Executive Incentives vs. Corporate Growth

There is growing concern about the likelihood of a slowdown in the long-term growth of the U.S. economy. The rate and adequacy of the economy’s growth depends on three factors: capital investment, improvements in labor productivity, and advances in technology.

While research and development expenditures as a percentage of gross national product have steadily declined in the United States during the past decade, just the reverse has taken place in other economically advanced countries like West Germany and Japan. Our declining leadership in technology lowers productivity, slows growth in employment, and spurs inflation.

The situation with respect to capital spending is not much more encouraging. While the headlines proclaiming a capital shortage crisis have mostly disappeared, industry’s need over the next decade to replace a substantial amount of outdated and shopworn capital equipment, as well as to expand its facilities, remains. The most recent economic problems of the steel industry serve as a reminder that the United States has the lowest ratio of capital investment to GNP and the highest percentage of obsolete production capacity among the major industrialized countries.

Most discussions by businessmen, economists, and public officials concerning the inadequate investment in innovation and productive facilities emphasize the crucial role of government in improving the situation. Invariably they urge adoption of investment incentives like higher tax credits and more liberal capital recovery allowances. Frequently they recommend less stringent regulation, particularly in the environmental control area. Finally, business seeks a greater degree of stability in government policy.

While such government initiatives would no doubt increase investment to more satisfactory levels, American business would do well to reexamine its own self-administered incentive systems in its search for ways to improve the long-term performance of individual companies and the economy as a whole.

American corporation management’s preoccupation with short-term financial results, particularly current-period reported earnings per share, is an important contributor to the lag in R&D investment and capital spending. Clearly, decisions based largely on short-term results, without taking into account the expected long-term consequences, can be economically inefficient from the viewpoint of both the company and the economy. What is economically rational from the corporate or social viewpoint may, however, be an irrational course of action for the executives charged with the decision making. If their incentives conflict with the longer-term view of economic efficiency, we can expect their resource allocation decisions to be “rational” but inefficient.

Short-Term Rewards vs. Long-Term Risks

Before I offer recommendations to improve the situation, let me examine two issues more closely: first, the shortcomings of EPS as a measure of business performance; second, the question of why, despite these shortcomings, management continues to employ EPS as a primary basis for decisions.

Shortcomings of EPS

In the minds of some, a rise in a company’s EPS represents unimpeachable evidence of the effectiveness of decisions made by its top executives. Those more familiar with the accountant’s financial reporting model recognize that many factors affecting the company’s future earning power are not reflected in the EPS figure. In fact, well-conceived decisions based on detailed projections of the future and proceeding according to expectations may, in the short term, produce lower reported EPS.

Capital investment and R&D expenditure decisions that involve a delay in generating revenues are prime examples of the “good decision—lower earnings” dilemma. The importance that management attaches to near-term earnings can in some cases dictate a deliberate bypass of better investment opportunities.

There is also a “poor decision-higher earnings” phenomenon. The conglomerate merger movement is replete with precipitately arranged acquisitions that, with the benefit of pooling-of-interests accounting, instantaneously pumped up reported EPS. Many of these acquisitions of the 1960s became prime candidates for divestiture in the 1970s. Arbitrary reductions in R&D, advertising, employee development programs, and other discretionary developmental outlays all contribute to higher earnings in the short term, but may adversely affect future earning power.

Motivation of managers

Why do managers continue to use short-term EPS as an essential criterion for decision making? Managers, like other people, act in their self-interest. After all, the theory of a market economy is based on individuals’ promotion of their self-interest via market transactions to bring about an efficient allocation of resources.

Conventional economic theory, however, may be viewed as a theory of the behavior of principals.¹ No market transaction takes place unless both principals expect to gain. In a world of agents (for example, managers) in which principals (for example, stockholders) have imperfect control over their agents, the latter may not always engage in transactions solely in the best interests of the principals. Agents have their own interests and it may sometimes pay them to sacrifice the others’ interests. The problem is complicated in large corporations, where it is difficult to identify the interests of principals because of the heterogeneous preferences held by a diverse set of stockholders ranging from institutional investors to individuals with miniscule holdings.

What then are top management’s “interests”? They, no less than the interests of other organizational participants, consist of a complex psychological bundle incorporating such notions as self-actualization, esteem, and power. Managers also have a strong sense of economic interests. These are conditioned not only by the desire to accumulate and consume wealth but also by the psychological benefits stemming from economic achievement.

The executives’ economic welfare is affected primarily by the company’s compensation plans and the market value of its stock insofar as market value is regarded as a key index for evaluating administrative performance. Let us then examine the “rational” resource allocation behavior of managers in light of prevailing executive compensation plans and the perceived behavior of the stock market.

Compensation plan astigmatism

The annual Business Week survey of executive compensation shows that bonuses for the top three executives of major corporations are closely tied to the previous year’s reported earnings. In a profitable year like 1976, bonuses can double the executive’s base salary. Usually the extra pay is highly leveraged—that is, once earnings reach an acceptable performance level, bonuses escalate rapidly. Business Week reported that in 1976 executive salaries increased 14.7%, while bonuses increased 67.1% over 1975.²

At the division level, bonus awards are generally determined on one of the following bases:

1. Absolute division profits or ROI.

2. Division profit improvement.

3. Profit performance compared with that of the company’s industry.

4. Achievement of a profit target or plan.

These incentive plans are powerful motivators not only because of the bonus feature, but also because these indexes help determine who will win promotion and reap the financial rewards linked to greater organizational responsibilities. In light of such incentives and the fact that the division executive usually remains in his or her position for only three to five years, he is compelled to concentrate on short-run results and adopt policies that may discourage growth and acceptance of reasonable risk. The ambitious person expecting a promotion in the next two or three years may abide by two guidelines for decisions concerning discretionary outlays of developmental funds: the risk must be low, and the project should yield a significant portion of its return in the next two or three years.

To this assertion his superiors might respond that a good manager will not only achieve this year’s financial performance target but also provide for the future vitality of the business. Top executives, however, reveal their preferences to subordinates not by what they say but by what they do. In light of the dominant performance evaluation systems employed for incentive bonuses and promotion, the attitude of many divisional managers can be summed up as: “It’s fine to talk about the long run, but I won’t be here in the long run if I don’t do something about the short run.”

Some businessmen and economists believe that the emphasis on short-run profits and ROI is one major reason why corporate capital spending has been slow to recover after the 1974–1975 recession.

Stock market myopia

Because investors and securities analysts use stock market price as an index for assessment of managerial performance, corporate executives are naturally deeply concerned about the value that the market attaches to the stock of their companies. As everyone knows, a sustained period of poor price performance relative to prices of competitors’ stock can lead to the replacement of incumbent management or provoke an unfriendly takeover attempt.

Of course, the economic interests of management are also tied to stock price to the extent that their personal wealth is invested in company stock and in stock options. Also the top officers are concerned insofar as the price affects the company’s cost of capital.

Conventional wisdom suggests that stock ownership by management not only induces the executives to identify with the shareholders’ economic interests, but also is a compelling long-term incentive. Indeed, it might be argued that stock ownership guarantees the congruence of incentives with the long-term view of economic efficiency (which assesses decisions in terms of the present value of estimated future cash flows).

This is not necessarily so. Whether it is rational for an executive to behave as an economic-oriented decision maker, with a long-term view of economic efficiency, or an accounting-oriented decision maker, with a short-term view, depends on:

• The perceived economic importance of short-term incentive compensation plans compared with the amount of stock held by the executive outright or in options. If he perceives the rewards from his company’s plan to be greater than the expected future dividends and capital gains resulting from decisions made with a long-term horizon in mind, personal economic rationality dictates that the manager act as an accounting-oriented, not an economic-oriented, decision maker.

• The length of his motivational time horizon. The manager who plans to leave the organization because of retirement or for some other reason, or who expects to sell his stock soon, is likely to behave as an accounting-oriented decision maker.

• The extent to which the company plans to use new equity to finance its growth. The greater the proportion of equity, the greater is management’s concern about near-term market price. Stock price dictates the “admission charge” to future shareowners. Obviously the higher the charge, the better off the present shareholders are.

• The manager’s beliefs about how stock prices are formulated. He may believe that they are based mainly on reported EPS. Or he may believe that they reflect all publicly available information relevant to an assessment of the company’s activities and prospects. (As such, he is a believer in so-called “market efficiency.”)

The executive who believes that, in setting today’s stock price, the market not only looks at the company’s currently reported earnings but also assesses the expected future returns from R&D and capital expenditures is more likely to adopt an economic-oriented resource allocation posture than the nonbeliever in market efficiency.

So in many situations management has powerful incentives to avoid taking risks when the expected benefits are delayed. Would anyone normally expect the manager’s and the stockholder’s viewpoints on risk to diverge?

It is reasonable to expect that corporate executives, acting only as economic agents, have a lower tolerance for risk than do stockholders. Why? Because managers generally operate under an “asymmetrical reward function”—that is, the penalties of failing to meet some minimum performance standard appear to be much greater than the uncertain rewards for exceeding that standard. Moreover, if the company invests in a risky project, stockholders can always balance this risk against other risks in their presumably diversified portfolios. The manager, however, can balance any project failure only against the other activities of the division or the company.

Harmonizing the Diverse Interests

Excessively risk-averse, play-it-safe decision making by corporate managers does not bode well for the long-term performance of the U.S. economy. Fortunately, there are many groups—boards of directors, top management, accounting policy bodies, the financial press, and the government—that can play a role in shaping a system that makes resource allocation decisions more consistent with both the interests of stockholders and the long-term performance of the economy. In the balance of this article I shall discuss steps that corporate officers, accounting policy bodies, and the government can take.

Corporate approaches

Corporate directors represent the critical link between principals and agents in the corporate governance framework. Creating incentives for efficient resource allocation enables the board to fulfill its obligations not only to stockholders but also to broader social interests. Corporate boards meet their social responsibilities best when they look after the continuing vitality of the companies they serve, for this vitality is what provides dividends and capital gains for investors, interest for creditors, job opportunities for employees, improved products and services for consumers, and economic stability.

Executive compensation and long-range planning are two areas of increasing concern to boards. The linking of compensation packages to long-range plans represents an opportunity for boards to induce management to allocate resources in a manner more consistent with long-term economic efficiency. Admittedly, the design problems are not trivial, but the potential rewards should justify the efforts required.

At least three approaches exist for obtaining better integration of management incentives and strategic planning:

1. The extended performance evaluation period approach.

2. The strategic factors approach.

3. The management accounting approach.

In the extended performance evaluation approach, the company compensates managers for achieving certain performance levels over several years rather than just for one. A performance share plan amounts to a deferred stock award that is contingent on reaching a given earnings growth target, usually over a three-to five-year period. The performance unit plan is similar to the performance share type except that the executive receives the value of the shares, not the stock itself, at the beginning of the evaluation period.³

A number of companies, including Kraft and CBS, have recently adopted extended performance evaluation plans. Even so, only a small portion of major corporations use them; in its 1977 survey of top executives’ compensation, McKinsey & Company reported that only 89 of 597 surveyed companies, or about 15%, used long-term, performance-based plans during 1976.

A second means of tying managerial incentives more closely to long-range plans is the strategic factors approach. This involves identification of the strategic factors governing future profitability, periodic measurement of the progress achieved in accomplishing each goal, and incorporation of the results in incentive packages. Depending on a company’s circumstances, the strategic factors may include such items as target market share, productivity levels, product quality measures, product development measures, and personnel development measures.

Incentives based in part on strategic factors promise not only to reduce the current emphasis on short-run profits at the potential expense of long-run earning capacity, but also to encourage more careful development of long-range plans by management and, in turn, more systematic monitoring of them by the directors. In this way, the board can evaluate top management’s ability to make plans as well as implement them.

A third avenue for improving incentive compensation systems is what I call the management accounting approach. The determined profit and investment bases used for profit center and investment center (ROI) performance evaluation almost invariably conform to financial accounting standards governing reports to stockholders. In contrast, the management accounting approach considers the motivational implications of accounting measurement and hence adjusts, rather than uncritically adopts, the financial accounting model for the company’s internal purposes.

Consider the case of R&D expenditures. Financial accounting standards dictate immediate expensing of all R&D outlays. To encourage executives to take reasonable business risks, the management accounting approach could call for capitalizing certain outlays and expensing them gradually in subsequent periods. Alternatively, profit might be calculated before R&D; thereby the evaluation of development costs would be separated from current operations.

As another illustration, consider the case of capital investment and the related depreciation expense. Many companies take accelerated depreciation for both book and tax purposes. While the main purpose in granting accelerated tax write-offs was to spur capital spending, use of accelerated depreciation in a business unit’s profit calculation may do just the reverse. Indeed, the management accounting approach might entail less rather than more depreciation during the initial years of the investment.

The foregoing approaches only illustrate the directions that corporations can take in designing management incentive systems likely to improve long-term performance. There may well be better ways. At any rate, management incentive systems should become a high priority item for board study and deliberation now.

Chief executives, in their roles as outside directors as well as in their own companies, have a unique opportunity to take the lead in calling for reconsideration of incentive systems at the board level. Organizations such as The Business Roundtable, the Committee for Economic Development, and The Conference Board may wish to conduct research on the potential costs and benefits of different incentive approaches.

Scope of accounting

There is a growing recognition that the establishment of financial accounting standards that govern what business corporations must report (that is, disclosure issues) and what measures they must use to describe their economic operations (that is, measurement issues) must be viewed more broadly than just from a technical accounting perspective. The intense interest of the business community and federal government in the subject is prompted by the belief that the setting of accounting standards can have far-reaching economic consequences. Financial Accounting Standards Board (FASB) and SEC pronouncements can affect the behavior of both the users and providers of financial reports.

Financial accounting standards, particularly disclosure requirements, obviously can affect stockholders’ and other investors’ decisions and thus alter a company’s stock price. Unions may use financial accounting reports as a basis for labor negotiations; regulatory bodies may use them as a basis for antitrust regulation, rate regulation, and environmental protection regulation; and competitors, suppliers, and customers may base their strategies on financial accounting disclosures. In addition, a corporation’s financial accounting numbers serve as an essential data base for the aggregate statistics that describe the state of the economy and, in turn, help form the basis for macroeconomic policy making.

Many of the claimed consequences of accounting standards arise when top management, anticipating adverse feedback from reported operating results, changes the company’s resource allocation decisions.⁴ A number of issued and proposed FASB statements have come under sharp criticism for their dysfunctional effects on managerial resource allocation. Here are some examples:

• Critics of Statement No. 2 contend that mandatory expensing of R&D costs creates a disincentive toward R&D investment among those companies that formerly capitalized a portion of such investment.

• Critics of Statement No. 5 claim that elimination of self-insurance reserves induces companies to purchase uneconomical insurance in order to stabilize the pattern of reported earnings.

• Critics of Statement No. 8 contend that the inclusion of foreign currency gains and losses in operating profit obliges multinational companies try to avoid fluctuations in reported earnings by engaging in uneconomical hedging transactions.

• Critics of the proposed Statement No. 19, requiring oil companies to charge off the costs of dry holes immediately instead of spreading them over several years, insist that this standard will discourage entry and exploration efforts by smaller companies. This result, in turn, assertedly will lessen competition in the industry and aggravate the energy crisis.

Some would contend that any accounting standard that causes undesirable economic consequences represents bad accounting. The business community has consistently criticized the FASB for its “insensitivity” to the economic consequences of its pronouncements. In its April 1977 report, the Structure Committee of the Financial Accounting Foundation recommended that the FASB include economic impact analyses in future exposure drafts of accounting standards. An analysis would presumably estimate how the proposed rule would affect the securities markets, corporate policy, and the economy.

Adoption of this step should be encouraged. The effort should not, however, distract attention from perhaps the most significant cause of economic consequences—management’s incentive structure and its resulting preoccupation with short-run financial results, particularly earnings. Without passing judgment on the merits of particular accounting standards, I suggest that corporations direct their attention away from the FASB and SEC and toward the compensation committees of their boards of directors.

Fuller disclosure

Accounting policy bodies can further the cause of efficient resource allocation by encouraging companies to supplement financial statements with forward-looking information. The less information and more uncertainty there is surrounding a company’s future prospects, the greater the importance attached to current earnings.

In 1977 the Advisory Committee on Corporate Disclosure to the SEC charted some directions for this type of disclosure. The committee recommended that the commission move away from its traditional policy of permitting disclosure of only “hard” information (that is, objectively verifiable facts) and continue its recently initiated movement toward permitting the disclosure of selected “soft” information (like opinions, predictions, analyses, and other subjective evaluations).

To encourage responsible experimentation with disclosure of soft information, the committee proposed a voluntary program with a “safe harbor” rule to provide legal liability protection unless the disclosure was found to have no reasonable basis or to have been made in bad faith.

To enable the investment community to relate financial results to assessment of the amounts, timing, and uncertainties of future cash flows, the committee recommended:

1. Explanation of material increases or decreases in discretionary items such as R&D, advertising, and maintenance expenses.

2. Disclosure of contingencies known to management that would cause reported financial statements to fail to indicate likely directions of future operating results or financial position, as well as matters affecting reported statements that are not expected to have an impact on future statements of the company.

3. Voluntary disclosure of earnings projections with an explanation of management’s plans and the assumptions underlying the projections.

4. Voluntary disclosure of planned capital expenditures for the current fiscal year and the succeeding four-year period, including amounts related to environmental control facilities.

Disclosure of this type, coupled with redesigned managerial incentive systems, should go far toward producing more efficient allocation of resources. It would also enable the financial press to move away from its sometimes myopic concentration on earnings per share, which only reinforces the conviction of shareowners and boards of directors that reported earnings represent the essential corporate performance evaluation criterion.

Government initiatives

No discussion of resource allocation can be complete without taking into account the coercive power of government regulation and its attendant ability to effect significant redistribution of wealth among various groups. Corporate executives are increasingly sensitive to the political costs associated with reported financial results.⁵ Accounting numbers, such as profits and ROI, have become politicized to a point where lobbying groups, as well as government officials, sometimes use them simplistically and irresponsibly.

Accounting numbers are commonly used to support a conclusion already reached rather than to reach a conclusion previously unknown. Labels such as “obscene profits,” rather than sound analysis, are loosely employed to call for the nationalization, breakup, or regulation of companies and industries.

While politicians may feel compelled to develop simple “solutions” which their constituencies can easily understand, they must recognize the social costs of their actions. Social costs materialize when companies allocate resources suboptimally while trying to produce results that minimize the chance of unfavorable government reaction.

Unfortunately, the political sector lacks the securities market’s incentives to be an efficient processor of corporate information. Elected representatives are motivated by votes, and appointed regulators often depend on elected representatives.

A strong effort to compel the federal government to issue economic impact studies for its legislative and regulatory initiatives could lessen our precarious dependence on the altruism of government officials. At the same time, the business community should conduct more rigorous analyses of estimated regulatory impact and avoid the simplistic rhetoric of accounting numbers.

New Life for the Entrepreneurial Spirit

American production capacity is growing lethargically. We have witnessed a gradual deterioration in the ability of some sectors of the economy to produce goods and services profitably. Compared with those of other industrialized nations, our federal tax policies have provided an inadequate impetus for increasing the capital available for investment. These tax policies, coupled with regulatory and environmental restrictions, often place a heavy burden on economic growth.

Government action could improve the climate for investment, but it alone cannot do the job. Corporate policy is shaped by managers’ decisions on behalf of the corporation. As one would expect in a market economy, they assess issues in terms of personal economic rationality. The challenge lies in designing incentive systems that induce executives to make decisions congruent with the long-term economic interests of the company—and, eventually, of the economy.

Ideally, restructured management incentives would offer the best of two worlds by reintroducing the risk-taking, entrepreneurial spirit characteristic of our earlier history without sacrificing the systematic cost-benefit approach to decision making that is a hallmark of contemporary professional management.

1. See Harvey Leibenstein, Beyond Economic Man (Cambridge: Harvard University Press, 1976), p. 6.

2. Business Week, May 23, 1977, p. 48.

3. See James F. Carey, “Successors to the Qualified Stock Option,” HBR January–February 1978, p. 140.

4. For a more comprehensive description of this process, see Prem Prakash and Alfred Rappaport, “Information Inductance and Its Significance for Accounting,” Accounting, Organizations and Society, Vol. 2, No. 1, 1976, p. 29.

5. For an empirical analysis of this proposition, see Ross L. Watts and Jerold L. Zimmerman, “Towards a Positive Theory of the Determination of Accounting Standards,” Accounting Review, January 1978, p. 112.