Accounting Based Incentive - Explained
What is an Accounting Based Incentive?
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Table of ContentsWhat is an Accounting-Based Incentive?A Little More on What is an Accounting-Based IncentiveBenefits and Drawbacks of Accounting-Based IncentivesReferences for Accounting Based Incentives
What is an Accounting-Based Incentive?
An accounting-based incentive is a type of compensation that is offered to C-level executives (high-ranking executives) of business firms based on certain long-term performance indicators set by the companys management. Typically, key performance indicators include (but are not restricted to) earnings per share (EPS), capital gains, cash flow, return on assets and gross profits. Accounting-based incentives are part of a performance incentive plan that offers rewards to executives in the form of cash bonuses or company equity or both. The primary objective of such incentives is to establish financial accountability of executives over the long term and ensure their participation in future performance improvement processes as a way to increase shareholder value of the company.
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How is an Accounting-Based Incentive Used?
Accounting-based incentives as a norm, gauge the direct contributions of company executives in enabling the company to reach certain predetermined earnings targets as well as Return on equity (ROE). These incentives usually constitute a significant proportion of an executive's compensation. Typically, the management of a company considers the following three criteria for evaluating accounting-based incentives:
- Salary levels of individual executives.
- Appraisal of firm-wide performance
- Appraisal of performance of specific business units.
Benefits and Drawbacks of Accounting-Based Incentives
Rewarding company executives with accounting-based incentives has its own share of benefits. For starters, such incentives are tax deductible to the company and as such, offer tax savings. Secondly, accounting-based incentives do not affect shareholder equity. Finally, accounting-based incentives can go a long way in aligning shareholder interests with executive compensation. On the other hand, there are certain disadvantages to the practice of accounting-based incentives as well. Since such compensation plans often rely heavily on a multitude of performance measurements, the overall process of bonus calculation becomes highly complicated. Secondly, there exist several types of executive compensation plans such as long and short term incentives and stock options. This makes it difficult for company management to select the compensation plan that best serves shareholder interests. Thirdly, financial metrics are not reliable tools to measure changes to a companys value. In other words, it is possible for a company to indicate a phenomenal growth in its earnings per share (EPS), while at the same time, using real relative losses or negative real returns to lower the value of the company for its shareholders. Lastly, its is often a risky decision to peg executive compensation to firm performance. In the event that executives fail to meet performance targets, the share price of the company is liable to fall. For decades, accounting-based incentives have been the reward of choice for businesses to offer to their high-performing executives. At the same time, a fair amount of research has gone into assessing the gradual evolution of performance parameters as well as the definition of commercial success in general. Nevertheless, all such studies have concluded that incentive compensation is majorly determined by the success in streamlining employee and executive performance targets with shareholder objectives, and adopting accounting measures as the preferred basis for comparison. However, accounting-based incentives are often a controversial subject. For starters, CEO compensation has shown an exponential growth in the past few decades, compared to the pay of typical workers. This has significantly widened the wealth gap between executives and workers, leading to widespread resentment amongst the latter. In fact, the topic of income inequality has been so fiercely debated by the media in the US and UK that many CEOs from these two countries have actually refused to accept accounting-based incentives and other similar perquisites. Paying executives in company stock has other disadvantages. Executives receiving such incentives are often wrongly motivated to concentrate on events that only affect share prices in the short term, instead of focusing on long-term planning and general stability of the business.