1 Incentive Issues CHAPTER 12 PowerPointPresentation by PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Managerial Accounting 11E Maher/Stickney/Weil

2 CHAPTER GOAL Chapter 12 discusses issues in design and use of management performance evaluation and incentive plans to motivate managers to act in the organization’s best interests. Good performance evaluation and incentive plans induce “win-win” results if they avoid incentives for fraudulent financial reporting. ☼☼

3 PAY INCENTIVES Managers receive bonuses for performance that may be based on divisional or corporate results. Bonuses may be based on annual performance or on performance over several years and may be paid immediately or deferred and spread over several years. LO 1

4 What forms do divisional incentives take? Divisional incentives can be cash or profit sharing for short-term performance; stock or stock options as deferred compensation; and special awards. LO 1 MANAGERS WANT TO KNOW! How will performance be evaluated? Performance can be evaluated based on accounting numbers, returns to stockholders or both.

5 DESIGNING INCENTIVE COMPENSATION Management must ascertain two things in designing incentive systems:  What behavior does the system motivate?  What behavior does management desire? LO 1 WARNING! Rewarding managers for performance reflected in annual accounting numbers gives managers incentives to take actions that make the numbers look good but not actions that benefit the organization.

6 INCENTIVES and PRODUCT LIFE CYCLE A major problem with short-run incentive plans is that managers are penalized for developing products that might produce long-run benefits. Under U.S.GAAP, firms write off research and development costs when incurred. IFRSs do not require as much write-off as U.S. GAAP LO 1

7 PRODUCT LIFE CYCLE : Stages Four stages of the product life cycle are:  Design and development: low sales but high research, design and development costs  Growth  Maturity  Decline LO 1

8 EXPECTANCY THEORY: Definition Maintains that people act in ways to obtain rewards they desire and prevent penalties they wish to avoid. LO 2

9 AGENCY THEORY: Definition Deals with relations between supervisors and workers and assumes employees will not necessarily behave as their employers desire. LO 2

EXHIBIT 12.2 LO 2 The objective of a good incentive compensation is to minimize agency costs.

11 What are extrinsic rewards ? Extrinsic rewards come from outside the individual, i.e., the supervisor, etc. LO 2 MANAGERS WANT TO KNOW! What are intrinsic rewards ? Intrinsic rewards come from inside the individual such as satisfaction for a job well done.

12 BALANCED SCORECARD: Definition Is a model of lead and lag indicators of performance including both financial and nonfinancial performance measures. LO 3

13 BALANCED SCORECARD PERSPECTIVES Four perspectives of the balanced scorecard approach are:  Learning and growth  Internal business and production process perspective  Customer  Financial LO 3

14 INCENTIVE QUESTION 1 Should rewards be based on current or future performance? An advantage to basing on future performance is the “golden handcuffs” that tie managers to the company. Most companies use a combination of current and deferred rewards. LO 3

15 INCENTIVE QUESTION 2 Should rewards be based on division or company-wide performance? When based on the manager’s responsibility center alone, it focuses the attention without considering the impact of their actions on the whole company. Most companies use both. LO 3

16 INCENTIVE QUESTION 3 Should rewards use a fixed formula or subjective judgment in providing rewards? The advantage of a formula-based plan is that managers know what is expected and what reward they will get if they meet expectations. LO 3

17 INCENTIVE QUESTION 4 Should rewards be based on accounting results or stock performance? Tying managers’ compensation to stock performance loads uncontrollable risk on them. Using EVA both focuses managers on creating value for shareholders and relies on nonstock performance measures. LO 3

18 INCENTIVE QUESTION 5 Should rewards be based on absolute or relative performance evaluation? Relative performance compares divisional performance with other divisions in the same industry with less than optimum comparisons. LO 3

19 INCENTIVE QUESTION 6 Should rewards be cash, stock or prizes? Many companies use a combination because of the different (current vs. deferred) methods of reward. Expectancy theory finds prizes more attractive and more motivating. LO 3

20 FRAUDULENT FINANCIAL REPORTING: Definition Is intentional conduct resulting in materially misleading financial statements. LO 4

21 TYPES OF FRAUD Fraudulent financial reporting usually falls into two categories:  Improper revenue recognition  Firm reports profit in wrong accounting period  Overstating inventory  Increases reported earnings in period of overstatement  In absence of continuing overstatement, must result in reduced earnings in next period LO 4

22 INTERNAL CONTROL: Definition Is a process designed to provide reasonable assurance that an organization will achieve its objectives in (a) operating effectiveness and efficiency; (b) reliability of financial reporting; and (c) compliance with applicable laws and regulations. LO 5

23 INDEPENDENT AUDITORS Independent audits  Are required by the SEC for firms selling securities across state lines  Help prevent fraud through reviews of internal controls LO 5

24 CORRUPTION According to economists, three elements that must be present for corruption to occur are:  Individual must have discretionary power to award contract or rights  Economic benefits are associated with discretionary power  Legal system must be unlikely to detect wrongdoing LO 5

25 End of CHAPTER 12