Chapter 10 Executive Compensation Nicole Fitzmaurice, Eric Poolman, Lisa Landon, Pang Koh & Ping Zhou

W HAT IS E XECUTIVE C OMPENSATION  An executive compensation plan is an agency contract between the firm and its manager that attempts to align the interests of owners and manager by basing the manager’s compensation on one or more measures of the manager’s performance in operating the firm In other words, how does a manager get paid on their performance.

A RE I NCENTIVE C ONTRACTS N ECESSARY ?  Fama (1980) argues that the managerial labour market controls moral hazard making incentive contracts unnecessary.  Managers with a reputation for creating high payoffs will increase their market value  Managers with poor reputations will decrease their market value  What about managers who hide their shirking by managing earnings?

W OLFSON (1985)  Wolfson examined contracts of oil and gas limited partnerships in the U.S.  Contracts between a General partner (agent) and limited partners (principal)  General partner privately learns of the drilling results leading to the “non- completion incentive problem”

W OLFSON (1985)  Information was collected on a sample of general partners from  It was found that the higher the reputation, the more that general partner would receive from limited partners  Also found that investors paid much less to buy into development wells due to the risk of the non-completion problem

RBC E XECUTIVE O FFICER C OMPENSATION P LAN  Objective: attract, motivate and retain executives  Offer total compensation that is competitive in the market place  Equitable – compensation reflects responsibilities  Compensation Committee  Responsible for setting and reviewing compensation plan  Competitive Compensation  Positioned at median of comparator group

E XECUTIVE C OMPENSATION P LAN OF R OYAL B ANK OF C ANADA 1.Officers are required to hold a significant amount of RBC shares. 2.Four compensation components: (a) Salary, paid in cash. (b) Short-term incentive plan bonus awards paid in cash or deferred share units. (c) Mid-term incentive plan, awards paid in deferred share units. (d) Long-term incentive plan, awards paid in stock options

3. Incentive effects apparent  Short-term and mid-term incentives – focus on current year’s performance  Long term incentives – focus on share price 4. Mix of short term and long term incentives  Determines Decision Horizon for Management  Trade-off E XECUTIVE C OMPENSATION P LAN OF R OYAL B ANK OF C ANADA

B ASE S ALARY  Established equitably to reflect the individual performance and responsibilities related to that position  Use median of comparative group as a guideline

A NNUAL S HORT T ERM I NCENTIVE A WARDS  Support achievement of corporate objectives  Balance Financial Targets with Strategic Business Objectives  Individual Contribution to corporate objectives  Target values used for awards

L ONG T ERM I NCENTIVE P ROGRAM  Major tool is stock options  Objectives:  Compensate and retain executives  Link executive officers interests with shareholders interests  Encourage executives to pursue value creating opportunities

S TOCK O PTIONS  RBC offers executives and key employees options to buy RBC shares  On occasion the compensation committee can approve special grants of stock options for individual recognition or further motivation  Term of an option is normally 10 years

D EFERRED S HARE U NIT P LAN  Designed to align the interests of executives with that of shareholders  DSUs have the same value as RBC shares and receive payments that are equal to dividends of RBC shares  Executives can choose to have 100% of their short term incentive award paid in DSUs  DSUs count toward an executives minimum share requirements

C ONCLUSION  Compensation Committee believes new strategy is competitive in the market  Policy strongly links compensation awards with corporate performance measures  Allows RBC to attract, motivate, and retain top executives within the company

10.4 T HE T HEORY OF E XECUTIVE C OMPENSATION  Desirable properties of a performance measure  Sensitivity: rate at which the expected value of the performance measure responds to manager’s effort  Precision: reciprocal of the variance of the noise in the performance measure  Generally, these properties have to be traded off Manager’s Effort Performance Measure Payoff SensitivityPrecision

T HE R ELATIVE P ROPORTIONS OF N ET I NCOME AND S HARE P RICE IN E VALUATING M ANAGER P ERFORMANCE  Share price  High in sensitivity, low in precision  Net income  Low in sensitivity, high in precision; WHY?  Ways to increase sensitivity of net income 1. Reduce recognition lag  Net income waits until many aspects of manager effort are realized  R&D, advertising, capital expenditure programs  Current value accounting reduces recognition lag, but decreases precision.

 Ways to increase sensitivity of net income (cont’d) 2. Full disclosure  Enables compensation committee to better evaluate earnings persistence 3. GAAP  More difficult for manager to disguise shirking through earnings management T HE R ELATIVE P ROPORTIONS OF N ET I NCOME AND S HARE P RICE IN E VALUATING M ANAGER P ERFORMANCE ( CONT ’ D )

 Controlling length of manager decision horizon  I.e., control the nature of manager effort  Long-run effort (R&D)  Short-run effort (cost-cutting)  Greater proportion of compensation based on share price relative to net income will increase long-run effort relative to short-run effort, and vice versa  Decision horizon has to be traded off with sensitivity and precision of performance measure T HE R ELATIVE P ROPORTIONS OF N ET I NCOME AND S HARE P RICE IN E VALUATING M ANAGER P ERFORMANCE ( CONT ’ D )

S HORT -R UN E FFORT AND L ONG -R UN E FFORT  Congruency of a performance measure  If performance measure (e.g., net income) is congruent to payoff, mix of short-run and long-run effort does not matter to firm owner (investor)  Each effort type equally effective in generating payoff

S HORT -R UN E FFORT AND L ONG -R UN E FFORT ( CONT ’ D )  If net income is not congruent to payoff, effort mix does matter  Firm owner can control manager’s effort mix (i.e., length of manager’s decision horizon) through proportion of net income vs. share price-based compensation

T HE R OLE OF R ISK IN E XECUTIVE C OMPENSATION  A manager has some compensation risk, which becomes the motivator  There is a trade-off for the manager between the risk and the return  The higher the risk means the higher the expected compensation for the manager

M ETHODS TO C ONTROL C OMPENSATION R ISK  Relative performance evaluation  Bogey of the compensation plan  Compensation committee

E MPIRICAL C OMPENSATION R ESEARCH  Compare return on shares and return on equity to explain managers’ cash compensation  Short term incentive awards are based on individual achievement and net income while stock option awards are not.  Return on equity (ROE) was more related to cash compensation than a return on shares

E MPIRICAL C OMPENSATION R ESEARCH CONT …..  Managerial compensation for growth firm executives had a lower relationship with return on equity than average  Firms where the correlation between share return and return on equity was low, there tended to be a higher weight on return on equity in the compensation plan

10.6 T HE P OLITICS OF E XECUTIVE C OMPENSATION  Many have argued that executives are overpaid  Jensen and Murphy argued that CEOs were not overpaid but that their compensation was far too unrelated to performance  Increased compensation costs are necessary to overcome the moral hazard problem between manager and owner

10.7 T HE P OWER T HEORY OF E XECUTIVE C OMPENSATION  The power theory of executive compensation suggests that compensation in practice is driven by manager opportunism, not efficient contracting  Bebchuk, Fried and Walker argue that managers have sufficient power to influence their own compensation  Better corporate governance required to reduce manager power:  Sarbanes-Oxley Act and related regulations in Canada  Regulators and accountants are responding to the political pressures that result when compensation reflects manager power

10.8 T HE S OCIAL S IGNIFICANCE OF M ANAGERIAL L ABOUR M ARKETS T HAT W ORK W ELL  Manager performance contributes to social welfare via high firm productivity  More informative performance measures enable more efficient compensation contracts  Results in higher firm productivity and social welfare

10.9 C ONCLUSIONS ON E XECUTIVE C OMPENSATION  Managerial labour markets reduce the severity of moral hazard  Labour markets are subject to adverse selection problems such as earnings management to disguise shirking  Financial reporting has an important role in motivating executive performance and controlling manager power.

H OW A RE E ARNINGS M ANAGED B Y : N ELSON, E LLIOT AND T ARPLEY Earnings Management “when managers use judgement in financial reporting and in structuring transactions to alter financial report to either mislead some stakeholders about the underling economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers.”

H OW A RE E ARNINGS M ANAGED B Y : N ELSON, E LLIOT AND T ARPLEY  Importance of understanding how earnings management occurs 1. Regulators and standard setters identify the areas most in need of regulatory change 2. Auditors evaluate and report on their clients' quality of earnings and train novice auditors about earnings management 3. CEOs, CFOs, audit committees, and investors focus attention on those areas of the FS where they should be most skeptical

H OW A RE E ARNINGS M ANAGED B Y : N ELSON, E LLIOT AND T ARPLEY  Importance of understanding how earnings management occurs (continued) 4. Managers and audit committees anticipate the transactions that investors will view most skeptically 5. Educators teach students about earnings management 6. Researchers focus their analyses on areas of high-earnings-management activities.

S TUDY F ORMAT 1. Classify attempts according to primary approach a) Expense recognition b) Revenue recognition c) Issues unique to business combination d) Other issues 2. Sub-classify by particular approaches

G ENERAL R ESULTS  Collected data from 253 auditors based on 515 earnings management attempts  53% increased current-year income  31% decreased current-year income  16% had no clear current-year income effects

R ESULTS Expense and other losses  Attempts include:  “Recognizing too much or too little reserves in current years”  “Reducing or not reducing previous accruals”  42% of time auditors did not require an adjustment to be made  Often decreased current-year income

R ESULTS Revenue and Other Gains  Attempts include:  “Cut-off Manipulation”  “Deferring too much or too little revenue”  “Timing the recognition of realized or unrealized gains or losses on investments”  75% increased current-period income  56% required adjustments by auditors

R ESULTS Business Combinations  Attempts include:  “Over-or understating assets, liabilities and offset with goodwill”  79% involved overstating liabilities and goodwill  “Over- or understating expenses involved in a period of acquisition”  Affected income in post-acquisition year

R ESULTS Other Approaches  Attempts include:  “Income statement classification issues:  “Inappropriate disclosure”  “Off-balance-sheet items”  “Accounting for large investments”

R ECAP I MPORTANCE OF U NDERSTANDING E ARNINGS M ANAGEMENT 1. Regulators and standard setters identify the areas most in need of regulatory change 2. Auditors evaluate and report on their clients' quality of earnings and train novice auditors about earnings management 3. CEOs, CFOs, audit committees, and investors focus attention on those areas of the FS where they should be most skeptical

R ECAP I MPORTANCE OF U NDERSTANDING E ARNINGS M ANAGEMENT 4. Managers and audit committees anticipate the transactions that investors will view most skeptically 5. Educators teach students about earnings management and 6. Researchers focus their analyses on areas of high-earnings-management activities.

Chapter 10 Executive Compensation QUESTIONS?