The Financial Performance Measures Accounting Essay

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During the last years, more and more attention is paid to the bonus structure of CEOs of large multinationals. CEO bonuses has become an international issue debated in the parliament and routinely featured in front-page headlines, cover stories, and television news shows. Several factors have contributed to the widespread interest in CEO bonuses. Firstly, the compensation of CEO has risen sharply during the last decades (Murphy, 1999). Secondly, some firms in the Netherlands were in real trouble during the financial crisis, they needed financial help from the government, but their CEOs still got a bonus (Hooft van Huysduynen, 2011). But since the rules about CEO compensation were completely unclear for companies which needed financial help from the government, more debates were held in the government and rules were changed frequently. This contributed to the widespread interest of the subject of executive compensation in The Netherlands (de Horde, 2011). And lastly, there has also been an explosion in academic research on executive compensation, which contributed to the rosen interest of CEO bonus-structure (Murphy, 1999).

CEO compensation

The compensation packages negotiated with chief executive officers (CEOs) of large corporations mostly contains four basic components: a base salary, an annual bonus tied to accounting performance, stock options, and long term incentive plans (including restricted stock plans and multi-year accounting-based performance plans) (Murphy, 1999). The incentive component often is comprised of both an annual bonus plan and a long-term incentive plan, where the payoffs from these plans depend on an intricate portfolio of performance measures (Bushman et al, 1996). The compensation committee can choose different performance measures, including stock return, accounting return and non-financial measures, to determine how much of each form of compensation the CEO will earn (Krolick, 2005).

Paying CEOs based on short run accounting profits provides incentives to increase short-run profits (by, for example, cutting R&D) even if doing so reduces value in the long run. Conceptually, the "perfect" performance measure for a CEO is the CEO's personal contribution to the value of the firm. This contribution includes the effect that the CEO has on the performance of others in the organization, and also the effects that the CEO's actions this year have on performance in future periods. Unfortunately, the CEO's contribution to firm value is almost never directly measurable; the available measures will inevitably exclude ways that the CEO creates value, and include the effects of factors not due to the efforts of the CEO, or fail to reveal ways that the CEO destroys value (Murphy, 2013).

A long line of literature has argued that compensation should be related to performance. The reasons for the linkage are both normative and positive. In a normative sense, compensation is considered fair if it has been ''earned'' through superior performance. In a positive sense, agency theorists argue that linking compensation to firm performance measures provides incentive to increase firm value (Balsam, 2002; Lewellen and Huntsman, 1970; Murphy, 1985).

Financial performance measures

Financial performance measures consists of measures of cash flow, net income, earnings-per-share, sales, economic value added, return on invested capital, return on assets, return on equity, return on sales, stock price return and cost reduction (Ittner et al, 1997). The literature documents that financial accounting measures, especially measures of profitability, are extensively used in executive compensation contracts. There is evidence of widespread, explicit use of profitability measures in the annual bonus plans and in the long-term performance plans of corporate executives. The implicit use of profitability measures in the board of director's evaluation and compensation of top officers is supported by a robust, positive statistical relation between profitability measures and various measures of executive pay, including managerial turnover probabilities (Bushman and Smith, 2001). The most important reason of using financial performance measures instead of using nonfinancial measures, is that financial targets are cheaper and easier to measure, since all companies are already mandatory to publish a balance sheet and an income statement (Epstein, 2006).

Paul (1992) shows that stock price need not provide efficient incentives in a multi-task setting because price captures the value of the firm rather than the value-added by the manager. Ittner et al (1997) argues that financial measures alone may not provide the most efficient means to motivate managers to act in the manner desired by the firm's owners. While companies use a variety of financial and non-financial performance measures in their annual CEO bonus plans, almost all companies rely on some measure of accounting profit such as net income, pre-tax income, or operating profit. Accounting profit measured over short intervals is not, however, a particularly good measure of the CEOs contribution to firm value, for several reasons. First, CEOs routinely make decisions (such as succession planning or R&D investments) that will increase long-run value but not short-run profit. Second, accounting profits (like equity-based measures) are invariably influenced by factors outside of the control of the CEO, including the effects of business cycles, world oil prices, natural disasters, terrorist attacks, etc. Third, while the measures of accounting profits typically used in bonus plans take into account both revenues and expenses, they ignore the opportunity cost of the capital employed. The use of these accounting measures provides incentives to invest in any project that earns positive accounting profits (not just those that earn more than the cost of capital), and provides no incentives to abandon projects earning positive accounting profits that are less than those required to cover their cost of capital (Murphy, 2013).

Non-financial performance measures

Non-financial performance measures consists of measures of employee satisfaction, product or service quality, efficiency or productivity, employee safety, market share, non-financial strategic objectives, process improvements and re-engineering, new product development, innovation, employee development and training, workforce diversity, leadership and customer satisfaction (Ittner et al, 1997). Recent evidence indicates that firms are increasingly using non-financial performance measures such as customer satisfaction and product quality in the contracting process within firms (Ittner et al, 1997). Prior literature shows that nonfinancial performance can compensate for "noise" and "goal incongruence" of financial performance measures. Another desirable contracting attribute of nonfinancial measures is their ability to predict future performance and to facilitate intertemporal matching between current investments and future returns (Matejka et al., 2009). Non-financial performance measures are assumed to facilitate the board's assessment of private managerial information so it can more closely monitor the executive decision-making process (Schiehll and Bellavance, 2009). The reason for the use of non-financial measures in compensation contracts is that they provide information incremental to accounting measures in rewarding and motivating managers (Davila and Venkatachalam, 2004).

Financial Crisis

Pearson and Clair (1998) developed a definition for organizational crisis': ''An organizational crisis is a low-probability, high-impact event that threatens the viability of the organization and is characterized by ambiguity of cause, effect, and means of resolution, as well as by a belief that decisions must be made swiftly.'' Several examples of organizational crisis' are: Extortion, Bribery, Hostile takeover, Information sabotage, Terrorist attack, Executive kidnaping, Product recall, Natural disaster that destroys corporate headquarters (Pearson and Clair, 1998).

The financial crisis started in September 2008. Various causes of the financial crisis have been cited, including lax regulation over mortgage lending, a growing housing bubble, the rise of derivatives instruments such as collateralized debt obligations, and questionable banking practices (Kothari and Lester, 2012). This research is focusing on this financial crisis, which started in September 2008, and is still continuing at the moment of writing this dissertation.

Ittner et al. (1997) argues that as the noise in financial measures increases, firms tend to place more weight on non-financial measures. At the other side, Matejka et al. (2009) find that profit urgency and financial distress (which make financial performance measures more congruent with firm goals) are associated with a lower emphasis on nonfinancial performance measures.

Hypothesis development

Although previous literature us not consistent the use of non-financial performance measures in times of financial crisis, more recent research (Matejka et al., 2009) leads to the assumption that the use of non-financial performance measures in CEO bonus contracts will drop during the current financial crisis. Based on this assumption, the next hypothesis is developed:

Hypothesis 1: The use of non-financial performance measures in CEO bonus contracts has been decreased from 2005 to 2010, due to the impact of the financial crisis.

III. Methodology

This section describes the research methods used to investigate the empirical association between the financial crisis and the use of non-financial performance measures.

Sample

A target sample of 27 firms is identified from Dutch companies listed on the Amsterdam Exchange Index (AEX) at the beginning of the year 2013. No distinction is made between different sectors, all AEX-listed companies were taken in the sample.

Data collection

Data was collected from proxy statements in annual reports in two different years. To measure the effect of the financial crisis, the first year which had been measured is 2005, since during 2005 no influence of the financial crisis could be perceived. The second year which is used to collect data, is the year 2010. 2010 has been chosen because it was in the middle of the financial crisis and all data is now available from this year. This research studies the relative weights placed on financial and non-financial performance measures in chief executive officer (CEO) bonus contracts (Ittner et al, 1997). This method is similar to the method adopted by Ittner et al (1997) and used by Schiehll and Bellavance (2009).

Variables

The empirical model of this research will be as follow:

Y = α + β1Xi +β2Xi

Where Y will contain the dependent variable use of non-financial performance measures, β1 will represent the situation of the use of a non-financial performance measure in 2005 (0 will represent the use of a financial performance measure in 2005, and 1 will represent the use of a non-financial performance measure in 2005), β2 will represent the situation of the use of a non-financial performance measure in 2010 (0 will represent the use of a financial performance measure in 2010, and 1 will represent the use of a non-financial performance measure in 2010), and Xi contains the firm.

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