Smeal College of Business Pennsylvania State University Managerial Accounting B A 521 Professor Huddart Compensation Concepts 1 Goals Recall that we would like the individuals within the firm to act in a cooperative manner The cooperative solution involves everyone promising to implement the action that everyone agrees is best for the firm and reveal all their information honestly However the cooperative solution the solution that makes everyone best off may not be self enforcing That is if everyone agrees to act in the cooperative manner for the agreed upon compensation it may be in the best interest of one individual to deviate from that agreement and implement an action other than the one he was directed to implement or dishonestly reveal his private information As a result people will act opportunistically 2 Sources of Divergences in Preferences What are the sources of divergence between individually rational and cooperative behavior which lead to this opportunistic behavior differences in the decision horizon between the firm s managers and shareholders differences in the risk preferences of the managers and shareholders the shareholders are nearly risk neutral because they are well diversified but the manager is not because he has a lot of firm specific human capital which he cannot diversify away differences in the preferences for effort and perquisites differences in the information available to each party if the manager observes that a good state is likely he can shirk and still get good outcome Based in part on a note by Stan Baiman c Steven Huddart 1995 2009 All rights reserved www personal psu edu sjh11 B A 521 Compensation Concepts differences in the human capital versus firm capital effects of decisions by managers 1 The effects of these problems on the behavior of the manager are taken into consideration in setting managerial compensation Shareholders are not fooled into believing that managers will not act opportunistically Thus managerial compensation is adjusted to redress these sources of divergence between individually rational behavior and cooperative behavior Everybody can be made better off when the effects of these divergences are reduced It is the role of the firm s compensation system to mitigate these problems The firm s compensation system consists of rules governing how each manager is to act and means of enforcing the desired behavior and the performance evaluation and monitoring mechanisms that measure the extent to which the manager is behaving as desired The monitoring system specifies what is to be measured and how it is to be measured for example i revenue and expense based on historical cost or current cost ii the firm s share price The performance evaluation measure is based on the output of the monitoring system NI RI ROI share price and EPS are all measures of performance 1 Assume that the manager is work neutral so there is no moral hazard problem but is risk averse Assume that managerial potential is unknown to both the manager and the shareholders Managers believe that the performance of the projects which they select will be read as a signal about their future potential Hence manager s market or opportunity wage will vary with the outcomes of his or her investment decisions That is investments or any other productive decision by management lead to two risky capital streams i human capital for the manager and ii financial capital for the shareholders If no explicit incentive structure is put in place managers will only be concerned about the human capital effects of their decisions while shareholders are only concerned with the financial effects Even given an incentive plan the manager is still concerned with the human capital effect of his decisions while shareholders are not Giving the manager a flat wage does not eliminate the human capital risk associated with his decisions only a lifetime contract would eliminate this problem The functioning of the labor market is usually thought to alleviate or eliminate the problems of motivating managers In this case it is the functioning of the labor markets which creates the problem of motivating the manager to make the right decision without the labor market there would be no human capital risk and hence no incentive problem Page 2 Compensation Concepts B A 521 Each manager s rewards monetary and non monetary are based on the performance evaluation measure 3 Discussion Performance measures most frequently used are accounting measures and share price measures Accounting measures can be manipulated by the choice of accounting techniques Sometimes the choice of accounting method is delegated to the person being evaluated Furthermore accounting profits are a single period measure Unlike present value of cash flows profits do not reflect the future effects of present decisions The effect of current actions especially strategic decisions may not show up in the income for several periods It is reasonable to expect the actions of high level executives to have effects far into the future Thus accounting based performance evaluation measures tend to bias managers in favor of short run considerations Accrual accounting tends to smooth the effects of actions over time On the other hand share price measures can be noisy can be manipulated by repurchasing or issuing stock need not reflect all information available to management and are harder to use for divisional management than top level corporate management Share price measures are unavailable for use in a privatelyheld firm Performance bonds are a stock of value that could be lost through bad behavior One s reputation contingent deferred compensation and unvested pension assets are examples Long term relationships can develop the stocks of value like reputation needed to enforce a contract Performance bonds may limit the need for monitoring Family businesses are frequently run with considerable discretion and little monitoring For these businesses there is probably a confluence of interests Non market sanctions such as family disapproval may also be a factor Page 3 B A 521 4 4 1 Compensation Concepts Motivational problems and ways to deal with them Horizon problem deferred compensation stock price based compensation reflects current as well as expected future performance If the manager leaves the firm forfeiture of performance bonds like deferred compensation serves as a way of repaying the firm for its investment in the manager s human capital 4 2