income.
Ch9. efficient contracts- contracts with the lowest contracting costs
Ch8.
Positive Accounting Theory
Ch5.Reasons For Market Response
Ch6. Auditor’s Legal liability