Performance measurement and annual
bonuses
A study on the effects and determinants of financial performance measures in annual bonus plans
Ernst Reinoud de Lange 10262040
21st of June 2014, first draft BSc Accountancy & Control ABS, UvA
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Table of Contents
Abstract/Samenvatting ... 3
1 Introduction ... 4
2 Background ... 6
2.1 Agency theory and the conflict of interest between managers and shareholders ... 6
2.2 Annual bonus plans ... 7
2.3 Financial performance measures... 8
2.3.1 Profitability ... 8
2.3.2 Liquidity ... 9
2.3.3 Investor ratios ... 10
2.3.4 External versus internal measures ... 11
3. The use of financial performance measures ... 12
4 Effects of financial performance measures ... 16
4.1 Effects of financial performance measures on short-term performance ... 16
4.2 Effects of financial performance measures on long-term performance ... 16
5 Alternative incentive plans ... 18
5.1 Fixed payment ... 18
5.1.1 Advantages ... 18
5.1.2 Disadvantages ... 18
5.2 Nonfinancial performance measures ... 19
5.1.1 Advantages ... 19 5.1.2 Disadvantages ... 19 5.3 Balanced Scorecard ... 20 5.1.1 Advantages ... 20 5.1.2 Disadvantages ... 20 5.4 Shareholding by managers ... 21 5.1.1 Advantages ... 21 5.1.2 Disadvantages ... 21 5.5 Discretion ... 21 5.1.1 Advantages ... 21 5.1.2 Disadvantages ... 22 6 Conclusion ... 23 Bibliography ... 25
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Abstract
This thesis is on the subject of financial performance measures and the annual bonus. Economic theory predicts an incentive problem by the separation of ownership and management within companies. The annual bonus is thought to solve the principal-agent problem. To award these bonuses, companies need to measure managerial performance. There are several ways to do this, off which financial performance measures is one. The main topic of research is what causes companies to choose for certain performance measures over other options. What is also researched is the short-term and long-short-term effects of these choices on the results of the company. It is found that the use of financial performance measures in annual bonus plans is widespread. The reasons behind the widespread use are found partially in psychology. The short-term effect of the use of financial performance measures is that financial performance does seem to increase. The long-term performance is generally overlooked by financial measures. It is recommended to supplement financial performance measures with other incentive plans that encourage long-term thinking.
Samenvatting
Deze scriptie gaat over financiële resultaten en de uitkering van de jaarlijkse bonus. Er wordt, door de scheiding van eigendom en leiding binnen bedrijven, een stimulans probleem voorspeld door de economische wetenschap. De jaarlijkse bonus wordt gedacht een oplossing te zijn voor het conflict van belangen. Om deze bonussen uit te keren moeten de behaalde resultaten gemeten kunnen worden. Er zijn verschillende manieren om dit te doen, het gebruik van financiële resultaten is hier één van. Het onderwerp van onderzoek is wat er voor zorgt dat bedrijven voor bepaalde
meetsystemen van resultaten kiezen boven andere methoden. Er is ook onderzocht wat de effecten van deze keuzes zijn op de korte- en langetermijnresultaten van het bedrijf. Het gebruik van
financiële resultaten om de jaarlijkse bonus uit te keren blijkt veel voorkomend. De reden achter het wijdverspreide gebruik worden deels gevonden in de psychologie. Het korte termijn effect van het gebruik van financiële resultaten is dat de financiële resultaten inderdaad verbeteren. De lange termijn resultaten van het bedrijf worden echter gemist door het gebruik van financiële resultaten. Er wordt aangeraden om het gebruik van financiële resultaten aan te vullen met andere factoren die een lange termijn focus aanmoedigen.
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1 Introduction
This thesis is on the subject of the effects and determinants of financial performance measures in annual bonus plans. In the years before the industrial revolution, people tended to produce goods individually. Often they grew or created products in or near their homes and sold these products. The profit these people made was the reward for their effort in producing the goods or services. During the industrial revolution people began working in factories where they were rewarded a salary for their efforts. This development gave rise to new theories which included agency theory. Agency theory tried to explain individual’s choices and the influence of risk on their behavior. Based on classic agency theory there is an incentive problem in modern businesses because of the separation of ownership and management. Because managers do not own the company they control their incentive to maximize the value of the company is decreased (Bushman & Smith, Financial accounting information and corporate governance, 2001). This specific problem is called the principal-agent problem. The agent (manager) and the principle (the shareholders) have differing interests. We assume that the manager wants to maximize his own payoff against the lowest effort. Businesses started thinking of ways to counter the incentive problem. One way to combat the principal-agent problem is to award managers with annual bonuses that reward managers based on the results for certain measures. The annual bonus is thought to solve the incentive problem because it gives managers a stimulus to work harder. The next issue was how to measure performance to determine the bonus. The measures that determine the bonus often include some financial performance measures. These financial performance measures include profitability, liquidity and investor ratio measures (Bushman, Indjejikian, & Smith, CEO compensation: The role of individual performance evaluation, 1996). These financial performance measures are thought to be under the control of the manager and he can improve the results by doing a good job.
The recent financial crisis has created doubt about whether the current way of rewarding managers should be changed or not. Critics of the current system state that the current way of compensating managers focuses too much on short term results and gives rise to risky behavior which could potentially harm the company (Ittner, Larcker, & Meyer, Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard, 2003). When governments had to bail out companies to prevent them from going bankrupt because their managers had taken too much risk, politicians too started asking if the current measures put too much focus on the short term performance of the company (Rigby, 2014).
Most of the existing literature on the subject pre-dates the economic crisis. Given the critique, on the annual bonus plans, during the economic crisis it should be interesting to view the subject and literature in a post economic crisis perspective.
5 financial performance measures in annual bonus plans?
This study is being done to try and figure out what the effects and determinants of financial performance measures are and if these measures align the goals of the company with the manager’s objectives.
From here the second part of this thesis is going to explain background information needed for a comprehensive understanding of the subject. The third part of the thesis contains information on what drives companies to use certain financial performance measures and how they are used. The forth section discusses the short-term and long-term effects of using financial performance measures to evaluate managerial performance in annual bonus plans. The fifth section contains several
alternative measurement systems and discusses their selling points and drawbacks. The sixth part is a conclusion which will contain recommendations on how and when to use financial performance measures.
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2 Background
2.1 Agency theory and the conflict of interest between managers and investors
The agency theory stems from the 1970s, during this time economists started thinking about how risk and objectives influence individuals in their decision making (Eisenhardt, 1989). An agency relationship can be defined as a relationship where one person acts on behalf of another person. These persons can respectively be referred to as the agent and the principal (Jensen & Meckling, 1976). What follows is an example to clarify incentive problems. Assume a factory worker is paid a fixed salary and has two levels of effort, high effort or low effort. The effort the factory worker puts in determines how much gets produced and in turn determines the factory owner’s profits. When he puts in little effort he has more free time and energy to spend doing things he likes more than working. He will receive the salary and does not have to work very hard to acquire this salary. If however, he puts in high effort he has a smaller amount of free time and less energy to use during his free time. In this case the factory worker still earns the same salary even though he works a lot harder than the previous situation. Most likely, the worker will choose to put in low effort. His boss would like to have his employees working as hard as they can but without an extra reward for their additional effort this is unlikely to happen. This example is what we call an incentive problem, the factory worker and his boss have conflicting interests. If we apply this situation to a company where the manager is the agent and the shareholder is the principal, we see a lot of similarities. When a founder of an organization sees his (or her) organization grow, he can often no longer keep control over all aspects of the organization. In order to keep the organization running smoothly he hires a manager to take over some of his tasks so he can keep his focus on broader issues. This manager is believed to be risk averse and trying to maximize his own utility at the lowest cost. The founder is now no longer assumed to be running the day to day operations within company but he is now the only shareholder of the company. The manager is now acting on behalf of the shareholder. Both actors in this situation are assumed to act in their self-interest. Because both have differing goals and risk preferences the actions they prefer are not the same. The manager will most likely want to maximize his own payoff against the lowest effort level. The payoff for the manager includes not only monetary rewards but also among others respect from his peers. Managers generally gain more respect from their peers if they manage a larger company. It is clear that this behavior does not necessarily lead to the highest payoff for the shareholder (Jensen & Meckling, 1976). The
shareholder will however want to maximize the manager’s efforts assuming that more effort leads to a higher payoff for the shareholder. This conflict of interest between the manager and the
shareholder is what we call the principal-agent problem. The shareholder can try to prevent the manager from serving his own interests instead of the shareholders by rewarding the manager to align the manager’s incentives with the goals of the company. The manager can also be monitored to
7 prevent behavior that is against the company’s best interest. The principal-agent problem is
intensified by information asymmetry. Information asymmetry is the difference between what the shareholder knows about the manager’s actions and efforts and what the manager himself knows. The asymmetry exists because the shareholder cannot monitor all of the manager’s actions. The shareholders can monitor the managers more to compensate for the information asymmetry but it is often quite expensive to monitor managers (Pindyck & Rubinfeld, 2008). It is also not practical for the shareholder to monitor all actions because in that case it would be better for the shareholder to perform these tasks instead of the agent acting on his behalf (Ross, 1973). There has to be a certain amount of discretion for the manager to operate on behalf of the shareholder. The information asymmetry leads to a situation where the manager is able to ‘’shirk’’ without the shareholder immediately noticing his lower effort (Pindyck & Rubinfeld, 2008).
Another aspect of the principal-agent problem is the occurrence of agency costs. Agency costs are the costs that are incurred by the principal when he lets an agent act on his behalf. Agency costs are defined as the sum of several separate costs. The first cost to be included is the agency loss. This loss is the lower welfare obtained by the shareholders when the manager makes decisions on behalf of the shareholders compared to the results achieved when the decisions are made by the shareholders, who are thought to have a greater interest and involvement in the organization. The second part of the agency costs are the costs incurred to bond the agent to the company. When an agent is more involved in the company, through for instance the acquisition of stocks, he is thought to act more in the interests of the shareholders. The last part of the agency costs are the costs related to the monitoring of managers by the shareholders. Even though the manager is allowed to act on behalf of the shareholders, it is still necessary to monitor some of his actions and results (Jensen & Meckling, 1976).
2.2 Annual bonus plans
The conflict of interest between the manager and the shareholders has led to much debate on how to solve this issue. The problem with the misalignment of interests is thought to be solved partially by the awarding of bonuses to managers if they perform in a way that best serves the shareholders. Bonuses exist in many forms. Companies can choose to reward managers with a wide array of options including: stock options, insurance plans and annual bonuses. For this thesis the focus will be on the annual bonuses. Annual bonuses are sums of money that are paid to managers to reward them for performing well over the last year. Most bonus plans are based on earnings results. In fact research by Fox shows that almost 90 percent of the 1000 largest companies in the United States use a bonus determined by earnings figures to reward their managers. In the same research it was shown that the median ratio of annual bonus to fixed salary was more than 50 percent. Usually in awarding
8 bonuses companies set a target for earnings or any other performance measure. When this target is achieved, a set percentage of the positive difference between the target and the actual performance is reserved for rewarding managers (Healy, 1985). When the performance measure turns out to be lower than the target, there is no reserve for the bonus plans and managers receive no bonus. In general the bonus is awarded by the board of directors who cannot partake in the bonus plans. The literature suggests a positive relation between financial performance and the compensation of managers in the form of a bonus. Bonuses also come in different shapes and sizes. They can focus on short-term results or long-term profitability (Gerhart & Milkovich, 1990).
Research found that when the bonus is compared to earnings there is a positive association between the two. If we look at times when performance is poor however, the association stops and the bonus will not decrease by the same percentage as earnings. The researchers state that when we look at accounting fundamentals instead of simply looking at earnings we see that these
fundamentals are also positively associated to the bonus. In times when earnings are poor, but managers still receive bonuses, they find that the accounting fundamentals are usually more positive. This partially explains why executives still receive bonuses when earnings are down. This does not necessarily have to mean that everything is going bad. This indicates that the bonus might be more closely related to performance than previously assumed (Jackson, Lopez, & Reitenga, 2008). To award bonuses managers need to have their performance evaluated. One method of measuring managerial performance is to asses them based on financial performance measures.
2.3 Financial performance measures
Financial performance measures are often seen as an objective way of measuring performance. First off, financial performance measures are thought to be the most inclusive measures of performance as every decision made by the manager is ultimately represented in these financial figures (Moers, 2006). Second, financial performance measures are leading indicators for share prices (Campbell & Shiller, 1988). Increasing share prices are in the best interest of the shareholders. Hence,
shareholders wish to increase share prices. Therefore, when share prices are influenced by
accounting profitability, as reflected by financial performance measures, they realign the goals of the manager and the company so that they are both trying to achieve the same objectives. The most used financial performance measures are calculated as part of profitability, liquidity or investor ratios.
2.3.1 Profitability
Profitability is about how the organization is able to use its assets to generate profits (Stolowy, Lebas, & Ding, 2010). Since a raw net income figure usually does not provide enough information to
9 data to measure performance (Marshall, McManus, & Viele, 2011). The gross profit margin is the most easily understood profitability measure. The gross profit margin is calculated by dividing the gross profit by the total amount of revenues. This calculates the amount of every euro of revenue that is not expensed as cost of goods sold. This very basic profitability measure is easy to calculate as the data needed for the calculation is readily available in the financial statements. The net profit margin is a profitability measure similar to the gross profit margin in that it calculates a margin of profit on every euro of revenue. The difference is that the net profit margin is calculated using net income instead of gross profit. This means that all expenses have been deducted to arrive at the net income figure for the period. The margin calculates the amount of net income for every euro of revenue. Another widely used profitability measure is the asset turnover. This measure is calculated by dividing the total revenues by the average assets over the period. It measures how the
organization is able to generate revenues using the assets at its disposal. The measure that follows the asset turnover is the return on assets (ROA), which is calculated as net income divided by the average assets over the period. The return on assets measures how efficiently the organization is able to use its assets to generate net income (Stolowy, Lebas, & Ding, 2010). Companies are able to have these assets at their disposal because they have capital. This capital comes from two sources, equity and liabilities. Equity can be defined as all the money that the owners have brought into the company plus any retained earnings that have been accumulated over the operational life of the company. Liabilities are sometimes also referred to as loans because this is capital that will have to be repaid when the loans for the capital becomes due. Some argue that including all capital in an organization, equity and liabilities, in measuring return, does not contribute to the objective nature of the return figure. It is argued that measuring return only over an organization’s equity is a better measure of their effectiveness and efficiency (Marshall, McManus, & Viele, 2011). This measure is called the return on equity (ROE). The formula for the ROE is the net income divided by the average value of equity for the period. The ROE calculates the return, in the form of net income, for every euro of shareholders’ equity (Stolowy, Lebas, & Ding, 2010).
2.3.2 Liquidity
Every organization has certain obligations to pay their liabilities as they become due. Liquidity measures calculate the organizations’ ability to pay these liabilities. The liquidity measures can globally be divided into short-term measures and long-term measures. The difference between the two is that the short-term measures measure the capability of the firm to pay its obligations that are due within one year. The long-term measures calculate the capability of the firm to pay the
obligations with a due date longer than a year from now (Marshall, McManus, & Viele, 2011). The cash ratio is the first measure that is going to be explained. The cash ratio measures the
10 marketable securities. In other words, if the organization were to go bankrupt today could it pay off its short-term liabilities using only money that is readily available? The formula for the ratio is cash plus any marketable securities divided by current liabilities. This ratio is uses the worst case scenario to make sure that the organization is not going to have any trouble paying of their current liabilities. One step above the worst case scenario is the quick ratio. This ratio also measures the organization’s ability to pay off its current liabilities using cash, marketable securities and accounts receivable. This measure assumes that money still has to be received from customers that can be used to offset the current liabilities. The formula for this ratio is cash plus marketable securities plus accounts
receivable divided by current liabilities. The last short-term solvency measure that will be discussed here is the current ratio. It calculates the organization’s ability to fulfill the obligations it has, in the form of its current liabilities, using all of its current assets. The difference between the current ratio and the quick ratio is that the current ratio also includes inventory and other current assets that might not be as easily converted into cash to pay off debts (Stolowy, Lebas, & Ding, 2010). The long-term liquidity measures show the organization’s ability to fulfill its long-term obligations. The first measure that is widely used is the debt ratio. This measure shows the ratio of the debt divided by the total amount of assets. This is an indication of the organization’s ability to pay their long term debts. Another measure often used is the debt to equity ratio. It measures the total amount of debt divided by the value of shareholders equity. This measure is given as an
alternative to the debt ratio because increasing debt has a smaller effect on the debt ratio than it has on the equity ratio. The last long-term liquidity measure that will be explained here is the long-term debt to equity ratio, which calculates the organization’s ability to pay their long-term debt solely (Stolowy, Lebas, & Ding, 2010).
2.3.3 Investor ratios
Companies whose shares are sold on the open market have their shares valued on stock exchanges. Potential and current shareholders wish to earn a return on the money they invest in the company. Ultimately shareholders are the owners of a company and they employ the manager to act on their behalf, it is crucial that the manager acts in the best interest of the shareholders. To measure if the manager has in fact done this several investor ratios have been developed. The most used ratio is earnings per share (EPS), it measures the amount of income that is earned on every share
outstanding. Hence, it is calculated by dividing net income by the average value of shares
outstanding. Secondly we have the price earnings ratio to measure performance related to shares. The price earnings ratio measures how many times the earnings per share shareholders are willing to pay for shares. Measuring the price earnings ratio is done by dividing the market price of the share by the EPS. The market to book ratio is the ratio that calculates the market price of the share divided by the book value of assets per share. The use of external financial performance measures, like the
11 price earnings ratio, focuses more on the external effects of the decisions by managers. This has led to debate about whether the share price is in control of the manager and therefore a result of his actions. Proponents of the usage of externally determined measures state that these measures are less open to manipulation by the manager. They also claim that internally produced financial data is included into the valuation of the stocks on the open market (Bushman & Smith, Financial accounting information and corporate governance, 2001). Last to be explained are two ratios related to
dividends. The first, the dividend yield ratio is found by dividing the cash dividends per share by the market price of the share. This calculation yields a number that is the actual cash return that investors see on each of their shares. The second ratio is related to how much of the earnings the company decides to payout in the form of dividends. The dividend pay-out ratio is the cash dividends per share divided by the EPS (Stolowy, Lebas, & Ding, 2010). Now that we have explained some of the most important financial performance measures, the next step is to find out what determines these financial performance measures and what their effects are.
2.3.4 External versus internal measures
Financial measures can globally be separated into externally determined measures, which are referred to here as investor ratios, and internally determined measures, which are referred to as profitability measures. When we compare examples of both categories, namely the shareholder return and the return on equity, we come up with some interesting conclusions. We define the shareholder return as the sum of the gain on the value of the share and the dividends on the stock. The return on equity is defined as the earnings before any extraordinary items divided by the average value of shareholders’ equity. What research shows is that the use of internal measures is more common when managers are awarded on a monetary basis as opposed to external measures that seem to be more prevalent in payment plans where managers are rewarded, among others, in the form of stock options. Another finding is that the use of external measures depends on the amount of noise in measuring the performance of the shareholders return relative to the noise in the internal measures. The idea of noise shall be explained further later in this thesis. Also, firms that are
experiencing significant growth are more likely to use external measures in their compensation plans. It is explained that this occurs because managers are more likely to be rewarded based on the future success of their efforts that, in a high growth company, might not be fully reflected in the current accounting data. Lastly, managers that receive a large portion of their reward outside of a salary or a bonus, most likely in the form of stocks, tend to be evaluated more based on the internal measures (Lambert & Larcker, 1987).
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3 The use of financial performance measures
All accounting measures are determined by other financial data. The definition of profit is usually similar to; all appropriate revenue minus the appropriate expenses for the period. This definition seems quite straightforward and suggests that it should be easy to measure profit for the purpose of awarding bonuses to managers. When we look at how we determine the appropriate revenues and expenses we find that there is in fact quite some discretion to selecting the amounts. According to the matching principle the expenses that are incurred to generate the revenues for the period must be deducted from the revenues for the period. This means that expenses like a payment to receive inventory in the next period should not be deducted from this periods revenues. The amounts for both revenues and expenses also have to match the time that the results are generated. Revenues should be recognized when the risks of the sale are transferred to the buyer. This often differs from the time payment is received. Companies often have a certain period, 30 days for example, after transferring the product to the customer where they expect full payment (Marshall, McManus, & Viele, 2011). Another example is the ROE. ROE is determined not only by the net income a company makes over a year but also important is the total amount of assets and the amount of leverage in the company. Looking at the simple formula for ROE, which divides net income by the average value of equity, does not give enough information about the factors that have an influence on this figure. An extended formula was found in the form of the DuPont formula. The DuPont formula for calculating ROE was developed by Donaldson Brown, who developed the formula for DuPont de Nemours. The organization was looking for a way to measure managers’ performance in achieving returns on equity capital being engaged (Stolowy, Lebas, & Ding, 2010). In the DuPont formula for calculating the ROE, we need the following data; net income, sales, average assets and the average equity to determine the ROE. The DuPont formula for calculating the ROE is stated to be; return on equity = Return on sales * Asset turnover * Financial leverage multiplier. Where the return on sales is calculated as net income divided by sales. The asset turnover is calculated as sales divided by average assets. The formula for the financial leverage multiplier is; average assets divided by the average equity (Stolowy, Lebas, & Ding, 2010). As we can see there are quite some factors that could potentially influence the ROE. Therefore, it is important that the manager is not being evaluated on factors that he does not have control over.
This was highlighted by Frank Moers in his research on the use of financial performance measures to solve the principal-agent problem. The quality of financial performance measures is a big factor that determines their effectiveness. According to Moers the higher the quality of financial performance measures the better they can be used to solve the principal-agent problem. Because the principal-agent problem is solved, shareholders can give the manager more responsibility and discretion. The increase in the delegation of tasks is used as a measure for the ability of the
13 performance measures to solve the principal-agent problem. In order to measure the quality of the financial performance measures Moers gives three criteria. The first of his criteria is the sensitivity of the measure. Sensitivity measures to what extent the manager’s actions have influence on the performance measure. The second criterion is the precision of the performance measure. Precision measures the influence of factors outside the control of the manager. Lastly he uses verifiability to measure the extent to which the process of measuring has an influence on the results for the financial performance measures. What he finds in his research is that there is a positive correlation between higher precision (i.e. less influence of outside factors) and the delegation of tasks. The same holds for the other two criteria, higher verifiability and higher sensitivity lead to more delegation. Even though Moers acknowledges there are several issues with his research it does seem to show that overall the use of financial performance measures relative to non-financial performance measures is a better system to solve the principal-agent problem, dependent on the quality of the financial performance measures (Moers, 2006).
Other research, done by Ittner, Larcker and Rajan, looks at how certain factors have an influence on the relative use of financial performance measures. Firstly there seems to be a negative relationship between the relative use of financial performance measures and companies that follow a quality strategy. In other words, companies that are more concerned with quality generally tend to focus more on non-financial performance measures. The reason behind this is that the short term financial measures do not give information about the quality that the company is trying to uphold. The second relationship that they find is that when companies are more innovative, they also favor non-financial performance measures. This makes sense since businesses that are trying to
differentiate themselves from the market generally pay less attention to cost leadership. They are more concerned with market share increase and other long-term results that are not reflected in the short term financial data used in financial performance measures. At the other end companies operating on a cost leadership strategy will be especially interested in financial data. The third relationship they find is a relationship between the level of regulation a company faces and the use of non-financial performance measures. Regulators are able to (partially) determine what prices a regulated company can charge for their products. These regulated companies usually operate in industries like the utilities. Because the regulators want the services to be provided at the best possible quality they use non-financial performance measures like customer satisfaction to measure how well the company is doing. The companies themselves get rewards for achieving high results on these measures so they will most likely reward their managers on this basis too.
What they find in their research is that when companies follow a more quality focused, innovative strategy they generally place less weight on financial performance measures, as do companies that face stricter regulations. There were also situations where the research found no clear or small
14 relationship with less emphasis on financial performance measures (Ittner, Larcker, & Rajan, The Choice of Performance Measures in Annual Bonus Contracts, 1997). The first situation is when there is considerable noise in financial performance measures. Financial reporting can be influenced by factors other than the managers’ effort. The influence of these other factors is what we call noise. Noise can occur in accounting earnings as well as shareholder returns (Lambert & Larcker, 1987). Noise can be compared to the precision criteria that Moers used in his research (Moers, 2006). Seeing the similarities between the two concepts we can link the notion of noise to the quality of performance measures (Lambert & Larcker, 1987). In the situation that the financial performance measures were clouded by outside influence and noise there was some evidence that this caused companies to focus more on the use of non-financial performance measures. The evidence however is slim. The last situation that is discussed is one where the CEO is considered powerful, as measured by his influence over the board of directors. The theoretical reasoning behind this is that they expected powerful CEOs to have a preference for non-financial performance measures, because these are not audited like financial performance measures, which they would be judged on because of their influence over the board of directors. The theoretical reasoning does not hold up in practice and there does not seem to be a relationship between powerful CEOs and the use of non-financial performance measures (Ittner, Larcker, & Rajan, The Choice of Performance Measures in Annual Bonus Contracts, 1997).
Aside from the previously mentioned arguments a lot of research has focused on the ability of mangers to influence the financial results of a company. Research done by Healy concludes that when managers are rewarded based on certain performance measures their decision making will favor increasing the results that are being measures. Managers will choose what gives them the highest payoff but this does not always mean that these decisions are in the best interest of the company. He provides indication that managers will use accrual policies to influence the results that they are being evaluated on. Another finding was that a change in accounting policy is often the result of an adoption of alteration of the bonus plan (Healy, 1985). In contrast, later research finds that managers did not use accruals to increase their bonus. The research concludes that managers used accruals to increase the company’s earnings. This is still a focus on the short term which means that decisions could be made that do not necessarily benefit the company in the long term (Gaver, Gaver, & Austin, 1995).
Seeing as there is quite some criticism on financial performance measures it is interesting that these measures are used so uniformly to evaluate managers (Bushman & Smith, Financial accounting information and corporate governance, 2001). One explanation for this is given in
research done by Ittner, Larcker and Meyer. They conclude that psychology might be the cause. They did an empirical study on a major financial services firm, where they tested the success of a
15 subjective balanced scorecard bonus plan. What they found was that superiors tended to favor using financial performance measures to evaluate managers. The superiors also tended to integrate measures that do not predict future financial performance and the superiors changed the criteria quarter to quarter. This was also supported by the claim from many managers that bias had a lot of influence in the bonus plans. The test concluded with the company deserting the balanced scorecard plan and adopting a bonus plan that was based on revenues exclusively (Ittner, Larcker, & Meyer, Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard, 2003). The psychological explanation seems to be supported by research that finds that companies facing comparable circumstances will often make different decisions about bonus plans (Gerhart & Milkovich, 1990).
When determining how to measure performance for the sake of bonus plans it is important not to forget that goals need to be set. Determining the target is also the subject of debate. Murphy argues that the targets should be set externally, so from an objective outside point of view. He states that companies that determine the goals internally see a greater occurrence of earnings smoothing than companies that have their targets set externally. His research also shows that this does tend to happen in practice when prior performance as a target is too noisy (Murphy, 2001).
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4 Effects of financial performance measures
4.1 Effects of financial performance measures on short term performance
Most studies agree that the use of financial performance measures increases short term
performance within businesses. The logic behind this is easily understood as managers are concerned for their personal payoff in the form of the annual bonus. Their self-interest motivates the managers. They will act to increase their performance on the financial performance measures to increase their bonus (Gerhart & Milkovich, 1990). Financial performance measures are said to provide the most comprehensive measure of managerial performance because all actions are reflected in these results. As previously mentioned the extent to which financial performance measures are good indicators of managerial performance depends on their sensitivity, precision and verifiability. If financial measures are more sensitive, precise and verifiable, these measures are cheaper to evaluate on than non-financial performance measures (Moers, 2006).
Since most of the financial performance measures only measure performance over the previous year it is easily understood that these indicators have a short-term focus. There is a significant correlation between the awarding of the annual bonus and the short-term performance. This indicates that financial performance measures do encourage higher performance in the short-term. With this short-term focus, the long-term thinking in the company is undermined. Financial performance measures generally do not inspire long-term thinking (Gerhart & Milkovich, 1990). More evidence on the short term focus of financial performance measures comes from Merchant. He claims that using financial performance measures in incentive contracts promotes accounting
manipulation to increase short-term profitability (Hirsch, 2010). There are several other articles that claim to have found that financial performance measures focus too much on the short-term
profitability of the company (Ittner, Larcker, & Meyer, Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard, 2003).
4.2 Effects of financial performance measures on long term performance
Simple financial performance measures like earnings figures are poor indicators of long-term performance for a company (Bushman & Smith, Financial accounting information and corporate governance, 2001). Since the focus of financial performance measures is generally on the short-term, many companies supplement the annual bonus plan with an incentive to promote long-term thinking (Bushman, Indjejikian, & Smith, CEO compensation: The role of individual performance evaluation, 1996). Because of this short-term focus, long-term investments are often overlooked (Ittner, Larcker, & Rajan, The Choice of Performance Measures in Annual Bonus Contracts, 1997).
There is indication that firms are starting to switch from financial performance measures to alternative measures to promote long-term thinking. Switching over to alternative measures of
17 performance has several reasons including; greater growth opportunities for the business and the distinguishing between components of earnings when evaluating managers for their yearly bonuses, by the board of directors (Bushman & Smith, Financial accounting information and corporate governance, 2001). The inclusion of non-financial performance measures to promote long-term thinking is not the only method to achieve this goal. Among others, the holding of shares by the managers is named as one of the ways to increase long-term thinking (Ittner, Larcker, & Rajan, The Choice of Performance Measures in Annual Bonus Contracts, 1997). The use of stock returns as a measure does provide the managers with an incentive to think about the long-term of the company because the long-term investment strategies and other long-term opportunities have a significant impact on the stock returns (Bushman & Smith, Financial accounting information and corporate governance, 2001). Another method that will increase the long-term focus is the delayed payment of salary. This way if the results are the effect of accounting manipulation, there is more time for the discrepancies to show up (Healy, 1985). Several other measuring systems that might increase long-term thinking will be discussed in the following paragraph.
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5 Alternative incentive plans and measuring systems 5.1 Fixed payment
Fixed payment plans are most easily understood by looking at minimum wages set by governments. It is normal in a lot of jobs to earn a fixed wage. This can be because there is no performance to objectively measure or it can be to provide the employee with the security of the feeling that they know what reward they can expect to earn every month (Nakamura & Nakamura, 1991).
5.1.1 Advantages
In economic theory it is assumed that people are risk averse. People would rather be sure of earning 50 euro’s versus having a 50/50 chance to earn 100 euros’. Because of this risk aversion it is logical that people would rather earn a fixed salary if this salary is equal to the average of performance based salaries. So employees would rather have a steady income to provide them with security. Even though the fixed salary system is creating the conflict of interests in the first place, the bonus system has its downsides too. Because people are assumed to be risk averse they demand a risk premium when they are paid according to their performance. In their research, Nakamura & Nakamura find evidence for this risk premium. This risk premium is an additional cost to the company for rewarding managers based on performance, which is avoided by a fixed payment plan. Other costs that are avoided by a fixed payment plan include measuring and monitoring costs (Nakamura & Nakamura, 1991).
5.1.2 Disadvantages
The risk with fixed payment plans is that competitors could still award bonuses and this could cause a sort of self-selection, as seen in the lemons problem, where managers who believe that they can achieve higher than normal returns will choose to work at a company that rewards them based on their performance. This would leave average and lower than average performance managers for the fixed salary company (Heckman & Sedlacek, 1985). Another downside of the fixing of salaries is that for companies labor expenses become almost completely invariable. This is especially bad for companies that face fluctuating demand and/or supply (Nakamura & Nakamura, 1991). In other research it is found that financial performance did not seem to be associated with base pay. This indicates that when given a fixed salary, managers tend to shirk in the same way as the
aforementioned factory worker in the incentive problem (Gerhart & Milkovich, 1990). Companies have to measure the benefits of rewarding managers with bonuses instead of increased fixed salary against this risk premium to see whether it has a positive effect on financial performance (Nakamura & Nakamura, 1991).
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5.2 Nonfinancial performance measures
Non-financial performance measures like customer satisfaction and product quality have risen in popularity.
5.2.1 Advantages
The nonfinancial performance measures are seen as being better indicators of future profitability. They are said to focus the attention on the long term goals of the company and steer away from short term thinking. There is little empirical evidence to support this claim for all alternative
measures given. Nonfinancial performance measures also include information that is not visible with financial performance measures. One article found that customer satisfaction specifically is a better indicator of future performance than financial performance measures (Banker, Potter, & Srinivasan, 2000). The idea of customer satisfaction as an indicator of future performance is also adopted by Ittner and Larcker. They conclude that customer satisfaction is indeed associated with future
performance, as seen by the higher future revenues and retention (Ittner & Larcker, Are Nonfinancial Measures Leading Indicators of Financial Performance? An Analysis of Customer Satisfaction, 1998). When nonfinancial performance measures supplement financial performance measures performance increases (Banker, Potter, & Srinivasan, 2000). For instance, research shows that including customer satisfaction increases performance of the company in the long run (Ittner & Larcker, Are Nonfinancial Measures Leading Indicators of Financial Performance? An Analysis of Customer Satisfaction, 1998). There is more indication that incorporating nonfinancial performance measures leads to an increase in the level of regulation, higher innovativeness of a company and more initiatives that are
strategically sound (Ittner, Larcker, & Rajan, The Choice of Performance Measures in Annual Bonus Contracts, 1997).
5.2.2 Disadvantages
However, there do seem to be some downsides to using customer satisfaction as a predictor for future performance. The positive association between satisfaction and future performance seems to weaken when customer satisfaction reaches high levels (Ittner & Larcker, Are Nonfinancial Measures Leading Indicators of Financial Performance? An Analysis of Customer Satisfaction, 1998). The increased complexity of reporting non-financial performance measures is one downside. The complexity leads to higher measuring costs. Also, superiors will often not understand the non-quantitative data they are presented and will prefer financial data (Ittner, Larcker, & Meyer, Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard, 2003).
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5.3 Balanced Scorecard
Several systems have tried to incorporate multiple performance measure systems to come to a more inclusive system that has all the benefits of the different systems. The most well-known system is the balanced scorecard. Introduced by Kaplan and Norton in 1992 it is designed to incorporate several measuring systems. The balanced scorecard is made up of four different aspects of business. The first is the financial aspect. Here the company’s financial success and results are measured. This includes profitability and financial risks. The second is the customer aspect. Several key customer indicators are measured. Among others it measures customer satisfaction and market shares. The third aspect is the internal business processes. The internal processes are evaluated the goal here is to make the processes run as smooth and efficient as possible. Lastly there is the learning and growth aspect. In order to have a viable business companies have to strive for growth and learning. The growth of the company and the learning opportunities are measured and evaluated here. Even though the financial aspect is the first to be named, it is still not nearly the only important thing in the balanced scorecard (Kaplan & Norton, 2001).
5.3.1 Advantages
The idea behind the balanced scorecard is that each division can decide what measures are important to them and evaluate performance based on those measures instead of standard
measures that might not represent their goals (Lipe & Salterio, 2000). The scorecard is more inclusive than other measuring systems as it includes four aspects of business as opposed to the solitary measuring of financial performance when using financial performance indicators (Kaplan & Norton, 2001).
5.3.2 Disadvantages
There are several potential drawbacks to the scorecard. Research by Ittner, Larcker and Meyer revealed that superiors used the discretion in the balanced scorecard to place more emphasis on measures that were the easiest for them to understand. Usually this ended up being financial performance measures. Because of this focus on the financial aspects of performance several important other factors were overlooked. Superiors did not pay attention to non-financial measures that were good indicators of future performance but instead they focused on short-term financial measures that did were not as good as the other measures. It was found that, as previously
mentioned, psychology has a large influence in the choice of performance measures (Ittner, Larcker, & Meyer, Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard, 2003). Another downside of the use of the balanced scorecard is its complexity.
Measuring the full spectrum of the balanced scorecard is more difficult and cumbersome than just measuring financial performance. Since the measures are not always quantifiable it takes
21 superiors having more difficulty understanding the results. The balanced scorecard is also associated with higher measuring costs (Lipe & Salterio, 2000).
5.4 Shareholding by managers
Rewarding managers with stocks in the company has risen in popularity since the 1990s (Bryan, Hwang, & Lilien, 2000). The manager is rewarded for his work by receiving a number of shares based on the results they obtain.
5.4.1 Advantages
Not only is the awarding of stock bonuses an effort to reward the manager for his work and thereby reducing the principal-agent problem, it is also an attempt to achieve goal congruence between the manager and the company. By receiving stocks the manager becomes one of the shareholders and it is in his interest to act in the best interest of the shareholders, because he too is a shareholder. Because of this stock rewards are seen as a good way to induce the manager to act in the best long-term interest of the company (Hirsch, 2010). It is claimed that stock rewards and stock options have created an incentive for risk adverse managers to take on more risk which ultimately led to higher financial results. Also it is seen as a good option for companies that face financial restraints in awarding their managers for good performance (Bryan, Hwang, & Lilien, 2000).
5.4.2 Disadvantages
The downsides of stock bonuses include that stock prices are determined on the open market and are therefore not fully in control of the manager or the company. This makes it less usable as a way to reward the manager for his efforts (Hirsch, 2010).
5.5 Discretion
Using discretion is another option when designing a measuring system for the annual bonus. Managers are evaluated on subjective judgments by their superiors.
5.5.1 Advantages
When financial performance measures are no longer a good indicator of future performance or are hard to measure firms tend to incorporate more subjectivity in determining bonus plans. Higher difficulty levels of obtaining targets and higher the consequences of not making the target also increase subjectivity. Subjectivity in compensation plans will only work when the manager trusts his superior to evaluate him in a fair way. If this is the case than the positive effects on efficiency, satisfaction and profitability become greater. There are several other circumstances that could lead to more subjectivity in the bonus plan. Besides the aforementioned reasons, firms operating a loss see a rise of the use of subjectivity in compensation plans. Higher investments in intangible long term assets and interdependencies in a company are given as two other factors associated with
22 subjectivity in bonus plans (Gibbs, Merchant, Van der Stede, & Vargus, 2004).
5.5.2 Disadvantages
It is found that discretion is often used to supplement financial performance measures as a way to reduce the risk of flexible pay for managers. This can be seen as a disadvantage as it undermines the bonus’s ability to reward the manager for their efforts. By using discretion to reduce the fluctuation of payment the bonus system starts to resemble a fixed payment plan with its disadvantages (Gibbs, Merchant, Van der Stede, & Vargus, 2004).
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6 Conclusion
At the start of this thesis a question was raised. What are the determinants and effects of financial performance measures in annual bonus plans? To answer this question background information was given to clarify the situation. Then the research focused on the factors that influence the choice of performance measures. Finally the effects of the use of financial performance measures in
determining the annual bonus were described.
There has been an ongoing debate about the use of financial performance measures in annual bonus plans. The so called principal-agent problem, which is predicted by economic theory, does seem to be partially solved by the use of incentive plans in the form of an annual bonus
(Jackson, Lopez, & Reitenga, 2008). Financial performance measures turned out to be determined by more factors than initially thought. The DuPont formula for calculating ROE showed that ROE is not only determined by net income and the value of equity but also, among others, the asset turnover (Stolowy, Lebas, & Ding, 2010). There are a lot of factors the manager has influence on and it is important to evaluate managerial performance based on measures that the manager has control over. Moers gave three criteria on which he evaluated financial performance measures to be good evaluation measures. He finds that common financial performance measures score well on his criteria of; sensitivity, precision and verifiability. The use of financial performance measures was also found to be influenced by circumstances like the following of a quality strategy, the innovativeness of a company and the level of regulation faced by a company. When these factors where higher the use of financial performance measures compared to non-financial performance measures declined (Moers, 2006). A lot of research has focused on the ability of managers to influence the accounting results of a company. It was shown that managers use their power to influence the accounting to increase their performance, and thus their bonus (Healy, 1985). Later research showed that
managers used their power to increase the accounting earnings for the company and not necessarily to increase their own performance in order to get a higher bonus. This does not mean that the earnings focus is best for the company’s long-term interests (Gaver, Gaver, & Austin, 1995). The widespread use of financial performance measures was found to be caused partially by psychology. Superiors, who evaluate managers, were given an alternative measurement system to evaluate the managers with. Superiors used the discretion given to them in designing the
measurement plan to focus on the financial results that are being measured by financial performance measures. This led to a situation where the additional costs of the alternative measurement system undermined its effectiveness and the superiors changed back to the original system of measuring financial performance (Ittner, Larcker, & Meyer, Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard, 2003). One article stated that the targets for the performance should be set externally to decrease the noise and bias in the targets (Murphy, 2001).
24 The use of financial performance measures is also associated with an increase in short-term financial performance. An argument for the use of financial performance measures is that when managers are rewarded based on certain measures they will increase their efforts to attain better results on these measures. Managers who were rewarded on certain measures did not seem to let other
performance decline indicating that managers will focus on the measures they are being evaluated on while still keeping their other results at the same level (Hirsch, 2010).
According to many researchers, using financial performance measures focuses too much on the short term performance of the company (Ittner, Larcker, & Meyer, Subjectivity and the
Weighting of Performance Measures: Evidence from a Balanced Scorecard, 2003). A myopic view on performance can also cause morals to drop and eventually hurt corporate performance (Hirsch, 2010). In order not to forget about the long-term it is recommended that financial performance measures be supplemented by alternative measures that give an incentive to focus on the long term (Ittner, Larcker, & Rajan, The Choice of Performance Measures in Annual Bonus Contracts, 1997). The measures that are found to increase long-term thinking include: shareholding by management, evaluation based on stock performance and delayed payment (Bushman & Smith, Financial accounting information and corporate governance, 2001).
An alternative incentive plan based on a fixed payment did not seem to increase
performance and hence is not a good method to solve the principal-agent problem. An alternative that does show some promise was the inclusion of non-financial performance measures in the incentive plan. Customer satisfaction turned out to be a good indicator of future performance (Ittner & Larcker, Are Nonfinancial Measures Leading Indicators of Financial Performance? An Analysis of Customer Satisfaction, 1998).The use of non-financial performance measures is associated with increased complexity in reporting (Ittner, Larcker, & Meyer, Subjectivity and the Weighting of Performance Measures: Evidence from a Balanced Scorecard, 2003).
One of the pitfalls of this thesis is that it is a literature research. In order to come up with definitive answers it is recommended to conduct a large scale empirical research that will test all the relationships between the use of financial performance measures and performance.
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