Chapter 10 Summary

An executive compensation plan is an agency contract between the firm and its manager
that attempts to align the interests of the owners and managers by basing the managers
compensation on one or more measures of the managers effort in operating the firm
Two measures of management effort are:
Net income
Share price
Both measures are important because they help control a managers risk and ensure that their
decisions support the shareholders goals. Accountants must understand the importance of net
income. If it can be used as a competent measure of manager effort, compensation plans will
become increasingly efficient and an accountants competitive advantage will be enhanced.
Are Incentive Contracts Necessary?
According to Fama, the managerial labor market eliminates the need for incentive contracts.
Compensation can be based on a managers reputation for maintaining high payoffs.
Those who are tempted to shirk will find that the resulting reduction in compensation
offsets its benefits.
Managers who are not disciplined by the managerial labor market will be disciplined by
internal monitoring (i.e. lower-level managers will report shirking in an attempt to
get ahead)
Conversely, Arya, Fellingham and Glover (AFG), and Wolfson found that market forces
only reduce moral hazard, they do not eliminate it. Therefore, incentive contracts are necessary.
AFG found that an efficient contract would exploit the ability of each manager to observe the
others efforts. With the knowledge that their actions are observable and that shirking will
reduce both managers payoffs, they will avoid shirking, therefore reducing risk.
Wolfson studied the non-completion incentive problem facing oil and gas companies.
Exploration wells are usually completed if their expected revenues are greater than their
completion costs. The general partner, who learns the results of drilling and must pay these
costs, may only complete wells where the return is greater than the costs. When comparing
exploratory and development wells, Wolfson found that while investors are aware of moral
hazard, they pay more for exploratory wells because of the reduced risk of non-completion.
Aspects of A Managerial Compensation Plan
1. Compensation plans can consist of salary, cash bonuses, share units and stock options.
2. A threshold level of performance (bogey) must be met before compensation is earned. An
upper limit is called a cap.
3. Incentive effects of a compensation plan should be apparent.
4. It is best to integrate both short-term and long-term incentives.
5. Since earnings-per-share and share prices are affected by macroeconomic events, their use
is risky.

The Theory of Executive Compensation

It has been suggested that historical-cost-based net income is more reliable and less volatile to
factors out of managements control and, therefore, is a good measure of manager effort.
However, compensation plans are very complex and one must consider incentives, risk and
decision horizons. Compensation based solely on net income may not reward current manager
effort because net income does not reflect activities that have long-term implications.
These problems imply that share price may be a better measure of performance because prices
in the efficient securities market are assumed to properly reflect all available information about
manager effort. However, share price cannot be the sole factor because it is affected by economywide events. Share prices also do not properly reflect all publicly available information because of
noise traders. Therefore, using share price as the only payoff measure creates too much risk for
managers.
Studies have shown that optimal contracts include both share price and net income as
performance measures. The theory of executive compensation states that the proportion of net
income based and share price based measurement is important in designing efficient
compensation contracts.
Role of Risk in Executive Compensation
Managers are risk-averse. However, unlike investors, they cannot diversify compensation
risk. Compensation plans try to minimize risk for a given level of motivation. If the level of risk is
too high, managers may only make safe decisions, which may not be in the companys best
interests. Conversely, if managers receive a higher level of return for higher risk they may engage
in activities that are too risky. To avoid this problem, bogeys and caps limit downside and upside
risk.
Manager risk can be reduced by relative performance evaluation (RPE). RPE sets
incentive awards relative to the average performance of other firms in the industry. RPE reduces
the systematic risk, which is uninformative about manager effort, and increases the correlation
between effort and performance measures. Sloan argues that RPE is not necessary since
economy-wide risk is limited by using both net income and share price in compensation plans.
Lambert and Larcker (L&L) investigated whether the theory of executive compensation is
actually used in designing compensation plans. They found four trends:
1. Return-on-equity (ROE) was more highly correlated to cash compensation.
2. The relationship of payoff measures to cash compensation varied systematically.
3. Growth firms compensation was less correlated with ROE than the average.
4. Firms with a low correlation between share return and ROE had a higher weight on ROE
in the compensation plan, indicating that net income is relatively uninformative to
investors, but informative in terms of manager effort.
According to L&L, the fundamental problem of financial accounting theory is that there is a
trade-off between the manager-performance-motivating and the investor-informing aspects of
information usefulness.
Politics of Executive Compensation
In Canada and the U.S many believe that top management is overpaid.
Jensen and Murphy (JM) believe that top management is not overpaid, but their
compensation is unrelated to performance.

JM concluded that CEOs are not properly motivated because they do not bear enough risk.
Therefore, they recommended that managers maintain larger stock holdings.
Three counter arguments to JMs findings were:
There should be a low pay-performance relationship for large firms because even a small
increase in firm performance will have a large impact on compensation.
Managers of large firms avoid good but risky projects if too much downside risk is placed
on them. However, upside risk must also be limited resulting in a low pay-performance
relationship.
Managements compensation is lower than expected because it can be given in the form of
stock options, which contain restrictions as to when they can be cashed. The decrease in
the value of compensation is proportional to managements risk aversion.
Gaver and Gaver found:
When earnings were positive there was a strong positive relationship between CEO cash
compensation and earnings
When earnings were negative, there was a weaker relationship
Extraordinary gains were usually reflected in cash compensation, while extraordinary
losses were not.
Regulations have been set requiring firms to disclose the compensation of management and
justify pay levels. These regulations should help shareholders evaluate management compensation
and change investment decisions if necessary.

Summary
Managerial labor markets reduce moral hazard, however they do not eliminate it, therefore
creating a need for incentive contracts that align the interests of owners and managers. For a
contract to be efficient it needs to increase motivation while maintaining risk at an optimal level.
Finally, the relative proportion of net income and share price can influence both long-term a shortterm decisions.

Chapter 10 Quiz
1. Most compensation plans are based on indicators of managements effort. These include:
a) net income
b) revenue
c) share price
d) all of the above
e) both a and b
f) both a and c
2. The upper and lower limits of compensation plans are called the:
a) maximum and base
b) peak and base
c) cap and base
d) cap and bogey
e) none of the above
3. True or False:
Managerial labor markets help to reduce the presence of adverse selection.
4. What is relative performance evaluation (RPE) and how does it work?
5. Justify whether or not, one would expect a risk-neutral manager in a firm with a high ERC
(earnings response coefficient) to want to have part of their compensation based on RPE.
6. What are some pros and cons of basing compensation entirely on share price? What is an
alternative?
7. You are auditing a widget company that uses f.o.b. shipping point and has an executive
compensation plan based entirely on net income. What is one method that a company may
employ in order to fraudulently increase net income? Which accounts would these actions
affect?
8. List and describe three important considerations in creating an effective compensation plan.

9. Investment guru Warren Buffet, recently expressed his displeasure with the re-pricing of
stock options for many of the executives of high tech firms. Discuss briefly whether or not
this is a positive action in terms of a companys executive compensation strategy and what
implications these actions may have.

10. While the majority of Canadas bank CEOs took home sizable bonuses last year it was said
at National Bank Financial, theres a CEO whotook one for the team last year. Kym
Anthony saw his compensation fall 26 per cent, while his units profit rose 22 per cent 1. Is
there a problem with this managers compensation plan? If so, how should the executive
compensation plan be changed to help solve this problem?

Bay Streets top dogs earn what theyre paid (usually); Andrew Willis; The Globe and Mail,
Toronto: February 27, 2002; pg. B15.
1

Chapter 10 Quiz Answers

1. f
2. d
3. False. It reduces moral hazard.
4. Relative Performance Evaluations goal is to reduce a managers risk while maintaining the
managers incentives. It accomplishes this goal by measuring performance relative to the
performance of other firms in the industry. As a result the industry-wide or systematic risk is
theoretically eliminated.
5. An earnings response coefficient measures the extent of a securitys abnormal market return in
response to the unexpected component of reported earnings of the firm issuing the
security(Scott 152). Thus, a firm with a high ERC would have a stronger market reaction to
good news than the average firm in the industry. As a result, the risk neutral manager of a firm
with a high ERC would rather have their compensation based on RPE when good news is
reported, but not bad news. This is because this firm would show inflated performance in either
direction relative to the market, thereby inflating the effect on managers compensation.
6. PRO: share price reflects all publicly available information and includes the information content
of net income.
CON: using share price may impose too much risk on management because it is affected by
economy-wide factors that are out of managements control. These factors include interest rate
changes, noise traders and exchange rates.
ALTERNATIVE: rather than using only share price, compensation can be based on a mixture of
share price and net income. Net income is not sensitive to economy-wide factors; therefore,
using both measures increases the efficiency of the contract. Also, the length of the decision
horizon will be reflected in the mix of the share price and net income used in compensation.
7. The companys incentive structure motivates managers to maximize net income. This could be
accomplished by fraudulently recording sales just before year-end that did not actually occur.
Since the widget company uses f.o.b. shipping point, sales are recorded when inventory is
placed on the delivery truck. If the company were to remove the widgets from inventory and
place them on the truck at year-end, they could record a fictitious sale and reverse it after yearend. By recording the sales, inventory will decrease and cost of goods sold, sales and
accounts receivable will increase, leading to a higher, bottom line net income figure. An
auditor may want to send out confirmation letters to all of the buyers at year-end to ensure that
all recorded sales had actually been ordered and delivered to the customers.

8. Any three of the following are possible solutions.

1) The plan can consist of different types of compensation such as salary, bonuses, share units
and stock options. Quantitative factors, creativity or initiative can be rewarded.

2) The plan should control the risk that management is exposed to. If management
compensation is based primarily on a performance measure that is affected by factors
outside managements control, it will most likely affect their performance.
3) A threshold level of performance (bogey) must be met before compensation is earned.
Some compensation plans also contain an upper limit (cap). Without limits, managers may
either avoid or rely too heavily on risky projects.
4) The incentive effects of the compensation plan should be apparent.
5) The plan should use an effective mix of both share price and net income because they are
closely related to manager performance.
9. By re-pricing stock options, high tech firms are trying to solve problems with compensation
plans created by economy-wide risk. Stock options are a popular method of rewarding
managers since they do not appear as liabilities on the balance sheet. Theoretically, managers
who work hard will improve the companys profitability and share price and as a result they will
be rewarded by the increased value of their stock options. The problem is that as the high tech
bubble burst, the share price of many of these firms plummeted, leaving mangers with stock
options that were worthless.
The re-pricing of these options can be argued to be a good thing according to managers
since many will claim that the drop in share price was due not to their performance, but
rather to macroeconomic factors over which they had no influence or control. They would
argue that if they had realized that this would happen that they would have taken their
compensation in other forms such as cash bonuses and higher salaries and that the re-pricing of
options was simply a method to help reward them for their good performance.
On the other hand, the lowering of stock option exercise prices may be viewed as a negative
action by shareholders. They may view this as a reward for sub-par actions of the managers
and feel that the mangers freely entered into their compensation contracts and accepted the risk
that they bore. Shareholders may be upset since they themselves are not being compensated for
the systematic risks of their investment while they managers seemingly are. The problem is that
the actual executive compensation no longer matches the original incentives set out by the
overall compensation plan and thus it can be seen as a negative.
An implication of this is that compensation contracts may consist of a lower proportion of stock
options or contain covenants that prevent the exercise price stock options from being lowered.
10. The problem with the compensation plan is that it may not properly reflect the goals of the
corporation. The manager may not be inspired to maximize profits because it does not have an
effect on his compensation. The manager may look to other areas of the business to increase
his own compensation, areas that may not reflect the shareholders goals and best interests. If
maximizing profitability is important to the shareholders, then perhaps a compensation plan that
ties executive compensation more closely with net income and profitability should be employed.