Accounting-Based Incentive Definition
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 company’s 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.
A Little More on What is an Accounting-Based Incentive
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 company’s 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.
References for Accounting Based Incentives
Earnings-based bonus plans and earnings management by business-unit managers1, Guidry, F., Leone, A. J., & Rock, S. (1999). Earnings-based bonus plans and earnings management by business-unit managers1. Journal of accounting and economics, 26(1-3), 113-142. This study tests the bonus-maximization hypothesis that managers make discretionary accrual decisions to maximize their short-term bonuses. By using the management and financial reporting database of a large conglomerate, we extend previous investigations in two ways. First, the analysis is conducted using business unit-level data, which reduces the aggregation problem that is likely to arise using firm-level data. Second, managers in this setting are paid bonuses based solely on business unit earnings. The potentially confounding effects of long-term performance and stock-based incentive compensation are thus absent. These innovations yield robust evidence consistent with Healy (1985).
Assessing empirical research in managerial accounting: a value-based management perspective, Ittner, C. D., & Larcker, D. F. (2001). Assessing empirical research in managerial accounting: a value-based management perspective. Journal of accounting and economics, 32(1-3), 349-410. This paper applies a value-based management framework to critically review empirical research in managerial accounting. This framework enables us to place the exceptionally diverse set of managerial accounting studies from the past several decades into an integrated structure. Our synthesis highlights the many consistent results in prior research, identifies remaining gaps and inconsistencies, discusses common methodological and econometric problems, and suggests fruitful avenues for future managerial accounting research.
Contextual analysis of performance impacts of outcome-based incentive compensation, Banker, R. D., Lee, S. Y., Potter, G., & Srinivasan, D. (1996). Contextual analysis of performance impacts of outcome-based incentive compensation. Academy of Management journal, 39(4), 920-948. This study investigated how contingency factors such as competitive intensity, customer profile, and behavior-based control influenced the effectiveness of an outcome-based incentive plan supporting a customer-focused service strategy. Empirical analyses were based on data for 77 months from 34 outlets of a major retailer, 15 of which implemented the incentive plan. Results support theoretical predictions: the positive impact of outcome-based incentives on sales, customer satisfaction, and profit increased with intensity of competition and proportion of upscale customers and decreased with level of supervisory monitoring.
Corporate tax-planning effectiveness: The role of compensation-based incentives, Phillips, J. D. (2003). Corporate tax-planning effectiveness: The role of compensation-based incentives. The Accounting Review, 78(3), 847-874. This study investigates whether compensating chief executive officers and business‐unit managers using after‐tax accounting‐based performance measures leads to lower effective tax rates, the empirical surrogate used for tax‐planning effectiveness. Utilizing proprietary compensation data obtained in a survey of corporate executives, the relation between effective tax rates and after‐tax performance measures is modeled and estimated using a two‐step approach that corrects for the endogeneity bias associated with firms’ decisions to compensate managers on a pre‐ versus after‐tax basis. The results are consistent with the hypothesis that compensating business‐unit managers, but not chief executive officers, on an after‐tax basis leads to lower effective tax rates.
Managerial ownership, accounting choices, and informativeness of earnings, Warfield, T. D., Wild, J. J., & Wild, K. L. (1995). Managerial ownership, accounting choices, and informativeness of earnings. Journal of accounting and economics, 20(1), 61-91. This article hypothesizes that the level of managerial ownership affects both the informativeness of earnings and the magnitude of discretionary accounting accrual adjustments. The hypothesis draws on the theory of the firm, and exploits: (1) separation of ownership from control of economic decisions, (2) the extent and consequences of accounting-based contractual constraints, and (3) managers’ incentives in selecting and applying accounting techniques. Results show managerial ownership is positively associated with earnings’ explanatory power for returns and inversely related to the magnitude of accounting accrual adjustments. Moreover, ownership is less important for regulated corporations, suggesting regulation monitors managers’ accounting choices.
Incentives versus standards: properties of accounting income in four East Asian countries, Ball, R., Robin, A., & Wu, J. S. (2003). Incentives versus standards: properties of accounting income in four East Asian countries. Journal of accounting and economics, 36(1-3), 235-270. The East Asian countries Hong Kong, Malaysia, Singapore and Thailand provide rare insight into the interaction between accounting standards and the incentives of managers and auditors. Their standards derive from common law sources (UK, US, and IAS) that are widely viewed as higher quality than code law standards. However, their preparers’ incentives imply low quality. We show their financial reporting quality is not higher than under code law, with quality operationalized as timely recognition of economic income (particularly losses). It is misleading to classify countries by standards, ignoring incentives, as is common in international accounting texts, transparency indexes, and IAS advocacy.
Taking care of business: Executive compensation in the United Kingdom, Conyon, M., Gregg, P., & Machin, S. (1995). Taking care of business: Executive compensation in the United Kingdom. The Economic Journal, 105(430), 704-714.
Financial reporting incentives for conservative accounting: The influence of legal and political institutions, Bushman, R. M., & Piotroski, J. D. (2006). Financial reporting incentives for conservative accounting: The influence of legal and political institutions. Journal of Accounting and Economics, 42(1-2), 107-148. This paper explores financial reporting incentives created by an economy’s institutional structure. The underlying premise of our analysis is that a country’s legal/judicial system, securities laws, and political economy create incentives that influence the behavior of corporate executives, investors, regulators and other market participants. Further, such incentives ultimately shape the properties of reported accounting numbers. We empirically analyze relations between key characteristics of country-level institutions and the asymmetric recognition of economic gains and losses into earnings (i.e., conditional conservatism). We also provide evidence on channels through which specific institutions manifest their influence on observed conservatism.
Innovations in performance measurement: Trends and research implications, Ittner, C. D., & Larcker, D. F. (1998). Innovations in performance measurement: Trends and research implications. Journal of management accounting research, 10, 205.
A field study of the impact of a performance-based incentive plan, Banker, R. D., Lee, S. Y., & Potter, G. (1996). A field study of the impact of a performance-based incentive plan. Journal of Accounting and Economics, 21(2), 195-226.Much management accounting research focuses on design of incentive compensation contracts. A basic assumption in these contracts is that performance-based incentives improve employee performance. This paper reports on a field test of the multi-period incentive effects of a performance-based compensation plan on the sales of a retail establishment. Analysis of panel data for 15 retail outlets over 66 months indicates a sales increase when the plan is implemented, an effect that persists and increases over time. Sales gains are significantly lower in the peak selling season when more temporary workers are employed.