Performance evaluation and compensation
Performance evaluation and compensation Incentive contracts
Executive compensation systems introduce a second major role of financial reporting, distinct from communicating useful information to investors — motivating and monitoring managerial effort. The ultimate payoff from the manager's current effort is usually not observable until some time after the end of the current period. However, the manager must be paid currently. Thus compensation must be based on a performance measure that gives some information about the manager's current performance. To the extent that net income is informative about managerial effort, it improves the operation of managerial labour markets and motivates productivity. This function of financial reporting is as important as improving the operation of capital markets and the efficient allocation of scarce capital in the economy.
Performance measurement is a complex function that takes into consideration human behaviour. Agency theory assumes the agent is self-interested and works to maximize his or her own utility as opposed to the principal’s. The supposed solution to this problem is to create incentive contracts that align shareholder and managerial interests in the presence of moral hazard. The idea behind such plans is that they reward managers for acting in owners’ best interests.
What is an incentive contract? A leading accounting theory textbook defines it as “… an agency contract between the firm and its manager that attempts to align the interests of the owner and the manager by basing the manager’s compensation on one or more measures of the manager’s performance in operating the firm.”Consider a contract that consists of only a large salary. This contract has a low compensation risk for the manager because the manager does not have to achieve a target in order to receive the compensation. It can be said that salary is risk-free as it is certain that the compensation will be received. However, compensation by salary reduces the manager’s effort motivation.
So, how are managers motivated? Accounting research argues that incentive contracts are not necessary --- managers will motivate themselves. That is, if a manager can establish a reputation for creating high payoffs for owners, that manager’s market value (compensation) w ill increase. A manager who avoids his duties (called shirking) and reports lower payoffs will suffer a decline in value. While these arguments seem logical, they depend on three key assumptions: ?There exists an efficient managerial labour market that properly values the manager’s reputation.
?A manager can disguise the effects of shirking only in the short run by managing the release of information.
?Internal monitoring limits shirking —managers would be reported on by
managers below them in order to get ahead.
Subsequent research has concluded that these assumptions are not completely supportable. In other words, while market forces can reduce the moral hazard problem, it cannot be completely eliminated. Therefore, incentive contracts are necessary, no matter what else is going on.
Unfortunately, these plans have to be carefully crafted in order to work. Consider Robert Nardelli’s tenure at Home Depot, which began in December 2000. Nardelli’s incentive plan guaranteed $210 million when he left the company. Nardelli made dramatic changes to the management structure and operations, which resulted in the doubling of sales; however, the stock price did not improve while the competition’s stock doubled. In January 2007, he was ousted by the board of Home Depot. Nardelli had little incentive to perform — he was guaranteed $210 million when, not if, he left Home Depot!
How can a company craft an efficient incentive plan? To answer this question, a review of agency theory is necessary: In employment contracts, the investor (the firm) is the principal and the manager is the agent. The risk preferences of the principal (risk neutral) and the agent (risk averse) both come into play. In addition, all parties are assumed to be effort averse; in other words, both the principal and the agent would prefer to do the least amount of work for the greatest reward.
These ideas lead to some complexities. Moral hazard is a type of information asymmetry whereby one or more parties to a business transaction, or potential transaction, can observe their actions in fulfillment of the transaction but other parties cannot. This may lead to the agent accepting risk knowing that any negative consequence will be borne by the principal (or by another person). Moral hazard is an especially troublesome issue when designing incentive plans. Managers have an incentive to shirk and to misrepresent their abilities since owners cannot easily differentiate the effect of managerial behaviour on firm performance from the effect of external factors. Also, managers often get paid before investors measure whether the payoff is worth what they paid the manager, as payoff is usually not observable until after the end of the current period.
What should the owner do? The owner could refuse to hire the manager. The owner could either go out of the business or run the firm himself. These are not very appealing alternatives. According to accounting theory, the owner has five other alternatives:
?Hire the manager (no monitoring)
?Engage in direct monitoring
?Rent the firm to the manager
?Give the manager a share of the profits
?Engage in indirect monitoring
If the fifth alternative is the way to go, what’s the problem? When compensation is based on a performance measure such as net income, information asymmetry is reduced because net income is jointly observable. The key is the “informativeness” of net income. By definition, net income is a “noisy” measure that is a weakening of the relationship between current financial statement information and future firm performance. Another drawback is recognition lag. For example, expenditures on R&D will show up in current income, but the benefits will not show up until (many) periods into the future. Net income tends to particularly lag behind firm performance when the firm is growing rapidly.
Even more critical is that the manager controls the accounting system and, to a certain degree, what is reported as net income. This is reflected in information asymmetry and, to the extent that the manager is able to do so, earnings management (although GAAP limits what is acceptable in this regard). In conclusion, what constitutes the most efficient incentive contract depends on what can be jointly observed by both principal and agent.
Executive compensation: Stock options and restricted stock
Accounting theory suggests that when managers are acting as agents for the owners, they may pursue strategies that maximize their own utility rather than that of the owners. Research takes this point further, arguing that managers, acting in their own best interests, sometimes take actions that destroy stockholder value. They accumulate too much cash, borrow too little, and make poor investments and acquisitions. By making managers owners, it is argued that the interests of managers can be aligned with those of shareholders. The idea is that managers who are also owners of the firm will work harder and bear part of the consequences of their own decisions.
Firms make managers owners by issuing stock options to managers as part of their compensation schemes. An employee stock option (ESO) is a call option on the common stock of a company. Consistent with the argument in the previous paragraph, the goal is to align managerial objectives with the firm’s objectives. If the firm’s share price rises above the call price, the manager will gain the difference between the market and the exercise prices. If the market price is below the stock exercise price, the manager is not obligated to exercise the option, in which case the option lapses.
The use of options is also tied to employee retention. Most employee stock option plans require the employee stay with the firm for a period of time (the vesting period) to lay claim to the compensation. Employees who receive options or restricted stock as compensation are therefore more likely to stay with a firm, especially if it represents a large proportion of their overall wealth. (Shares that cannot be sold before vesting and unvested shares are usually forfeited if the employee leaves the
firm.)
The ability of employee stock options to control risk is ambiguous. On one hand, since the lowest an employee stock option can be worth is zero, these options operate like a contract bogey to eliminate downside risk. However, there is strong perception that using stock options to align firm and management goals does not always have positive effects on the firm’s performance. The reason is that options can be manipulated by the executives. Also, recent research has questioned the effectiveness of equity-based compensation in mitigating agency problems. Employee stock options are seen as encouraging managers to take on excess risk. This risk may improve managers’ own benefits but jeopardize the firm’s long-run performance; thus, it defeats the whole purpose of stock options (which was to align firm and employee goals and reduce risk). In fact, the high leverage of many financial institutions leading up to the 2007-2008 market meltdowns may have been encouraged by the stock option component of managerial compensation systems.
Compensation can also be in the form of restricted stock. Restricted stock is a form of incentive compensation that awards shares to the manager. These shares are typically transferable under certain conditions. Examples of the conditions include employment or reaching a specific performance measure such as earnings per share or net income.
In conclusion, management compensation systems are a mix of long- and short-term performance motivators. When designing a plan, it is essential that the behavioural consequences of the plan be considered. A plan that consists mostly of deferred rewards will see little attention paid to short-run matters; a plan that focuses on short-run results will see long-term strategic matters ignored. Management’s ability to act opportunistically given information asymmetry must always be a factor to consider in plan design. there is a move away from stock options toward more performance-based restricted stock and stock appreciation rights.
To sum up firms seek to align manager and shareholder interests, and managers are given the flexibility to choose different accountig policies consistent with efficient contracting. Positive accounting theory (PAT) is concerning with predicting the choice managers will make and how managers will respond to proposed new accounting standars.