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