Smeal College of Business Managerial Accounting: B A 521Pennsylvania State University Professor HuddartExecutive Compensation1. Types of CompensationManagers’ 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. Belowwe describe some features of these compensation components.SalaryThis is the most common form of compensation. Higher level managershave higher salaries and promotion to higher salary levels depends onperformance. That is, salaries in the long run depend upon performance.Cash BonusMost bonus schemes are either linear or piece-wise linear in the respec-tive 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 po ol is a fixed proportion of after-tax profits which exceed sometarget level T , where T is expressed as a fraction of the total capital stock ofthe company. [For example, recently Goodyear Tire Company offered 10% ofits after-tax net income above T , where T was 5% of capital stock. GeneralMotors Corporation offered 8% of income above 7% of capital stock, untilincome was 15% of capital stock, and then it offered 5% thereafter.]A bonus pool is typically divided among top managers, usually inproportion 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/sjh11Goodyear GM5%Net Income7% Net Income10% 8%5%15%of Capital of Capital of CapitalBonusPoolBonusPoolB A 521 Executive CompensationDeferred CompensationThis type of compensation takes many forms:(a) Deferred Bonuses are based on performance of the company for thelast 3–5 years, and are paid only if the manager does not leave thecompany. Alternatively, bonuses are paid after retirement, based onlifetime performance. One common form of deferred compensation is apension plan. Some of these plans are introduced for tax reasons.(b) Performance Shares are similar to deferred bonuses, except that theyare based on cumulative growth in earnings-per-share (EPS) for the last4–6 years. The award is made in terms of a number of company shares.(c) Stock Appreciation Rights (SAR’s), Phantom Stock are similar to de-ferred bonuses, except that they are based on increases in stock price inthe recent past.Participating Unit PlansThese are awards based on performance evaluation of managers by theBoard of Directors, or of divisional managers by the general managers. In-cluded in the performance evaluation are: returns on investment, comparisonof 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 andwelfare schemes for workers, employment of women and minorities, etc.Page 2Earningsfrom sale ofstock-optionsPrice of stock in ten yearsE = max{0, S – X }Xoption strike priceS : is the stock priceX : is the option strike priceExecutive Compensation B A 521Stock OptionsIn this arrangement the manager is given the right to purchase sharesat some future date at a fixed price. A manager, for instance, can be offeredthe option to buy his employer’s shares in ten years at the price of $120 pershare. This is valuable to the manager only if the market price of shares inten years exceeds $120 per share. Suppose, for example, the price is $140 pershare, and the manager holds 1,000 stock options; then he can earn $20,000by obtaining these shares at $120 and selling them on the market at $140.Such an arrangement may encourage managers to undertake projects likelyto increase the price of the firm’s stock.Non-pecuniary rewardsOne final component of compensation is non-cash perks such as theprestige and special rights that attach to an office. A high percentage ofAmerican companies offer perks: first-class air travel (52%), a companyairplane (46%), a company car (73%), chauffeur service (33%), country clubmemberships (67%), financial planning (60%), an executive dining room(23%), home security (13%), and communications equipment (31%).11Source: “The American Advantage,” The Wall Street Journal April 17, 1991.Page 3B A 521 Executive Compensation2. Strength of the Pay for Performance RelationshipM.C. Jensen and K.J. Murphy, “Performance Pay and Top-ManagementIncentives” Journal of Political Economy 98 (1990) 225–264.Data: There are 2,213 CEOs listed in Forbes’ Executive Compen-sation Surveys 1974–1986, about 7,000 observations.Regression: ∆(CEO wealth)t= a + b∆(shareholder wealth)ta = $31,700; b =$3.251,000= 0.00325.Implication: An annual return on shares that is two standard deviationsbelow 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 ofactions.• Relative performance evaluation is widely employed.• Accounting measures of performance dominate stock price returns.• Unobservable (to the researcher) measures of performance exist thatdominate stock price returns.• Non-pecuniary rewards constitute a large component of performancepay.• The market for takeovers or the managerial labor market are theprincipal sources of managerial discipline.• Implicit regulation or political costs preclude the pay for performancecontracts suggested by agency theory.Page 4Executive Compensation B A 5213. Earnings ManagementP.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 arerelated to income-reporting incentives of their bonus contracts, and (2)changes in accounting procedures by managers are associated with adoptionor modification of their bonus plan.”In light of Healy’s findings, the following characteristics of an accountingmeasure (e.g., earnings) determine its usefulness in an incentive contract.• A quantitative, verifiable measure is less likely to be manipulated by theexecutive.• Comparability and predictability are desirable to assure that perfor-mance in the current period can be