1. © 2006 Pearson Education Canada Inc.10-1 CHAPTER 10 Executive Compensation

2. © 2006 Pearson Education Canada Inc.10-2 Reporting On Manager Performance A Second Major Role For Financial Reporting

3. © 2006 Pearson Education Canada Inc.10-3 Two Aspects of Reporting On Manager Performance Enable the Managerial Labour Market to Properly Value Manager Performance and Reputation Provide a Performance Measure for Managerial Incentive Contracts

4. © 2006 Pearson Education Canada Inc.10-4 Manager “Effort” Manager Effort Really a Set of Activities Partition the Set Into Short-Run and Long-Run Decision Horizon Activities –Short-run activities example Cost control –Long-run activities examples R&D, planning, capital expenditures

5. © 2006 Pearson Education Canada Inc.10-5 Desirable Property of a Managerial Performance Measure Highly Informative about Manager Effort (stewardship) –Informativeness depends on Precision of the performance measure Sensitivity of the performance measure

6. © 2006 Pearson Education Canada Inc.10-6 Net Income as a Performance Measure Sensitivity of Net Income –Historical cost-based net income “waits” until many aspects of manager effort are realized (recognition lag) R&D, advertising Capital expenditure programs –May encourage a short-run decision horizon –May be managed Reduces sensitivity by disguising shirking

7. © 2006 Pearson Education Canada Inc.10-7 Net Income as a Performance Measure, Cont’d. Impact of fair value accounting on sensitivity –Increases sensitivity by reducing recognition lag

8. © 2006 Pearson Education Canada Inc.10-8 Net Income as a Performance Measure, Cont’d. Precision of Historical Cost-based Net Income –Relatively unaffected by economy-wide and other events that are uninformative about manager effort

9. © 2006 Pearson Education Canada Inc.10-9 Net Income as a Performance Measure, Concl. Impact of Fair Value Accounting on Precision of Net Income –Less precise than historical cost-based net income since more subject to economy-wide factors If Reduction of Precision Outweighs Increase in Sensitivity –Historical-cost based net income may be more informative

10. © 2006 Pearson Education Canada Inc.10-10 Share Price As a Performance Measure Sensitivity of Share Price –Reflects manager effort “sooner” (less recognition lag) Efficient market recognizes expected economic effects of manager effort without waiting for realization –R&D, advertising –Capital expenditure programs –May encourage long-run decision horizon

11. © 2006 Pearson Education Canada Inc.10-11 Share Price As a Performance Measure, Cont’d Precision of Share Price –More volatile than net income Impacted by economy-wide events, reducing informativeness about effort –Interest rate changes –deregulation –booms, recessions –Less ability to manage

12. © 2006 Pearson Education Canada Inc.10-12 Share Price v. Net Income As Performance Measures Conclude: –Net income (historical cost-based) relatively precise but low in sensitivity –Share price relatively sensitive but low in precision

13. © 2006 Pearson Education Canada Inc.10-13 Share Price v. Net Income As Performance Measures, Cont’d. Not a Question of Either/Or –Holmström (1979) suggests use both –Can control manager’s decision horizon by the proportion of net income to share price in the incentive contract (Bushman & Indjejikian, 1992) More net income  shorter horizon, and vice versa

14. © 2006 Pearson Education Canada Inc.10-14 How Can Accountants Increase Role of Net Income In Incentive Plans? Fair Value Accounting? –Intangibles (goodwill) –ESOs Full Disclosure –Enables compensation committee to evaluate earnings persistence

15. © 2006 Pearson Education Canada Inc.10-15 The BCE Compensation Plan Salary Short-Term Incentive Awards –Share units or cash bonus, based on Attainment of strategic objectives, e.g. market share, customer satisfaction Attainment of financial targets, e.g., EPS Individual creativity and initiative, e.g., succession planning, management development Note that the more senior the manager, the more compensation depends on performance. Why?

16. © 2006 Pearson Education Canada Inc.10-16 The BCE Compensation Plan, Cont’d. ESOs –Promote longer-term manager incentives –Value to manager based on share price performance –Awarded to bring total compensation up to that of comparable companies –ESOs voluntarily expensed in 2003

17. © 2006 Pearson Education Canada Inc.10-17 The BCE Compensation Plan, Concl. 2004 Revisions to Compensation Plan –Reduce ESOs by 50%. Why? –Shorten decision horizon. Why? Shorten ESO time to expiry Mid-term compensation plan –Restricted share units

18. © 2006 Pearson Education Canada Inc.10-18 Role of Risk Too Little Risk –Reduces effort incentive Too much risk –Manager avoids risky projects –Excessive hedging Controlling Risk –Relative Performance Evaluation Fine in theory, but hard to find in practice –Role of Board, compensation committee

19. © 2006 Pearson Education Canada Inc.10-19 Empirical Compensation Research Lambert & Larcker (1987) –Cash compensation (salary + bonus) more highly correlated with ROE than with return on shares –Correlation higher as noise in NI lower –Correlation lower for growth firms –Higher weight on ROE in compensation plan when correlation between ROE and return on shares low, and vice versa

20. © 2006 Pearson Education Canada Inc.10-20 The Politics Of Executive Compensation Is Executive Compensation Too High? –Jensen & Murphy, “CEO Incentives…” HBR (1990) No, but managers do not bear enough risk--they need to hold more stock –BCE: reduce role of ESOs, replace with restricted stock –Value of ESOs and stock to manager is less than fair value, since cannot diversify