Academic journal article Journal of Managerial Issues

The Effectiveness of Long-Term Accounting-Based Incentive Plans

Academic journal article Journal of Managerial Issues

The Effectiveness of Long-Term Accounting-Based Incentive Plans

Article excerpt

Considering the growing criticism of large executive compensation packages in the popular press, further discussion of the effectiveness of compensation plans in general is timely and relevant. Recently, compensation consultants and academics have argued against the use of accounting-based compensation. [1] In a survey of top level executives and compensation consultants, Rich and Larson (1984) found dissatisfaction with accounting-based incentive plans because these plans do not target "appropriate" variables.

Still, compensation plans based on accounting-based performance goals make up a large share of executive remuneration, and are used by a large proportion of firms. Studies conducted by Murphy (1985) show that, on average, salary plus bonus make up 80% of executive compensation. Also, about 35% of firms surveyed by the Conference Board use long-term accounting-based performance plans (The Conference Board, 1995, 1996). So, why do firms continue to use accounting-based compensation plans?

The goal of this study is to examine whether long-term accounting-based compensation plans (also called performance plans) actually contribute to future performance improvements. Our sample consists of 175 firms that adopted long-term performance plans between 1971 and 1980. Based on prior research, we focused on two specific accounting variables that these contracts tend to target--earnings per share growth and return on equity. We use an industry-based benchmark to evaluate these contract target variables. We find that in the years prior to plan adoption, firms generally perform at or below the industry median level, and following plan adoption, the adopting firm's contract target variables are significantly higher than the industry median.

To examine whether the performance changes are driven by efficiency improvements rather than risk shifting or earnings manipulation, we test for changes in asset risk and operating returns, an efficiency variable that is difficult to manipulate. We find that the performance improvements do not appear to be driven by risk shifting or earnings manipulation. In addition, the performance improvements do not appear to be driven by the stock-based components that some of these plans contain. The findings are consistent with the hypothesis that accounting-based incentive compensation effectively aligns the interests of the shareholders and management.

The review of typical performance plans (below) sets the stage for the research. This is followed by the sample description and research methodology. The analyses and the results that follow lead to the conclusions with implications for research and practice.

REVIEW OF PERFORMANCE PLANS

Executive compensation plans can be classified according to the type of performance variables that these plans target. The first group is the stock Price-based plans, which include compensation components such as stock options, stock appreciation rights, phantom stock, stock dividend units, and restricted stock. The second group is comprised of the accounting performance-based plans, which include compensation components such as annual salary adjustments, yearly bonuses, and long-term performance plans. While some salary and bonus plans may be somewhat arbitrary (possibly based on both stock price and accounting variables), performance plans explicitly target specific accounting measures of performance over a specified time period. The performance plan award period generally ranges from three to six years.

Performance plans are of two types, depending on how the executive earns the reward, which is either in cash ("performance unit plans") or in shares ("performance share plans"). Under a performance unit plan, at the beginning of the award period a given number of units with a fixed dollar value for each unit are reserved for each executive. At the end of the award period the executive's remuneration is the number of units actually earned and awarded times the predetermined dollar value per unit. …

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