Relationship Between Compensation Plans and Accounting Measures

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Abstract

The issue of executive compensation has been one that is being subjected to continued debates. Based on the nature of businesses and the extent of the control and expertise required of the CEOs and other top executives a number of compensation packages are evolved by corporations. These compensation plans generally are made to motivate the top executives to work for the enhancement of shareholders’ wealth. These bonuses and incentive plans are mostly linked to the performance of the executives concerned. One of the ways of measuring the performance of the executives is to use the earnings as reported by the accounting reports. Since the managers invariably control the accounting policies and preparation of financial statements, they have a tendency to manipulate the accounting to result in increase of personal benefits to them. There are a number of factors that influence the decisions of the managers to take such decisions. This paper addresses some of the issues in the context of executive compensation analyzing the views of Healy (1985) on the subject.

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Introduction

Incentives to top executives and managers of any business organization typically are note based on their ability to enlarge shareholders’ wealth. Improved firm performance is also found to be one of the considerations for fixing the terms of incentives. Accounting measures are often considered as capable of assessing firm performance and consequently are recognized as one of the variables for basing the remuneration of the CEO or any other top executive of the organization. However, Healy (1985) argues that basing the executive compensation may turn out to be counterproductive when based on accounting measures of performance. According to Healy (1985) and Dechow & Sloan, (1991)such practice of using accounting measures for fixing the incentives may motivate managers to take decisions which will have the effect of increasing their own wealth rather than focusing on enlarging the shareholder wealth. (Kaplan & Atkinson, (1989) provide many examples of the ways in which a manager can manipulate and overstate the earnings and at the same time decrease the firm value. Generally Accepted

Accounting Principles (GAAP) point towards the possibility of managers manipulating the accounting variables so that they can enhance their own earnings. In this context this paper examines the validity behind the proposition of Healy (1985) in stating “bonus schemes create an incentive for managers to select accounting procedures and accruals to maximize the value of their bonus awards.” (Healy, 1985) The paper also looks into other literature to make a critical review of the argument of Healy (1985).

Agency Theory and Executive Compensation

Agency theory is an important element in the study of theory of firms. According to the agency theory, because the ownership and control of the firm is often separated, there is always the potential for likely conflicts between managers (the agents) and the investors or shareholders (the principals). It will be the endeavor of the manager to maximize his own benefit always rather than that of the shareholders. In the presence of the agency problems, the incentive contracts between the managers and the firms act as an effective mechanism to provide the necessary incentive to the managers to act to increase the shareholders’ wealth. However, the managers usually get a large control on the management of the affairs of the firm due to the presence of a number of factors like the infeasibility to enter into complete and precise contract (Grossman & Hart, 1986; Hart, 1995). In addition, there is the issue of asymmetry of information that results in getting incomplete information by the shareholders (Myers & Majluf, 1984). Finally the expertise of the managers in managing the firms efficiently than the investors also adds to the accumulation of control with the managers. This provides an opportunity to the manager to exhibit entrenchment behavior.

Corporate Governance and Managerial Remuneration

Corporate governance plays an important role in the issues relating to managerial remuneration. There are many aspects like the incentive contract, legal protection available to minority shareholders, capital structure of the company covering the proportion of debt and equity and concentration of ownership. The incentive contracts for the managers in general are designed to motivate them to enlarge the firm value. The way in which the CEOs are paid is more important than the amounts paid to them. This makes the composition of the compensation contract an important aspect in firm management. In practice the proxy statements filed by the firms with SEC disclose a variety of information which include (i) annual compensation broken down into various elements such as salary, bonus and other emoluments, (ii) long-term compensation awards – this may include restricted stock, incentive payouts and stock options and (iii) all other compensation including terminal benefits and life insurance policies and the like. “Equity-based compensation is argued to provide better incentive for the manager to maximize the shareholder value than the cash-based compensation, while bonus-based compensation is considered to be easily leading to managerial myopic behavior.” (Du, 2002)

Changes in the value of CEO holdings of stocks and stock options solely determine the pay-performance relationship for the CEOs. There is a problem with equity based compensation in that it is not always possible to relate it to CEO performance because of the volatility in the stock prices. In the case of managers who are risk-averse, there may be a tendency among them to try to manipulate the risk of the firm, while making investment decisions, so that they could bear lesser risk in terms of their compensation. Another aspect of equity-based compensation is that since the compensations are based on the stock returns, and the importance of higher earnings of the company to boost the stock values in the market, the managers may decide to cut the R&D expenses and advertisement budgets to enhance the firms’ earnings and thereby to increase the stock values in the market. However, in the case of an efficient market which reacts to all information about the firms available, then the managers may tend to enlarge the R&D expenditure to boost the image of the company. This happens especially in the case of growth and high-tech companies. The severance packages of the change of control for CEOs may have the effect of increasing the private benefits of the CEOs and in that case there will be reduction in the myopic investments by the managers. One cannot rule away the impact of the presence of institutional investors and large outside block-holders in fixing the managerial remuneration packages. These agencies do have a say in the management decisions and thus affect the formulation of compensation plans for the top level executives.

Studies on Managerial Compensation and Earnings Manipulation

Several past studies including Healy (1985) have considered the effect of managerial compensation schemes on the manipulation of accounting earnings. Gaver et al., (1995) and Holthausen et al., (1995) have looked at instances of managers manipulating the earnings with a view to maximize their performance-based incentives. Healy (1985) cites evidences of the managers either increasing the current earnings to increase their bonus for the current period or decreasing the earnings of the firm for the current period to result in enlarged earnings for the future period. According to Healy (1985) the managers undertake these processes when the bonus payable to them are capped or in some other way limited based on the earnings of the firm. Healy (1985) looked at the correlation between the decisions of the managers on the accrual and other accounting procedures and their incentives based on income reported by the accounting records. Healy found that managers choose accounting procedures and accruals that have the ability to maximize the value of their bonus award entitlements. The managers resort to such practices only when the bonus schemes are created with a link to the earnings of the firm. The study by Healy, (1985) has revealed a higher incidence of voluntary changes made in the accounting procedures during the periods immediately following the adoption or modification of an existing bonus plan.

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Study by Dechow & Sloan, (1991) focused on finding whether earnings-based performance measures induce executives to concentrate on short-term performance of the firms. The study looked at the behavior of CEOs in regulating Research & Development expenses in the final year of their tenure. The authors found in most of the firms studied the CEOs had the tendency to restrict the outlay on Research & Development expenditure which show that the contractual terms of the firm for CEO appointments do not completely eliminate the opportunistic behavior of the managers in respect of their remuneration. This presupposes the apparent ability of managers to enhance their personal earnings at the cost of the firm’s value. However it is observed that a large percentage of executive compensation plans still are made to include incentives that are calculated based on accounting measures. Studies point out that out of 350 largest companies studied, 61% of the firms formulated long-term performance plans based on accounting measures (Mercer et al., 1996).

Literature is ripe with empirical evidence on identifying the tendency of the managers to manipulate the earnings of the firm in order to alter the quantum of their compensation. According to Ke, (2001) CEOs of firms who have been awarded high amount of equity incentives in the form of unrestricted stock and immediately exercisable options are more likely to indulge in earnings management. These executives report small earnings increase rather than small earnings decreases. They also resort to reporting long strings of increasing earnings. Based on measurement of absolute values of discretionary accruals, Gao & Shrieves, (2002) have observed that the intensity of the management increases in respect of options and bonuses. However they have observed a decreasing trend in respect of salaries. Cheng & Warfield, (2005) established an association between the quantum of stock-based compensation and the magnitude of abnormal accruals to report that with an increase in the compensation levels there was a corresponding increase in the abnormal accruals. In the case of corporations offering compensation schemes providing higher stock-bases studies have observed a lower earnings coefficient. This situation suggests the existence of a strong correlation between the information of the earnings of the firm and the executive compensation in the firms offering such higher stock-based compensation plans.

Executive Compensation and Accounting Frauds

The impact of the phenomena of accounting fraud on executive compensation and the tendency of the managers to perpetrate accounting frauds has been dealt with by few empirical studies. The studies have evoked mixed evidence on the correlation between the two phenomena. Dechow et al., (1996) have observed no correlation between executive compensation and SEC enforcement actions. This situation has been observed specifically where the firm had an earnings-based bonus plan. Erickson et al., (2006) have reported an increase in the accounting frauds in relation to total executive compensation that is stock-based. However the governance structure of the firm concerned has a role to play in determining the chances of such occurrences.

Recent Developments affecting Compensation

Over the past two decades there have been numerous developments which have significant impact on the executive compensation. These developments have affected the ways in which firms create, view and manage compensation plans of the executives. Beginning 1994, tax-deduction by companies covering executive compensation over a cap of $ 1 million that is not linked with performance has been denied. In addition, stocks options are considered as performance related if they were not issued “in the money” (the term “in the money” implies the issue of shares “with an exercise price less than the fair market value of the underlying stock on the date of the grant.”

The disclosure requirement of Financial Accounting Standards Board (FASB) to report on the stock options granted to employees even in respect of non-performance based issues will also affect the compensation contracts proposed by the firms. Public image is another serious issue that plays a dominant role in the determination of compensation plans. Continued criticism by the shareholders, employees and the general public over exorbitant compensation paid to corporate heads acts to alter the incentive plans to have more realistic base for determining the compensation plans.

Disclosure requirements mandated by Sarbanes – Oxley Act in the United States and similar statutory requirements in other countries have been attempting to discourage manipulation of accounting and preventing accounting frauds have had significant impact on the ability of the managers to indulge in earnings management to increase monetary benefits to them. Stricter vigil by external auditors, focus on auditors’ independence, formulation of audit committees, requirements as to certification by the CEO and CFO on the presence and effectiveness of internal control systems and adherence to various accounting standards have impacted the manipulation of accounting largely. Consequently there appears to be a change in the ways of linking the executive compensation with real profitability and increase in shareholders’ wealth.

Conclusion

Latest developments in the statutory compliances with respect to drafting and reporting of financial statements and institution and maintenance of effective internal control systems has raised significant apprehensions on the ability of the management to manipulate accounting variables. Aftermath of the detection of accounting and financial frauds in large corporations like Enron and WorldCom have given rise to higher levels of transparency and review of the financial performance by the audit committees and external auditors. Therefore, it can reasonably be stated that the chances of manipulations in accounting variables have considerably reduced, if not eliminated completely. Under such circumstances it is not obvious that whether the compensation packages containing accounting-based measurements will be helpful in achieving the desired goals of enhanced firm performance. The responses of the shareholders to the adoption such accounting-based incentive plans are not concrete and consequently it does not clarify the relevance and effectiveness of accounting measures based bonus plans. Therefore this paper concludes that in the present day context the findings of Healy (1985) may not be considered valid because of stricter corporate governance measures and regulatory requirements with respect to disclosure and transparency of the financial performance of firms.

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Reference List

Cheng, Q. & Warfield, T., 2005. Equity Incentives and Earnings Management. The Accounting Review, 80, pp.441-76.

Dechow, P. & Sloan, R., 1991. Executive incentives and the horizon problem: An empiricalinvestigation. Journal of Accounting & Economics, 14, pp.51-89.

Dechow, P., Sloan, R. & Sweeney, A., 1996. Causes and Consequences of Earnings Manipulation: AnAnalysis of Firms Subject to Enforcement Actions by the SEC. Contemporary Accounting Research, 13, pp.1-36.

Du, C., 2002. The Determinants of Corporate Investments: Does Managerial Entrenchment Matter?. Web.

Erickson, M., Hanlon, M. & Maydew, E., 2006. Is There a Link Between Executive Compensation andAccounting Fraud? Journal of Accounting Research, 44, pp.113-44.

Gao, P. & Shrieves, R., 2002. Earnings Management and Executive Compensation: A Case of Overdose ofOption and Underdose of Salary. Working Paper. Knoxville Tennessee: Northwestern University and University ofTennessee.

Gaver, J., Gaver, K. & Austin, J., 1995. Additional evidence on bonus plans and income management.. Journal of Accounting and Economics, 19(1), pp.3-28.

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Grossman, J.S. & Hart, D.O., 1986. The Costs and Benefits of Ownership: A Theory of Vertical and Lateral Integration. Journal of Political Economy, 94(4), pp.691-719.

Hart, O., 1995. irms, Contract, and Financial Structure. New York, New York: : Oxford University Press.

Healy, P., 1985. The effect of bonus schemes on accounting decisions. Journal of Accounting& Economics , 7, pp.85-107.

Holthausen, R.W., Larcker, D.F. & Sloan, R.G., 1995. Annual Bonus Schemes and the Manipulation of Earnings,. Journal of Accounting and Economics, 19, pp.29-74.

Kaplan, R.S. & Atkinson, A.A., 1989. Advanced Management Accounting. New Jersey: Prentice Hall.

Ke, B., 2001. Why Do CEOs of Publicly Traded Firms Prefer Reporting Small Increases in Earnings and LongDuration of Consecutive Earnings Increases? Working Paper. Pennsylvania State University.

Myers, S.C. & Majluf, N.S., 1984. Corporate Financing and Investment Decisions When Firms Have Information That Investors Do Not Have,. Journal of financial Economics, 13, pp.187-221.

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BusinessEssay. "Relationship Between Compensation Plans and Accounting Measures." February 11, 2022. https://business-essay.com/relationship-between-compensation-plans-and-accounting-measures/.