Final 5 30 October 2019, questions and answers PDF

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CHAPTER 20: MANAGEMENT COMPENSATION, BUSINESSANALYSIS, AND BUSINESS VALUATIONQUESTIONS20-1 The key objective of the firm is to develop management compensation plans that support the firm’s strategic objectives: 1. To motivate managers to exert a high level of effort to achieve the firm’s goals. 2. T...

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

CHAPTER 20: MANAGEMENT COMPENSATION, BUSINESS ANALYSIS, AND BUSINESS VALUATION QUESTIONS

20-1 The key objective of the firm is to develop management compensation plans that support the firm’s strategic objectives: 1. To motivate managers to exert a high level of effort to achieve the firm’s goals. 2. To provide the right incentive for managers, acting autonomously, to make decisions that are consistent with the firm’s goals. 3. To fairly determine the rewards earned by the manager for their effort and skill, and for the effectiveness of their decision making. 20-2 Management compensation includes one or more of the following: salary, bonus, and benefits or perquisites (“perks”). Salary is a fixed payment, while a bonus is based upon the achievement of performance goals for the period. Perks include special services and benefits for the employee, such as travel, membership in a fitness club, life insurance, medical benefits, tickets to entertainment events, and other “extras” paid for by the firm. 20-3 Risk aversion is the tendency to prefer decisions with assured outcomes over those with uncertain outcomes. It is a relatively common decision-making characteristic of managers. A risk-averse manager is biased against decisions that have an uncertain outcome, even if the expected outcome is favorable. The risk-averse manager prefers choices with certain outcomes to choices with more favorable outcomes which are not certain. The effect is that certain decisions that would be preferred by top management might be rejected by the manager because of the manager’s risk aversion. Compensation plans can be adapted to deal with risk aversion by, for example, making sure that a significant part of total compensation is salary, which is not subject to risk. Other means include rewarding the manager for achievement of critical success factors, such as an investment in a promising new research area, in addition to the financial measures which compensation is typically based upon (such as earnings or earnings per share).

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-4 Management compensation plans designed to motivate managers can have undesired unethical effects. The presence of very strong motivation due to a compensation plan, without compensating accounting controls designed to detect and prevent fraud, can lead to unethical behavior. Examples include sales-based bonuses that create incentives for fraudulent or incorrectly timed sales. Examples of compensating controls include reviews and reconciliations to confirm sales are legitimate and correctly timed (in a class discussion of the question, the instructor can have the class develop a list of possible ways that the different compensation plans can promote or reduce the incentive for unethical behavior). The best method to reduce the potential for unethical behavior is explained in Chapter 1: adopting and adhering to the Institute of Management Accountants Code of Ethics.

20-5 From a financial reporting standpoint, the most desirable form of compensation is deferred payment plans, which delay the expense on the income statement. 20-6 From the standpoint of taxes paid by the individual manager, the least desirable forms of compensation are ones which have immediate tax consequences. These include salary increases and cash bonuses. The most desirable form of compensation is perks, which are not shown as income (subject to limitations set out by the Internal Revenue Service for certain types of perks). The most desirable form of compensation from the standpoint of the firm is also perks as well as salaries or cash bonuses, since they are deductible immediately for tax purposes. 20-7 The three bases for incentive bonus plans are stock price, a strategic performance measurement systems (cost, revenue, profit, or investment center), and the balanced scorecard. See Exhibit below:

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

Advantages and Disadvantages of Bonus Compensation Bases Bonus Base Stock Price

Strategic Performance Measures (cost, revenue, profit, and investment center)

Balanced Scorecard (Critical Success Factors)

Motivation (+/-) depends on whether stock and stock options are included in base pay and/or bonus (+) aligns management compensation with shareholder interests (+) strongly motivating if noncontrollable factors are excluded

(+) strongly motivating if noncontrollable factors are excluded (+) aligns management compensation with long-term shareholder interests

Right Decision (+) consistent with shareholder’s interests

Fairness (-) lack of controllability

(+) intuitive, clear, and easily understood (-) measurement issues: differences in accounting conventions, cost allocation methods, financing methods, etc. (+) if carefully (+) consistent with defined and management’s measured, CSFs strategy (-) may be subject to are likely to be inaccurate reporting perceived as fair (-) potential of financial and measurement nonfinancial issues, as for measures strategic performance measures (see Ch. 19) (+) generally a good measure of economic performance (-) typically has only a short term focus (-) if bonus is very high, can cause inaccurate reporting

Key: (+) means the base has a positive effect on the objective; (-) means the base has a negative effect on the objective.

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-8 The six financial ratios used in the evaluation of liquidity are: The first and second ratios are the accounts receivable and inventory turnover ratios which measure the firm’s ability to manage two important elements of current assets - accounts receivable and inventory. The lower the balance in these accounts relative to sales, the less cash will be tied up in these accounts, and therefore the more cash the firm will have to pay its current obligations. The greater these ratios, the better, and the higher the evaluation of the firm’s liquidity. A third measure is the current ratio, current assets divided by current liabilities, which measure the firms’ short-term ability to pay operating expenses. The fourth measure, the quick ratio, is a very short-term measure of liquidity, since the relatively less liquid inventory is not included. The fifth measure, the cash flow ratio (cash flow from operations to current liabilities) The sixth measure, free cash flow ratio (net free cash flow divided by current liabilities) measures the effect of the firm’s free cash flow on liquidity. 20-9 The two types of bonus pools are unit-based and firmwide. The unit-based pool is determined from earnings in the unit only, while the firmwide pool is determined from the earnings of the aggregate firm. See below: Advantages and Disadvantages of Different Bonus Pools

Unit-Based

Firm-Wide

Motivation (+) strong motivation for an effective manager the upside potential (-) unmotivating for manager of economically weaker units (+) helps to attract and retain good managers throughout the firm, even in economically weaker units (-) not as strong a motivation for the individual manager as the unit-based pool

Right Decision (-) provides the incentive for individual managers not to cooperate with and support other units, when needed for the good of the firm (+) effort for the good of the overall firm is rewarded motivates teamwork and sharing of assets, etc, among units

Fairness (-) does not separate the performance of the unit from the manager’s performance

(+) separates the performance of the manager from that of the unit (+) can appear to be more fair to shareholders and others who are concerned that executive pay is too high

Key: (+) means the pool has a positive effect on the objective; 20-4

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

(-) means the pool has a negative effect on the objective. 20-10 The four types of bonus payment options are current cash bonus, deferred bonus, stock options, and performance shares. See Exhibit below: Advantages and Disadvantages of Different Bonus Payment Options Motivation (+) strong motivation for current performance; stronger motivation than for deferred plans

Right Decision (-) short term focus (-) risk averse manager avoids risky but potentially beneficial projects

Deferred Bonus

(+) strong motivation for current performance, but not as strong as for the current bonus plan, since the reward is delayed (+) tax advantages of deferred compensation

(-) same as for current bonus`

Stock Options

(+) unlimited upside potential is highly motivating (-) delay and uncertainty in reward reduces motivation somewhat (+/-) same as for stock options

(+) incentive to consider longer-term issues (+) provides better risk incentives than for current or deferred bonus plans (+) consistent with shareholder interests (+) incentive to consider long-term issues that affect stock price (+) consistent with the firm’s strategy, when critical success factors are used (+) consistent with shareholder interests, when earnings per share is used

Current Bonus

Performance Shares

Fairness (+/-)depends on the clarity of the bonus arrangement and the consistency with which it is applied (-) difficult to measure economic performance in one or a few financial measures (-) simple measures are easily manipulated by managers (+/-) as for current bonus (-) difficult to measure economic performance in one or a few financial measures (-) simple measures are easily manipulated by managers (+/-) as above, plus (-) uncontrollable factors affect stock price

(+/-) depends on the clarity of the bonus arrangement and the consistency with which it is applied (-) difficult to measure economic performance in one or a few financial measures (-) simple measures are easily manipulated by managers

Key: (+) means the payment option has a positive effect on the objective; (-) means the payment option has a negative effect on the objective. 20-5

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-11 This question is intended for class discussion. There are a number of possible views on this question. The goal of the discussion should not be to determine the equity of a certain level of executive pay, but rather to show the ethical issue as a potentially important factor in developing management compensation plans. The firm and the management accountant who is developing the compensation plan should be sensitive to the concerns of shareholders and other constituents of the firm. 20-12 The five methods discussed in the chapter for directly measuring the value of a firm include: book value of equity, market value of equity (market capitalization), the discounted cash flow method, multiples-based valuation, and enterprise value. The book value method takes the amount of equity from the balance sheet. This method has the advantage of being based on reliable numbers but the disadvantage of being based on historical numbers, which may not reflect current value. The market value method is the most simple and direct. The value of the firm is determined from the number of outstanding shares multiplied by the current market price of the shares. The discounted cash flow (DCF) method develops the value of the firm as the discounted present value of the firm’s net free cash flows. It has the advantages that (1) it considers the time value of money and the cash flows from operations, and (2) it is not subject to the same effects of different accounting policies as are the book value of equity method. This is the most commonly used method when the share price is not available or is unreliable. The multiples-based method computes value as the product of expected annual sales, earnings, or cash flow times a multiplier. There is a different multiplier for each accounting measure: sales, earnings, or cash flow. When the earnings multiplier is used, the multiplier is often estimated from the price-toearnings ratios of the stocks of comparable publicly-held firms, and then adjusted for discounting. The earnings multiplier has important limitations. It is based on accounting earnings, and is therefore subject to the limitations of accounting earnings. The advantage is that the earnings multiplier is easy to apply. The enterprise value method takes market capitalization, adds debt and subtracts cash to arrive at an amount that would approximate the price of the whole firm in an acquisition. In practice, it is common for the management accountant or analyst to use two or more of the valuation techniques and to evaluate the assumption in each in order to arrive at an overall valuation assessment. 20-13 Bonuses are the fastest growing part of total compensation. The growth of interest in bonus plans is likely the result of firms’ increasing competition for the very best executive talent. Also, shareholders prefer bonus plans to other forms of compensation, since, when the managers perform well the shareholders benefit as well as the managers. 20-6

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-14 The goal of strategic cost management is the success of the firm in maintaining competitive advantage, so it is important to evaluate the overall performance of the firm, as well as that of each of the individual managers. 20-15 The firm’s strategy changes as its product(s) move through the different phases of the sales life cycle - product introduction, growth, maturity, and decline (the sales life cycle is covered in Chapter 13). As a firm’s product moves from the growth phase to the maturity phase, the firm’s strategy might also move from product differentiation to cost leadership. When this happens, the compensation plan should change in response to the new strategy. The exhibit below illustrates how the mix of the three types of compensation (salary, bonus, perks) might change as the firm and its products move through different phases of the sales life cycle.

Compensation Plans Tailored for Different Strategic Conditions Product Sales Life Compensation Plan Cycle Phase Salary Bonus Benefits First: Product High Low Low Introduction Second: Growth Low High Competitive Third: Maturity Competitive Competitive Competitive Fourth: Decline High Low Competitive Key to Exhibit: “Competitive” lies between low and high.

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

BRIEF EXERCISES

20-16 Answer: b - to reduce the taxes of the firm and employee Note: a, c, and d are the three key objectives of management compensation

20-17 Answer: d - Perks From a tax perspective, perks are best for the firm and the employee since they provide a tax deduction for the firm and are not taxed to the employee (note, however, that the 2017 Tax Cuts and Jobs Act disallows the deductibility of certain perks and reduces that of others)

20-18 Economic Value Added

= EVA-based Net Income – Cost of Capital x EVA-based Invested Capital = $200,000 – (10% x $750,000) = $125,000

20-19 DCF Value

= PV of cash flows + marketable securities – market value of debt = $400,000 + $150,000 – $250,000 = $300,000

20-20 Multiples-Based Valuation = Earnings Multiplier x Earnings = 7 x $250,000 = $1,750,000 20-21 Gross Profit Margin = _Gross Profit_ Net Sales = _$250,000_ $1,500,000 = 16.67% Percentage Achievement = _16.67%_ 10% = 167%

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

20-22 Inventory Turnover = _Cost of Goods Sold_ Average Inventory = ______$400,000______ ($50,000 + $70,000) / 2 = _$400,000_ $60,000 = 6.67 Percent Achievement

= 6.67 / 6 = 111%

20-23 Market Value of Equity = Stock Price x # Shares Outstanding = $25 x 100,000 = $2,500,000

20-24 Answer: a Business valuation and business analysis are defined at the heading, Business Analysis and Business Valuation. Business analysis is defined as the use of the balanced scorecard, economic value added, and financial ratios to assess the performance of a company. In contrast, business valuation directly values a firm through the use of stock price, discounted cash flow, and/or cash flow or earnings multiples.

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Chapter 20 - Management Compensation, Business Analysis, and Business Valuation

EXERCISES 20-25 Compensation, Strategy, and Market Value (20 min) Response: A. Measurement (the firm is not measuring customer service properly); Strategic causal linkage (customers are looking for other things before customer service) Jackson Supply is experiencing the anomaly of achieving its strategic goals (customer service) while the stock price is falling relative to competitors. The most likely explanations can be explored with the following two questions: 1. Is the firm properly measuring customer service? Perhaps more direct and effective measures are needed. 2. Could it be that investors do not value the firm’s customer service goals? The investors may be looking for cost reduction, for production diversification and innovation, supply-chain management innovation, or other strategic initiatives. What are competitors doing? The firm might benefit from consulting with industry experts or financial analysts that specialize in medical supply. In the end, Jackson Supply must realize that its ultimate strategy must be to satisfy shareholders, and the specific goals that are chosen, such as customer service, must be linked to that strategy. Success is judged by investors and not by top management.

20-26 Evaluating an Incentive Pay Plan; Strategy (15 min) Response: B. No, because the plan is likely to reduce profits Unless Fox is rewarded significantly by the boat manufacturers for volume of sales, the current incentive plan is likely to reduce profits by increasing sales at the expense of profit margins. Sales representatives’ incentives are to sell as many boats as possible, and since reducing the price will help them to achieve this goal, they are 20-10

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