Chapter 10 Executive Compensation Chapter 10 Executive Compensation 10.2 Are Incentive Contracts Necessary? • No: Fama (1980) – Forces of reputation on managerial labour market enough to motivate manager to work hard – Assumes managerial labour market works well • Yes: Wolfson (1985) – Forces of reputation help to motivate manager, but incentive contract still needed – Suggests that managerial labour markets not work fully well – See Supp slides for details 10.3 The BCE Compensation Plan • Components of senior management compensation – Salary – Short-term incentive awards • Cash bonus or deferred share units, based on attainment of financial targets (e.g., EPS ) & new business development, • Individual contribution (based on a third performance measure: creativity & initiative) – More suitable for less senior managers? 10.3 The BCE Compensation Plan (continued) • Compensation components, cont’d – Stock options, based on share price performance – Executives required to hold BCE shares • All compensation components except salary increase alignment – Since investors and managers both want firm to well 10.3 The BCE Compensation Plan (continued) • Revisions to compensation plan 2004 – Mid-term incentive plan (2 year) – Reduced stock option awards • Restricted share units instead – Reasons for revisions • To shorten manager decision horizon, but not too short • Improve BCE corporate governance credibility 10.4 Theory of Executive Compensation • Desirable properties of a performance measure – Sensitivity – Precision – Generally, these properties have to be traded off • Share price – High in sensitivity, low in precision • Net income – Low in sensitivity, high in precision 10.4 Theory of Executive Compensation (continued) • How to increase sensitivity of net income – Reduce recognition lag • Net income “waits” until many aspects of manager effort are realized – R&D, advertising, legal & environmental liabilities – Capital expenditure programs • Current value accounting reduces recognition lag – But decreases precision 10.4 Theory of Executive Compensation (continued) • How to increase sensitivity of net income, cont’d – Full disclosure • More difficult for manager to disguise shirking by earnings management • Enables compensation committee to better evaluate earnings persistence 10.4 Theory of Executive Compensation (continued) • Two types of manager effort – Short-run – Long-run • If net income congruent to payoff, mix of shortrun and long-run effort does not matter to investor – Each effort type equally effective in generating payoff The Question to be Addressed • In a multi-period context, can market forces (i.e., reputation effects) eliminate shirking? – If so, no need to motivate managers by means of incentive contracts Tax-Advantaged Limited Partnerships to Drill for Oil and Gas (U.S.) • Principal: the limited partner, who invests and receives advantageous tax treatment • Agent: the general partner/manager – Conducts drilling and on basis of drilling results decides whether or not to complete the well Two Types of Drilling • Exploratory – Riskiest (low probability of high payoff) • Developmental – Least risky (high probability of low payoff) An Incentive Contract • A common sharing rule (contract) – Tangible drilling costs: must be capitalized for tax purposes – Intangible drilling costs: immediately tax deductible – Agent (manager) pays tangible costs – Principal (limited partner, investor) pays intangible costs – Let revenue from well be R – Manager gets, e.g., 40R – Investor gets 60R Information Asymmetry • Manager knows expected R, investor does not • This leads to incentive problems of moral hazard and possible shirking by manager – Noncompletion problem (manager shirks by not completing well) The Noncompletion Problem (Well is Drilled But Not Yet Completed) • A model of revenue from well: – E(R) = K(D + C) • D: drilling costs Paid by investor • C: completion costs To be paid by manager • K: manager’s skill (e.g., K = 2) – Manager generates $2 in revenue for each dollar spent • Manager knows E(R) and C, investor does not The Noncompletion Problem (continued) • From standpoint of society (and investor) – Complete well if R ≥ KC, since D is sunk • From standpoint of manager – Complete well if 40R > KC • Thus manager may not complete well (i.e., may shirk) when completion is in best interests of principal and society • NB: Noncompletion problem greater for development wells Controlling the Noncompletion Problem • Direct monitoring of manager drilling effort and results (too costly) • Manager establishes a reputation (multi-period) to convince principal that he/she will not shirk Testing For Reputation Effects • For each general partner (manager) in the sample of limited partnerships: – Expected return rating (ERR) • A measure of a manager’s reputation, based on past performance • Analogous to past income statements – Net return rating (NRR) • Expected oil and gas finding rate A measure of the cost to “buy in” to the manager’s partnership Lower NRR implies higher cost to buy in, since limited partners (investors) then get lower expected return • NRR analogous to a managerial labour market (i.e., measures the manager’s worth) Testing For Reputation Effects (continued) • Is higher reputation associated with higher cost to buy in? – Yes: Wolfson reports statistically significant evidence that higher reputation (higher ERR) associated with higher cost to buy in (lower NRR) – It appears investors are willing to accept a lower expected return the higher the manager’s reputation • Conclude: reputation reduces the non-completion problem of manager shirking Testing For Reputation Effects (continued) • Does reputation eliminate the noncompletion problem? – No: Wolfson reports higher NRR for development wells – Development wells • Average NRR for his sample = 2.695 – Exploratory wells • Average NRR for his sample = 2.357 • Thus lower price to buy into development wells Testing For Reputation Effects (continued) • Wells more subject to the noncompletion problem (development wells) are priced lower by investors than wells less subject to the noncompletion problem (exploratory wells) • If reputation completely eliminated the noncompletion problem, the prices would be the same Conclusion to Testing For Reputation Effects • Conclude: reputation effects not completely eliminate the need for an incentive contract • Managerial labour market works, but not fully well Implications for Accountants • roles for accounting information – Market forces of reputation reduce but not eliminate manager shirking • Thus compensation contracts and performance measures such as net income still needed – Net income should be informative about manager effort • i.e., the ability of market forces to motivate effort is improved as accountants reduce ability of managers to shirk through higher quality reporting – Both roles benefit society The End Thank you .. .Chapter 10 Executive Compensation 10. 2 Are Incentive Contracts Necessary? • No: Fama (1980) – Forces of reputation... point where need for an incentive contract is eliminated Chapter 10 Supplement Wolfson (1985) Study of Oil and Gas Limited Partnerships 10. 2 Empirical Evidence of Incentive Problems and Their... a third performance measure: creativity & initiative) – More suitable for less senior managers? 10. 3 The BCE Compensation Plan (continued) • Compensation components, cont’d – Stock options, based