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

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

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 Fama’s: argument assumes an efficient managerial labour market that properly values the manager’s reputation. Arya, Fellingham and Glover: Designed a two period model where two managers can observe each other’s efforts and their payoffs are based on a joint effort. So if one manager shirks in one period than the other will threaten to shirk in the next period which results in both manager’s monitoring each other and ensuring an efficient contract. Bushman, Engel & Smith: They analyzed a large sample of firms over 1970-2000.

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 DSU’s-the holders of the shares may not redeem them as long as they are in the employ of the company Refer to chapter 3 and portfolio diversification and how it’s not in a manager’s best interest to have his income and a large part of his portfolio coming from the same source Ask them about whether this is contributes to a diversified portfolio?

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

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

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

10.3 A Managerial Compensation Plan Short-Run Incentives Like Employment Stock Options (ESOs) Can Create Dysfunctional Behaviour As It Shortens The Decision Horizon ESO- employee stock options- gives them the right to buy stock over some period of time

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 Other Long Term Compensation $2,455,578 Total Calculated Compensation $6,959,161

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 Sensitivity: : rate at which the expected value of the measure responds to manager effort Precision : reciprocal of the variance of the noise in the measure, also depends on effects on economy-wide factors TRADEOFF BETWEEN SENSITIVTY AND PRECISION

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

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

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 Managers are risk averse individuals, and trade off risk and return. Thus, to motivate the manager at the lowest cost, designers of efficient incentive compensation plans try to get the most motivation for a given amount of risk imposed Or, equivalently, the least risk for a given level of motivation.

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) Under RPE, if industry has low performance and company does well, you should see higher bonuses if industry has high performance and company does well, you should see lower bonuses

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 – Downside risk: Compensation may be less than expected, worst case 0 compensation – Upside risk: Compensation may be more than expected, best case is the capped amount

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

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

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 high Corr (total comp, NI) NI is use for management stewardship If there is high Corr(NI, Share price) NI is use for investment decisions Corr(total comp, NI) High sensitivity and low precision Corr(total comp, share prices) Low sensitivity and high precision

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

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

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

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

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 Due to the extensive interaction between accountants and managers, reporting on manager performance is equally important to society as reporting to investors.

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 Ch3. Expected Utility Maximization- In chapter 10 it’s where the manager is trying to maximizing his expected utility by working hard in the short run and long run Ch6. Auditor’s legal liability- Ensuring CEO’s are using conservative accounting practices and using the measurement approach(involves greater usage of current values in the financial statements)- Making sure that Managers are working within international financial reporting standards. Ch8. Having an incentive contract that doesn’t align the interests of the executive and the firm is an inefficient contract in the sense that the executives decision are going to only consider the factors that will maximize their remuneration that may not be in the best-interests of the firm. Ie. Managers choosing accounting policies that shift reported earnings from future periods to the current period because their remuneration is heavily based on net income. Ch9. efficient contracts- contracts with the lowest contracting costs Ch8. Positive Accounting Theory Ch5.Reasons For Market Response Ch6. Auditor’s Legal liability