EXECUTIVE COMPENSATION Sven-Olof Yrjö Collin

Me: Sven-Olof Yrjö Collin - Professor in Business Administration with emphasis on Corporate Governance and Accounting - Teach in corporate governance, accounting, management control, corporate finance, strategy, scientific method and supervise on all levels. - Research in corporate governance, for example riding schools, municipal corporations, family firms, but also executive compensation, accounting choice and auditing, duty. Homepage:

AIM OF LECTURE TO PRESENT EXECUTIVE COMPENASTION - AS RELEVANT AS POSSIBLE, i.e., AS AN HUNGARIAN SOUP AND THEN PRESENT - ONE ACCOUNTING THEORY VERSION, i.e., THE SIMPLE WATER SOUP BY POSITIVE ACCOUNTING THEORY

THE COMPENSATION PUZZLE Size of the firm Performance of the firm Executive Pay 40% 5%

IN THE PRINCIPAL - AGENT CONFLICT? Size: Goal of managers AGENT PRINCIPAL Profit: Goal of shareholders

INSTITUTIONAL DIFFERENCES OWNERSHIP STHRENGT EXECUTIVE COMPENSATION € US, UK Germany Sweden Japan lowhigh TENDENCY TO USE OPTION SCHEMEShighlow

Situation AGENCY R I S K PRINCIPAL’S OBSERVATION CompetenceBehaviourPerformance PRINCIPAL - AGENT RELATIONSHIP

SEPARATING THE PROCESS OF COMPENSATION Mechanism of compensation Criteria for compensation Consequence

WHO TO COMPENSATE Individual Figure head Individual ‘unfair’ Group Collaboration Mutual Monitoring ‘back stabbing

MECHANISM OF COMPENSATION - Contract - Monitoring Objectivity Predictability Precision Transparency Risk Fairness

CRITERIA FOR COMPENSATION Performance Behaviour Individual characteristics Labour market price Position Peer comparison

PERFORMANCE MARKET MEASUREMENTS ACCOUNTING MEASUREMENTS SUBJECTIVE MEASUREMENTS Noise Influence Informational Motivational - Goal! - Strategy etc.

STRATEGY Strategy Structure Market dominancePerformance criteria: Sales growth

CEO DISCRETION INFLUENCING PAY Task programmability Uncertainty CEO DiscretionCompensation

WHEN PAY - PERFORMANCE? uncertainty CEO influence

BEHAVIOUR CRITERIA Actions performed by the agent subjective costly time evaluators competence

INDIVIDUAL CHARACTERISTICS EDUCATION COMPETENCE NETWORK

LABOUR MARKET supply demand Price = Wage Upper bound Consultants? Reservation wage Bidding-up hypothesis

POSITION COMPENSATION Figure head (Tournament theory) Social recognition Hierarchical level - responsibility - higher pay on next level Information-processing requirements

PEER COMPARISON REFERENCE POINT Peers Significant others

WHO DECIDES ABOUT COMPENSATION? The Board The Chairman of the Board The Dominant Owner The Remuneration Committee - consultants...

RELATIONAL CONTRACT Exchange create externality Experience => mutual expectations No time horizon => trust Tenure => No correlation Pay & Performance Tenure => Less explicit control

SOCIETY INFLUENCING COMPENSATION Media Social groups Ideology...more market-dependent decision makers, more fashionable compensation package

KAUSALITY? DECIDE ABOUT COMPENSATION IN ORDER TO - ATTRACT AN INDIVIDUAL TO BECOME A CEO (recruitment) -MOTIVATE AN INDIVIUDAL TO PROPER PERFORMANCE (incentive) -ATTRACT INVESTORS TO THE SHARE (client effect, i.e., legitimation)

CONSEQUENCE Base pay Variable pay Employment Prospects through reputation Intrinsic rewards

ALIGNING COMPENSATION Environment Organisation Strategy Individual

WHAT IS RISK? Return variance: Risk averse (Financial economics) Probability of loss: Loss averse (Behavioural finance) Expected value Bonus today or options for tomorrow

EMPLOYMENT CONSEQUENCES Downward risk: unemployment Upward risk: Promotion

REPUTATION - WAGE age Value of reputation

INTRINSIC REWARDS Job satisfaction Prospects of development Responsibility Power Good cause Nice atmosphere at the job Fun

EXECUTIVE COMPENSATION IN ACCOUNTING THEORY From an spicy Hungarian soup to a simple soup of water (i.e., markets) containg two ingredients, shareholders and managers, and their risk attitudes and endless needs of profit. The strength of simplicity, i.e., abstraction, The weakness of empirical insignificance and practical irrelevance

POSITIVE ACCOUNTING THEORY “…the only accounting theory that will provide a set of predictions that are consistent with observed phenomena is one based on self-interest” (Watts & Zimmerman, 1979:300).

ECONOMIC CONSEQUENCES ACCOUNTING POLICY CHOICE, LACKING DIRECT CASH FLOW INFLUENCE, CAN INFLUENCE THE VALUE OF THE FIRM BECAUSE - INEFFICIENT CAPITAL MARKET - INDIRECT WEALTH EFFECTS - FOR MANAGEMENT - FOR THE FIRM - FOR INVESTORS - FOR DEBT HOLDERS - FOR SOCIETY, -I.E. MOST STAKE HOLDERS

SHIRKING MANAGERS MANAGERS WITH THEIR OWN GOALS, … SO WHAT? MONITORING IS COSTLY - DIVISION OF LABOUR THROUGH SEPARATION OF OWNERSHIP AND CONTROL COMPETENCE TO MONITOR: INFORMATION – THEORY (EXPERIENCE)  TO MANAGE THE MANAGER One mechanisms is executive compensation

ESSENCE OF EXECUTIVE COMPENSATION FOR POSITIVE ACCOUNTING THEORY RISK SHARING INCENTIVE FOR SHAREHOLDER GOAL ATTAINMENT AND CONGRUENCE Not fairness, intrinsic rewards, employment etc

PAT PREDICTION I: THE BONUS HYPOTHESIS MANAGERS WITH BONUS WILL CHOOSE ACCOUNTING PROCEDURES THAT SHIFT REPORTED EARNINGS FROM FUTURE TO CURRENT PERIOD

PAT PREDICTION II: THE DEBT/EQUITY HYPOTHESIS MANAGERS IN FIRMS WITH HIGH DEBT/EQUITY (I.E., LOW SOLIDITY) WILL CHOOSE ACCOUNTING PROCEDURES THAT SHIFT REPORTED EARNINGS FROM FUTURE TO CURRENT PERIOD HIGH FINANCIAL RISK IS A TREATH TO MANAGERS AUTONOMY IF THE FIRM HAS CONSTRAINTS ON DEBT LEVELS

PAT PREDICTION III: THE SIZE HYPOTHESIS THE LARGER THE FIRM, THE STRONGER INCENTIVE THE MANAGER HAVE TO DEFER REPORTED EARNINGS FROM CURRENT TO FUTURE PERIODS Large firms have higher political costs, media attention, union attention and so on, that stimulate wage increase, tax changes, more charity and so on.