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Chapter 10

Chapter 10. Executive Compensation. Chapter 10 Executive Compensation. 10.2 Are Incentive Contracts Necessary?. No: Fama (1980) Forces of reputation on managerial labour market enough to motivate manager to work hard Assumes managerial labour market works well Yes: Wolfson (1985)

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Chapter 10

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  1. Chapter 10 Executive Compensation

  2. Chapter 10Executive Compensation

  3. 10.2 Are Incentive Contracts Necessary? • No: Fama (1980) • Forces of reputation on managerial labour market enough to motivate manager to work hard • Assumes managerial labour market works well • Yes: Wolfson (1985) • Forces of reputation help to motivate manager, but incentive contract still needed • Suggests that managerial labour markets do not work fully well • See Supp. slides for details

  4. 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? • Continued

  5. 10.3 The BCE Compensation Plan (continued) • Compensation components, cont’d. • Stock options, based on share price performance • Executives required to hold BCE shares • All compensation components except salary increase alignment • Since investors and managers both want firm to do well • Continued

  6. 10.3 The BCE Compensation Plan (continued) • 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

  7. 10.4 Theory of Executive Compensation • Desirable properties of a performance measure • Sensitivity • Precision • Generally, these properties have to be traded off • Share price • High in sensitivity, low in precision • Net income • Low in sensitivity, high in precision • Continued

  8. 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 • Continued

  9. 10.4 Theory of Executive Compensation(continued) • How to increase sensitivity of net income, cont’d. • Full disclosure • More difficult for manager to disguise shirking by earnings management • Enables compensation committee to better evaluate earnings persistence • Continued

  10. 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-run effort does not matter to investor • Each effort type equally effective in generating payoff • Continued

  11. 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) • Continued

  12. 10.4 Theory of Executive Compensation (continued) • Controlling length of manager decision horizon • Greater proportion of performance based on share price relative to net income increases long-run effort relative to short-run effort, and vice versa • Recall BCE 2004 compensation plan revisions • Why did BCE want to shorten decision horizon?

  13. 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 • Continued

  14. 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 • Continued

  15. 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?

  16. 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)

  17. 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

  18. 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

  19. 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

  20. The Power Theory in Action • Late timing of ESO awards • Another way to camouflage excessive compensation

  21. 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

  22. 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

  23. 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

  24. 10.9 Conclusions • Financial accounting-based performance measures are an important input into compensation contracts • Full disclosure helps compensation committees tie pay to performance, control manager power, and increase contract efficiency • 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

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