Bonuses in a responsible way : how can bonuses for today’s managers contribute in a responsible way to the purpose for which they were initially intended?

Bonuses in a responsible way

“How can bonuses for today’s managers contribute in a responsible way to the purpose for which they were initially intended?” Bachelor thesis

Filippa Bakker - 10401075

Supervisor Lukáš Tóth

2 February 2016 University of Amsterdam Faculty of Economics and Business

Statement of Originality

This document is written by Student Filippa Bakker who declares to take full responsibility for the contents of this document.

I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it.

The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents

Abstract

The aim of this thesis is to gain more knowledge about why bonus has been introduced and which form of bonus pay contributions to the best interest of the company and therefore the company's long-term strategy. Nowadays, the subject bonuses for managers and executives is very actual and a lot of people think managers get too much in bonuses in proportion to the hours of work and commitment. For the performance of the firm, it is important that managers act in the interests of the firm instead of their own interests. That’s why in this thesis is investigated how bonuses for today’s managers can contribute in a responsible way to the purpose for which they were initially intended. This is done by a theoretical outline of the literature about bonuses, compensation forms, earnings management and performance measures. One of the most well known theories that serves as support for the granting of an additional compensation for managers is the agency theory of Jensen and Meckling (1976). It is true that in today’s business environment, it is often not possible to attract managers without giving them high compensation prospects. The key problem that can arise with additional compensation to managers that this the danger of earnings management entails. In this thesis, there is looked at the short- and long-term bonuses and whether and if yes, the extent to which earnings management occurs. Further, the different measures and types of compensation forms are compared. Concluded is that bonuses these days can contribute in a responsible way for the purpose by which they initially intended, by using long-term bonus plans in stock options in combination with short-term bonus incentives, because the first ensures the manager strives for the long-term strategy and this last motivates managers to exert more effort. Further, non-financial measures above financial measures turn out to be increasingly important in the composition of compensation plans. The bonus should be paid both in cash and shares, because shares give the manager an incentive to strive for the long-term strategy of the firm. Which means the best interest of the firm and thus a bonus based on partly shares contributes in a responsible way to the purpose for which the bonus initially is intented. From this thesis can be concluded that the Balanced Scorecard is the best instrument to define the strategy of the company and with this the most responsible bonus compensation for the manager.

Contents

Page

Chapter 1: Introduction 5 Chapter 2: Compensation forms 7

2.1 Why bonuses? 7 Chapter 3: Bonuses vs earnings management 9 3.1 Short- vs long-term bonus and earnings management 10 3.2 Short-term bonus and earnings management 10 3.3 Long-term bonus and earnings management 12 Chapter 4: Different types of bonuses 13 4.1 Cash vs equity 13 4.2 Financial measures 14 4.3 Non-financial measures 15 4.4 Balanced scorecard 17 4.4.1 Financial perspective 17 4.4.2 Customer perspective 18 4.4.3 Perspective on internal processes 18 4.4.4 Growth and learning perspective 18 4.4.5 Advantages and disadvantages 19 4.4.6 Study about the Balanced Scorecard 19 Conclusion 20 References 22

Chapter 1: Introduction

Nowadays, the subject of managerial bonuses is very actual and there are lot of discussions going on about it. In 2008, ABN AMRO Bank was funded by the Dutch State and a salary package was approved. It consisted of a base salary and a bonus of up to 50% on top. The managers would receive the payment in 2014. Given the fuss about salaries of bankers in the past years the bank recently agreed on a salary increase of just Euro 100.000,- and the skip of bonus.

A lot of people think managers get too much in bonuses in proportion to the hours of work and commitment. In the Netherlands, a bonus cap of 20% of the base salary is introduced on February 7 2015 (Rijksoverheid, 2015). A disadvantage could be that this regulation won’t attract good international bankers. However, one of the reasons for the implementation of this bonus cap is that the government strives for a healthy and reliable financial sector, and perverse incentives such as high salaries and bonuses are seen as one of the causes of the financial crisis. The new remuneration policy is part of a package of measures designed in order to contribute to the restoration of confidence (Rijksoverheid, 2015).

A point of discussion in response to bonuses is the selfish behavior of managers when bonuses get paid. They often go for a short run effect to earn an additional bonus. For example, a manager can decide not to invest in a certain project, so he earns a bonus. When he’d invest in this project, the long run profit for the company would increase, which is better for the firm. But managers only look at their own interest and often decide for the short-run profit and thus bonus for themself instead of (long run) profit for the company. The degree in which managers manipulate the earnings in own interest, is an issue in financial accounting. (Gaver, Gaver and Austin, 1995). Existing literature has shown that different forms of compensation, such as bonuses, performance plans and stock options help to ensure that managers misrepresent the accounts in order to increase their additional compensation. For the performance of the firm, it is important that managers act in the interests of the firm instead of their own interests.

My thesis thus addresses the following research question: “How can bonuses for today’s managers contribute in a responsible way to the purpose for which they were

initially intended?” where responsible is interpreted as “taking into account the interest of shareholders and other stakeholders of the company” for the remainder of the thesis.

Bonuses have been introduced in order to provide an agent incentives to exert efforts in the best interest of the company (Jensen and Meckling, 1976). It is important to pursue the long-term strategy of the company and that agents (managers) only take actions which are best for the firm. When an agent acts in own interest in stead of the firms interest, earnings management can occur. Among other things this phenomen will be discussed in this thesis. Healy (1987) investigates whether there is a relation between the accounting is done and the calculation of earnings-based remuneration and there is concluded that earnings management occurs when managers have bonuses in the short-term outlook. Richardson and Waegelein (2002) have done research about the relationship between long-term performance plans and earnings management and found that a long-term performance plan leads to less earnings management.

This thesis is based on several well known papers. Dechow and Sloan (1991) investigate the hypothesis whether earning-based performance measures provide executives with incentives to focus on short-term performance. Ittner, Larcker, and Rajan (1997) examine the factors influencing the relative weights placed on financial and non-financial performance measures in CEO bonus contracts.

To answer my research question, I have to look at compensation forms. I look at the different types of bonus plans and compare these with each other. I examine the short- and the long-term bonuses and compare the ways managers act (in own interest) when receiving a short- or long-term bonus. Further, I investigate what requirements a good bonus plan should meet and which types of measures would be the best fitted in a compensation plan.

The remainder of the thesis is organized as follows. Before looking for the ideal design of compensation it is important to get a good picture of the onset of bonuses and why they are important. I discuss this in chapter two. In chapter three, the short- and long-term bonuses are compared to earnings management. In chapter four, the different measures and types of compensation forms will be compared. Non-financial measures are increasingly important for the determination of bonuses. The balanced scorecard is a good solution for the problem with compensation forms based on only financial measures. The last part of the thesis concludes that compensation forms should include different types of measures, financial as well as non-financial. Furthermore, the use of the Balanced Scorecard

can help bonuses to contribute in a responsible way to the purpose for which they were initially intended.

Chapter 2: Compensation forms

2.1 Why bonuses?

If a compensation scheme does not add value to a company, it would be advised not to introduce any compensation at all. For the remainder of this thesis, a compensation supplement always refers to the fixed salary. The focus is also on the research on the compensation of top managers of large companies.

It is known that bonus systems lead in a greater or lesser extent to more earnings management than situations where there is no bonus system (Healy, 1985). This raises the question why additional compensation to reward executives for their efforts is used so frequently. One of the main arguments for this approach stems from the agency theory developed by Jensen and Meckling (1976). The core of this theory is that it is necessary to provide a manager incentives to exert efforts in the best interest of the company and that these incentives are not provided by mere the payment of a fixed salary. It is true that in today’s business environment, it is often not possible to attract managers without giving them high compensation prospects. The key problem that arises here is that on one hand the additional compensation to managers is necessary for improving the functioning of the company, and on the other hand the danger of earnings management entails. The latter as a result of a short-term interest of the manager. It is important (Jensen and Meckling, 1976) to provide an agent incentives to exert efforts in the best interest of the company. Lazear (2000) tested the change in productivity of the worker when the compensation depends no longer on hourly wage, but on performance. The results are in line with economic theory and supported by empirical results. When the firm switches to piece-rate pay, this has a significant effect on average levels of output per worker. The result is a 44-percent gain in output. Even with a 7-percent increase in compensation per worker, this was remunerative for the firm. So, when workers get paid based on performance, they are induced to give more output in order to increase wage. This incentive must be taken into account when composing a compensation package and this is a reason why giving incentives in the form of extra salary is important for both the

agent and the firm. Namely, it increases motivation and thereby output and earnings for the firm.

One of the most well known theories that serves as support for the granting of an additional compensation for managers is the already mentioned agency theory of Jensen and Meckling (1976). The essence of this theory is that a principal, the shareholder, is not capable to entirely control the behavior of the agent, the manager. The agency theory is based on a few assumptions. To begin, the principal and agent should have different risk characteristics. Second, a conflict of interest should exist between the principal and the agent. A third assumption is asymmetric information. This means that the agent has more information than the principal. In this situation the principal can’t perfectly observe the agent’s effort, which gives the agent an incentive to shirk. This problem is called ‘hidden action’ (Eisenhardt, 1989). The agent’s action is hidden because he knows perfectly what action he has taken but the principal doesn’t. The problem that arises here is ‘moral hazard’ and arises because of hidden action. The agent doesn’t bear the whole consequenses of his actions and can use this information asymmetry to his own advantage. Given the self-interest of the agent, he may behave differently than agreed in the contract (Eisenhardt, 1989). This problem often arises because it is expensive or not possible to monitor the actions taken.

In a common relationship in between agents (managers) and principals (shareholders), this problem can solved by aligning the interests of the agents (managers) with the interests of the principals (shareholders). This can be done by incentive contracts. For example by giving the agent bonus that depend on the company’s profitability or shareholder value (Eisenhardt, 1985). Since the input performance of the measure can’t be monitored, we have to measure and pay for the agent’s output, or well known ass effort. Jensen and Meckling (1976) already found that increasing the firm ownership of managers will lead to less managerial opportunism. When a manager gets stock options, his interest is more aligned with the shareholder, because his bonus depends on the shareholder value. Since this depends on the average long-term result, it has no effect when a managers manipulate the accounts. This means the bonus contribute in a responsible way, because it takes into account the interest of the shareholders and other stakeholders of the company.

Shortly, one can conclude that according to the agency theory, it is desirable to make the compensation depend on the performance of the agent. If this link is missing, the motivation to exert himself for the principal decreases.

Chapter 3: Bonuses vs earnings management

An issue in financial accounting is the degree in which managers manipulate the earnings in own interest (Gaver, Gaver and Austin, 1995). Earnings management is a much-discussed topic in the accounting literature and has led to many discussions. There are a lot of definitions of earnings management, which are about changing numbers, misleading stakeholders and influence the outcome of the profit. For the puspose of this thesis, I use the definition formulated by Healy and Wahlen (1999):

“Earnings management occurs when managers use judgment in financial reporting and in structuring transactions to alter financial reports to either mislead some stakeholders about the underlying economic performance of the company or to influence contractual outcomes that depend on reported accounting numbers”.

In short, earnings management is controlling the gain in the desired direction by the management. It is not easy to measure the degree of earnings management. In order to still measure earnings management, most studies use accruals to determine whether there is any earnings management. Accruals are defined as the difference between reported annual earnings and annual operating cash flows (Healy, 1985). Total earnings can be increased or decreased by the level of accruals (Dechow and Sloan, 1991 ). Accruals can be positive or negative. An example of a negative accrual is amortization, this reduces profits but not cash flow. Particular attention was given to the accrual posts over which managers have a large degree of choice, often referred as to discretionary accruals (Healy and Wahlen, 1999). Discretionary accruals are seen as accruals that can provide earnings management and are established by the freedom of action of management. An extreem example of earnings management that led to huge problems comes from Imtech (de Telegraaf, 2015). Imtech is a technical service provider in the fields such electrical engineering and ICT. For years, Imtech was one of the stock market darlings of the Damrak,

but the share was since the beginning of 2014 under heavy fire. Fraud and mismanagement have brought the company into serious financial difficulties. Imtech went bankrupt on 13 August 2015 (de Telegraaf, 2015). How can the compensation of managers ensure that this can be avoided? 3.1 Short- vs long-term bonus and earnings management

Managers can get their compensation in different ways, for example deferred salary payment, insurance plans, non-qualified stock options, performance plans, bonus schemes and stock appreciation rights. For this thesis, I won’t discuss them all. For this chapter, I use two of these forms of compensation, bonus schemes and performance plans. These two forms depend explicitly on accounting earnings (Healy, 1985). In the previous chapter, we saw that earnings management is often measured with accruals. So, with compensation forms that depend on accounting earnings, the extent to which earnings are manipulated, could be measured.

Even though a lot of companies use both forms of compensations bonus schemes and performance plans, there is a difference between the two (Healy, 1985). In a performance plan, managers get paid the value of performance units or shares in cash or stock if certain long-term earnings’ targets are achieved. With long term, Healy (1985) means three or five years. The bonus plans have a similar format as performance contracts, except that they specify annual rather than long-term earning goals (Healy, 1985).

These two compensation forms depend explicitly on accounting earnings and because we saw in the previous chapter that earnings management can be measured with accruals, we focus on the choice of accruals of managers. In this chapter, I look at the short- and long-term bonuses and whether and if yes, the extent to which earnings management occurs. 3.2 Short-term bonus and earnings management As already said, earnings management is often measured by accruals. We now look at the extent to which managers manipulate earnings in order to receive more bonus in the short run. Healy (1985) investigated the link between decisions made about accruals and accounting procedures and the variable remuneration of the agent. He focuses

on the link between short-term bonuses and earnings management, so on the compensation form ‘bonus scheme’. He took into account the fact that the bonus of managers often has a lower and upper limit. At the bottom, a certain threshold that needs to be achieved, and on the top a maximum a manager can receive in bonuses, the amount of bonuses that is paid is limited. In the other studies of Healy, he didn’t take this into account (Healy, 1985). The manager, in Healy’s study of 1985, has the incentive to maximize his bonus in the current year, but also in the future. When the manager reaches the upper limit this year, he is incentivized to postpone some earnings to future years. In contrast, when the manager knows that he will not reach the upper limit this year, he is incentivized to move current earnings towards future periods. This implies that depending on where the profit is before earnings management, a manager will choose positive or negative accruals and thus not in all cases only positive accruals (Healy, 1985). Healy developes a hypothesis that a manager selects positive accruals if the thus-created additional profit contributes to his bonus, and negative accruals if it is not the case. In that case, the manager ‘reserves’ his profits in the hope that this bonus adds to his bonus next year. Healy made a sample that consists of 94 companies from the Fortune 250, followed over the period 1930-1980. As a measure of earnings management looks Healy to the total accruals. Then, it was tested whether the accrual behavior by portfolio corresponded to what was expected according to the hypothesis. The results are consistent with the hypothesis and Healy therefore concluded that earnings management occurs when managers have bonuses in the short-term outlook. Holthausen, Larcker and Sloan (1995) did a replication of the study by Healy (1985). The only difference is that they use data from other years and another measure of earnings measurement, namely the discretionary accruals measured on the basis of the modified Jones-model. Holthausen et al (1995) find evidence on downward manipulation when the manager reaches the upper limit but they do not find evidence on the downward manipulation when not reaching the upper limit, which Healy did find. However, when managers are far below the minimum required profit for getting a bonus, where Healy (1985) expected negative accruals, Holthausen et al (1995) find positive accruals.

Gaver, Gaver and Austin (1995) have done a replication of Healy (1985) and came to the same conclusion as Healy (1985). They assign the observation of positive accruals to the income-smoothing hypothesis, which means that the profit will continue smoothly over the

years. Income smoothing prevents a sharp drop or a strong increase assumes that managers pursue stability in their profit (Guay, Kothari and Watts, 1996).

Besides this, according to research there are also positive sides to short-term incentives (from now called ‘STI’). For example, it would contribute to motivation and when monitored it could have a positive effect on productivity (Kroumova and Lazarova, 2009). Henderson (2003) also finds reason to believe STI enhances productivity. Furthermore, STI seems easy to implement, because it can be applied to all employees (Wynter-Palmer, 2012). Zingheim and Schuster, as in Wynter-Palmer (2012) see STI as “flexible, agile, adaptable, responsive and capable of rewarding a combination of individual and collaborative results, as well as focusing on a host of measures and goals, from financial to strategic. “

3.3 Long-term bonus and earnings management

In the already discussed investigations it went about compensation with a short-term focus, bonus schemes, and so where the goals are set on annual basis. The other compensation form performance plans have a longer term and are characterized by a longer-term objectives based on accounting performance (Gaver, 1992). Richardson and Waegelein (2002) have done research about the relationship between long-term performance plans, called LTPP from now on, and earnings management. LTPP runs over several years and overlap, which makes the move from profits to other years less useful. For this reason, Richardson and Waegelein (2002) think there is less motivation for the agent to move with the profits and so less manipulation of the earnings. They create the next hypothesis: ‘’managers of firms with long-term performance plans will be less likely to manage earnings than managers of firms with only short-term bonus plans’’.

Their sample consist of 521 companies whose shares were traded on the New York Stock Exchange between 1987 and 1992 and for which sufficient information is available. These companies work operate in 46 different industries. About 25% of the sample use LTPP. As a measure for earnings management, Richardson and Waegelein (2002) use the mean absolute accruals measured on the basis of the modified Jones-model and the presence of a LTPP in the regression model is processed as dummy variable. Table 2 (Richardson and Waegelein, 2002) shows that with the presence of a LTPP, the coefficient of -0.0086 and a significance level of p<0.01 (2-tailed). This means that the presence of a long-term

performance plan (LTPP) leads to less accruals and thus to fewer earnings management than in situations where only on the basis of short-term bonuses is compensated (Richardson and Waegelein, 2002).

Chapter 4: Different types of bonuses

Once is determined whether there should be paid a bonus and the length of period the bonus will be rewarded is determined, the next question is ‘What is the best way to pay the bonus?’ The payment of bonus may take the form of cash or in different ways with equities. Also, a combination of the two is possible. In this chapter, I first discuss the payment in cash and second the payment in equities. A company wants every action of the manager, which has a positive influence on the business operation, to be included in the bonus system, making the year-end bonus a representation of all the actions of a manager for a year. Unfortunately, this is organisationally hardly feasible, but I look at various aspects of the different compensations forms and try to come to a good solution for the content of bonuses.

4.1 Cash vs equity If huge amounts of high bonuses have to be paid by a principal, this has a negative impact on the liquidity and solvency of the company. This is because of the decreasing money balance, which makes it more difficult to meet the short-term commitment. Therefore, it would be wiser not to pay out large sums of money, but to pay through shares or share options. Here we come at the other payment of bonus, bonuses in equity. When a manager gets stock options or shares, his interests are more aligned with the shareholder, because his bonus depends on the shareholder value. And that is what we want to see in a good compensation form, that the bonus is responsible and refers to the long-term strategy of the firm. With a full share bonus is meant that the managers receive a number of shares which they are allowed to sell only after a certain period. In many cases, this period is about three to five years. As the manager gets his shares free and may sell them only after a certain time, this form of reward is seen as a way of having to retain managers, more than to motivate them (Merchant and Van der Stede, 2012). But this is not entirely correct, because the manager

also benefit from having as the share price rises. He might give more money for its shares to sell.

A disadvantage of bonuses in share options is as follows. Because managers can buy the shares, the number of issued shares of a company increases. Thus, the dividend has to be distributed over a larger number of shares, which may result in a lower share price (Merchant and Van der Stede, 2012).

Since compensation payment in cash and equity have both advantages and disadvantages and provide other incentives for the management, it is useful to use both forms side by side and not just choose one of the two forms.

4.2 Financial measures

Traditionally, bonus plans focused on easily measurable, financial performance measures, such as turnover, profit or return on investment (Ittner et al, 1997). Because these measures are based on financial data, and this data is costless to use, there is no effort needed to obtain the data.

A disadvantage of financial performance measures is that they are proved to be one-sided and don’t show the strategy of the company (Ittner et al, 1997). Annual bonus schemes that are based solely on financial results are thought to over-emphasize short-term accounting returns and discourage long-term investments (Kaplan and Norton, 1992). Hoque (2009) found the same about the use of only financial measures in a bonus scheme. A manager with a goal received from the company he works for, will not look behind that year and do everything to achieve the goal for that year, whereby he may pay less attention to ensuring the long-term strategy of the company (Hoque, 2009). This is the fact, because a manager needs to achieve some financial goals for the firm in a calendar year in order to achieve a bonus, and thus the manager is motivated to go for mainly short-term results (Schiehll and Bellavance, 2009).

From the early nineties many firms started to look for other performance measures, because managers felt that the traditional performance measures were not sufficient any more (Kaplan and Norton, 1992).

4.3 Non-financial measures

In addition to financial performance measures, non-financial results are increasingly important in evaluating the performance of managers. Examples are customer satisfaction, employee motivation, efficiency, safety, quality and environment (Ittner et al, 1997). Itnerr et al (1997) made a data analysis of 317 US firms. They measure the relative weight placed on non-financial measures in the annual bonus contract of the CEO, where the weights of financial and non-financial measures together sum to 100 procent. About 36 procent of the sample use non-financial measures already in evaluating performance. The most common non-financial measure that is disclosed in the analysis, is customer satisfaction, which is used by 36,8 percent of the firms that using non-financial measures (Ittner et al, 1997). The analysis shows that especially companies that focus on innovation- and quality-oriented strategy tend to put relatively more weight on non-financial performance in their annual bonus contract. This happens because in these companies, a manager is forced to think about efficiency, market share and the quality of the products. Furthermore, this ensures that the manager keeps the long-term strategy of a company more closely, because the points he will be rewarded on, are contributing to achieve the long-term goals of the company. So, these strategies underpin the idea that companies endeavor to link compensation policies to strategic objectives to ensure that management incentives and the goals of the organization are aligned (Ittner et al, 1997).

And thus, in order to enhance the effectiveness, a bonus system should always have a mix of financial and non-financial performance measures (Said et al, 2003) where an important note is that there needs to be looked at the strategy of the company and in that way a weight should be given to each performance measure. If each company links the performance measures to its business strategy, the managers’ interest is more likely to coincide with the interest of the company and thus this would prevent earnings management.

Hoque (2005) links environmental uncertainty to the relation between non-financial measures and performance. He concludes that environmental factors are important in the effectiveness of a performance measure system. Especially, the research of Hoque (2005) has provided a better understanding of the importance of the role of non-financial performance measures in improving the performance of a company. Namely, it can be concluded that when there is more reliance on non-financial performance measure, this

goes along with increased performance. This means that non-financial performance measures do have a positive impact, on the company’s performance. However, this is only true when the height of environmental uncertainty is high (Hoque, 2005).

Schiehll and Bellavance (2009) studied the associations between the board of director’s choice to implement non-financial performance measure into the CEO bonus plan. They also studied the association with board independence and CEO ownership, but that is not relevant for this thesis. Schiehll and Bellavance (2009) conclude that the use of non-financial performance measures in the CEO bonus plan varies predictably. The results give evidence that firms with greater growth opportunities tend to include non-financial performance measure into the CEO bonus plan (Schiehll and Bellavance, 2009).

However, it is hard to assign the correct weights to non-financial performance standards. For example, if there exists both a link between customer satisfaction and shareholder value, and environmental performance and shareholder value, a weight on these non-financial measures can determine how hard a manager has to work on one measure compared to the other. The manager would ask himself questions like ‘How many times is customer service more important than a good environmental policy?’ Due to lack of information on this, managers will be inclined to say that the most easily achievable targets would most affect shareholder value and thus, that measurement gets a higher weight. Of course, this is not in line with the expectations of maximizing the profit of the firm, but it is profitable for the manager. It increases the chance that these managers get a bonus, while not necessarily contributing to the improvement in profit and shareholder value (Ittner & Larcker, 2003). This is a disadvantage of non-financial measures, because it indicates that they are not totally objective. In this example, it is hard to determine how a manager has contributed exactly to the customer satisfaction. This could lead to tensions, because managers get different bonuses while they might felt like they give the same performance (Ittner et al, 2004). Another disadvantage is that non-financial measures are less reliable since it is not audited by an external firm (Ittner et al, 1997). Furthermore, it can be costly to acquire these data, for example to measure customer satisfaction, a survey could be necessary.

4.4 Balanced scorecard

According to Kaplan and Norton (1997), managers require, like pilots, multiple instruments so that they have information on all aspects of the environment and the performance of the organization. A pilot also doesn’t have enough to just one instrument, such as only a tool that controls the fuel. They also need information on the altitude and air velocity. Using multiple instruments, the board can determine if they are still on the right course to achieve good results in the future too.

Nowadays companies are located in a complex and competitive environment. To be successful, it is important that a company's strategy is clearly defined and that it can be properly translated into concrete performance measures. Therefore, Kaplan and Norton developed the Balanced Scorecard, which gives managers the tools they need. The Balanced Scorecard translates the purpose and strategy of an organization into specific performance measurements (Kaplan and Norton).

Within the Balanced Scorecard, both financial and non-financial performance measures are used (Hoque and James, 2000). In the Balanced Scorecard all aspects of performance are processed in a system consisting of four perspectives. According to Kaplan and Norton, high-performing organizations should achieve good results on at least four performance perspectives. These four perspectives are a financial perspective, a customer perspective, a perspective on internal processes and finally, an innovation and learning perspective (Kaplan and Norton, 1997). 4.4.1 Financial perspective Financial data have a short-term focus and are not very focused on the future and the long-term strategy of a company, as told in chapter three. However, this information is essential because it is an important and reliable indicator for controlling the business operation and the accuracy of the company's strategy.

The financial targets serve as a hub for the goals and measurements in all other perspectives. Therefore it is important for a company to know how to present themselves as attractive as possible. Each performance should be part of a chain of causal relationships that ultimately leads to the financial results of the company. In this way the financial perspective ensures that successes regarding the other perspectives managed to translate

into financial success (Kaplan and Norton, 1997). Examples of performance measurements within the financial perspective are the size of the net cash flow and Return on Investestment.

4.4.2 Customer perspective

In the second perspective, the customer perspective, companies identify within which segments (customer and market) they wish to operate. Further there is paid attention to product standards that will be delivered to specific market segments. On this basis, goals can be formulated such as entering new markets or increasing the amount of customers in certain segments. Performance measures typically within this perspective are customer satisfaction and corresponding preservation of the number of customers and market share (Kaplan and Norton, 1997).

4.4.3 Perspective on internal processes

In the third perspective, companies identify the internal processes that are important for the sustainable existence of the company. Much attention is paid to internal processes which have a major impact on customer satisfaction and financial objectives of the company, and are therefore crucial. Based on this, objectives can be formulated, such as the creation of new internal processes for a new product or the improvement of a number of processes within the company. Typical performance measures within this perspective are quality, (product) costs, innovations and the length of the production process (Kaplan and Norton, 1997).

4.4.4 Growth and learning perspective

In the latter perspective, the learning and growth perspective, companies identify the infrastructure required for a company to continue to grow and continue to improve themselves in the long term. In addition, also the employees of an organization might feel they want or have to change. For example, there may be a gap between the capacity of a worker and the capacity which is necessary in order to realize the innovations (Kaplan and Norton, 1997). This gap can be healed by investing in the recovery, re-skilling of staff.

Objectives within the learning and growth could be improving technology to spread knowledge or creating new products.

4.4.5 Advantages and disadvantages

An advantage of the Balanced Scorecard is that it offers the advantages of both systems. On one hand, performance can be measured, because in each of the four perspectives within the Balanced Scorecard performance measures have been formulated. Besides measuring performance, the Balanced Scorecard makes it possible to perform management processes, such as translating the vision and mission of the company to strategic objectives In this way the Balanced Scorecard functions as well as a system for measuring performance as a strategic management system (The Geuser et al., 2009). Another advantage is that the problems that occur in traditional financial performance measures are solved, since use is made of non-financial performance measures too. This also provides more insight into the reasons for example extremely good or bad performance of a company. A disadvantage of the blanced Scorecard is that filling of the entire Balanced Scorecard is a process that takes a lot of time. Additionally, the Balanced Scorecard will often need new information, which in time will lead to investments in new data collection systems and thereby new responsibilities for employees. Together, this would be able to evoke a response from the resistor workers (Mooraj et al., 1999).

4.4.6 Study about the Balanced Scorecard

Davis and Albright (2004) did a study on the effect of the Balanced Scorecard on financial performance. The research was conducted at a bank located in the southeastern United States. As a research method is chosen for a field study of 24 months. The study has been used the research model of Cook & Campbell (1979), to see whether after the implementation of the Balanced Scorecard an improvement in the financial performance of the bank is note. This is the experimental group. The other group, the control group, reflects the situation without the implementation of the Balanced Scorecard (Davis and Albright, 2004).

To measure the variable performance, they used a combination of nine critical financial measures formulated in the financial perspective of the Balanced Scorecard of the

various subsidiaries that have implemented the Balanced Scorecard (Davis and Albright, 2004). The combination of these financial measures are called in this study ‘the Composite Key Financial Measure’ (CKFM). The CKFM is a performance measure that want to maximize all compartments of the bank (Davis and Albright, 2004). To come to a conclusion, a Wilcoxon test is done to see whether the CKFM for the experimental group were significantly higher after the implementation of the Balanced Scorecard. There is also checked whether the change in the CFM's is significantly greater than the expected change in the CKFM of the control groups, if there are no Balanced Scorecard which would be implemented (Davis and Allbright 2004).

The examination of Davis and Allbright (2004) shows that the performance of the experimental and the control group are equal at the beginning of the observation period. Out of the Wilcoxon test it is to note that for the experimental group, there is a significant difference in the CKFM's before and after the implementation of the Balanced Scorecard. There is revealed by the Wilcoxon test that for the experimental group, that there is a greater improvement in the CKFM's than in the control group. It is concluded that the use of the Balanced Scorecard has a significant and positive impact on the CKFM's, or the financial performance of the various subsidiaries. This means that the measures together in the Balanced Scorecard contribute in a responsible way to the purpose for which they were intended.

Conclusion

According to the agency theory, an agent should be provided by incentives by his principal, in order to get motivation and exert more effort in the best interest of the company and should not consist of only a fixed salary, but a variable part too. Jensen and Meckling (1976) already found that increasing the firm ownership of managers leads to less managerial opportunism. This means it is important to give a manager the incentives to get motivated to contribute at the long-term stategy of the company. By giving the manager stock options, the managers has that long-term strategy in mind and this means (a part of the) compensation in stock options would be a responsive form of compensation.

The short- and long-term bonuses are examined to look whether and if yes, the extent to which earnings management occurs. Healy (1985) focuses on the link between

short-term bonuses and earnings management with accruals as measurement for earnings management. He found that earnings management occurs when managers have bonuses in the short-term outlook. About the relationship between long-term performance plans and earnings management there is found that a long-term performance plan leads to less earnings management (Richardson and Waegelein, 2002). This means long-term performance plans are preferred to short-term performance plans when looking at responsive bonuses. With a long-term performance plan, it makes no sense for managers to manipulate the accruals and thus the bonus is more aligned with the interest of the firm and keeps in mind the long-term strategy of the company.

Bonuses can be paid in money, in equity or a combination of both. Since compensation in the form of cash and equity both have advantages and disadvantages and provide other incentives for the management, it is useful to use both forms side by side and not just choose one of the two forms.

An excessive focus on financial performance measures could have the effect of over-emphasize short-term accounting returns and discourage long-term investments (Kaplan and Norton, 1992). Non-financial results as performance measures instead of only financial results turn out to be increasingly important in evaluating the performance of managers.

Ittner, Larcker, and Rajan (1997) prove that the manager keeps the long-term strategy of a company more closely when there is a weight on non-financial performance measures too. This means non-financial measures should be included in a responsible compensation scheme. The weight should be assigned to the non-financial performance standard but this is hard because non-financial performance measures are not totally objective. Another disadvantage is that non-financial measures are less reliable since it is not audited by an external firm (Ittner et al, 1997).

To deal with the disadvantages and other deficiencies of traditional techniques for measuring performance, Kaplan and Norton developed in 1992 a new technique for measuring performance and strategic management called the Balanced Scorecard. The Balanced Scorecard uses both financial and non-financial performance measures (Hoque and James, 2000) and consist of four perspectives, namely a financial perspective, a customer perspective, a perspective on internal processes and finally, an innovation and learning perspective (Kaplan and Norton, 1997). These perspectives can therefore by the cause-and-relationship of investment in staff training lead to an increase in financial result.

The Balanced Scorecard is not only seen as a performance measurement system, but also as a method of strategic approach because the strategy may be more easily identified (Kaplan and Norton, 2001). The benefits of the Balanced Scorecard are especially the disadvantages that occur when using only financial measures, are eliminated. Also, managers are more aware of the strategy which increases involvement. Drawbacks include the amount of time it takes to implement, with the time required to complete the Balanced Scorecard, and the necessary investments including possible resistance from employees in the company (Mooraj et al., 1999). Davis and Albright concluded that the use of the Balanced Scorecard has a significant and positive impact on the CKFM's, or the financial performance of the various subsidiaries. This means that the measures together in the Balanced Scorecard contribute in a responsible way to the purpose for which they were intended. However, in the study by Davis and Albright (2004) companies are observed for a period of 24 months. To make a real improvement in performance statements, which retains its continuity in subsequent years, it is necessary to take a longer observation period.

So, bonuses nowadays can contribute in a responsible way for the purpose by which they initially intended, by using long-term bonus plans in combination with short-term bonus incentives, because this motivates managers to exert more effort. Further, not only financial performance measures should be included. Non-financial measures turn out to be increasingly important in the composition of compensation plans. From this thesis can be concluded that the Balanced Scorecard is the best instrument to define the strategy of the company and with this the performance measures of the compensation of the manager.

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