Chapter 10 Incentive Issues IDIS 364 – Spring 2007

Divisional Incentive Compensation Plans Nearly all managers of decentralized profit centers are eligible for bonuses and other nonsalary incentives Often make up 25% to 50% of their salaries Form of bonus plan varies with payments made in: Cash, Stock or stock options, Performance shares, Stock appreciation rights, and/or Participating units

Divisional Incentive Compensation Plans Bonus can be: Contingent on corporate or divisional results Based on annual performance or on performance over several years Paid out immediately, deferred, or spread out over several years

Divisional Incentive Compensation Plans Most divisional incentive compensation plans have the following characteristics: Cash bonuses and profit sharing plans reward managers for short-term performance Deferred compensation arrangements give manages incentive to take actions that increase long-run share value Special awards may be given for certain accomplishments or for extraordinary performance

Divisional Incentive Compensation Plans When designing incentive plans, management must determine two things: The behavior the system motivates The behavior management desires Some argue that incentive compensation plans may motivate managers to take actions that make the numbers look good but may not benefit the organization in the long-run

Incentives and the Product Life Cycle One problem with short-run incentive plans is that managers can be penalized for developing new products that could produce long-run profits New product development costs are typically expensed as incurred, reducing net income (and perhaps bonuses) Incentive plans should encourage new product development activities

Views of Behavior Expectancy theory view - maintains that people act in ways to obtain rewards and to prevent penalties, so incentive plans should: Provide rewards that are desirable Provide a good chance that behaving as the organization desires will lead to those rewards

Views of Behavior Agency theory - focuses on: Relations between principals and agents where principals assign responsibility and agents work on behalf of the principal The cost of agents pursuing their own interests instead of those of the principal Agency theory views the objective of an incentive plan as minimizing agency costs, essentially trading off the costs of control and incentives against the cost of agents pursuing their own interests

Balanced Scorecard The balanced scorecard is a model of performance indicators that include both financial and nonfinancial measures Most companies use four categories or “perspectives” of performance measures A company can build an incentive plan around these four perspectives

Balanced Scorecard Learning and growth perspective - indicates how well the infrastructure for innovation and long-term growth is working Focuses on developing the capabilities of employees Key measures for evaluating manager performance in this area might include: Employee satisfaction Employee retention Employee productivity

Balanced Scorecard Internal business & production process perspective - indicates how well internal business processes are working Closely related to the learning and growth perspective Employees are the best source of better ideas for better business processes Supplier relations are critical for success Company may provide incentives for good supplier relations such as certification programs

Balanced Scorecard Customer perspective - indicates how the company’s strategy and operations add value to customers Focuses on how a company should look to its customers for success Company should provide incentives to employees to meet customer expectations Performance measures might include: Customer satisfaction and retention Market share Customer profitability

Balanced Scorecard Financial perspective - indicates whether company’s strategy and operations add value to shareholders Performance measures include: Net income Return on investment

Motivational Issues in Designing Incentive Systems When designing incentive systems, choices must be made regarding whether rewards are based on: Current or future performance Division or company-wide performance Fixed formulas or subjective assessments Accounting results or stock performance Absolute or relative performance Cash awards, stock awards, or prizes

Problems With Incentive Compensation Plans Managers and other employees are many times placed under great pressure to meet short-term performance standards like profits and return on investment Employees may be tempted to “cook the books” by: Carrying obsolete inventory on the books Overstating revenue, Understating costs, or Other methods

Fraudulent Financial Reporting Fraudulent financial reporting is intentional conduct resulting in materially misleading financial statements For financial reporting to be fraudulent It must result from intentional or reckless conduct Resulting misstatements must be material to the financial statements

Types of Fraud Two most common types of fraud Improper revenue recognition Example: reporting profit-increasing effects of revenue in the wrong accounting period Overstating inventory Leads to overstated earnings

Causes of Financial Fraud Fraudulent financial reporting may occur because of a combination of pressures, incentives, opportunities, and environment May result from: High-pressure performance evaluation systems The environment top management sets for dealing with ethical issues Lack of, or inadequate, internal controls

Internal Controls Companies establish internal controls to help prevent fraud Internal controls are policies and procedures designed to assure management that actions undertaken by employees will meet organizational goals A basic internal control would involve a separation of duties so that one employee could not carry out a series of tasks to commit fraud and take steps to hide it

Auditing Internal auditors can deter fraud by reviewing and testing internal controls and ensuring controls are in place and working properly Independent auditors provide an opinion on the financial statements Fraud detection is not their primary responsibility, but presence of auditors and their review of the internal control system should help to deter it

End of Chapter 10