Smeal College of Business Managerial Accounting: B A 521Pennsylvania State University Professor HuddartCompensation Concepts1. GoalsRecall that we would like the individuals within the firm to act in acooperative manner. The cooperative solution involves everyone promisingto:• 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 bestoff—may not be self-enforcing. That is, if everyone agrees to act in thecooperative manner for the agreed upon compensation, it may be in the bestinterest of one individual to deviate from that agreement and implement anaction other than the one he was directed to implement or dishonestly revealhis private information. As a result, people will act opportunistically.2. Sources of Divergences in PreferencesWhat are the sources of divergence between individually rational andcooperative behavior which lead to this opportunistic behavior?• differences in the decision horizon between the firm’s managers andshareholders;• differences in the risk preferences of the managers and shareholders—theshareholders are nearly risk-neutral because they are well-diversified butthe manager is not because he has a lot of firm-specific human capitalwhich he cannot diversify away;• differences in the preferences for effort and perquisites;• differences in the information available to each party—if the managerobserves that a good state is likely, he can shirk and still get goodoutcome;Based in part on a note by Stan Baiman.cSteven Huddart, 1995–2009. All rights reserved. www.personal.psu.edu/sjh11B A 521 Compensation Concepts• differences in the human capital versus firm capital effects of decisionsby managers.1The effects of these problems on the behavior of the manager are takeninto consideration in setting managerial compensation. Shareholders are notfooled into believing that managers will not act opportunistically. Thus,managerial compensation is adjusted to redress these sources of divergencebetween individually rational behavior and cooperative behavior. Everybodycan be made better off when the effects of these divergences are reduced.It is the role of the firm’s compensation system to mitigate theseproblems. The firm’s compensation system consists of:• rules governing how each manager is to act and means of enforcing thedesired behavior, and• the performance evaluation and monitoring mechanisms that measurethe extent to which the manager is behaving as desired.– The monitoring system specifies what is to be measured and howit 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 themonitoring system. NI, RI, ROI, share price, and EPS are allmeasures of performance.1Assume that the manager is work-neutral (so there is no moral hazard problem) butis risk-averse. Assume that managerial potential is unknown to both the manager and theshareholders. Managers believe that the performance of the projects which they select willbe read as a signal about their future potential. Hence, manager’s market or opportunitywage 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 concernedabout the human capital effects of their decisions, while shareholders are only concernedwith the financial effects. Even given an incentive plan, the manager is still concerned withthe human capital effect of his decisions while shareholders are not. Giving the managera flat wage does not eliminate the human capital risk associated with his decisions—onlya lifetime contract would eliminate this problem. The functioning of the labor market isusually thought to alleviate or eliminate the problems of motivating managers. In thiscase, it is the functioning of the labor markets which creates the problem of motivating themanager to make the right decision—without the labor market there would be no humancapital risk and hence no incentive problem.Page 2Compensation Concepts B A 521• Each manager’s rewards (monetary and non-monetary) are based on theperformance evaluation measure.3. DiscussionPerformance measures most frequently used are accounting measuresand share price measures. Accounting measures can be manipulated by thechoice of accounting techniques. Sometimes the choice of accounting methodis delegated to the person being evaluated.Furthermore, accounting profits are a single-period measure. Unlikepresent value of cash flows, profits do not reflect the future effects of presentdecisions. The effect of current actions, especially strategic decisions, maynot show up in the income for several periods. It is reasonable to expectthe actions of high-level executives to have effects far into the future. Thus,accounting based performance evaluation measures tend to bias managers infavor of short run considerations. Accrual accounting tends to smooth theeffects 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 corporatemanagement. Share price measures are unavailable for use in a privately-held firm.Performance bonds are a stock of value that could be lost through badbehavior. One’s reputation, contingent deferred compensation, and unvestedpension assets are examples. Long term relationships can develop the stocksof value (like reputation) needed to enforce a contract. Performance bondsmay limit the need for monitoring.Family businesses are frequently run with considerable discretion andlittle monitoring. For these businesses, there is probably a confluence ofinterests. Non-market sanctions such as family disapproval may also be afactor.Page 3B A 521 Compensation Concepts4. Motivational problems and ways to deal with them4.1 Horizon problem– deferred compensation– stock price based compensation (reflects current as well as expectedfuture performance)If the manager leaves the firm, forfeiture of performance bonds