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EXECUTIVE EXECUTIVE COMPENSATIONCOMPENSATION
Sven-Olof Yrjö Collin
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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: [email protected]: www.svencollin.se
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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
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THE COMPENSATION PUZZLE
Size of the firm
Performance of the firm
Executive Pay
40%
5%
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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
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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
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Situation Situation
AGENCY R I S K
PRINCIPAL’SOBSERVATION
Competence Behaviour Performance
PRINCIPAL - AGENT RELATIONSHIP
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SEPARATING THE PROCESS OF COMPENSATION
Mechanism of compensation
Criteria for compensation
Consequence
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WHO TO COMPENSATE
Individual
Figure headIndividual‘unfair’
Group
CollaborationMutual Monitoring‘back stabbing
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MECHANISM OF COMPENSATION
- Contract
- Monitoring
Objectivity Predictability Precision
Transparency Risk Fairness
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CRITERIA FOR COMPENSATION
• Performance• Behaviour• Individual characteristics• Labour market price• Position• Peer comparison
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PERFORMANCE
MARKET MEASUREMENTS
ACCOUNTING MEASUREMENTS
SUBJECTIVE MEASUREMENTS
•Noise•Influence•Informational•Motivational
- Goal!- Strategy etc.
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STRATEGY
Strategy Structure
Market dominance Performance criteria: Sales growth
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CEO DISCRETION INFLUENCING PAY
Task programmabilityUncertainty CEO Discretion Compensation
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WHEN PAY - PERFORMANCE?
uncertainty
CE
O in
flue
nce
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BEHAVIOUR CRITERIA
Actions performed by the agent
• subjective• costly
time evaluators competence
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INDIVIDUAL CHARACTERISTICS
•EDUCATION•COMPETENCE•NETWORK
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LABOUR MARKET
supplyde
man
d
Price = Wage
Upper boundConsultants?
Reservation wage
Bidding-up hypothesis
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POSITION COMPENSATION
• Figure head (Tournament theory)• Social recognition• Hierarchical level
- responsibility- higher pay on next level
• Information-processing requirements
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PEER COMPARISON
REFERENCE POINT
• Peers
• Significant others
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WHO DECIDES ABOUT COMPENSATION?
• The Board• The Chairman of the Board• The Dominant Owner• The Remuneration Committee
- consultants...
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RELATIONAL CONTRACT
• Exchange create externality• Experience => mutual expectations• No time horizon => trust
Tenure => No correlation Pay & PerformanceTenure => Less explicit control
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SOCIETY INFLUENCING COMPENSATION
• Media• Social groups• Ideology
...more market-dependent decision makers,
more fashionable compensation package
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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)
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CONSEQUENCE
Base pay
Variable pay
Employment
Prospects through reputation
Intrinsic rewards
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ALIGNING COMPENSATION
Environment
OrganisationStrategy
Individual
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WHAT IS RISK?
Return variance: Risk averse (Financial economics)
Probability of loss: Loss averse (Behavioural finance)
Expected value
Bonus today or options for tomorrow
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EMPLOYMENT CONSEQUENCES
Downward risk: unemploymentUpward risk: Promotion
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REPUTATION - WAGE
age
Val
ue o
f re
puta
tion
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INTRINSIC REWARDS
•Job satisfaction•Prospects of development•Responsibility•Power•Good cause•Nice atmosphere at the job•Fun
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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
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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).
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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
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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
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ESSENCE OF EXECUTIVE COMPENSATION FOR POSITIVE ACCOUNTING THEORY
RISK SHARING
INCENTIVE FOR SHAREHOLDER GOAL ATTAINMENT AND CONGRUENCE
Not fairness, intrinsic rewards, employment etc
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PAT PREDICTION I:THE BONUS HYPOTHESIS
MANAGERS WITH BONUS WILL CHOOSE ACCOUNTING PROCEDURES THAT SHIFT REPORTED EARNINGS FROM FUTURE TO CURRENT PERIOD
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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
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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.