Chapter 10 The Resource Service

10.3 The BCE Compensation Plan • Components of senior management compensation – Salary – Short-term incentive awards • Cash bonus or deferred share units, based on attainment of financia

Chapter 10

Executive Compensation

Chapter 10 Executive Compensation

10.2 Are Incentive Contracts Necessary?

10.3 The BCE Compensation Plan

• Components of senior management compensation

– Salary

– Short-term incentive awards

• Cash bonus or deferred share units, based on attainment of financial targets (e.g., EPS ) & new business development,

• Individual contribution (based on a third performance measure: creativity & initiative)

– More suitable for less senior managers?

• Compensation components, cont’d.

– Stock options, based on share price performance– Executives required to hold BCE shares

• All compensation components except salary

• Revisions to compensation plan 2004

– Mid-term incentive plan (2 year)

– Reduced stock option awards

• Restricted share units instead

– Reasons for revisions

• To shorten manager decision horizon, but not too short

• Improve BCE corporate governance credibility

10.3 The BCE Compensation Plan

(continued)

10.4 Theory of Executive Compensation

(continued)

• How to increase sensitivity of net income

– Reduce recognition lag

• Net income “waits” until many aspects of manager effort are realized

– R&D, advertising, legal & environmental liabilities

– Capital expenditure programs

• Current value accounting reduces recognition lag

– But decreases precision

10.4 Theory of Executive Compensation

10.4 Theory of Executive Compensation

(continued)

• Two types of manager effort

– Short-run

– Long-run

• If net income congruent to payoff, mix of

short-run and long-short-run effort does not matter to

investor

– Each effort type equally effective in generating payoff

10.4 Theory of Executive Compensation

(continued)

• If net income not congruent to payoff (more

likely), effort mix does matter

– Firm owner may wish to control manager’s effort

mix (i.e., length of manager’s decision horizon)

10.4 Theory of Executive Compensation

10.4.3 The Role of Risk in Executive

Compensation

• Risk goes both ways

– Downside risk: Compensation may be less than expected

– Upside risk: Compensation may be more than expected

• Source of compensation risk

– Lower performance measure precision higher →risk

• Manager must bear some risk to motivate effort

10.4.3 The Role of Risk in Executive

Compensation (continued)

• Too little compensation risk

– Reduces effort incentive

• Too much compensation risk

– Manager avoids risky projects

– Excessive hedging

• Goal is to control compensation risk, not

eliminate it

10.4.3 The Role of Risk in Executive

Compensation (continued)

• Controlling compensation risk

– Relative Performance Evaluation

• Fine in theory, but hard to find in practice

– Bogey of compensation plan

• Controls downside risk

– Cap of compensation plan

• Controls upside risk

– Role of Board, compensation committee

– Role of conservative accounting

– Golden parachutes

• Eliminate too much risk?

10.5 Empirical Compensation Research

• Research suggesting efficient contracting

– 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

– Indjejikian & Nanda (2002)

– Bushman, Indjejikian & Smith (1996)

– Baber, Kang & Kumar (1999)

10.6 Politics Of Executive

Compensation

• Is executive compensation too high?

– If so, suggests inefficient contracting

• Jensen & Murphy (1990)

– According to authors, not too high, but managers do not bear enough risk they need to hold more stock

– Does executive compensation ignore extraordinary losses?

• What about extraordinary gains?

• Ignoring losses and including gains increases compensation

Value of Shares and ESOs to Manager Less than Cost to Firm

• Manager compensation not as high as some

believe

– Manager risk averse, cannot diversify share holdings

– Ability to sell shares and ESOs usually restricted

– Therefore, shares and ESOs worth less to manager than their expense to firm

• Recall expense to firm based on opportunity cost

10.7 The Power Theory

• Power theory disputes efficient contracting

version of PAT

– Manager uses power in firm opportunistically, to earn more than reservation utility

• Opportunism limited by “outrage”

• Devices to camouflage excessive compensation

– Compensation consultants

– Peer groups

The Power Theory in Action

• Late timing of ESO awards

– Another way to camouflage excessive compensation

Controlling Excessive Manager

Power over Compensation

• Good corporate governance needed

– Corporate governance helped by full disclosure

• To reduce ability of manager to cover up shirking by earnings management

• To help identify persistent earnings

• To enable compensation committee to better tie pay to performance

• To limit excessive compensation by full disclosure of compensation amounts

Two Roles for Financial Reporting

for Executive Compensation

• To provide a performance measure for compensation contracts

– But must compete with share price

• To inform the managerial labour market about

manager performance and value

– Reputation at least partially motivates effort

• Recall Fama/Wolfson arguments

– Reputation determines manager’s reservation

utility

• Both roles can be accomplished simultaneously

10.8 Social Significance of Well-Working

Managerial Labour Markets

• Full disclosure helps the managerial labour

market to work well

– Manager’s reservation utility (i.e., manager’s

market value) will then better reflect his/her ability and effort

• Well-working managerial labour markets

encourage productivity and social welfare

• Financial accounting-based performance measures can improve the operation of managerial labour markets

– Full disclosure improves working of managerial labour

market

• But not to point where need for an incentive contract is eliminated

Chapter 10 Supplement

Wolfson (1985) Study of Oil and Gas Limited Partnerships

10.2 Empirical Evidence of Incentive Problems and Their Mitigation in Oil

and Gas Tax Shelter Programs

Mark A Wolfson (1985)

An application of agency theory

The Question to be Addressed

• In a multi-period context, can market forces (i.e., reputation effects) eliminate shirking?

– If so, no need to motivate managers by

means of incentive contracts

Tax-Advantaged Limited Partnerships to Drill for Oil and Gas

(U.S.)

• Principal: the limited partner, who invests and receives advantageous tax treatment

• Agent: the general partner/manager

– Conducts drilling and on basis of drilling results

decides whether or not to complete the well

Two Types of Drilling

An Incentive Contract

• A common sharing rule (contract)

– Tangible drilling costs: must be capitalized for tax purposes

– Intangible drilling costs: immediately tax deductible– Agent (manager) pays tangible costs

– Principal (limited partner, investor) pays intangible costs

– Let revenue from well be R

– Manager gets, e.g., 40R

– Investor gets 60R

The Noncompletion Problem

(Well is Drilled But Not Yet Completed)

• A model of revenue from well:

– E(R) = K(D + C)

• D: drilling costs Paid by investor

• C: completion costs To be paid by manager

• K: manager’s skill (e.g., K = 2)

– Manager generates $2 in revenue for each dollar spent

• Manager knows E(R) and C, investor does not

The Noncompletion Problem

(continued)

• From standpoint of society (and investor)

– Complete well if R ≥ KC, since D is sunk

• From standpoint of manager

– Complete well if 40R > KC

• Thus manager may not complete well (i.e., may shirk) when completion is in best interests of principal and society

• NB: Noncompletion problem greater for development wells

Controlling the Noncompletion

Problem

• Direct monitoring of manager drilling effort and results (too costly)

• Manager establishes a reputation (multi-period)

to convince principal that he/she will not shirk

Testing For Reputation Effects

• For each general partner (manager) in the sample of limited partnerships:

– Expected return rating (ERR)

• A measure of a manager’s reputation, based on past performance

• Analogous to past income statements – Net return rating (NRR)

• Expected oil and gas finding rate A measure of the cost to “buy in” to the manager’s partnership Lower NRR implies higher cost to buy in, since limited

partners (investors) then get lower expected return

• NRR analogous to a managerial labour market (i.e., measures the manager’s worth)

Testing For Reputation Effects

– It appears investors are willing to accept a lower

expected return the higher the manager’s reputation

• Conclude: reputation reduces the non-completion

problem of manager shirking

Testing For Reputation Effects

• Average NRR for his sample = 2.357

• Thus lower price to buy into development wells

Testing For Reputation Effects

(continued)

• Wells more subject to the noncompletion problem

(development wells) are priced lower by investors than wells less subject to the noncompletion problem

(exploratory wells)

• If reputation completely eliminated the noncompletion problem, the prices would be the same

Conclusion to Testing For

Implications for Accountants

• 2 roles for accounting information

– Market forces of reputation reduce but do not

eliminate manager shirking

• Thus compensation contracts and performance measures such as net income still needed

– Net income should be informative about manager

The End Thank you