Smeal College of Business Pennsylvania State University Managerial Accounting B A 521 Professor Huddart Executive Compensation 1 Types of Compensation Managers compensation takes various forms including salary bonus deferred compensation like stock appreciation rights and phantom stock participating unit plans stock options and non pecuniary rewards Below we describe some features of these compensation components Salary This is the most common form of compensation Higher level managers have higher salaries and promotion to higher salary levels depends on performance That is salaries in the long run depend upon performance Cash Bonus Most bonus schemes are either linear or piece wise linear in the respective performance measure One example is a sales commission Often a bonus pool is decided on the basis of a company s annual profit Usually this pool is a fixed proportion of after tax profits which exceed some target level T where T is expressed as a fraction of the total capital stock of the company For example recently Goodyear Tire Company offered 10 of its after tax net income above T where T was 5 of capital stock General Motors Corporation offered 8 of income above 7 of capital stock until income was 15 of capital stock and then it offered 5 thereafter A bonus pool is typically divided among top managers usually in proportion to their salaries and the achievement of some pre specified goals Bonuses may be paid in cash or in the form of company shares Based on notes by Nahum Melumad and Stefan Reichelstein c Steven Huddart 1995 2009 All rights reserved www personal psu edu sjh11 B A 521 Executive Compensation Goodyear Bonus Pool GM Bonus Pool 5 10 5 of Capital 8 7 of Capital Net Income 15 of Capital Net Income Deferred Compensation This type of compensation takes many forms a Deferred Bonuses are based on performance of the company for the last 3 5 years and are paid only if the manager does not leave the company Alternatively bonuses are paid after retirement based on lifetime performance One common form of deferred compensation is a pension plan Some of these plans are introduced for tax reasons b Performance Shares are similar to deferred bonuses except that they are based on cumulative growth in earnings per share EPS for the last 4 6 years The award is made in terms of a number of company shares c Stock Appreciation Rights SAR s Phantom Stock are similar to deferred bonuses except that they are based on increases in stock price in the recent past Participating Unit Plans These are awards based on performance evaluation of managers by the Board of Directors or of divisional managers by the general managers Included in the performance evaluation are returns on investment comparison of targets and forecasts with actual performance e g of revenues or costs or productivity comparison with other companies in the same industry achievement of other company goals such as establishment of training and welfare schemes for workers employment of women and minorities etc Page 2 Executive Compensation B A 521 Stock Options In this arrangement the manager is given the right to purchase shares at some future date at a fixed price A manager for instance can be offered the option to buy his employer s shares in ten years at the price of 120 per share This is valuable to the manager only if the market price of shares in ten years exceeds 120 per share Suppose for example the price is 140 per share and the manager holds 1 000 stock options then he can earn 20 000 by obtaining these shares at 120 and selling them on the market at 140 Such an arrangement may encourage managers to undertake projects likely to increase the price of the firm s stock Earnings from sale of stock options E max 0 S X X option strike price Price of stock in ten years S is the stock price X is the option strike price Non pecuniary rewards One final component of compensation is non cash perks such as the prestige and special rights that attach to an office A high percentage of American companies offer perks first class air travel 52 a company airplane 46 a company car 73 chauffeur service 33 country club memberships 67 financial planning 60 an executive dining room 23 home security 13 and communications equipment 31 1 1 Source The American Advantage The Wall Street Journal April 17 1991 Page 3 B A 521 2 Executive Compensation Strength of the Pay for Performance Relationship M C Jensen and K J Murphy Performance Pay and Top Management Incentives Journal of Political Economy 98 1990 225 264 Data Regression There are 2 213 CEOs listed in Forbes Executive Compensation Surveys 1974 1986 about 7 000 observations CEO wealth t a b shareholder wealth t a 31 700 Implication b 3 25 0 00325 1 000 An annual return on shares that is two standard deviations below the mean costs CEOs 5 400 on average Agency hypotheses that may explain Jensen and Murphy s findings Executives are risk averse High pay performance contracts are not feasible Firm value changes are imperfect measures of the CEO s choice of actions Relative performance evaluation is widely employed Accounting measures of performance dominate stock price returns Unobservable to the researcher measures of performance exist that dominate stock price returns Non pecuniary rewards constitute a large component of performance pay The market for takeovers or the managerial labor market are the principal sources of managerial discipline Implicit regulation or political costs preclude the pay for performance contracts suggested by agency theory Page 4 Executive Compensation 3 B A 521 Earnings Management P M Healy 1985 The Effect of Bonus Schemes on Accounting Decisions Journal of Accounting and Economics 7 85 107 The test results suggest that 1 accrual policies of managers are related to income reporting incentives of their bonus contracts and 2 changes in accounting procedures by managers are associated with adoption or modification of their bonus plan In light of Healy s findings the following characteristics of an accounting measure e g earnings determine its usefulness in an incentive contract A quantitative verifiable measure is less likely to be manipulated by the executive Comparability and predictability are desirable to assure that performance in the current period can be meaningfully related to past performance and to the performance of executives in other parts of the organization or in other companies Measures that are both sensitive and precise are most informative of the