1

Incentive Issues

CHAPTER 12

PowerPointPowerPoint Presentation by Presentation by

LuAnn BeanLuAnn BeanProfessor of AccountingProfessor of AccountingFlorida Institute of TechnologyFlorida Institute of Technology

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in

part, except for use as permitted in a license distributed with a certain product or service or

otherwise on a password-protected website for classroom use.

Managerial Accounting 11E

Maher/Stickney/Weil

2

CHAPTER GOAL

Chapter 12 discusses issues in design and use of management performance evaluation and incentive plans to motivate managers to act in the organization’s best interests. Good performance evaluation and incentive plans induce “win-win” results if they avoid incentives for fraudulent financial reporting.

☼ ☼

3

PAY INCENTIVES

Managers receive bonuses for performance that may be based on divisional or corporate results. Bonuses may be based on annual performance or on performance over several years and may be paid immediately or deferred and spread over several years.

Managers receive bonuses for performance that may be based on divisional or corporate results. Bonuses may be based on annual performance or on performance over several years and may be paid immediately or deferred and spread over several years.

LO 1

4

What forms do divisional incentives

take?

Divisional incentives can be cash or profit sharing for short-term performance; stock or stock options as

deferred compensation; and special awards.

LO 1MANAGERS WANT TO KNOW!

How will performance be evaluated?

Performance can be evaluated based on

accounting numbers, returns to stockholders or

both.

5

DESIGNING INCENTIVE COMPENSATION

Management must ascertain two things in designing incentive systems:What behavior does the system motivate?What behavior does management desire?

LO 1

WARNING! Rewarding managers for performance reflected in annual accounting

numbers gives managers incentives totake actions that make the numbers look

good but not actions that benefitthe organization.

6

INCENTIVES and PRODUCT LIFE CYCLE

A major problem with short-run incentive plans is that managers are penalized for developing products that might produce long-run benefits. Under U.S.GAAP, firms write off research and development costs when incurred. IFRSs do not require as much write-off as U.S. GAAP

A major problem with short-run incentive plans is that managers are penalized for developing products that might produce long-run benefits. Under U.S.GAAP, firms write off research and development costs when incurred. IFRSs do not require as much write-off as U.S. GAAP

LO 1

7

PRODUCT LIFE CYCLE: Stages

Four stages of the product life cycle are:Design and development: low sales but high

research, design and development costsGrowthMaturityDecline

LO 1

8

EXPECTANCY THEORY: Definition

EXPECTANCY THEORY: Definition

Maintains that people act in ways to obtain rewards they desire and prevent penalties

they wish to avoid.

LO 2

9

AGENCY THEORY: DefinitionAGENCY THEORY: Definition

Deals with relations between supervisors and workers and assumes employees will not necessarily behave as their

employers desire.

LO 2

10

EXHIBIT 12.212.2

LO 2

The objective of a good incentive

compensation is to minimize agency

costs.

The objective of a good incentive

compensation is to minimize agency

costs.

11

What are extrinsic rewards ? Extrinsic rewards come

from outside the individual, i.e., the

supervisor, etc.

LO 2MANAGERS WANT TO KNOW!

What are intrinsic rewards ?

Intrinsic rewards come from inside the individual such as satisfaction for a

job well done.

12

BALANCED SCORECARD: Definition

BALANCED SCORECARD: Definition

Is a model of lead and lag indicators of performance

including both financial and nonfinancial performance

measures.

LO 3

13

BALANCED SCORECARD PERSPECTIVES

Four perspectives of the balanced scorecard approach are:Learning and growthInternal business and production process

perspectiveCustomer Financial

LO 3

14

INCENTIVE QUESTION 1

Should rewards be based on current or future performance?

An advantage to basing on future performance is the “golden handcuffs” that tie managers to the company. Most companies use a combination of current and deferred rewards.

Should rewards be based on current or future performance?

An advantage to basing on future performance is the “golden handcuffs” that tie managers to the company. Most companies use a combination of current and deferred rewards.

LO 3

15

INCENTIVE QUESTION 2

Should rewards be based on division or company-wide performance?

When based on the manager’s responsibility center alone, it focuses the attention without considering the impact of their actions on the whole company. Most companies use both.

Should rewards be based on division or company-wide performance?

When based on the manager’s responsibility center alone, it focuses the attention without considering the impact of their actions on the whole company. Most companies use both.

LO 3

16

INCENTIVE QUESTION 3

Should rewards use a fixed formula or subjective judgment in providing rewards?

The advantage of a formula-based plan is that managers know what is expected and what reward they will get if they meet expectations.

Should rewards use a fixed formula or subjective judgment in providing rewards?

The advantage of a formula-based plan is that managers know what is expected and what reward they will get if they meet expectations.

LO 3

17

INCENTIVE QUESTION 4

Should rewards be based on accounting results or stock performance?

Tying managers’ compensation to stock performance loads uncontrollable risk on them. Using EVA both focuses managers on creating value for shareholders and relies on nonstock performance measures.

Should rewards be based on accounting results or stock performance?

Tying managers’ compensation to stock performance loads uncontrollable risk on them. Using EVA both focuses managers on creating value for shareholders and relies on nonstock performance measures.

LO 3

18

INCENTIVE QUESTION 5

Should rewards be based on absolute or relative performance evaluation?

Relative performance compares divisional performance with other divisions in the same industry with less than optimum comparisons.

Should rewards be based on absolute or relative performance evaluation?

Relative performance compares divisional performance with other divisions in the same industry with less than optimum comparisons.

LO 3

19

INCENTIVE QUESTION 6

Should rewards be cash, stock or prizes?

Many companies use a combination because of the different (current vs. deferred) methods of reward. Expectancy theory finds prizes more attractive and more motivating.

Should rewards be cash, stock or prizes?

Many companies use a combination because of the different (current vs. deferred) methods of reward. Expectancy theory finds prizes more attractive and more motivating.

LO 3

20

FRAUDULENT FINANCIAL REPORTING: Definition

FRAUDULENT FINANCIAL REPORTING: Definition

Is intentional conduct resulting in materially misleading

financial statements.

LO 4

21

TYPES OF FRAUD

Fraudulent financial reporting usually falls into two categories:Improper revenue recognition

Firm reports profit in wrong accounting period

Overstating inventoryIncreases reported earnings in period of

overstatement In absence of continuing overstatement, must

result in reduced earnings in next period

LO 4

22

INTERNAL CONTROL: DefinitionINTERNAL CONTROL: Definition

Is a process designed to provide reasonable assurance that an organization will achieve its objectives in (a) operating

effectiveness and efficiency; (b) reliability of financial reporting; and (c) compliance with applicable laws

and regulations.

LO 5

23

INDEPENDENT AUDITORS

Independent audits Are required by the SEC for firms selling

securities across state linesHelp prevent fraud through reviews of

internal controls

LO 5

24

CORRUPTION

According to economists, three elements that must be present for corruption to occur are: Individual must have discretionary power to award

contract or rightsEconomic benefits are associated with

discretionary powerLegal system must be unlikely to detect

wrongdoing

LO 5

25

End of CHAPTER 12