Chapter 10 * Executive Compensation

Group C
 Executive plans
 Necessity of incentive plans
 Look at theories
 RBC example
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
 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
 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- 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
The Politics of Executive
 The question of manager compensation has been a
longstanding one in the United States and Canada.
 Many have argued that top mangers are overpaid.
The Politics of Executive
 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
 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
 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
 In 2009, some more support for an argument
that mangers are not overpaid is provided by
Gayle and Miller.
The Politics of Executive
 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
 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
 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
 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
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
 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.

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