EXECUTIVE EXECUTIVE COMPENSATIONCOMPENSATION

Sven-Olof Yrjö Collin

Me: Sven-Olof Yrjö Collin- Professor in Business Administration with emphasis on Corporate Governance and Accounting- Teach in corporate governance, accounting, management control, corporate finance, strategy, scientific method and supervise on all levels. - Research in corporate governance, for example riding schools, municipal corporations, family firms, but also executive compensation, accounting choice and auditing, duty.E-mail: sven.olof.collin@lnu.seHomepage: www.svencollin.se

AIM OF LECTURE

TO PRESENT EXECUTIVE COMPENASTION

- AS RELEVANT AS POSSIBLE, i.e., AS AN HUNGARIAN SOUP

AND THEN PRESENT

- ONE ACCOUNTING THEORY VERSION, i.e., THE SIMPLE WATER SOUP BY POSITIVE ACCOUNTING THEORY

THE COMPENSATION PUZZLE

Size of the firm

Performance of the firm

Executive Pay

40%

5%

5 - 40IN THE PRINCIPAL - AGENT CONFLICT?

Size of the firm

Performance of the firm

Executive Pay

40%

5%

Size: Goal of managersAGENT

PRINCIPALProfit: Goal of shareholders

INSTITUTIONAL DIFFERENCES

OWNERSHIP STHRENGT

EX

EC

UT

IVE

CO

MPE

NSA

TIO

N€

US, UK

Germany

Sweden

Japan

low high

TENDENCY TO USE OPTION SCHEMEShigh low

Situation Situation

AGENCY R I S K

PRINCIPAL’SOBSERVATION

Competence Behaviour Performance

PRINCIPAL - AGENT RELATIONSHIP

SEPARATING THE PROCESS OF COMPENSATION

Mechanism of compensation

Criteria for compensation

Consequence

WHO TO COMPENSATE

Individual

Figure headIndividual‘unfair’

Group

CollaborationMutual Monitoring‘back stabbing

MECHANISM OF COMPENSATION

- Contract

- Monitoring

Objectivity Predictability Precision

Transparency Risk Fairness

CRITERIA FOR COMPENSATION

• Performance• Behaviour• Individual characteristics• Labour market price• Position• Peer comparison

PERFORMANCE

MARKET MEASUREMENTS

ACCOUNTING MEASUREMENTS

SUBJECTIVE MEASUREMENTS

•Noise•Influence•Informational•Motivational

- Goal!- Strategy etc.

STRATEGY

Strategy Structure

Market dominance Performance criteria: Sales growth

CEO DISCRETION INFLUENCING PAY

Task programmabilityUncertainty CEO Discretion Compensation

WHEN PAY - PERFORMANCE?

uncertainty

CE

O in

flue

nce

BEHAVIOUR CRITERIA

Actions performed by the agent

• subjective• costly

time evaluators competence

INDIVIDUAL CHARACTERISTICS

•EDUCATION•COMPETENCE•NETWORK

LABOUR MARKET

supplyde

man

d

Price = Wage

Upper boundConsultants?

Reservation wage

Bidding-up hypothesis

POSITION COMPENSATION

• Figure head (Tournament theory)• Social recognition• Hierarchical level

- responsibility- higher pay on next level

• Information-processing requirements

PEER COMPARISON

REFERENCE POINT

• Peers

• Significant others

WHO DECIDES ABOUT COMPENSATION?

• The Board• The Chairman of the Board• The Dominant Owner• The Remuneration Committee

- consultants...

RELATIONAL CONTRACT

• Exchange create externality• Experience => mutual expectations• No time horizon => trust

Tenure => No correlation Pay & PerformanceTenure => Less explicit control

SOCIETY INFLUENCING COMPENSATION

• Media• Social groups• Ideology

...more market-dependent decision makers,

more fashionable compensation package

KAUSALITY?

DECIDE ABOUT COMPENSATION IN ORDER TO

- ATTRACT AN INDIVIDUAL TO BECOME A CEO (recruitment)

- MOTIVATE AN INDIVIUDAL TO PROPER PERFORMANCE (incentive)

- ATTRACT INVESTORS TO THE SHARE (client effect, i.e., legitimation)

CONSEQUENCE

Base pay

Variable pay

Employment

Prospects through reputation

Intrinsic rewards

ALIGNING COMPENSATION

Environment

OrganisationStrategy

Individual

WHAT IS RISK?

Return variance: Risk averse (Financial economics)

Probability of loss: Loss averse (Behavioural finance)

Expected value

Bonus today or options for tomorrow

EMPLOYMENT CONSEQUENCES

Downward risk: unemploymentUpward risk: Promotion

REPUTATION - WAGE

age

Val

ue o

f re

puta

tion

INTRINSIC REWARDS

•Job satisfaction•Prospects of development•Responsibility•Power•Good cause•Nice atmosphere at the job•Fun

EXECUTIVE COMPENSATION IN ACCOUNTING THEORY

From an spicy Hungarian soup to a simple soup of water (i.e., markets) containg two ingredients, shareholders and managers, and their risk attitudes and endless needs of profit.

The strength of simplicity, i.e., abstraction,

The weakness of empirical insignificance and practical irrelevance

POSITIVE ACCOUNTING THEORY

“…the only accounting theory that will provide a set of predictions that are consistent with observed phenomena is one based on self-interest”

(Watts & Zimmerman, 1979:300).

ECONOMIC CONSEQUENCES

ACCOUNTING POLICY CHOICE, LACKING DIRECT CASH FLOW INFLUENCE, CAN INFLUENCE THE VALUE OF THE FIRM

BECAUSE- INEFFICIENT CAPITAL MARKET- INDIRECT WEALTH EFFECTS

- FOR MANAGEMENT- FOR THE FIRM- FOR INVESTORS- FOR DEBT HOLDERS- FOR SOCIETY,-I.E. MOST STAKE HOLDERS

SHIRKING MANAGERS

MANAGERS WITH THEIR OWN GOALS,

… SO WHAT?

MONITORING IS COSTLY

- DIVISION OF LABOUR THROUGH SEPARATION OF OWNERSHIP AND CONTROL

COMPETENCE TO MONITOR:

INFORMATION – THEORY (EXPERIENCE)

TO MANAGE THE MANAGER

One mechanisms is executive compensation

ESSENCE OF EXECUTIVE COMPENSATION FOR POSITIVE ACCOUNTING THEORY

RISK SHARING

INCENTIVE FOR SHAREHOLDER GOAL ATTAINMENT AND CONGRUENCE

Not fairness, intrinsic rewards, employment etc

PAT PREDICTION I:THE BONUS HYPOTHESIS

MANAGERS WITH BONUS WILL CHOOSE ACCOUNTING PROCEDURES THAT SHIFT REPORTED EARNINGS FROM FUTURE TO CURRENT PERIOD

PAT PREDICTION II: THE DEBT/EQUITY HYPOTHESIS

MANAGERS IN FIRMS WITH HIGH DEBT/EQUITY (I.E., LOW SOLIDITY) WILL CHOOSE ACCOUNTING PROCEDURES THAT SHIFT REPORTED EARNINGS FROM FUTURE TO CURRENT PERIOD

HIGH FINANCIAL RISK IS A TREATH TO MANAGERS AUTONOMY IF THE FIRM HAS CONSTRAINTS ON DEBT LEVELS

PAT PREDICTION III: THE SIZE HYPOTHESIS

THE LARGER THE FIRM, THE STRONGER INCENTIVE THE MANAGER HAVE TO DEFER REPORTED EARNINGS FROM CURRENT TO FUTURE PERIODS

Large firms have higher political costs, media attention, union attention and so on, that stimulate wage increase, tax changes, more charity and so on.