Chapter 10 Executive Compensation

1. Chapter 10 Executive Compensation Nish Vairavanathan AthavanThulakanathan Sally Zhu http://www.youtube.com/watch?v=vh0U0V8246U

2. Agenda • 10.2- Are Incentive Contracts Necessary? • 10.3- A Managerial Compensation Plan • 10.4.1- Using Net Income and Share price in Evaluating Manager Performance • 10.4.2- Short-Run and Long-Run Effort • 10.4.3- The Role of Risk in Executive Compensation • 10.5- Empirical Compensation Research • 10.6- The Politics of Executive Compensation • 10.7- The Power Theory of Executive Compensation • 10.8- Social Significance of Managerial Labour Markets That Work well

3. 10.2 Are Incentive Contracts Necessary? • Most Of The Research Suggests Incentive Contracts Are Necessary: • Fama: • Incentive Contract’s Aren’t Necessary Because Managerial Labour Markets Control For Moral Hazard • Arya, Fellingham, and Glover (AFG): • Incentive Contracts For Lower Level Managers Are Necessary • Wolfson: • Found That Market Forces Reduce Moral Hazard Likelihood But Does Not Eliminate It • Bushman, Engel, & Smith • Markets Can’t Value a manager’s reputation perfectly based on accounting information and therefore incentive contracts might be necessary

4. 10.3 A Managerial Compensation Plan • Many Managerial Compensation Plans Require: • Holding A Significant Amount Of Company Shares • Holding Three Main Compensation Components: • Salary • Annual Short-Term Incentive Awards (i.e. Cash Bonuses, DSUs) • Stock Options

5. 10.3 A Managerial Compensation Plan • Many Managerial Compensation Plans Require: • A Performance Measure Be Reached Before Incentive Compensation Becomes Payable • Threshold Level Of Performance Is Called The Bogey • Upper Limit Of Compensation Is Called Cap

6. 10.3 A Managerial Compensation Plan • A Mix of Short And Long-Term Incentive Components Is Important For The Following Reasons: • To Maximize Current Year Performance • To Reinforce Longer-Term Considerations • A High Proportion Of Long-Term Incentive Components Should Produce Longer Manager Decision Horizon

7. 10.3 A Managerial Compensation Plan • Along with Short-Term and Long-Term Incentive Components, A Firm Can Also Create Mid-Term Incentive Components: • Restricted Share Units Are Units Of Stock That Are Awarded When One Or More Targets Are Met

8. 10.3 A Managerial Compensation Plan • Short-Run Incentives Like Employment Stock Options (ESOs) Can Create Dysfunctional Behaviour As It Shortens The Decision Horizon

9. 10.3 Real Example of Executive Compensation • Barrick Gold CEO: Aaron Regent TOTAL COMPENSATION IN 2010* • Total Annual Cash Compensation • $1,544,810 • Total Short Term Compensation • $1,544,810 • Other Long Term Compensation • $2,455,578 • Total Calculated Compensation • $6,959,161

10. 10.4 The Theory of Executive Compensation • Two Performance Measures: • Share price (High in sensitivity, Low in precision) • Net Income (Low in sensitivity, High in precision) • Banker and Datar (1989); lower the noise in net income and the greater its sensitivity to manager effort, the greater should be the proportion of net income to share price in determining the manager’s overall performance

11. 10.4 Theory of Executive Compensation • How To Increase Sensitivity of Net Income? • Reduce recognition lag e.g. current value accounting reduces recognition lag but tradeoff is precision • Full disclosure

12. 10.4 Theory of Executive Compensation • Manager effort can be divided into SR & LR: • Controlling length of manager decision horizon is important because expected net income is more likely to be not congruent to expected payoff [ Example 10.1, pg. 375 ] • Greater proportion of performance based on share price relative to net income, increases long-run effort to short-run effort, and vice versa

13. 10.4 Theory of Executive Compensation • Compensation risk affects how the manager operates the firm: • Not enough risk = low manager effort • Too much risk = manger avoids risky projects • Goal is to control compensation risk, not eliminate it

14. 10.4 Theory of Executive Compensation • Controlling Compensation Risk: • Relative performance evaluation (Holmstrom,1982), measured by the difference between the firm’s net income and/or share price performance and the average performance of a group of similar firms • Idea is to eliminate the industry wide risk and allow a net performance that more precisely reflects the manager’s efforts • However, despite theoretical appeal, there is weak evidence for RPE (Antle and Smith, 1986)

15. 10.4 Theory of Executive Compensation • Controlling compensation risk: • control downside risk by implementing a ‘bogey’ • placing a cap controls upside risk • role of board e.g. compensation committee • role of conservative accounting • One measure is not better than another, idea is to have a mix of performance measures

16. A Short Clip • http://www.youtube.com/watch?v=8TgcNsaUfrg&feature=related

17. 10.5 Empirical Compensation Research • Research suggesting efficient compensation contracting • Lambert & Lacker (LL) – (1987) • ROE was more highly related to cash compensation than return on shares • Lower the noise in net income, better prediction in payoff • Lower correlation in compensation and ROE for growth firms • Net income less sensitive to management effort than average firms • Higher weight in ROE when low correlation between ROE and return on shares

18. 10.5 Empirical Compensation Research Summary of LL Research: • Corr(total comp, NI) >Corr(total comp, share prices): • Bonus plans are more popular • If there is highCorr (total comp, NI) • NI is use for management stewardship • If there is high Corr(NI, Share price) • NI is use for investment decisions

19. 10.5 Empirical Compensation Research • Other Research: • Indjejikian & Kanda (2002) • Lower variability of ROE higher the target bonus relative to base salary • Bushman, Indjejikian & Smith (1996) • Growth firm CEOs derived greater proportion of compensation from individual performance measure relative to NI and stock-based measures • Baber, Kang & Kumar (1999) • Effect of earnings changes on compensation increase with persistence of those earnings changes

20. 10.6 The Politics of Executive Compensation • CEO compensation may be less than it seems at first glance • Jensen and Murphy (JM) 1990: • CEOs earn $2.59 increase per $1,000 in increase in shareholder wealth. • Variability (std) of CEO compensation = variability of compensation of workers • Conclusion: CEO did not bear enough risk to motivate good performance, and recommended larger stock holding by managers

21. 10.6 The Politics of Executive Compensation • Counterarguments to JM: • Low relationship between pay and performance • Limited downside risks • Exclude extraordinary loss in bonus rewards and include extraordinary gain • Encourage risky projects • Market downturn than bad performance • Golden Parachutes

22. 10.7 The Power Theory of Executive Compensation • Power theory: executive compensation in practice is driven by manager opportunism, not efficient contracting • Manager have power to influence own compensation • Influence board of directors and compensation committee’s appointments • Camouflage excessive compensation • Compensation consultants • Peer groups • Late timing of ESO awards

23. 10.8 Social Significance of Managerial Labour Markets • A Manager Making Good Capital Investment Decisions And Improving Firm Productivity Contributes To Social Welfare • Accountants Can Contribute To Social Welfare by: • Full Disclosure • Contribute To Informativeness Through An Appropriate Tradeoff Between Sensitivity And Precision

24. How Does Chapter 10 Relate To Concepts In Previous Chapters? Ch1.Moral Hazard & Adverse selection Ch2. Relevance & Reliability Ch3. Expected Utility Maximization Ch9. Efficient Contracts & Agency Theory Ch. 10 Executive Compensation Ch4. Management’s Discussion & Analysis Ch8. Positive Accounting Theory Ch5.Reasons For Market Response Ch6. Auditor’s Legal liability