CHAPTER 12 PowerPoint Presentation by Incentive Issues LuAnn Bean Professor of Accounting Florida Institute of Technology © 2012 Cengage Learning All Rights Reserved May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use Managerial Accounting 11E Maher/Stickney/Weil ☼ CHAPTER GOAL ☼ Chapter 12 discusses issues in design and use of management performance evaluation and incentive plans to motivate managers to act in the organization’s best interests Good performance evaluation and incentive plans induce “win-win” results if they avoid incentives for fraudulent financial reporting LO PAY INCENTIVES Managers Managers receive receive bonuses bonuses for for performance performance that that may may be be based based on on divisional divisional or or corporate corporate results results Bonuses Bonuses may may be be based based on on annual annual performance performance or or on on performance performance over over several several years years and and may may be be paid paid immediately immediately or or deferred deferred and and spread spread over over several several years years LO MANAGERS WANT TO KNOW! What forms divisional incentives take? How will performance be evaluated? Divisional incentives can be cash or profit sharing for short-term performance; stock or stock options as deferred compensation; and special awards Performance can be evaluated based on accounting numbers, returns to stockholders or both DESIGNING INCENTIVE COMPENSATION LO Management must ascertain two things in designing incentive systems: What behavior does the system motivate? What behavior does management desire? WARNING! Rewarding managers for performance reflected in annual accounting numbers gives managers incentives to take actions that make the numbers look good but not actions that benefit the organization INCENTIVES and PRODUCT LIFE CYCLE LO A A major major problem problem with with short-run short-run incentive incentive plans plans is is that that managers managers are are penalized penalized for for developing developing products products that that might might produce produce long-run long-run benefits benefits Under Under U.S.GAAP, U.S.GAAP, firms firms write write off off research research and and development development costs costs when when incurred incurred IFRSs IFRSs do not not require require as as much much write-off write-off as as U.S U.S GAAP GAAP LO PRODUCT LIFE CYCLE: Stages Four stages of the product life cycle are: Design and development: low sales but high research, design and development costs Growth Maturity Decline LO EXPECTANCY EXPECTANCY THEORY: THEORY: Definition Definition Maintains that people act in ways to obtain rewards they desire and prevent penalties they wish to avoid LO AGENCY AGENCY THEORY: THEORY: Definition Definition Deals with relations between supervisors and workers and assumes employees will not necessarily behave as their employers desire LO The Theobjective objectiveof ofaa good goodincentive incentive compensation compensationisistoto minimize minimizeagency agency costs costs EXHIBIT 12.2 10 LO MANAGERS WANT TO KNOW! What are extrinsic rewards ? What are intrinsic rewards ? Extrinsic rewards come from outside the individual, i.e., the supervisor, etc Intrinsic rewards come from inside the individual such as satisfaction for a job well done 11 LO BALANCED BALANCED SCORECARD: SCORECARD: Definition Definition Is a model of lead and lag indicators of performance including both financial and nonfinancial performance measures 12 BALANCED SCORECARD PERSPECTIVES LO Four perspectives of the balanced scorecard approach are: Learning and growth Internal business and production process perspective Customer Financial 13 LO INCENTIVE QUESTION Should Should rewards rewards be be based based on on current current or or future future performance? performance? An An advantage advantage to to basing basing on on future future performance performance is is the the “golden “golden handcuffs” handcuffs” that that tie tie managers managers to to the the company company Most Most companies companies use use aa combination combination of of current current and and deferred deferred rewards rewards 14 LO INCENTIVE QUESTION Should Should rewards rewards be be based based on on division division or or company-wide company-wide performance? performance? When When based based on on the the manager’s manager’s responsibility responsibility center center alone, alone, itit focuses focuses the the attention attention without without considering considering the the impact impact of of their their actions actions on on the the whole whole company company Most Most companies companies use use both both 15 LO INCENTIVE QUESTION Should Should rewards rewards use use aa fixed fixed formula formula or or subjective subjective judgment judgment in in providing providing rewards? rewards? The The advantage advantage of of aa formula-based formula-based plan plan is is that that managers managers know know what what is is expected expected and and what what reward reward they they will will get get ifif they they meet meet expectations expectations 16 LO INCENTIVE QUESTION Should Should rewards rewards be be based based on on accounting accounting results results or or stock stock performance? performance? Tying Tying managers’ managers’ compensation compensation to to stock stock performance performance loads loads uncontrollable uncontrollable risk risk on on them them Using Using EVA EVA both both focuses focuses managers managers on on creating creating value value for for shareholders shareholders and and relies relies on on nonstock nonstock performance performance measures measures 17 LO INCENTIVE QUESTION Should Should rewards rewards be be based based on on absolute absolute or or relative relative performance performance evaluation? evaluation? Relative Relative performance performance compares compares divisional divisional performance performance with with other other divisions divisions in in the the same same industry industry with with less less than than optimum optimum comparisons comparisons 18 LO INCENTIVE QUESTION Should Should rewards rewards be be cash, cash, stock stock or or prizes? prizes? Many Many companies companies use use aa combination combination because because of of the the different different (current (current vs vs deferred) deferred) methods methods of of reward reward Expectancy Expectancy theory theory finds finds prizes prizes more more attractive attractive and and more more motivating motivating 19 LO FRAUDULENT FRAUDULENT FINANCIAL FINANCIAL REPORTING: REPORTING: Definition Definition Is intentional conduct resulting in materially misleading financial statements 20 LO TYPES OF FRAUD Fraudulent financial reporting usually falls into two categories: Improper revenue recognition Firm reports profit in wrong accounting period Overstating inventory Increases reported earnings in period of overstatement In absence of continuing overstatement, must result in reduced earnings in next period 21 LO INTERNAL INTERNAL CONTROL: CONTROL: Definition Definition Is a process designed to provide reasonable assurance that an organization will achieve its objectives in (a) operating effectiveness and efficiency; (b) reliability of financial reporting; and (c) compliance with applicable laws and regulations 22 LO INDEPENDENT AUDITORS Independent audits Are required by the SEC for firms selling securities across state lines Help prevent fraud through reviews of internal controls 23 LO CORRUPTION According to economists, three elements that must be present for corruption to occur are: Individual must have discretionary power to award contract or rights Economic benefits are associated with discretionary power Legal system must be unlikely to detect wrongdoing 24 End of CHAPTER 12 25 ...☼ CHAPTER GOAL ☼ Chapter 12 discusses issues in design and use of management performance evaluation and incentive plans to motivate managers to act in the organization’s... based based on on accounting accounting results results or or stock stock performance? performance? Tying Tying managers’ managers’ compensation compensation to to stock stock performance performance... advantage advantage to to basing basing on on future future performance performance is is the the “golden “golden handcuffs” handcuffs” that that tie tie managers managers to to the the company