The difference between value-in-use and the fair value shows the value of management’s performance. Thus, if the value-in-use is higher than the fair value of the assets, it shows that the market expects management to create excess returns.

In the real world where market conditions are not necessarily perfect and complete we face two problems. First, assets and liabilities must be valued at fair value. This is usually possible for assets and liabilities which are traded on liquid market markets or where similar assets and liabilities are traded on liquid markets. Financial instruments, standard vessels or downtown offices may be examples of such assets and liabilities. However, for many types of assets and liabilities market values are not available. This includes the value of a brand, a claim and specialized plant and equipment. Hence a balance sheet based on fair value can only rarely be prepared. Second, the value-in-use must be estimated by management, where management has private information and may exercise discretion in its estimation. Thus, the measurement of the value creation in general and management’s contribution to the value creation specifically is not a trivial task when market conditions are imperfect and incomplete.

An effective incentive plan has the following characteristics:

• Congruence (criterion 1)
• Controllability (criterion 2)
• Simplicity (criterion 3)
• Accounting issues (criterion 4)

1. Choice of performance measure(s)
   1. Does it support the firm’s strategy?
   2. How can it be avoided that management focuses solely on short term performance?
   3. Should an incentive plan be based on one or multiple performance measures?
2. Choice of performance standards
   1. Should performance be based on internal or external standards?
   2. Should incentives be based on reported earnings, budgets or some other measures when internal standards are used?
   3. What are proper benchmarks for external standards?
   4. What are the pros and cons of internal and external standards?
   5. How and when should the performance standard be calibrated?
3. Choice of pay to performance structure
   1. Should the incentive be linearly tied to performance without an upper/lower limit?
   2. Should bonus be non-linear with a minimum (floor) and a maximum (cap)?
   3. Should bonus be paid as a lump sum?

Typically measures based on accounting numbers – examples include revenue, EBITDA and EBIT

Typically measures based on financial ratios – examples include ROIC, ROE and EVA

Single period performance measures including absolute as well as relative performance measures.

Multiple period performance measures such as shareholder value added discussed in chapter 3.

Single period performance measures are usually simple and easy to calculate and are based on audited accounting numbers. However, single period performance measures provide management with incentives to focus on short-term performance, which in the compensation literature is defined as the ‘horizon problem’. Value creation, however, is a long-term phenomenon. Multiple period performance measures address the horizon problem. However, a multiple period performance measure such as SVA must usually be estimated by management, where management has private information and may exercise discretion in its estimation.

There is a need to consider non-recurring items on a case by case basis.

Ideally the impact of changes in accounting policies and estimates on the performance measure used should be eliminated.

Exemplified by earnings per share (EPS):

• An increase in earnings per share should have a positive effect on firm value
  • EPS does not take into account risk and investments
  • EPS depends on applied accounting policies
  • EPS is affected by share buy-backs
  • If maximisation of EPS is the objective, then every investment pays, as long as it generates a return above the borrowing rate

• Consistent with value creation
• Cost of capital becomes visible
• Simple to communicate
• General applicability
  • Based on past earnings; does not consider future earnings
  • Prone to accounting distortion (can be avoided by using change in EVA)
  • Does not take the horizon problem (single vs. multi period performance measures) into consideration
  • May not be easy to communicate to lay men

“Internally determined” standards are directly affected by management actions in the current or prior year.

• Budget standards
• Prior-year standards
• Cost of capital
• Discretionary standards
• Timeless standards

External standards are standards which are defined in relation to elements outside the firm and include benchmarking against competitors.

The following represents pay to performance structure candidates:

1. Linearity between performance and bonus
2. Non-linearity with a minimum and a maximum bonus
3. A lump sum bonus

A linear pay to performance relation (i.e. linear relation with no cap or floor) avoid problems with earnings management. However, there may be other issues - such as to whether pay can be negative or extremely large (as compared to common standards).

A bonus bank separates the calculation of bonus from its actual payment. The basic idea is that bonuses are not being paid in full unless a satisfactory performance is obtained in subsequent years.