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10.1 OVERVIEW

In this chapter we consider executive compensationplans. We will see that real incentive plans follow from theagency theory developed in Chapter 9, but are morecomplex and detailed, and span multiple periods. They

involve a delicate mix of incentive, risk, and decision horizonconsiderations.An executive compensation plan is an agency contract

between the firm and it s manager that attempts to align the interests of owners and manager by basing the manager's compensation on one or more measures of th e manager's

performance in operating the firm.

Many compensation plans are based on two performancemeasures net income and share price. That is, the amountsof cash bonus, shares, options, and other components of

executive pay that are awarded in a particular year dependon both net income and share price performance. Theanalyses of Holmstrom (1979) and Felrham and Xie (1994)outlined in Section 9.8.1 suggest that multiple performancemeasures increase contracting efficiency.

The role of net income in motivating managerperformance is equally as important as its role in informinginvestors. This is because the motivation of responsiblemanager performance and improving the operation of managerial labour markets are desirable social goals. Theyare equally as important as the enabling of good investment

decisions and securities market operation. Consequently,an understanding of the properties that net income needsin order to measure manager performance is important foraccountants. Unless net income has desirable qualities of sensitivity and precision, it will not be informative aboutmanager effort. That is, it will not measure performanceefficiently and will not enable the market to properly valuethe manager's worth. It will also be "squeezed out" of efficientcompensation plans.

Figure 10.1 outlines the organization of this chapter.

10.2 ARE INCENTIVE CONTRACTS NECESSARY?



Fama (1980) makes the case that incentive contracts of the type studied in Section 9,4.2 are not necessary because themanagerial labour market controls moral hazard. If a managercan establish a reputation for creating high payoffs forowners, that manager's market value (i.e., the compensationhe or she can command) will increase. Conversely, a managerwho shirks, thus reporting lower payoffs on average, will suffera decline in market value. As a manager who is tempted toshirk looks ahead to future periods, the present value of reduced future compensation, Fama argues, will be equal to orgreater than the immediate benefits of shirking. Thus, themanager will not shirk. This argument, of course, assumes anefficient managerial labour market that properly valuesthe manager's reputation. Analogous to the case of a capitalmarket, the operation of a managerial labour market isenhanced by full disclosure of the manager's performance.

Fama also argues that for lower-level managers, any

shirking will be detected and reported by managers belowthem, who want to get ahead. That is, a process of "internalmonitoring" operates to discipline managers who may be lesssubject to the discipline of the managerial labour marketitself.

Since the owner knows which action the managerwill take in the single-period models of Chapter 9, thesemodels do not reveal any information about manager effortand ability. Thus they cannot deal directly with the multi-period horizon that is needed for reputation formation andinternal monitoring. Recall that in the single period model,

the manager's market value enters only through thereservation utility constraints the utility of the compensationof the next best available position. In a one period model, thisutility is taken as a constant. Farna's argument is that if the manager contemplates the downwards effect of currentshirking on the reservation utility of future employmentcontracts, shirking will be deterred.

The agency model can be extended to deal with someof these considerations. With respect to internal monitoring,we outline the study of Arya, Fellingham, and Glover(1997) (AFG). They design a two-period model with one owner

and two risk-averse managers. The managers' efforts producea joint, observable payoff in each period. The owner cannot



observe either manager's effort but each manager knowsthe effort of the other. One way for the owner to motivatethe managers to work hard is to offer each of them anincentive contract similar to the ones in Section 9.4.2, ineach period. However, AFG show that the owner can offer amore efficient contract by exploiting the ability of eachmanager to observe the other's effort. Since the payoff is a joint effort, shirking by either manager will reduce thepayoff for both . Then, in the AFG contract, each managerthreatens the other that he/she will shirk in the secondperiod if the other shirks in the first. If the contract isdesigned properly, the threat is credible and each managerworks hard in both periods. The resulting two-periodcontract is more efficient because it imposes less risk thana sequence of two single-period contracts. As a result,managers can attain their reservation utility with lowerexpected compensation.

The important point for our purposes is that thecontract continues to base manager compensation on somemeasure of the payoff. In effect, while exploitation of theability of managers to monitor each other can reduce agencycosts of moral hazard, it does not eliminate them. Thus,AFG's model suggests that an incentive contract for lower-level managers is still necessary.

With respect to the ability of manager reputation tocontrol moral hazard, Fama's argument does not considerthat the manager may be able to disguise the effects of shirking, at least in the short run, by managing the release of

information. That is, the manager may try to "fool" the marketby opportunistically managing earnings to cover up shirking.Since persons with a tendency to do this will be attractedto the opportunity, the managerial labour market is subjectto adverse selection as well as moral hazard.

Of course, GAAP limits, to some extent, the manager'sability to cover up shirking. Also, since accruals reverse,such behaviour will eventually be discovered, in which casethe manager's reputation will be destroyed, The questionthen is, are the expected costs of lost reputation strongenough to supply the missing effort motivation ? If they are,

then an incentive contract would not be necessary, as Famaargues. The manager could be paid a straight salary, and the



manager's reputation on the managerial labour marketwould prevent shirking.

In this regard, some empirical evidence on themarket's ability to control the manager's incentive to shirkwas presented by Wolfson (1985). He examined contracts of oil and gas limited partnerships in the United States. These are tax-advantaged contracts between a generalpartner (agent) and limited partners (principal) to drill foroil and gas. The general partner provides the expertise andpays some of the costs. The bulk of the capital is providedby the limited partners.

Such contracts are particularly subject to moral hazardand adverse selection problems, due to the highly technicalnature of oil and gas exploration. For example, the generalpartner privately learns the results of the drilling. Thisleads to the "noncompletion incentive problem." Oncedrilled, a well should be completed (i.e., brought into

production) if its expected revenues-call them R-exceedthe costs of completion. However, for tax reasons, completioncosts are paid by the general partner. If the general partnerreceives, say, 40% of the revenues, then, from his/herperspective, it is worthwhile to complete only if 0.40R isgreater than the completion costs. Given that only thegeneral partner knows R, a well may not be completed(i.e., the manager covers up shirking by withholdinginformation about R) unless R is very high.

Wolfson studied two types of well-drilling: exploratorywells and development wells. The noncompletion problem is

not as great for exploratory wells since, if an exploratory welldoes come in, the chances are that R will be high indeed.Investors will be aware of this noncompletion problem,

of course, and will bid down the price they are willing to payto buy in, possibly to the point where the general partnercannot attract limited partners at all. The question then is,can a general partner ease investor concerns by establishinga reputation, thereby increasing his/her market value andthe amounts that investors are willing to pay?

To measure reputation, Wolfson collected informationon the past performance of a sample of general partners

over 1977-1980. The higher a general partner's past successin generating a rerum for limited partners, the higher that



partner's reputation was taken to be. Wolfson found thatthe higher the reputation of a general partner, the morehe/she received from limited partners to buy in, suggestingthat investors were responding to the manager's reputation.

However, Wolfson also found that investors paidsignificantly less to buy into development wells than intoexploratory wells. As mentioned, the undercornpletionproblem is greater for development wells.

Combination of these two findings suggests that whilemarket forces can reduce the managers' moral hazard problem,they do not eliminate it. If reputation-building completelyeliminated the under completion problem, we would not seeinvestors paying less when the problem is greater.

While Wolfson's results apply only to a small sample of oiland gas contracts, they are of more general interest because of their implication that the managerial labour market is notcompletely effective in controlling moral hazard, contrary to

Fama's argument. An agent's past success in generatingpayoffs for investors does not perfectly predict that he/shealways "works hard."

A more recent study, in a broader context, isconsistent with Wolfson's results. Bushman, Engel, andSmith (2006) analyzed a large sample offirms over 1970-2000. They reported a correlation of .34 between security marketresponse to a firm's earnings and the change in its managers'cash compensation. This suggests that net income ispartially informative about manager effort-higher cashcompensation awarded by compensation committees is

accompanied by increased investor probability of high futurefirm performance, and vice versa. However, net income is notcompletely informative about effort if it was the correlationwould be 1. Consequently, the market is not able ro perfectlyvalue a manager's reputation on the basis of accountinginformation. But, if the market cannot value a manager'sreputation with complete accuracy, an incentive contract tomotivate effort is needed.

We conclude that while internal and market forcesmay help control managers' tendencies to shirk, they do noteliminate them. Thus, effort incentives based on some

measure of the payoff are still necessary. We now tum to anexamination of an actual managerial compensation contract



of a large corporation, As we will see, incentives loom large.

10.3 A MANAGERIAL COMPENSATION PLAN

In this section, we present an example of a managerialcompensation plan. The following exhibit describes the planof BCE lnc., a large Canadian corporation with shares, atthe time, traded on the Toronto, New York, and Zurich StockExchanges. Exhibit 10.1 presents excerpts from BCE's 2004Management Proxy Circular.

Several aspects of this compensation plan should benoted. First, officers are required to hold a significant amountof BCE shares, ranging from two to five times base salary.Second, there are three main compensation components:salary; annual short-term incentive awards, consisting of cashbonuses or, for senior officers, deferred share units (DSUs);and stock options. DSUs are BCE shares that cannot be

sold while the holder remains with the company.Observe that the short-term incentive awards dependon both corporate performance and individual creativity andinitiative. Corporate performance includes the attainment of financial targets such as earnings per common share (a netincome-based measure of performance) and achievement of strategic corporate business objectives such as market shareand customer satisfaction. The more senior the manager, themore his/her compensation depends on corporateperformance, and the less on individual performance. Forexample, the target award of the president and CEO is set at

125% of base salary, whereas awards for other seniorexecutives are as low as 30%. The target award is the bonusto be paid if performance objectives for the year are met. If objectives are exceeded, higher bonuses may be paid, andvice versa.

Stock options are awarded under the long-termcomponent of the plan. Since the value of the stock optionsdepends on BCE's share price, these provide an incentiveto increase share price.

Third, many compensation plans require that a certainlevel of earnings, or other performance measure, be reached

before incentive compensation becomes payable. Thethreshold level of performance is called the bogey. Also,



many plans contain an upper limit to compensation, calledthe cap.

In BCE's case, no formal bogey or cap is stated. However,these seem implicit. We are told that totaL compensation ispositioned between the 50th and 75th percentiles of that of a group of comparable companies, thereby placing anupper limit on compensation. Also, the amounts of short-term incentive awards are geared to targets set at thebeginning of the year. If these bogeys are not met, theawards are, presumably, zero, or at least reduced. Also, theshort-term awards are capped at two rimes the amountbased on the target.

It should be noted that the compensationcommittee of BCE's board of directors (MRCC) has theultimate say in the amounts of salary, bonus, and optionawards, within the above guidelines. The compensation.committee is a corporate governance device, to deal with

the fact that the BCE plan, like all real compensationcontracts, is incomplete (see the discussion of complete andincomplete contracts in Section 9.8.2). While con' tractstend to be rigid, the compensation committee may havesome discretion to deal with the effects on compensation of an unanticipated outcome. For example, we are told thatshort-term incentive awards were reduced by 50% of targetsince corporate objectives for 2003 were not fully achieved.One might expect that if targets are not achieved, to bonusis payable. However, the MRCC must have felt thatsufficient progress was made that some bonus was justified.

Fourth, the incentive effects of BCE's compensationplan should be apparent. For highest. ranking officers,annual incentive awards are based primarily on attainmentof financial targets, such as earnings per share and returnon capital, and are paid either in cash or DSUs. Since theshort-term incentive awards depend largely on current year'sperformance, this creates an incentive to maximize thecurrent year's levels of the performance measures. Note,however, that maximizing current reported performance,such as earnings per share, may be at the expense of thefirm's longer-run interests, leading to dysfunctional tactics

such as deferral of maintenance, underinvestment in R&D,premature disposal of facilities in order to realize a gain, and



other opportunistic earnings management techniques.However, the requirement of substantial share ownershipgives officers a longer-term interest in the success of the firm.Presumably, this reduces the temptation to engage indysfunctional practices such as those mentioned.

To reinforce these longer-term considerations, allexecutives and other key employees participate in the stockoption-based long-term incentive plan. Here, recipients willbenefit to the extent that BCE's common share price whenan option is exercised exceeds the price when the option isgranted. Note that the exercise price of the option isgenerally equal to the market value of a BCE share on the dayprior to the effective date of the grant (the subscriptionprice). In terms of our discussion of ESOs in Section 8.3,the option's intrinsic value is zero. Accounting for ESOschanged, however, beginning in 2004, when Canadianaccounting standards required ESO expensing-see our

discussion in Section 8.3. Note that BCE has anticipated thisrequirement by voluntarily expensing its ESOs from January1, 2003.

The options have a to-year term, and, normally, theright to exercise early is not fully available until four yearsafter the grant dace.

Fifth, the mix of short and long-term incentivecomponents in a compensation plan is important. Asmentioned above, a high proportion of long-term incentivecomponents should produce a longer manager decisionhorizon, and vice versa. The MRCC can influence the

mix, since it determines the size of the annual short-termincentive awards. That is, since options are awarded tobring an executive's total compensation up to the 50th to75th percentile of that of comparable corporations, thegreater the size of the short-term award the smaller theoptions award and vice versa, other things equal. We willoutline in Section 10.4.2 why some flexibility in the short-term/long-term incentives mix is desirable.

Finally, consider the risk aspects of BCE's plan.Certainly, compensation IS risky for BCE managers sinceeconomy and industry-wide events, which may not be

informative about the manager's effort, will affect bothearnings per share and share price. However, aspects of the



BCE plan operate to limit compensation risk. Base salary, of course, is relatively risk-free. Also, the lower limit on bothshort-term Incentive awards and stock option value is zero. This reduces downside risk since, if the bogey is notattained or if share value falls below the exercise price, (hemanager does not have to pay the firm. In addition, asmentioned, total compensation is adjusted to the 50th to75th percentile of that of the comparison group. By settingtotal compensation in this way, an averaging effect isintroduced, which would tend to make a BeE executive'stotal compensation less subject to variations in theperformance of BeE itself.

In sum, the BCE compensation structure appears to bequite sophisticated in terms of its incentives, decision horizon,and risk properties. For our purposes, the most importantpoint to note is that there are two main incentivecomponents: short-term incentive awards based on earnings

and individual achievement, and longer-term stock optionswhose value depends on share price performance. Thus,both accounting and market-based performance incentivesare embedded in the plan. These give management a vitalinterest in how net income is determined, both becauseearnings per share is a direct input into compensation andbecause, as we saw in Chapter 5, net income affects shareprice.

Of particular interest are the changes in compensationstrategy for 2004. Two aspects of the new strategy should beparticularly noted:

• An increase in total compensation (to help retainexecutive talent) combined with a greater proportion of totalcompensation depending on performance.

• A shortening of the decision horizon, byincreasing the weight of the short-term incentive awards,creation of a new mid-term) compensation component, andreductions in the value and vesting period of stock options.

The reduced role of stock options consists of a 50%reduction in the value granted plus a reduction of term to

expiry from 10 to six years. These reductions are due,presumably, to the " pump and dump " ESO abuses in recent



years whereby it seems that many CEOs artificially inflatedshare price so as to increase the value of their vested options(see Section 8.3). In effect, ESOs seem to have motivated veryshort-run decision horizons the opposite of the longer-runhorizons that were intended. While no such allegationshave been made against BCE, it is one of several largecompanies that have reduced their usage of ESOs.

The shortening of decision horizon is of particularinterest. As mentioned earlier, BeE did not achieve all of its short-term corporate objectives in 2003. It seems thatthe company wants to increase incentives to attain theseobjectives in future. However, this raises the possibility of dysfunctional behaviour to increase reported performancein the short run, as described above. Consequently, thecompany has created a mid-term compensation plan. Thisplan introduces a two-year performance period, and payscompensation in the form of restricted share units. These

are units of company stock that will only be awarded if oneor more targets are met, such as attainment of a specifiedreturn on assets and/or a specified share price. In the caseof BCE, the restricted stock vests only if some specific two- year operational objectives are attained. Presumably, thecombination of a two-year performance period and a reductionin ESOs will control tendencies for dysfunctional short-runbehaviour. We now tum to a more general considerationof the compensation issues raised above.

10.4 THE THEORY OF EXECUTIVE COMPENSATION

10.4.1 The Relative Proportions of Net Income andShare Price in Evaluating Manager Performance

Much of the theory of executive compensation derivesfrom the agency models developed in Chapter 9, despitetheir single-period orientation. In particular, theanalysis of Holmstrom (Section 9.8.1) predicts that theefficiency of a compensation contract may be increased if itis based on two or more performance measures. The BCEInc. contract discussed above is consistent with this

prediction. The question then is, what determines therelative importance of net income and share price in



compensation committee to better evaluate manager effortand abiliry, and also to evaluate earnings persistence.Persistent earnings are a more sensitive measure of currentmanager effort than transitory or price-irrelevant earnings,which may arise independently of effort. Notice also thatGAAP can reduce the scope for opportunistic earningsmanagement, as illustrated in Example 9.7. Reducedearnings management increases sensitivity by reducing themanager's ability to disguise shirking.

With respect to share price, a major reason for itsrelatively low precision derives from the effects of economy-wide factors. For example, if interest rates increase, theexpected effects on future firm performance will quickly showup in share price. These effects may say relati vely littleabout current manager effort, however. As a result, theymainly add volatility to share price. Nevertheless, as wepointed out in Section 9.8.1, Holmstrom's analysis shows

that share price could never be completely replaced as aperformance measure as long as it contains some additionaleffort information. The sensitivity of share price is sufficientlygreat that it will always reveal additional payoff informationbeyond that contained in net income. Thus, we may expectboth measures to coexist.

This coexistence, however, creates an opportunityfor the compensation plan to influence the length of themanager's decision horizon. To explain, assume two types of manager effort---short-run and long-run. The owner canadjust the relative proportions of net income-based and

share price-based compensation to exploit the fact thatcurrent net income aggregates the payoffs from only somemanager activities in the current period. For example, toencourage more R&D (i.e., long-run effort), the owner canreduce the proportion of the manager's compensation basedon net income and increase the proportion based on shareprice. Compensation wIll now rise more strongly due tosecurities market response to an increase in R&D, and rherewill be less compensation penalty from writing R&D costs off currently. Consequently, it will be in the manager'sinterest to increase R&D. More generally, firms with

substantial investment opportunities will want to increasethe proportion of share price-based compensation.



Alternatively, suppose that the firm has to cut costs(i.e., short-run effort) due, for example, to an increase incompetition or an increase in the domestic exchange rate.Net income will aggregate the favourable cash flow effects of cost cutting quickly and accurately, perhaps even more sothan share price, particularly if the cost-cutting measuresare complex or constitute inside information, or if themarket is concerned about the longer-run effects of costcutting. Also share price may not perfectly aggregate thecost-cutting information in the presence of noise trading ormarket inefficiencies. Then, the firm may wish to increasethe weight of net income relative to share price in themanager's compensation.

In effect, when share price and net incomedifferentially reflect the short and long-run payoffs of currentmanager actions, the length of the manager's decisionhorizon can be influenced by the mix of share price-based

and net income-based compensation more share-basedcompensation produces a longer decision horizon and viceversa. This was demonstrated theoretically by Bushman andIndjejikian (1993). As we pointed out in Section 10.3, theBCE compensation plan allows the compensation committeesome flexibility with respect to the mix of short and long-termcompensation. Furthermore, the 2004 revisions to BCE'scompensation plan seem to shorten the decision horizon.

The mix of performance measures was further studiedby Datar, Kulp, and Lambert (2001). Their analysis suggeststhat decision horizon must be traded off with the sensitivity

and precision of performance measures. For example, theowner will increase the weight on a performance measure,even if this results in a manager decision horizon that isnot exactly what the owner wants, if that performancemeasure is sensitive and precise. The reason is that such aperformance measure "tells more" about effort, hence enablesa more efficient contract. This greater efficiency is traded off against the benefits of controlling the manager's decisionhorizon. Consequently, sensitivity and precision remain asimportant characteristics in the presence of more than onetype of managerial effort.



*10.4.2 Short-Run and Long-Run Effort

OUf discussion of agency theory in Chapter 9assumed that manager effort is single-dimensional-amodelling device to encompass the whole range of managerialactivities. Thus, we were interested in the intensity of effort,and envisaged two levels of intensity- "working hard" or"shirking." To enable us to better understand executivecompensation, we now extend the agency model to regardeffort as multidimensional. Specifically, we pursue theassumption in the previous section that effort consists of short-run effort (SR) and long-run effort (LR). Now, however, weview these two effort components as separate managerdecisions.

SR is effort devoted to activities such as cost control,maintenance, employee morale, advertising, and other day-to-day activities that generate net income mainly in the current

period. LR is effort devoted to activities such as long-rangeplanning, R&D, and acquisitions. While LR effort maygenerate some net income in the current period, most of thepayoffs from these activities extend into future periods. Ourdevelopment here is based on Feltham and Xie (1994).

The manager can either work hard or shirk alongeither or both effort dimensions. Then, we can regard currentperiod net income (NI) as being generated by the followingequation:

where SR and LR are the quantities of short-run and

long-run effort, respectively. There are now two sensitivities of net income rather than one. Thus Ui is the sensitivity of earnings to SR effort and 1 L 2 is sensitivity to LR effort. Theassumption that the random factors affecting net incomehave expected value of zero implies that net income is notsubject to manager manipulation and bias, consistent withour assumption in Section 9.4.2.

The firm's payoff x is also affected by these SR and LRactivities. Thus, we can write the payoff as:

where bl and b2 are sensitivities of the payoff to SR and LR

effort, respectively. We assume here that the manager exertseffort only in the first period, and that net income is reported at



the end of this period. However, consistent with our assumptionin Chapter 9, the pay-off is not fully observable until the nextperiod. That is, the full payoffs from the manager's SR and LRfirst-period effort decisions are not realized until that time.Net income is a message that predicts what these payoffs willbe. The manager is compensated based on first-period netincome. The payoff in the next period goes wholly to theowner.

Recognition of effort as a set of activities introduces anew concept--the congruency of a performance measure. Toillustrate congruency, consider the following example.

In our example, the owner will want high R&D, becauseof its high ultimate payoff (i.e., bz is greater than bl in Table10.4). But the manager, whose compensation is based onfirst period net income, will tend towards a short-rundecision horizon since effort allocated to SR activities

generates greater expected net income and compensation(i.e., fJ.l is greater than )).,2 in Table 10.4). The compensationcontract must now consider not only the intensity of manager effort but also the allocation of effort acrossactivities. Raising the manager's profit share will not serveto lengthen the manager's decision horizon it will simplyencourage more SR effort. As a result, the owner settles forless LR effort than he/she would like.

The question, then, is what might the owner doabout this? One possibility is to replace net income with amore congruent performance measure, such as share price. It

is not hard to see that share price is more congruent withpayoff than net income, since it is less subject to recognitionlag. Then, favourable share price sensitivity to R&D willmotivate the manager to increase LR effort. However, shareprice is less precise than net income. Consequently, it is notclear that basing compensation only on share price wouldincrease contracting efficiency.

A second possibility is to use both performancemeasures. As noted in Section 9.S.1, Feltharn and Xie showconditions under which Holmstrom's (1979) result continuesto apply when effort is multidimensional. Then, theory

predicts that compensation will depend on both net incomeand share price, consistent with what we observe in real



compensation contracts.

10.4.3 The Role of Risk In Executive Compensation

We can also consider the manager's effort from a riskperspective since, as pointed out in Chapter 9, in thepresence of moral hazard the manager must bear somecompensation risk if effort is to be motivated. Since managers,like other rational, risk-averse individuals, trade off risk andrerum, the more risk managers bear the higher must betheir expected compensation if reservation utility is to beattained. Thus, to motivate the manager at the lowest cost,designers of efficient incentive compensation plans try to getthe most motivation for a given amount of risk imposed or,equivalently, the least risk for a given level of motivation.

It is important to realize that compensation risk affects

how the manager operates the firm. If not enough risk isimposed, the firm suffers from low manager effort. If too muchrisk is imposed, the manager may under invest in riskyprojects even though such projects would benefit diversifiedshareholders.

There are several ways to control compensation risk.Perhaps the most important of these from a theoreticalperspective is relative performance evaluation (RPE). Here,instead of measuring performance by net income and/orshare price, performance is measured by the differencebetween the firm's net income and/or share price performance

and the average performance of a group of similar firms. suchas other firms in the same industry. The theory of RPE wasdeveloped by Holmstrom (1982). By measuring themanager's performance relative to the average performanceof similar firms, the systematic or common risks that theindustry faces will be filtered out of the incentive plan,especially if the number of firms in the industry is large. To seethis, note that when there are noisy performance measuresin the contract, there will be some risks that are common toall firms in the industry. For example, at least some of theeffects on share price and earnings of a downturn in the

economy, such as a reduction in sales, will also affect otherfirms in the industry. RPE deducts the average earnings and



behaviour to "soften" competition, as AS put it. This raisesprofits for all firms in the industry. To encourage thiscooperative behaviour, compensation plans put positive,not negative, weight on other firms' performance.Furthermore, the magnitude of this positive weight shouldbe stronger the greater the degree of competition in theindustry. AS report empirical evidence consistent with thisprediction. The BCE plan has a similar characteristic, sincetotal compensation is positioned at the median of that paidby a group of comparable companies. To the extent thatprofits, and thus compensation, of BCE's competitors arehigh, BCE's compensation will also rise. The difficultyoffinding empirical support for RPE could be due tocountervailing effects such as these.

Another way to control risk is through the bogey of thecompensation plan. Consider the manager in Example 9.3 whoreceives compensation of 0.3237 of earnings. Suppose the

firm loses $50 million. That is, earnings ate negative, and sowould be the manager's compensation. Instead of receivingcompensation, the manager would have ro pay the firm over$16 million! Under such a risky connan, the average level of compensation needed for the manager to attain reservationutility would be prohibitive. In other words, fear of personalbankruptcy is probably not the most efficient way to motivatea manager to work hard. For this reason, compensation plansusually impose a bogey. That is, incentive compensation doesnot kick in until some level of financial performance--10 %return on equity, for example-is reached. The effect is that

if the bogey is not attained, the contract does not award anyincentive compensation. However, an ancillary effect is thatthe manager does not have to pay the firm if there is a loss

If downside risk is limited, it seems reasonable for upsidefisk to be limited too; other- wise the manager would haveeverything to gain and little to lose, which could encourageexcessive risk raking. As a result, many plans impose acap, whereby incentive compensation ceases beyond acertain level. For example, no bonus may be awarded forreturn on equity exceeding, say, 25%. Note that the BCEplan imposes a cap on short-term incentive awards of two

times the target award.Conservative accounting also controls upside risk by



delaying recognition of unrealized gains and discouragingpremature revenue recognition. Watts (2003) argues thatconservative accounting promotes contract efficiency byconstraining the manager's ability to inflate currentearnings, and hence compensation, by recording unrealizedgains. However, basing compensation on conservative earningsgives the manager little incentive to invest in risky projects. Nocompensation will be received unless and until a projectstarts to generate realized profits. This creates a role for share-based compensation. Since share price will quickly reflectunrealized profits on long-term projects, managers can beencouraged to invest in such projects (equivalently, to incurupside risk) by basing compensation on share priceperformance. For example, ESOs provide this incentive since,if they succeed, they can become very valuable. Yet, if they donot succeed, the lowest the ESOs can be worth is zero.

Indeed, ESOs may be too effective in this regard. While

they encourage upside risk, they impose little downside risk,and so may promote excessive risk taking. Thus, ESOs seemto have been a driving force behind horror stories such asEnron and WorldCom, as described in Section 1.2. It seemsthat manager effort was diverted away from value-increasingprojects into opportunistic actions to increase share price,hence the value of their ESOs. The resulting risky anddeceptive practices eventually led to the firms', and themanagers', downfall.

Nevertheless, one should not conclude that ESOsshould be eliminated from compensation plans. In this regard,

it is interesting to recall BCE's changes to compensation for2004, in Exhibit 10.1. These include a 50% reduction in ESOawards, not their elimination. Rajgopal and Shevlin (2002),in a sample of oil and gas firms over 1992-1997, found thatESOs did motivate managers to increase firm risk. Thisincreased risk showed up both in increased explorationrisk and reduced hedging activity. Rajgopal and Shevlinalso found, however, that the effect of ESOs in theirsample firms was to encourage risk-averse managers toundertake risky projects when these projects wereeconomically desirable, not to encourage excessive risk

taking. In effect, as in the results of Guay (1999) outlined inSection 8.5.4, their findings are consistent with efficient



contracting.In sum, we arrive once again at a conclusion that a mix

of performance measures is desirable. Compensation in theform of ESOs and/or company shares encourages upside riskand a longer run decision horizon, while net income-basedcompensation imposes down side risk to discourage excessiverisk taking that pure share-based compensation may create.

Another approach to controlling risk is through thecompensation committee. As we saw in the BCE plan, thiscommittee has the ultimate responsibility to determine theamounts of cash and stock compensation, and it has theflexibility to take special circumstances into account. Forexample, if the firm reports a loss, or earnings below the bogey,it may award a bonus anyway, particularly if it feels thatthe loss is due to some low- persistence item such as anunusual, non-recurring, or extraordinary event However, thecommittee must exercise some restraint in this regard. If it is

overly generous in not penalizing the manager for staterealizations that are not his/her "fault," this will destroycontract rigidity and reduce effort incentive.

Given the amount of risk imposed on the manager bythe compensation plan, it is important that the managernot be able to work out from under this risk. The managercan shed compensation risk by, for example, selling sharesand options acquired and investing the proceeds in arisk-free asset and/or a diversified portfolio. However,compensation plans typically constrain this possibility byrestricting the manager's ability to dispose of shares and

options. Thus the BCE plan requires officers t o hold fromtwo to five times annual base salary in BeE shares. Also,stock options will not be fully exercisable until three yearsafter the grant date.

The manager can also shed risk b y excessive hedging.Not only is hedging costly, but effort incentive will sufferif the manager works out from under risk this way.Consequently, the firm may limit the manager's hedgingbehaviour.

10.5 EMPIRICAL COMPENSATION RESEARCH

The research of Rajgopal and Shevlin outlined above



provides some evidence that real compensation plans aredesigned efficiently. In this section, we review otherempirical studies bearing on the relation betweencompensation theory and practice, concentrating on studiesthat examine the role of accounting information. An earlystudy in this area was conducted by Lambert andLarcker (1987) (LL).

Using a sample of 370 U.S. firms over 1970-1984inclusive, LL investigated the relative ability of return onshares and return on equity to explain managers' cashcompensation (salary plus bonus). If, for example,compensation plans and compensation committeesprimarily use share return to motivate manager performance,then share return should be significantly related to cashcompensation. Alternatively, if they primarily use net incomeas a motivator, return on equity (a ratio based on netincome) should be significantly related to cash compensation.

Note that LL examined only cash compensation.Empirically, accounting variables do not seem to explainthe options component of manager compensation. Indeed,this can be seen in the BCE plan. While short-term incentiveawards are based on individual achievement and net income,stock option awards are nor. Rather, they are made to bringtotal compensation up to the 50th to 75th percentiles of thatpaid by the group of comparison companies. Consequently,many studies of the role of net income in compensationconcentrate on cash awards.

LL found that return on equity was more highly

related to cash compensation than was return on shares.Indeed, several other studies have found the sameresults. This supports the decision horizon-controlling andrisk-controlling roles for net income in compensationplans that were suggested in Sections 10.4.1 and 10.4.3.

LL also found that the relationship of these two payoff measures to cash compensation varied in systematic ways. Forexample, they found some evidence that the relationshipbetween return on equity and cash compensationstrengthened when net income was less noisy relative toreturn on shares. They measured the relative noisiness of

net income by the ratio of the variability of return on equityover 1970-1984 to the variability of return on shares over



the same period. The lower the noise in net income, thebetter it predicts the payoff, as illustrated in Example 9.4. This finding is also consistent with Banker and Datar'sanalysis.

LL also found that managerial compensation for growthfirms' executives tended to have a lower relationship withreturn on equity than average. This too is consistent withBanker and Datar, since, for growth firms, net income isrelatively less sensitive to manager effort than it is for theaverage firm. Historical cost-based net income tendsparticularly to lag behind the real economic performance of agrowth firm, because this basis of accounting does notrecognize value increases until they are realized. The efficientmarket, however, will look through to real economicperformance and value the shares accordingly. Thus, rerumon equity should be related less to compensation thanshare return for such firms, consistent with what LL found.

Perhaps the most mteresting finding of LL, however,was that for firms where the correlation between share returnand return on equity was low, there tended to be a higher weighton return on equity in the compensation plan, and viceversa. In other words, when net income is relativelyuninformative to investors (low correlation between sharereturn and return on equity) that same net income isrelatively Informative about manager effort (higher weight onreturn on equity in the compensation plan). This providesempirical evidence on the impact of the fundamentalproblem of financial accounting theory-the investor-informing

and the manager performance-motivating dimensions of usefulness must be traded off.Further evidence of efficient compensation contracting

was provided by lndjejikian and Nanda (2002). In a sample of 2,981 seruor executives over 1988-1995, they found that,on average, the lower the variability of return on equity thehigher the target bonus'' relative to base salary. This suggeststhat firms substitute out of salary (riskless, but little incentiveeffect} into bonus (risky, but greater incentive) as firm risk isless. This is consistent with efficient contracting since,when firm risk is relatively low, the incentive benefits of a

bonus can be attained with relatively low compensation riskloaded onto the manager. Indjejikian and Nanda also found



that target bonuses, especially for the CEOs in their sample,tended to increase, relative to bast: salary, with the volatilityof return on shares. One interpretation is that firms in high-risk environments (hence, more volatile share prices) relymore on accounting-based performance measures relative tothose based on stock price performance. Again, this isconsistent with theory.

Bushman, Indjejikian, and Smith (1996) found thatCEOs of growth firms, and of firms with long productdevelopment and life cycles, derived a greater proportion of their compensation from individual performance measuresrelative to net income and stock price-based measures. Thisis consistent with theory since net income, and perhapseven stock price, will be low in both sensitivity and precisionfor such firms, hence relatively uninformative aboutindividual effort. Sensitivity and precision of net incomeand stock price, being based on overall firm performance,

will also be low for managers who are lower down in theorganization. Recall that BCE's compensation plan basesshort-term incentive awards on individual creativity andinitiative in addition to earnings.

In Section 10.4.1, we suggested that full disclosurecould improve the sensitivity of net income to manager effortby enabling identification of persistent earnings by thecompensation committee. Evidence that suggestscompensation committees do value persistent earnings morehighly for compensation purposes than transitory or price-irrelevant earnings is provided by Baber, Kang, and Kumar

(1999). In a sample of firms over the years 1992 and 1993,their results include a finding that the effect of earningschanges on compensation increases with the persistence of those earnings changes.

In sum, the above empirical results suggest that, likeinvestors, compensation committees are on average quitesophisticated in their use of accounting information. Justas full disclosure of reliable, value-relevant information willincrease investors' use of this information, full disclosureof precise, "effort informative" (i.e., sensitive) informationwill increase its usage by compensation committees, thereby

maintaining and increasing the role of net income inmotivating responsible manager performance.



put much downside risk on an executive, as we argued inSection 10.4.3. An executive whose pay is highly related toperformance would have so much to lose from even a smalldecline in firm value that this would probably lead toexcessive avoidance of risky projects. As a result, thecompensation committee may, for example, excludeextraordinary losses when deciding on bonus awards,particularly if the extraordinary loss is low in persistence andthus relatively uninformative about manager effort.Extraordinary losses do, however, lower company valueand net income. Consequently, such exclusions lower thepay-performance relationship. If, in addition, upside riskis limited, the relationship is further lowered. Whileexcluding extraordinary items from compensation does lowerthe CEOs' risk, it may be that this risk reduction is consistentwith efficient contracting since, as mentioned, extraordinaryitems may be low in persistence and informativeness.

BCE's exclusion of an extraordinary loss, as justdescribed, is consistent with the results of Gaver andGaver (1998). For a sample of large u.s. firms over the years 1970-1996, these authors found that whileextraordinary gains tended to be reflected in CEO cashcompensation, extraordinary losses were nor. A possibleexplanation is that compensation committees feel thatreducing manager compensation for extraordinary lossesimposes excessive downside risk on the manager, since theextraordinary loss may be the result of a market downturn

rather than manager shirking. Of course, to the extent thatextraordinary losses are informative about manager effort,their exclusion from bonus calculations is questionable,since their anticipation reduces the manager's effortincentive.

While extraordinary losses may not lead to reducedcompensation, there is evidence that extraordinary gains dolead to increased compensation. The results of Gaver andGaver just described provide such evidence with respect tocash compensation. Bertrand and Mullainathan (2001) find asimilar result for ESO compensation, particularly for firms

with weak corporate governance.Despite these counterarguments to JM, compensation



concerns continue to appear. For example, political attentiongrew in the 1990s and early 2000s with respect to ESOs. ForCEOs of large u.s. corporations, the market value of theseawards often ran into the hundreds of millions of dollars. Thisattention intensified as the proportion of compensationbased on ESOs steadily increased during the 1990s. Forexample, according to Hall and Murphy (2002), optiongrants to CEOs of the S&P 500 industrial firmsincreased from 22% of median total compensation in 1992 to56% in 1999. Furthermore, option grants continued to rise inthe early 2000s, despite a severe decline in the stock market.

Another focus of political attention involves "goldenparachutes." These components of compensation contractsoften oblige a company to pay multimillion dollar settlementsto executives who leave, for whatever reason.

Since ESOs bear little down side risk, and goldenparachutes reward even poor performance, some support is

provided for JM's claim that executives do not bear enoughrisk. BCE's move to award restricted stock units (payablein BCE shares) from 2004 instead of ESOs is consistent withan intent to increase manager risk. In effect, the BCEmanager who receives restricted share units is forced to holdcompany shares for two years, assuming they vest, whereasBCE's ESOs vested at the rate of 25% per year. Thus, withrestricted stock, the BCE manager is less able to work out fromunder compensation risk by immediately disposing of vestedshares.

To fully understand the politics of executive

compensation, however, it is important to realize that thevalue of a given amount of risky compensation to a manageris lower than it might appear at first glance. For example,the cost of ESOs to the firm is usually based on an optionpricing model such as Black/Scholes. This provides areasonable measure of the f i r m ’ s ESO cost, since this is theopportunity cost of issuing ESOs to managers (see Section8.3). However, Black/Scholes assumes that options canbe freely traded, whereas compensation plan ESOs usuallyvest over a period of several years. If a manager is forced tohold ESOs, he/she cannot diversify compensation risk by,

for example, selling the acquired shares and buying adiversified portfolio. These restrictions reduce ESO value



to the manager. The more risk-averse the manager, andthe less diversified the manager's other wealth, the greaterthe reduction.

This effect was studied by Hall and Murphy (2002)(HM), building on an earlier analysis by Lambert, Larcker,and Verrecchia (1991). HM report, for example, that themedian 1999 total compensation of CEOs of S&P 500mdustrial firms was $5.695 million U.S., of which 74% was inthe form of ESOs and company stock (ESOs valued on aBlack/Scholes basis). For a moderately risk-averse anddiversified CEO, however, the cash- equivalent value of this compensation, after allowing for restrictions ondisposal, was $3.420 million, a reduction of almost 40%. For amore risk-averse CEO. the reduction was almost 55%. Byignoring risk and diversification factors, media andpoliticians substantially overstate CEO compensation.

From an optimal contracting perspective, whether

restricted stock is a more efficient compensation device thanESOs depends on a number of factors, such as employeerisk aversion and the volatility of the firm's operations. HM'sanalysis, for example, supports the increasing use of restrictedstock in place of ESOs. If an increase in stock-basedcompensation is accompanied by a reduction in CEO cashcompensation, as opposed to simply being added on to existingcompensation (this is consistent with the manager notreceiving more than reservation utility), the firm is better off to use restricted stock rather than ESOs with a positivestrike price. The reason, according to HM, derives from the

fact that, other things equal, a share of restricted stock ispreferred by the CEO to an ESO (since the ESO requirespayment of the strike price while no payment is requiredfor a share). Consequently the CEO is willing to give upmore cash compensation for restricted stock than for ESOs. Then, for a given reduction in. cash compensation, the firmcan issue more shares via restricted stock than via ESOs.increasing the CEO's incentive to work hard.

If restricted stock can be a more efficient motivatorthan ESOs, why have ESOs been a more popularcompensation vehicle? The answer seems to be that

issuing restricted stock has always required expensing,whereas ESOs have required expensmg only since 2004.



Some firms were apparently willing to use a less efficientcompensation device (ESOs) in order to report higher netincome. Once ESO expensing was required, this advantagedisappeared. We would thus expect to see many firmsmoving towards more restricted stock compensation overtime.

To summarize, requirements to expense ESOs will likelyresult in many firms reducing ESO usage in favour of restricted stock. Furthermore, the risky component of CEOcompensation is less than it may appear at first glance, andseems justified in relation to shareholder value created.Nevertheless, sensitivity of shareholders, media, andpoliticians to perceived excessive compensation remains.

10.7 THE POWER THEORY OF EXECUTIVECOMPENSATION

Our discussion to this point has generally supportedthe efficient contracting view of executive compensation. Thus, we concluded in Section 10.5 that compensationcommittees are quite sophisticated in their use of accountmginformation and, in Section 10.6, that CEO compensationmay be less than it seems at first glance. However, ourdiscussion contained hints of another theory, the powertheory of executive compensation. This theory suggests thatexecutive compensation in practice is driven by manageropportunism, not efficient contracting.

The power theory is set forth by Bebchuk, Fried, andWalker (2002) (BFW). They argue that managers havesufficient power to influence their own compensation, andthat they use this power to generate excessive pay, at theexpense of shareholder value. If so, managers receive morethan their reservation utility, contrary to our assumptionin Chapter 9 that market forces prevent this. In effect, thepower theory questions the efficient operation of themanagerial labour market, much like behavioural financequestions efficient securities market theory (Section 6.2).

The source of manager power, BFW argue, is the ability

of the CEO to influence the board of directors, including thecompensation committee. Even though a majority of the



board may be nominally independent, the CEO caninfluence their appointment. Furthermore. once appointed,even an independent director may feel that if he/she blocksexcessive CEO compensation awards, an anti-managementreputation will quickly be acquired. Such a reputationwill hamper his/her interaction with other directors andreduce the likelihood of appointment to other boards.

The theory acknowledges that there are limits to themanager's power over compensation, namely "outrage." If compensation awards become too high, they attract negativepublicity and at some point the board will have to step LOto exercise its responsibility. However, as BFW point out, thereare ways to "camouflage" excessive compensation. One way isto hire a compensation consultant to add legitimacy tocompensation awards. However, since the CEO also hasinfluence over their appointments, compensation consultantsmay well feel that if they recommend <1 compensation plan

that is unfavourable to the CEO, this will quickly get aroundand they will have difficulty obtaining other consultingengagements.

Another camouflage device is to tie total compensationto a peer group of similar companies. Recall that BCE Inc.adjusts total compensation to the 50th to 75th percentiles of itscomparison group. BFW point out that most companies dothis. Obviously, if companies pay more than the averagecompensation of their peer groups, total compensation willratchet up over time.

The power theory raises several questions about the

efficient contracting view of executive compensation. Forexample, BFW ask, why are ESO awards not adjusteddownwards for gains that are not under manager control? The results of Bertrand and Mullainathan referred to earlierprovide empirical support for this question. Anotherquestion is why managers have so much freedom to controlthe exercise of ESOs. Recall from Section 8.3 that ESOs canbe exercised any rime between vesting date and expiry.Indeed, it is this exercise date flexibility that hascomplicated accountants' efforts to estimate the cost of ESO awards, since exercise dare has to be estimated.

Furthermore, after exercise, managers have considerablefreedom to sell the acquired shares. Under efficient



contracting, a manager's ability to manage compensationrisk would be more constrained.

Additional support for the power theory is providedby Core, Holthausen, and Larcker (1999), whose study of asample of 205 U.S. firms revealed that a significant portionof CEO compensation is explained by corporate governancevariables-poorer governance is associated with greater excesscompensation. If the efficient contracting version of compensation held, there would be no excess compensation,since compensation would depend only on CEO quality.

Revelations of late timing of ESO awards, discussed inSection 8.3, are a recent example of the power theory in action.Many firms, especially in the United States, backdated theirESO grant dates to create instant gains for the managersince the ESOs were, in effect, in the money when they wereactually awarded.

Scandals such as late timing suggest that the power

theory does hold, at least to some degree. The question then is,how can manager compensation practice be moved towardsmore efficient contracting! One response is to improvecorporate governance, particularly since studies such asBertrand and Mallainathan, and Core, Holrhausen, andLarcker, referenced above, suggest that pay is moreexcessive when governance is weak. The Sarbanes-Oxley Actand related regulations LO Canada (Section 1.2) provide animpetus towards better governance.

Accountants can also assist the governance process. Fulldisclosure enables better identification of earnings components

with low persistence and informativeness. This helpscompensation committees to tie pay to performance, and, if they do not, improves the ability of investors and media todiagnose excessive pay. Expensing of ESOs also plays a role,since an effect of expensing is to encourage firms to move topossibly more efficient compensation vehicles, such as restrictedstock.

Of course, if the efficiency of compensation plans isto be controlled, politicians, media, and investors mustknow how much compensation the manager is receiving.In this regard, the SEC imposed regulations in 1992 to

require firms to give more disclosure of their executivecompensation, including a detailed explanation of the



compensation of the five highest-paid executives and a reportfrom (he compensation committee justifying the pay levels.Similar requirements were adopted in Canada in 1993. Theserequirements were extended by the SEC in 2006 to include aCompensation Discussion and Analysis, a clear statementof total compensation received by five senior officers, andextensive disclosure of share-based compensation. Alsorequired are disclosures of any late timing of ESO awards andof any golden parachutes. Similar requirements are currentlyproposed in Canada. Presumably, the securities commissionsfeel that if investors have enough information to intelligentlyevaluate manager compensation levels and components,they will take appropriate action if these appear excessive.

Some evidence that full disclosure of compensationdoes have the desired effect was reported by La (2003). Lostudied the subsequent operating performance (measuredby ROE and ROA) and share price performance of firms that

had lobbied against the 1992 SEC regulations, relative to acontrol sample of similar firms that did not lobby. Note that if

a firm's compensation contract is biased in the manager'sfavour, so that the manager receives excess compensation,that firm's manager has an incentive to lobby against fullerdisclosure' of compensation plan details. La found that onaverage both the operating and share returns of thelobbying firms improved relative to the control firmssubsequent to the new regulations. This improvedperformance is consistent with more efficient compensationcontracts, imposed on the lobbying managers as more

compensation information became available.A further attempt to control excessive pay is to limitthe amount of manager compensation deductible for taxpurposes, in the United States, compensation in excess of $1 million is not tax deductible, except for compensationbased on achievement of performance targets set by thecompensation committee. However, since ESOs are regardedas performance based (their value derives from share priceperformance), this exception may have been anothercontributor to the tremendous increase in ESO awardsduring the 19905, rather than contributing to reduced total

compensation.We conclude that regulators and accountants are



responding to the political pressures that result whencompensation reflects manager power. To the extent theseresponses are successful, the operation of managerial labourmarkets is improved,

10.8 THE SOCIAL SIGNIFICANCE OF MANAGERIAL LABOURMARKETS THAT WORK WELL

In a capitalist economy, manager performancecontributes to social welfare. Welfare is increased to theextent managers "work hard," that is, make good capitalinvestment decisions and bring about high firm productivity.

Attainment of these desirable social goals is hamperedto the extent that measures of manager performance are notfully informative. More informative performance measuresenable more efficient compensation contracts and better

operation of the managerial labour market, resulting inhigher firm productivity and social welfare. Accountantscan contribute to informativeness both by an appropriatetradeoff between sensitivity and precision of net income andby full disclosure.

10.9 CONCLUSIONS ON EXECUTIVE COMPENSATION

Managerial labour markets undoubtedly reduce theseverity of moral hazard, However, past manager performance

is not an ironclad indicator of future performance, Also,labour markets are subject to moral hazard and adverseselection problems, such as earnings management to disguiseshirking. Consequently, incentive contracts are stillnecessary even if managers' reputations on managerial labourmarkets fully reflect publicly available information.

Executive compensation contracts involve a delicatebalancing of incentives, risk, and decision horizon. To properlyalign the interests of managers and shareholders, an efficientcontract needs to achieve a high level of motivation whilecontrolling compensation risk, Too little risk discourages

manager effort. Too much risk may shorten a manager'sdecision horizon, encourage earnings-increasing tactics that



are against the firm's longer-run interests, lead to avoidanceof risky projects, and encourage excessive hedging. Managersare particularly sensitive to risk, because the compensationcontract may restrict their ability to di versify it away, unlikeshareholders.

To attain proper alignment, incentive plans usuallyfeature a combination of salary, bonus, and equity-basedcompensation such as restricted stock and options. Thesecomponents of compensation are usually based on twoperformance measures-net income and share price. We canthink of these as two noisy measures of the future payoff fromcurrent-period manager effort. Theory predicts that therelative proportion of each in the compensation plan dependson both their relative precision and sensitivity, and thelength of manager decision horizon that the firm wantsto motivate. Empirically, it appears that executivecompensation is related to performance but that the

strength of the relationship is low. However, for large firms atleast, this low relationship is to be expected. Also, therelative proportion of net income based and share price-based compensation components seems to vary as the theorypredicts.

Executive compensation is surrounded by politicalcontroversy. Much of this controversy results from CEOs whoexploit their power, using it to generate excessivecompensation. Regulators have responded by expanding theinformation available to shareholders and others, on theassumption that they will take action to eliminate inefficient

plans, or the managers and firms that have them. There issome evidence that expanded information is having thedesired effect. However, politicians, media, and shareholdersshould realize that the value of risky compensation to risk-averse managers is usually less than it may seem at first glance.

We conclude that financial reporting has an importantrole in motivating executive performance and controllingmanager power. This role includes full disclosure, so thatcompensation committees and investors can better relatepay to performance. It also includes expensing of stockoption awards to help control their abuse and encourage more

efficient compensation vehicles. As a result. responsiblemanager performance is motivated and the extent to which



manager reputation is based on incomplete Or biasedinformation is reduced. This improves the operation of themanagerial labour market, a goal equally important to societyas promoting good investor decisions and improving theoperation of securities markets.

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