Module 8: Performance measurement and compensation

Transcription

1 file:///f /Courses/ /CGA/MA2/06course/m08intro.htm Module 8: Performance measurement and compensation Overview In Module 8, you evaluate the effects of different performance measurement methods on your analysis of corporate strategies and strategic business units. You also look at how different performance measurement methods are used in evaluating management and operations. The module provides examples of compensation related to performance measurement outcomes, and relates this to ethical issues in executive compensation packages for senior management. Test your knowledge Begin your work on this module with a set of test-your-knowledge questions designed to help you gauge the depth of study required. Assignment reminder Assignment 3 (see Module 9) is due at the end of week 9 (see Course Schedule). You are encouraged to review it now so that you are familiar with the requirements as you work through Modules 8 and 9. Topic outline and learning objectives 8.1 Financial and nonfinancial performance measures Outline the need for financial and nonfinancial performance measures. (Level 1) 8.2 Accounting-based performance measures Describe how accounting-based performance measures are designed. (Level 2) 8.3 Responsibility centres and performance measures Determine how different business units are evaluated. (Level 1) 8.4 Return on investment, residual income, and economic value added, and return on sales Recommend appropriate profitability measures based on an understanding of return on investment, residual income, economic value added, and return on sales. (Level 1) 8.5 Time horizon of performance measures Determine the effect of time horizon on performance measures. (Level 2) 8.6 Alternative measurements of assets Calculate the effects on performance measures of different measurement alternatives for assets. (Level 2) 8.7 Selecting performance goals and timing of feedback Describe the effects of targeted levels of performance and timing of feedback on performance evaluation. (Level 2) 8.8 Global performance measurement Describe the effects of performance measurement systems on subunits of multinational enterprises. (Level 2) 8.9 Evaluation of managers and organizational units Describe how performance evaluation of managers relates to performance evaluation of organizational subunits. (Level 2) 8.10 Executive performance measures and compensation Describe how salaries, performance incentives, and executive compensation affect an organization s strategy. (Level 2) file:///f /Courses/ /CGA/MA2/06course/m08intro.htm (1 of 2) [09/09/2010 1:58:03 PM]

2 file:///f /Courses/ /CGA/MA2/06course/m08intro.htm 8.11 Performance measures and fraud Explain how moral hazard and adverse selection can result in performance measures that lead to management fraud, and describe the impact of IFRS on performance measurement. (Level 1) Module summary Print this module file:///f /Courses/ /CGA/MA2/06course/m08intro.htm (2 of 2) [09/09/2010 1:58:03 PM]

3 file:///f /Courses/ /CGA/MA2/06course/m08t01.htm 8.1 Financial and nonfinancial performance measures Learning objective Outline the need for financial and nonfinancial performance measures. (Level 1) Required reading Chapter 24, page 1138 (to Accounting-Based Performance Measures) LEVEL 1 Management uses performance measurement to evaluate subunits. The board of directors uses performance measurement to determine senior management bonuses and compensation. Performance measurement systems are a critical component of a company s management control system because they provide the feedback companies need to evaluate the effectiveness and efficiency of their corporate and business-level strategies. Effective management control systems also promote effective management behaviour and encourage alignment with organizational goals. However, in the age of global corporations, it has become more difficult to evaluate managers and operations in parts of the world where they may be facing different economic situations. Many organizations supplement traditional financial-based performance measures because financial-based measures can be manipulated through accounting policy choices such as depreciation or inventory valuation are lag, not lead, indicators, representing the results of the past period do not represent the important asset of intellectual capital, and do not represent some important goals, such as customer satisfaction in a service organization. The Balanced Scorecard uses both financial and non-financial measures to assess performance. The scorecard s customer, internal business, and learning and growth perspectives use nonfinancial measures. Companies whose business success depends on nonfinancial as well as financial results need to know whether they have the capabilities to successfully address these perspectives. For example, corporate courier companies aim for on-time delivery to satisfy customers; however, customer satisfaction measures do not show up explicitly in figures of net income. The relationship between learning and growth, internal processes, and customer satisfaction will ultimately have an effect on financial results, providing management with more detail about how the financial results were formulated throughout the organization. file:///f /Courses/ /CGA/MA2/06course/m08t01.htm [09/09/2010 1:58:04 PM]

4 file:///f /Courses/ /CGA/MA2/06course/m08t02.htm 8.2 Accounting-based performance measures Learning objective Describe how accounting-based performance measures are designed. (Level 1) Required reading Chapter 24, page LEVEL 2 In designing accounting-based performance measures, management considers how each measure helps to achieve the organization s overall goals. Managers also identify how the measures promote management effectiveness and autonomy and how they help to create goal congruence. To begin the process of designing accounting-based performance measures, managers follow a six-step process (see Exhibit 24-1 on page 1139): Step 1: Determine variable(s) that are congruent with the company s financial goals. Step 2: Determine the time horizon that will provide effective feedback of each performance measure. Step 3: Define the variables that represent each measure. Step 4: Choose appropriate measurement methods. Step 5: Choose the criteria target against which to gauge performance. Step 6: Based on a level of urgency, determine the timing of feedback. (These steps are numbered for reference and not necessarily performed sequentially.) file:///f /Courses/ /CGA/MA2/06course/m08t02.htm [09/09/2010 1:58:04 PM]

5 file:///f /Courses/ /CGA/MA2/06course/m08t03.htm 8.3 Responsibility centres and performance measures Learning objective Determine how different business units are evaluated. (Level 1) LEVEL 1 In evaluating individual management and responsibility centres (Module 6), managers consider each segment or subunit separately. In your introductory management accounting course you learned that total costs can be subdivided into variable costs and fixed costs; fixed costs can be further subdivided into those that are controllable by managers (discretionary) and those that are not controllable (committed). Some costs are considered to be common costs and cannot be traced to a specific subunit. Consider the following example, in which two divisions of a company are evaluated by head office. Example 8.3-1: Performance evaluation Division A and Division B Management can make different decisions depending on which costs are included or excluded from the decision, as shown in the following exhibit. Exhibit 8.3-1: Segment margin Managers use contribution margin levels to make short-term decisions. Variable and discretionary fixed costs are under the manager s control. Companies often use contribution margin levels to evaluate management efforts in the short-term. Variable, discretionary, and committed costs are associated with a particular subunit and are used in evaluating long-run decisions, such as dropping a segment related to a specific subunit. Costs common to both units A and B are deducted from total costs because they relate to decisions that affect the overall profitability of the organization. file:///f /Courses/ /CGA/MA2/06course/m08t03.htm [09/09/2010 1:58:05 PM]

6 file:///f /Courses/ /CGA/MA2/06course/m08t04.htm 8.4 Return on investment, residual income, economic value added, and return on sales Learning objective Recommend appropriate profitability measures based on an understanding of return on investment, residual income, economic value added, and return on sales. (Level 1) Required reading Chapter 24, LEVEL 1 To be effective, measures used to evaluate organizational and management performance must meet the criteria of goal congruence, management evaluation, and manager autonomy. Return on investment (ROI), residual income (RI), economic value added (EVA), and return on sales (ROS) are the common measures used to evaluate financial performance. Return on investment Return on investment (ROI, also called the accounting rate of return) is the most widely used measure of evaluating performance. Return on investment = Income Investment Investment refers to the resources or assets used to generate income. The return-on-investment formula can be further subdivided into what is known as the Dupont formula by determining two additional ratios, the profit margin ratio and asset (investment) turnover. Return on investment = Income Revenues Revenues Investment This formulation expresses the return on investment as a function of a profit margin (Earnings/Sales) and an investment turnover (Sales/Investment). Here is the rationale behind this formulation: With the same profit margin, the higher the turnover, the higher the ROI. With the same turnover, the higher the margin, the higher the ROI. The return on investment becomes even higher if both factors are increasing. Example 8.4-1: Centre Media ROI and RI calculations This example illustrates ROI and RI for the three divisions of a multi-media company, and analyses the effects the different calculations would have on performance evaluation of the division managers. Exhibit 8.4-1: Centre Media Data and ROI for 20X8 fiscal year file:///f /Courses/ /CGA/MA2/06course/m08t04.htm (1 of 5) [09/09/2010 1:58:05 PM]

7 file:///f /Courses/ /CGA/MA2/06course/m08t04.htm Entertainment Telecom. Publishing Technology Data: Sales $120,000 $200,000 $200,000 Total assets 30,000 95,000 65,000 Income 6,000 18,000 8,780 ROI calculation: Return on sales (Income Sales) 5% 9% 4.39% X X X Investment turnover (Sales Investment) Return on investment 20% 18.9% 13.5% Entertainment ranks first, followed by Telecommunications and Publishing Technology. Compared to Telecommunications, Entertainment had a much lower return on sales but doubled its investment turnover. This may reflect different strategies employed by the two divisions or different market conditions. Entertainment's lower return on sales is consistent with a more competitive market than the market facing Telecommunications. Publishing Technology had the lowest return on sales but it reached a decent ROI with a medium investment turnover. Calculating return-on-investment income, which is based on accounting income, allows management to manipulate the financial statements through accounting policy choices. Further, a division manager could decide not to reinvest in new assets (assets will decline due to depreciation, all else being equal). This decision could increase return on investment but at the expense of investing in areas such as equipment upgrades and research and development. Residual income The following formulation converts accounting income into economic profit. RI = Income Capital charge = Income (Cost of capital Investment) By investing in the company, shareholders incur an opportunity cost (also called the imputed cost), which is profit forgone related to the next-best investment in another company. The formulation of the investment centre's profit should reflect the opportunity cost. The capital charge precisely measures the shareholders opportunity cost, and uses invested required rate of return as a surrogate for the opportunity cost. The cost of capital or the required rate of return, as commonly termed by management is the weighted average cost of capital (WACC) or the rate of return that the firm must pay the market to raise capital. (See pages for an example of how to calculate WACC.) The capital cost assigned to an investment centre may be different from that of the company as a whole, and its magnitude depends on the extent of risk incurred by the centre. An investment centre with a high risk will be attributed a higher cost of capital than a centre with a low risk. Use the data from Exhibit and assume the following required cost of capital is necessary. Entertainment = 15% Telecommunications = 18% Publishing Technology = 13.5% Exhibit 8.4-2: Centre Media Calculation of residual income file:///f /Courses/ /CGA/MA2/06course/m08t04.htm (2 of 5) [09/09/2010 1:58:05 PM]

8 file:///f /Courses/ /CGA/MA2/06course/m08t04.htm It is difficult to rank investment centres when they vary in size, as in this example. The investment in Telecommunications is more than 3 times the investment in Entertainment and almost 1.5 times that in Publishing Technology. According to RI, the ranking is: Entertainment, Telecommunications, Publishing Technology. This happens to be the same as in the ranking under ROI but ROI and RI do not necessarily provide the same ranking in practice. Entertainment's ROI exceeds its cost of capital; Telecommunications exceeds its cost of capital but not by much; and Publishing Technology's ROI is about equal to its cost of capital. Consider the following points: 1. Suppose that each investment centre receives an investment opportunity that would generate a certain return next year (20X9) of 18.9% on a $10,000 (in thousands of dollars) investment. If managers are evaluated and rewarded on the basis of ROI, which of them would accept it? Entertainment would not accept the investment proposal because its current ROI is 20% and an 18.9% return would lower the combined ROI. The ROI combining present operations with the proposal would be 19.7% [($6,000 + $1,890) ($30,000 + $10,000)]. By the same logic, Telecommunications would be indifferent to the proposal because its ROI is already 18.9%. Publishing Technology would accept it because its ROI is only 13.5%. 2. Suppose that each investment centre receives an investment opportunity that would generate a certain return next year (20X9) of 18% on a $10,000 (in thousands of dollars) investment. If managers are evaluated and rewarded on the basis of RI, which of them would accept it? Telecommunications would still be indifferent because the return is equal to its cost of capital. Entertainment would accept the investment because the return of 18% is greater than the capital cost of 15%. Depending on the size of expected increase in sales and income, in some cases the investment may further improve its ROI. Assuming that the capital charge under RI represents shareholders' opportunity cost of investing in Entertainment, the interests of Entertainment are now aligned with the shareholders' interests. The decision to reject the proposal based on ROI would not align with shareholders interests because the proposal increases residual income. In this case, Publishing Technology would still accept it, assuming that its income will remain at the same level, because the opportunity will improve its residual income. However, generally speaking, the improvement of its ROI ultimately depends on the additional sales and incremental income that the investment opportunity will generate. 3. Is it fair to impose different costs of capital on different investment centres? It is fair and appropriate if the investment centres face different risk factors within the industries or geographical locations in which they operate. The cost of capital assigned to Telecommunications is greatest but that division also has the greatest growth potential and associated risk. Economic value added Economic value added (EVA) is an elaborated extension of the residual income measure of performance. EVA is a technique for both planning (identifying high-return projects and redirecting resources to them) and control (formulating incentive compensation plans that promote long-term gain). The key to this concept lies in understanding the following calculations. The EVA formula is as follows: EVA = Adjusted accounting earnings (Weighted average cost of capital [WACC] Total capital) The adjusted accounting earnings are represented by net operating profit after taxes (NOPAT). Note: The footnote file:///f /Courses/ /CGA/MA2/06course/m08t04.htm (3 of 5) [09/09/2010 1:58:05 PM]

9 file:///f /Courses/ /CGA/MA2/06course/m08t04.htm on page 1143 recommends adjusting the profit as necessary, to provide a more accurate representation of assets used to earn income. This is also discussed in the following points. Total capital represents total assets less current liabilities WACC represents the after-tax average cost of all long-term funds used in the organization. The EVA formula can also be written as follows: EVA = adjusted NOPAT (WACC Total capital) As the following table shows, EVA is a type of residual income calculation. Economic value added EVA = NOPAT (WACC Assets minus current liabilities) Residual income RI = income (Cost of capital Investment) The amount deducted from actual or adjusted income is a capital charge in both EVA and RI; it is a hurdle that must be cleared in order for shareholders to earn a return above the opportunity cost of holding stock in the company. Under the EVA approach, however, more care is taken in adjusting income and in treating the capital charge. Pay particular attention to note 5 on the bottom of page 1143, which discusses several adjustments made to operating income and asset numbers based on GAAP. Expenses related to R&D, restructuring costs, and long-term leases included on the income statement prepared using International Financial Reporting Standards will also be adjusted. The following example illustrates how accountants calculate EVA. Work through the required before reading the solution. Example 8.4-2: Atlantic Division, EVA calculations Atlantic Division is an investment centre of Cuthbert Inc. The following information is available for the year ended December 31, 20X9. Assume that R&D costs for the year occur on January 1, 20X9. Capitalized development costs are amortized over a period of five years in GAAP income; research and development costs that were expensed in GAAP income are amortized over the same period when adjusting income for EVA. Exhibit 8.4-3: Cuthbert Inc. and Atlantic Division Cuthbert Inc. Marginal tax rate 40% Market yield on equivalent debt 12% Cost of equity 18% Capital structure (net of current liabilities) is one-quarter debt and three-quarters equity. Atlantic Division Net Operating 20X9 income before taxes $ 300,000 EVA-adjusted total capital, Dec. 31, 20X8 1,200,000 Research costs in 20X9 expensed under GAAP 50,000 Development costs in 20X9 expensed under GAAP 20,000 Development costs in 20X9 capitalized under GAAP 8,000 Impairment loss of goodwill attributed to Atlantic Division and included in its calculation of GAAP income 34,000 Required Calculate 20X9 EVA. Solution file:///f /Courses/ /CGA/MA2/06course/m08t04.htm (4 of 5) [09/09/2010 1:58:05 PM]

10 file:///f /Courses/ /CGA/MA2/06course/m08t04.htm In summary, RI and EVA are similar performance measures as both are based on the same conceptual formula. Both can be used to reduce agency problems by aligning the interests of managers and shareholders. Performance measures can be adjusted in various ways to provide different incentives for the managers being evaluated. As shown in Example 8.4-2, the EVA adjustment for R&D spending also encourages investment in intellectual capital as opposed to physical capital. Return on sales The income-to-revenue measure or return on sales (ROS), which measures the ability of management to control costs, is another frequently used measure. ROS is a partial measure used in the Dupont formula in evaluating total return on investment (ROI). ROS = Operating income Revenues file:///f /Courses/ /CGA/MA2/06course/m08t04.htm (5 of 5) [09/09/2010 1:58:05 PM]

11 file:///f /Courses/ /CGA/MA2/06course/m08t04sol.htm Example Solution Calculation of WACC as follows: After-tax cost of debt = 12% (1 0.4) = 7.2% WACC = 0.25(0.072) (0.18) = 15.3% (This is a simplified version of the following: Calculation of NOPAT: $ 300,000 Net operating income before taxes Add back R&D not capitalized under GAAP 70,000 Deduct 20X9 amortization of R&D*: ($70,000 5) (14,000) Add back impairment loss of goodwill included in 20X9 GAAP income 34,000 Adjusted net operating income before taxes NOPAT = $390,000 (1 0.4) = $234,000 $390,000 *No adjustment of the capitalized portion of development costs is needed. GAAP and EVA treatments of this item are the same. Calculation of EVA is as follows: EVA = NOPAT (WACC Total capital) = $234,000 (15.3% $1,200,000) = $50,400 The EVA for the benefit of shareholders (that is, the cash-on-cash yield generated by Atlantic Division) is $50,400. The EVA figure is used to evaluate the division's performance in the same way as RI (calculated using accounting income in accordance with GAAP). However, the EVA calculation changes the division manager's incentives with respect to spending on R&D. A net of $56,000 ($70,000 14,000) was added to GAAP income in the current period (20X9), which gave the manager more incentive to invest in R&D. This would not be the case with a GAAP-based RI calculation, which yields a lower figure. In this case, EVA relieves some of the pressure felt by the Atlantic Division manager to maximize short-run income. file:///f /Courses/ /CGA/MA2/06course/m08t04sol.htm [09/09/2010 1:58:06 PM]

12 file:///f /Courses/ /CGA/MA2/06course/m08t05.htm 8.5 Time horizon of performance measures Learning objective Determine the effect of time horizon on performance measures. (Level 2) Required reading Chapter 24, pages LEVEL 2 In Step 2 of the process of performance evaluation system design, companies review the time horizon being considered in ROI, RI, and EVA to determine how the timeline will affect managers decision making. Managers can make short-term decisions that have a positive impact on measures such as ROI but are harmful to the long-term viability of the organization. Since ROI can be positively affected by decreasing either costs or investments, a decrease in investments such as not updating to new technology will give a short-term rise in ROI but the decision can hurt the company s competitiveness in the long-run. Because results of investment in research and development will not show up in net income for many periods, management evaluation requires multi-period analyses. Many companies (especially in high-tech or biotechnology industries) therefore use multiple measures, including both net income and share price. Since potential shareholders consider investment in research and development positively, this type of investment is reflected in the share price, even though the effect does not show up in the current period s net income. A number of alternatives can be used when considering investment in the calculations of ROI, RI, and EVA: Total assets available all business assets, regardless of intended purpose Total assets employed total assets less idle assets and assets purchased for further expansion (for example, land held for future expansion) Working capital (current assets less current liabilities) plus long-term assets excludes current assets financed by short-term creditors Shareholders equity total assets less total liabilities Capital assets employed shareholders equity plus long-term liabilities Note: Unless instructed otherwise, for purposes of this course use the definitions provided in the textbook when making these calculations. file:///f /Courses/ /CGA/MA2/06course/m08t05.htm [09/09/2010 1:58:06 PM]

13 file:///f /Courses/ /CGA/MA2/06course/m08t06.htm 8.6 Alternative measurements of assets Learning objective Calculate the effects on performance measures of different measurement alternatives for assets. (Level 2) Required reading Chapter 24, pages (to Selecting Performance Goals and Timing of Feedback) LEVEL 2 In Steps 3 and 4 of performance evaluation system design, companies look at different ways to measure assets included in the investment calculation decisions. Choices include whether to use historical cost, present value, current cost, or current disposal cost, and whether long-term assets should be considered at gross or net book value. Note: The most commonly used definitions of investment are total assets available, or capital assets employed. Unless instructed otherwise, for assignment purposes, the version of assets to be used is determined by the question asked. For example, for ROI and residual income, it will be total assets available; for return on capital, it will be shareholders equity plus long-term liabilities; and for return on equity, it will be total assets less total liabilities. EVA is calculated using market value of interest bearing debt (long-term) and equity. Current costs Current cost is the replacement cost, in today s dollars, of the asset(s) under consideration. Exhibit 24-3 on page 1149 illustrates a step-by-step approach to incorporate current-cost estimates into ROI calculations. The process requires updating historical cost to current costs for long-term assets, adjusting the depreciation (amortization) to reflect the updated cost of the long-term assets, and re-computing operating income. Assuming inflationary pressures, the result of this calculation is a reduction in ROI as shown in the example. It is important to accurately determine the current cost of assets. For example, a building purchased in 1980 in downtown Vancouver for $8M might be worth $20M today; however, an exact cost of the building may be difficult to determine because various appraisers might give a range of prices from $18M to $22M. The issue of relevance versus reliability is represented in this example because the $8M paid for the building is reliable (amortized, it might be worth less than $2M on the books), yet the building has a relevant value of $20M. Investors and creditors would want to know this valuation to properly assess the value of the company. This problem arises with the emergence of IFRS, which uses fair-value accounting. This case also requires financial statement preparers to determine whether the $20M value should be provided to users from the information perspective as supplementary information (that is, Provide users relevant information in whatever format is valid ) or from the measurement perspective in the principle financial statements (that is, Companies should reflect the proper valuation because users are not capable of making valid assumptions alone using the information perspective ). Note: IFRS have stricter regulations on how the value is reported on financial statements. This issue is best left to financial accounting and accounting theory courses; however, students in management accounting should be aware of the limitations imposed by this issue. Long-term assets: Gross or net book value Managers must decide whether to use gross or net book value in computing ROI, as the following exhibit shows for two assets of the same value at different ages. Exhibit 8.6-1: ROI using Net book value and Gross book value file:///f /Courses/ /CGA/MA2/06course/m08t06.htm (1 of 2) [09/09/2010 1:58:07 PM]

14 file:///f /Courses/ /CGA/MA2/06course/m08t06.htm Net book value (NBV) Gross book value ROI using NBV ROI using gross value Asset Operating income Accumulated depreciation 1 $200,000 $700,000 $300,000 $1,000, % 20% 2 $200,000 $300,000 $700,000 $1,000, % 20% Using net book value distorts the ROI due to the age of the assets. Using gross book value allows a better comparison of subunits. file:///f /Courses/ /CGA/MA2/06course/m08t06.htm (2 of 2) [09/09/2010 1:58:07 PM]

15 file:///f /Courses/ /CGA/MA2/06course/m08t07.htm 8.7 Selecting performance goals and timing of feedback Learning objective Describe the effects of targeted levels of performance and timing of feedback on performance evaluation. (Level 2) Required reading Chapter 24, pages LEVEL 2 In Step 5 of performance evaluation system design, companies choose the target against which to gauge performance. Historical cost ROIs can be used to evaluate current performance if the ROI is adjusted to compensate, using reliable measures such as the construction cost index. Continuous improvement targets also allow analysis of year-to-year changes rather than absolute measures, which prevents the pitfalls of historical-cost ROI. In Step 6, companies choose the timing of feedback, which depends on how critical the information is to the decision-making process. Cursory or summary information can be looked at on a less frequent basis than critical information. For example, daily summaries of tolerance measures for a manufacturing plant are important because levels of tolerance can change quickly. Sudden changes could have a significant impact on total production output if the summaries are looked at only on a monthly basis. file:///f /Courses/ /CGA/MA2/06course/m08t07.htm [09/09/2010 1:58:07 PM]

16 file:///f /Courses/ /CGA/MA2/06course/m08t08.htm 8.8 Global performance measurement Learning objective Describe the effects of performance measurement systems on subunits of multinational enterprises. (Level 2) Required reading Chapter 24, pages (to Levels of Analysis Differ Between Managers and Subunits) LEVEL 2 Economic, legal, social, and cultural systems present challenges in comparing international divisions or subunits. Differences in currencies, exchange rates, inflation, access to capital, and financial and human resources also present problems when making international comparisons: Should calculations be made in the foreign or domestic currency? If the currency is domestic, what exchange rate should be used (beginning, end, or average for the measurement period)? Should the same rate be used for revenues and costs as for assets? Is a 20% ROI in Peru, for example, better or worse than a 16% ROI in Canada? To address these issues, calculate foreign ROI in Canadian dollars using two exchange rates. Operating income is converted at the average exchange rate for the current year because these costs and revenues are incurred during the year. Assets are converted at the exchange rate in place at the time of the asset purchase because they are on the books at historical cost and not updated to reflect current costs. Therefore, current assets and current liabilities are converted using the exchange rate based on the balance sheet date. Example 8.8-1: Braebury Braebury has assets of 15,000,000 Hong Kong dollars purchased in 20X5, when the exchange rate was HK$6 = C$1. Operating income for the current year was HK$3,500,000, and the current exchange rate is HK$7.80 = C$1. The average exchange rate during the current year was HK$7.20 = C$1. Operating income = HK$3,500, = C$486,111 Assets = HK$15,000,000 6 = C$2,500,000 ROI = C$486,111 C$2,500,000 = 19.44% Residual income can be adjusted the same way. The following computer illustration asks you to analyze an international corporation using ROI, RI, and EVA. You look at whether or not translating the financial numbers into Canadian dollars makes sense to determine the most appropriate method of evaluating the performance of its divisions. Computer illustration 8.8-1: International performance measurement Solution file:///f /Courses/ /CGA/MA2/06course/m08t08.htm [09/09/2010 1:58:07 PM]

17 file:///f /Courses/ /CGA/MA2/06course/m08t08ci.htm Computer illustration 8.8-1: International performance measurement Updated September 7, 2010, MA2-10-TU04 The Van Cauwenbergh Brewery has two geographic locations. The original brewery is located in Antwerp, Belgium. The second brewery is located in Vancouver, B.C. Each brewery has two divisions for performance evaluation. The first divisions create award-winning beer with the Antwerp brewery servicing Europe and the Vancouver brewery servicing the North American market. The second divisions are based on the tourist trade, operating brewery tours with live entertainment and maintaining a small restaurant-pub. The Antwerp Brewery has been in operation since 1654 and recently updated its facilities in The restaurant was updated and remodeled in The Vancouver Brewery was built in 1985 and its restaurant was updated in The Canadian dollar has been strengthening against the euro this year. The R& D expenses are attributable to the brewery segment only. The corporate tax rate is 35%. Exchange rates for the significant dates are as follows: Exchange rate $ As at year end As at beginning of year Average for year At date of purchase of brewery assets At date of purchase of restaurant assets Both Antwerp and Vancouver have been engaging in R&D in the brewery division. Both fully expensed the research this year. Antwerp spent 2.3 million euros on researching changes to the mix of grains used because of problems with hops crops in Europe. Vancouver spent C$575,000 on research into a method of speeding up the lautering stage of the process. The organization as a whole has a required rate of return of 18%. Differences in the financing and risk between the divisions have led to differences between the required rate of return and the weighted-average costs of capital. Similarly, if a division raises its own capital without the corporation as a whole raising the funds, individual divisions can have different WACCs. For example, the Antwerp division s WACC is 9.5%, while the Vancouver division has a WACC of 7.8%. Interest on long-term debt is related to debt common to both the brewery and restaurant in each division. Since management has decided that interest on long-term debt is a corporate-wide cost, it is not considered when performing divisional analysis using ROI and RI. The company president has asked you to recommend a performance measurement plan to fairly evaluate the two divisions. He has heard of ROI, RI, and EVA and wants a comparison of these three methods. The president is also interested in learning whether the analysis holds when the performance measures are compared using the same currency, and would also like to see the measures that are based on financials translated into Canadian dollars. Finally, knowing that there are differences in the ages of the assets, he would like to see the effect of using gross assets in the calculations compared to net book values. Material provided File MA2M8P1 containing a partially completed worksheet M8P1 and the solution worksheet M8P1S. Required The relevant information has been entered into the data table in the spreadsheet. Using this data, 1. provide the president of Van Cauwenbergh Brewery with comparative ROI, RI, and EVA, and 2. prepare a report comparing and contrasting the various performance measures. Procedure file:///f /Courses/ /CGA/MA2/06course/m08t08ci.htm (1 of 2) [09/09/2010 1:58:08 PM]

18 file:///f /Courses/ /CGA/MA2/06course/m08t08ci.htm 1. Start Excel. 2. Open the file MA2M8P1. Go to TAB M8P1. 3. Review the spreadsheet. The data table is found in the range A6 to K34. Starting at cell A36 and going to cell K99 is the area for performing the comparative performance measure calculations. 4. Go to cell A36. This is the section for calculating ROI using NBV with no currency exchange. Enter the appropriate formulas into cells B39 to C41 referencing the data table. 5. Cell A43 starts the section for calculating ROI using NBV with all numbers translated into Canadian funds at the appropriate rate. Enter the appropriate formulas in cells B46 to C Cell A51 starts the section for calculating ROI using gross book values with no currency translation. Enter the appropriate formulas in cells B54 to C Cell A58 starts the section for calculating the ROI using gross book values and all numbers translated into Canadian dollars. Enter the appropriate formulas into cells B61 to C Cell A65 starts the section for calculating RI with no currency translation. Enter the appropriate formulas into cells B69 to G Cell A74 starts the section for calculating RI with all numbers translated into Canadian funds. Enter the appropriate formulas into cells B78 to G Cell A83 starts the section for calculating EVA with no currency translation. Enter the appropriate formulas into cells B88 to K Cell A93 starts the section for calculating EVA with all necessary numbers translated into Canadian funds. Enter the appropriate formulas into cells B97 to K99. file:///f /Courses/ /CGA/MA2/06course/m08t08ci.htm (2 of 2) [09/09/2010 1:58:08 PM]

19 file:///f /Courses/ /CGA/MA2/06course/m08t08sol.htm Computer illustration Solution 1. Click on tab M8P1S to view the solution and analyze and discrepancies between the solution and your calculations. TO: The President, Van Cauwenbergh Brewery Overview The organization has two major geographic divisions, each with two operating divisions. To facilitate the decision-making process, a review of performance measures was done to determine appropriate measures to use in evaluating the divisions and their managers. The final decision will have an impact on the managers compensation, and will affect capital budgeting decisions and other long-term decisions made at the divisional level. It is important to ensure that the measures chosen accurately reflect the overall corporate goals and strategies. Issues 1. The assets in the different divisions are different ages. 2. The divisions operate in different countries with different economic conditions. 3. Within a geographic location, the two divisions have quite different risk and return potentials. 4. Nonfinancial benefits are provided by the restaurants. Analysis ROI If you use 18% as a hurdle rate for assessing the various divisions, then the four different calculations of ROI can have a significant impact on the decisions made at corporate and divisional levels. ROI calculated using NBV and no currency exchange shows both geographic locations performing above the hurdle. ROI using NBV in Canadian dollars, however, shows the Canadian division achieving better than hurdle results, while the Belgian division slips below the hurdle. This may be a function of the appreciating Canadian dollar. Because of differences in the age of the assets employed, the ROI using net book value (NBV) measure both divisions in Canadian dollars and, with no exchange, show significant differences between the two geographic locations. When the same calculation is made using gross book values, the difference disappears in the untranslated ratio and is minimized in the calculation, which uses translated-to-canadian dollars financial numbers. This tells me that the operations are very similar in performance. Most differences are due to the difference in ages of the equipment. Looking at the gross book value in Canadian dollars you can see that Vancouver is making a better return on investment. This would seem to indicate that the Canadian market is still a growth market for the organization. The Belgian market, in which the firm has been active for 350 years, is mature and so has less growth potential. However, the appreciation of the Canadian dollar that is reflected in the changes in the exchange rate may also be showing up in the translated ROI. This is not a bad time to be invested in Canadian dollars. RI The residual income calculations show that the Vancouver divisions are out-performing the Belgian divisions, although the differences between the two divisions are not significant. The high exchange rate at the time of the purchase of the assets for the restaurant in Belgium is responsible for the high negative RI number. However, the restaurants in neither geographic location come close to the hurdle rate of return and both provide a negative residual income. file:///f /Courses/ /CGA/MA2/06course/m08t08sol.htm (1 of 2) [09/09/2010 1:58:08 PM]

20 file:///f /Courses/ /CGA/MA2/06course/m08t08sol.htm EVA Although residual income and EVA are similar methods of evaluating performance, the large research component in Antwerp has resulted in a significantly higher EVA. The Vancouver EVA is also higher than the RI. There is much to be said for promoting research and development, and the EVA calculation does a good job of positively reinforcing that philosophy. EVA also shows the restaurant divisions in a better light because the capital charge is taken on working capital plus long-term assets and not on total assets. This definition of investment takes out the portion of short-term assets that are financed by current liabilities. As the division managers are responsible for the short-term debt load, and therefore for working capital maintenance, this is a valid adjustment to the investment number for evaluating their performance. Non-financial issues When looking at the numbers produced by the various performance measures, care must be taken to look at the potential for non-financial benefits that the numbers miss. For example, while the restaurants in both divisions seem not to be providing adequate return, it is likely that they provide many non-financial benefits to the divisions, including gaining new customers from tourists testing new beer, ale, and lager recipes on a small group of customers before making an international launch of a new product, and finding new uses for brewery products, which are then sold through the restaurant and marketed through a recipe book. Recommendations I recommend the use of EVA translated into a common currency for evaluating the management of the two divisions. This measure uses working capital in lieu of total assets, which is a more accurate measure of assets under the direction and control of managers. EVA also uses an adjusted operating income number for the calculation. This takes into account certain long-term investments that must be expensed under GAAP. In the case of these two divisions, the expensed investments are research and development. Future growth will come from this research, so managers must not be penalized for taking on the expense. The calculations on income are on an after-tax basis, as this is a close approximation to cash flow. For the capital charge, EVA used weighted-average cost of capital (WACC) rather than an organization-wide hurdle rate. WACC more accurately reflects the cost of doing business on an individual division basis, and provides a more accurate assessment of the value added by the division. file:///f /Courses/ /CGA/MA2/06course/m08t08sol.htm (2 of 2) [09/09/2010 1:58:08 PM]

21 file:///f /Courses/ /CGA/MA2/06course/m08t09.htm 8.9 Evaluation of managers and organizational units Learning objective Describe how performance evaluation of managers relates to performance evaluation of organizational subunits. (Level 2) Required reading Chapter 24, pages LEVEL 2 Up to this point, you have been looking at performance measurement from the perspective of evaluating organizational units. You studied challenges of using historical cost-based assets for calculating performance measures, and analyzed subunits operating in different countries with corresponding unique political and economic realities. Management compensation is also tied to subunit performance, and a subunit s performance evaluation can be tied to the evaluation of its managers. Compensation based on salary plus performance-based measures creates a tradeoff between creating incentives and imposing risks. The more a manager s compensation is based on subunit performance, the more risk the manager is exposed to because many factors that the manager does not control are nevertheless evaluated in subunit performance. Owners therefore offer differing amounts of performance-based compensation ranging up to 100% of a manager s compensation package. Information asymmetry then becomes a problem for owners. Because researchers report that many employees tend to be both risk and effort averse, owners may not know whether a manager is exerting the appropriate amount of effort. Paying an employee with a flat wage that is guaranteed regardless of effort reduces incentive for the employee to provide superior performance, so performance-based incentives are often included in compensation packages. This introduces a level of risk for employees and the greater the risk, the greater the reward that must be offered. Risk-averse managers may alter their behaviour to reduce risk, thereby not taking on projects that could be in the best interest of owners. In such situations, owners can use multiple performance measures to mitigate some of the risks. A Balanced Scorecard, for example, includes nonfinancial measures that are specific to the situation, and can more accurately assess factors that managers can control. It is important to note that evaluating managers on factors that are outside their control is not only unfair, but also likely to be counter-productive. In some cases, especially when economic conditions or outside events have an impact on performance, owners may also use relative performance measures to benchmark operations and managers. For example, if the economy is in recession and performance has suffered generally, using a relative benchmark against competitors can determine how well a unit performed given current economic conditions, which would give a better assessment of the manager s contribution. Not all managers are motivated by financial gain, however, and not all managers are effort averse. Some managers are competitive or driven by other motivations and goals. In developing performance evaluation methods, remember to look at the full range of actual motivations and develop an appropriate response to them. When dealing with specific evaluation situations, it is important to take nonfinancial motivators into consideration and not take advantage of them. Because a person is willing to work for peanuts does not mean that is what they should be paid unless that is what the job is worth. Fairness must go both ways. file:///f /Courses/ /CGA/MA2/06course/m08t09.htm [09/09/2010 1:58:09 PM]

22 file:///f /Courses/ /CGA/MA2/06course/m08t10.htm 8.10 Executive performance measures and compensation Learning objective Describe how salaries, performance incentives, and executive compensation affect an organization s strategy. (Level 2) Required reading Chapter 24, pages (to Strategy and Levers of Control) LEVEL 2 Executive compensation packages are often a combination of salary, annual incentives such as cash bonuses, long-term incentives such as stock options, and a variety of fringe benefits. Ideally, all management compensation packages enhance achievement of organizational goals, are straightforward to administer, and are viewed as fair by all stakeholders. A well-designed plan mixes both short-term and long-term goals, and balances the risk-reward tradeoff. Most companies use a combination of net income or ROI, RI, and EVA to focus managers attention on achieving short-term goals. Stock options, based on share price, reflect long-term goals. In Canada, both the provincial securities commissions and the federal Securities Exchange Commission require detailed disclosure of compensation arrangements of senior managers and the expensing of stock options. Most employees have multifaceted jobs, and this can have an indirect financial impact on the organization. For example, an employee could be responsible for both cost control and customer satisfaction. Focusing measures solely on cost control might reduce customer satisfaction if the employee has no incentive to focus on that aspect of the job. However, companies can use multiple measures such as the Balanced Scorecard, which measures both quantity and quality initiatives, to assess individual job performance. Individual employees working in teams are often evaluated on team results, with the aim of enhancing team cooperation. For example, employees at Bell Canada working on putting together a bid on a government contract would be evaluated on the success of the team in getting the bid. A potential problem in team evaluation is that shirking of responsibilities by some members of the team could be masked when the entire team is evaluated as a unit. At the same time, it is important to note that team evaluation can also create issues around too much team loyalty. For example in some resource extraction industries, workers ignore safety regulation to try to win team bonuses for productivity. This type of response underscores the need for multiple performance measures at the individual activities level. file:///f /Courses/ /CGA/MA2/06course/m08t10.htm [09/09/2010 1:58:09 PM]

23 file:///f /Courses/ /CGA/MA2/06course/m08t11.htm 8.11 Performance measures and fraud Learning objective Explain how moral hazard and adverse selection can result in performance measures that lead to management fraud, and describe the impact of IFRS on performance measurement. (Level 1 ) LEVEL 1 Executive compensation packages that are linked to performance may provide incentive for managers to inflate net income figures for their own financial gain (for example, manipulating accounting accruals in the short-term). It is more difficult to manipulate net income in the long-run, however, because of the iron law of reversal of accruals. Information asymmetry is part of a larger body of research known as agency theory (Module 7). Information asymmetry arises when company owners are unable to see what the management team is doing. For example, an owner purchasing shares of a company usually cannot know exactly what the managers of the company are doing, which leads to information asymmetry in two forms: Adverse selection Managers have access to information that is not shared with those outside the organization (insider trading or timing of the release of information). Moral hazard Managers' actions are not readily visible by individuals outside the organization; a manager could therefore shirk responsibility and cover up any resulting losses by manipulating the financial statements. The life-insurance field can be used to illustrate the cumulative effects of adverse selection. People pay a life-insurance company to provide a guaranteed amount of money should they die unexpectedly. An early death would prevent the individual from generating an income that would benefit their loved ones either immediately or through a distribution of savings. Since insurance policies require an outlay of cash, it could be argued that the insurance tends to attract a large number of individuals in poor health. These individuals would have motivation to misrepresent their health status, either to assure that they get on the plan or to keep their premiums low. As these sick individuals die prematurely, the company would find it necessary to raise premium rates to continue to make a profit. The higher rates would force the healthy customers out; the proportion of sick to healthy customers would go up; there would be more early payouts; premiums would have to be raised; and more healthy customers would decide the cost wasn t worth it and would drop out. Eventually only individuals in poor health would participate in the market, there would be no profit, and the market for life insurance would collapse. There are a number of solutions to this problem. A common one is to require health exams by company-approved doctors. Other solutions include marketing life insurance as something other than an income stream replacement (such as advertising that good loving spouses always have a life-insurance policy) in hopes of attracting and maintaining a healthier mix of customers. In the case of no-health-exam policies, a waiting period could be implemented before the customer is eligible for payment. This way the sickest individuals die before payment is required. The ideal solution would be for all clients to represent their health and propensity to accident honestly. This would allow the market for life insurance to continue with reasonable rates, immediate coverage, and no resources "wasted" on monitoring activities. The best way to control for adverse selection is through increased and timely disclosures as has been done with the Sarbanes Oxley Act (SOX). Information asymmetry can run in both directions. Sometimes the principal knows more than the agent and can exploit the agent. For example, a company s owners intending to move manufacturing operations offshore tell the domestic staff that the domestic operation has long-term viability. Even though the staff knows most manufacturers in their field have moved offshore, the false reassurance from the owners is an example of moral hazard. The use of net or operating income to evaluate managers through ROI, RI, and EVA is not a solution, as managers can shift earnings through different accruals (such as choice of revenue recognition policies, depreciation, or inventory methods). Managers whose compensation is tied to performance have increased incentive to manipulate earnings for their own gain (see Exhibit ). Where a manager receives a bonus between certain ranges (for example, a 5% bonus if a floor ROI of 8% is achieved (called the bogey) up to a 20% bonus if a cap of 22% ROI is achieved), the manager could try to inflate earnings by recognizing revenues early or delaying expenses if the minimum 8% is achieved this year. This is usually done up to a maximum cap. Beyond the cap, managers would reverse the process, delaying revenues and recognizing expenses to try to achieve a higher return again next period. If a manager is not going to meet the minimum floor, they will often take a big bath, which means, "if we re going to have a bad year, we might as well have a really bad year." This entails reducing file:///f /Courses/ /CGA/MA2/06course/m08t11.htm (1 of 3) [09/09/2010 1:58:10 PM]

24 file:///f /Courses/ /CGA/MA2/06course/m08t11.htm earnings by recognizing expenses in the current year from future periods, such as taking a restructuring charge to reduce future expenses. Exhibit : Earnings recognition A number of different tools are available to control earnings management: Auditors External accountants check to make sure that managers are providing information in accordance with GAAP or IFRS for comparability. Regulators Accounting and securities regulators provide requirements to reduce or eliminate fraudulent activities. Regulators also try to reduce information asymmetry through acts such as SOX to reduce adverse selection and penalties for insider trading. Regulators also try to increase the decision usefulness of the financial statements by: increasing the sensitivity of net income (ability to observe management effort in net income) and increasing the precision of net income (ability to identify that net income determines the true state of nature). Board of directors Management compensation packages are designed to reduce the impact of fraud and to control managers behaviour by mixing the levels of short and long-term goals through combination of net income and share prices. Managerial labour market A manager s reputation will in part determine salary. A well-defined managerial labour market will value strong managers (that is, those who do not manage earnings over the long-term). Here are the main areas where managers are most likely to manage earnings: Bonus plans Managers of companies with bonus plans are more likely to choose accounting policies that shift earnings to current period from future periods. Debt covenant Firms that are close to violation of debt covenants are more likely to manage earnings than firms that are not close to violations. Political cost The greater the political costs are for a company to report high earnings, the greater the chance that its managers will manage earnings to avoid being in the public eye. Source: Adapted from William R. Scott, Financial Accounting Theory, 5th Edition; Pearson (2009), pp This is not to say that all earnings management is bad. In some cases, it is beneficial to manage earnings when restrictions of GAAP do not allow managers to release information, such as when managers know that negative earnings will not persist file:///f /Courses/ /CGA/MA2/06course/m08t11.htm (2 of 3) [09/09/2010 1:58:10 PM]

25 file:///f /Courses/ /CGA/MA2/06course/m08t11.htm into the future. It is possible to overreact to the potentials of moral hazard and to impose too many controls. Not only are too many controls costly, but they can also be offensive or upset the moral sensibilities of employees. For example, if a bakery s manager decides that employees pilfering the occasional cookie is a problem, then imposing strip searches would be considered an overreaction. The employees would probably consider the process outrageous, and the bakery would fairly quickly find itself without any employees. To control the impact of information asymmetry, accounting theory uses one of two approaches. Increased disclosure (through increased transparency) will reduce the ability of management hide or control information release. Increased transparency and release of information allows investors and users to make fewer estimations; this reduces estimation risk for users, and can lead to an increase in reliability of the financial statements. Changes resulting from SOX, and changes to Canadian GAAP in sections 1100 and 1400, require the exclusive use of GAAP and increased disclosure commitments by management. The second approach is to use more fair-value or current accounting, which tends to increase the relevance of the financial statements by stating fair values of assets and liabilities. However, this is done at the cost of reliability because of the number of estimations necessary to determine the fair valuations. IFRS and earnings management IFRS tend toward relevant accounting, which uses fair-value accounting methods. This results in a decrease in reliability and can lead to enhanced earnings management due to the amount of estimations necessary to provide current-value accounting (which reduces estimation risk by providing valuations for assets and liabilities). Relevant accounting methods also lead to an enhanced role for auditors in ensuring that management is providing accurate estimations. file:///f /Courses/ /CGA/MA2/06course/m08t11.htm (3 of 3) [09/09/2010 1:58:10 PM]

26 file:///f /Courses/ /CGA/MA2/06course/m08t12.htm 8.12 Performance measures and fraud Learning objective Explain how moral hazard and adverse selection can result in performance measures that lead to management fraud, and describe the impact of IFRS on performance measurement. (Level 1) LEVEL 1 Executive compensation packages that are linked to performance may provide incentive for managers to inflate net income figures for their own financial gain (for example, in the short-term, through manipulation of accounting accruals). It is more difficult to manipulate net income in the long-run, however, because of the iron law of reversal of accruals. Information asymmetry is part of a larger body of research known as agency theory (see Module 7); information asymmetry arises when company owners are unable to see what the management team is doing. For example, an owner purchasing shares of a company usually cannot know exactly what the managers of the company are doing, which leads to information asymmetry in two forms: Adverse selection Managers have access to information that is not shared with those outside the organization (insider trading or timing of the release of information). Moral hazard Managers' actions are not readily visible by individuals outside the organization; a manager could therefore shirk responsibility and cover up any resulting losses by manipulating the financial statements. The life-insurance field can be used to illustrate the cumulative effects of adverse selection. People pay a life-insurance company to provide a guaranteed amount of money should they die unexpectedly. An early death would prevent the individual from generating an income that would benefit their loved ones either immediately or through a distribution of savings. Since insurance policies require an outlay of cash, it could be argued that the insurance tends to attract a large number of individuals in poor health. These individuals would have motivation to misrepresent their health status, either to assure that they get on the plan or to keep their premiums low. As these sick individuals die prematurely, the company would find it necessary to raise premium rates to continue to make a profit. The higher rates would force the healthy customers out; the proportion of sick to healthy customers would go up; there would be more early payouts; premiums would have to be raised; and more healthy customers would decide the cost wasn t worth it and would drop out. Eventually only individuals in poor health would participate in the market, there would be no profit, and the market for life insurance would collapse. There are a number of solutions to this problem. A common one is to require health exams by company-approved doctors. Other solutions include marketing life insurance as something other than an income stream replacement (such as advertising that good loving spouses always have a life-insurance policy) in hopes of attracting and maintaining a healthier mix of customers. In the case of no-health-exam policies, a waiting period could be implemented before the customer is eligible for payment. This way the sickest individuals die before payment is required. The ideal solution would be for all clients to represent their health and propensity to accident honestly. This would allow the market for life insurance to continue with reasonable rates, immediate coverage, and no resources "wasted" on monitoring activities. The best way to control for adverse selection is through increased and timely disclosures as has been done with the Sarbanes Oxley Act (SOX). Information asymmetry can run in both directions. Sometimes the principal knows more than the agent and can exploit the agent; for example, a company s owners intending to move manufacturing operations offshore while telling the domestic staff that the domestic operation has long-term viability. Even though the staff knows most manufacturers in their field have moved offshore, the false reassurance from the owners is an example of moral hazard. The use of net or operating income to evaluate managers through ROI, RI, and EVA is not a solution, as managers can shift earnings through different accruals (such as choice of revenue recognition policies, amortization, or inventory methods). Managers whose compensation is tied to performance have increased incentive to manipulate earnings for their own gain. Where a manager receives a bonus between certain ranges (for example, a 5% bonus if a floor ROI of 8% is achieved up to a 20% bonus if a cap of 22% ROI is achieved), the manager could try to inflate earnings by recognizing revenues early or delaying expenses if the minimum 8% is achieved this year. This is usually done up to a maximum cap. Beyond the cap, managers would reverse the process, delaying revenues and recognizing expenses to try to achieve a higher return again next period. If a manager is not going to meet the minimum floor, they will often take a big bath, which means, "if we re going to have a bad year, we might as well have a really bad year." This entails reducing earnings by recognizing expenses in file:///f /Courses/ /CGA/MA2/06course/m08t12.htm (1 of 3) [09/09/2010 1:58:10 PM]

27 file:///f /Courses/ /CGA/MA2/06course/m08t12.htm the current year from future periods, such as taking a restructuring charge to reduce future expenses. To control earnings management, a number of different tools are available: Auditors External accountants check to make sure that managers are providing information in accordance with GAAP for comparability. Regulators Accounting and securities regulators provide requirements to reduce or eliminate fraudulent activities. Regulators also try to reduce information asymmetry through acts such as SOX to reduce adverse selection and penalties for insider trading. Regulators also try to increase the decision usefulness of the financial statements by: i) increasing the sensitivity of net income (ability to observe management effort in net income) and ii) increasing the precision of net income (ability to identify that net income determines the true state of nature). Board of directors Management compensation packages are designed to reduce the impact of fraud and to control managers behaviour by mixing the levels of short and long-term goals through combination of net income and share prices. Managerial labour market A manager s reputation will in part determine salary. A well-defined managerial labour market will value strong managers (that is, those who do not manage earnings over the long-term). Here are the main areas where managers are most likely to manage earnings: Bonus plans Managers of companies with bonus plans are more likely to choose accounting policies that shift earnings to current period from future periods. Debt covenant Firms that are close to violation of debt covenants are more likely to manage earnings than firms that are not close to violations. Political cost The greater the political costs are for a company to report high earnings, the greater the chance that its managers will manage earnings to avoid being in the public eye. Source: Adapted from Financial Accounting Theory, 4th Edition, William R. Scott, Pearson (2005), p.243. This is not to say that all earnings management is bad. In some cases, it is beneficial to manage earnings when restrictions of GAAP do not allow managers to release information, such as when managers know that negative earnings will not persist into the future. file:///f /Courses/ /CGA/MA2/06course/m08t12.htm (2 of 3) [09/09/2010 1:58:10 PM]

28 file:///f /Courses/ /CGA/MA2/06course/m08t12.htm It is possible to overreact to the potentials of moral hazard and to impose too many controls. Not only are too many controls costly, but they can also be offensive or upset the moral sensibilities of employees. For example, if a bakery s manager decides that employees pilfering the occasional cookie is a problem, then imposing strip searches would be considered an overreaction. The employees would probably find the process outrageous and the bakery would find itself without any employees fairly quickly. IFRS and earnings management To control the impact of information asymmetry, accounting theory uses one of two approaches. Increased disclosure (through increased transparency) will reduce the ability of management hide or control information release. Increased transparency and release of information allows investors and users to make fewer estimations; this reduces estimation risk for users, and can lead to an increase in reliability of the financial statements. Changes resulting from SOX, and changes to Canadian GAAP in sections 1100 and 1400, require the exclusive use of GAAP and increased disclosure commitments by management. The second approach is to use more fair-value or current accounting, which tends to increase the relevance of the financial statements by stating fair values of assets and liabilities. However, this is done at the cost of reliability because of the number of estimations necessary to determine the fair valuations. The IFRS tend toward relevant accounting, which uses fair-value accounting methods. This results in a decrease in reliability and can lead to enhanced earnings management due to the amount of estimations necessary to provide currentvalue accounting (which reduces estimation risk by providing valuations for assets and liabilities). Relevant accounting methods also lead to an enhanced role for auditors in ensuring that management is providing accurate estimations. file:///f /Courses/ /CGA/MA2/06course/m08t12.htm (3 of 3) [09/09/2010 1:58:10 PM]

29 file:///f /Courses/ /CGA/MA2/06course/m08selftest.htm Module 8 self-test Question 1 Multiple choice Solution 1. XYZ Inc. has operating income of $240,000. The company has gross book value of assets of $960,000 and accumulated depreciation of $320,000. The company has a 10% required rate of return and uses the net-book-value method. What is the residual income for the firm? 1. $240, $24, $176, $144, The following information is available for an investment centre of Decentralized Company (all numbers are in thousands of dollars): Sales revenue $ 75,000 Expenses 72,000 Total investment 25,000 Which of the following lists the return on sales, investment turnover, and ROI respectively? 1. 4%, 3, 12% 2. 12%, 1/3, 4% 3. 12%, 3, 36% 4. 36%, 1/3, 12% 3. ROI, RI, and EVA are examples of which type of control system? 1. Diagnostic 2. Boundary 3. Belief 4. Interactive 4. Jackson Corp. has operations in France and Canada. The French division has 40,000,000 of assets purchased in 20X5 when the exchange with the Canadian dollar was 0.6 = C$1. During the current year 20X8, the French division had revenues of 35,000,000 and costs of 22,000,000. The income was earned evenly throughout the year. The exchange rate on January 1, 20X8 of 0.65 = C$1, and December 31, 20X8, of 0.75 = C$1. What is the ROI of Jackson s French operation in Canadian dollars (rounded to nearest 1 decimal)? % % % % 5. Which of the following is not considered a reason for earnings management? Question 2 1. Debt covenant 2. Political cost 3. Managerial labour market 4. Bonus plan Financial information regarding the year 20X0 for Divisions I and II of Bicameral Corp. is presented as follows. Each division is allowed to choose its own accounting principles. file:///f /Courses/ /CGA/MA2/06course/m08selftest.htm (1 of 3) [09/09/2010 1:58:11 PM]

30 file:///f /Courses/ /CGA/MA2/06course/m08selftest.htm DIVISION I Total assets Cash $ 22,000 Accounts receivable 76,000 Inventory 140,000 Property, plant and equipment (net of $590,000 accumulated depreciation) 862,000 Total assets $ 1,100,000 Divisional income statement Sales revenue $ 497,000 Variable expenses 227,000) Divisional contribution margin 270,000 Fixed expenses traceable to division 138,000) Income traceable to division $ 132,000 DIVISION II Total assets Cash $ 33,000 Accounts receivable 114,000 Inventory 210,000 Property, plant and equipment (at gross book value) 1,293,000 Total assets $ 1,650,000 Divisional income statement Sales revenue $ 745,500 Variable expenses (250,000) Divisional contribution margin 495,500 Fixed expenses traceable to division (347,500) Income traceable to division $ 148,000 ROI was calculated to be 12% ($132,000 1,100,000) for Division I and 8.97% ($148,000 1,650,000) for Division II. The cost of capital relevant to both divisions is 5%. Is it correct to conclude that Division I performed better? Explain your answer, using calculations if possible. Solution Question 3 The Ontario division of Synergy Inc. is considering development of a new plant. The investment will cost $25 million. The expected revenues from the plant will average on a yearly basis: Revenue $21,000,000 Variable cost $14,000,000 Fixed cost $ 4,000,000 Operating income $ 3,000,000 file:///f /Courses/ /CGA/MA2/06course/m08selftest.htm (2 of 3) [09/09/2010 1:58:11 PM]

31 file:///f /Courses/ /CGA/MA2/06course/m08selftest.htm The current ROI of the Ontario division is 15%. The manager of each division is evaluated based on ROI. Required 1. Would the manager be willing to go ahead with the development of this plant? Why or why not? 2. If the required rate of return for Synergy shareholders is 11%, should the manager go ahead with the plant? Under what conditions should the plant go forward? Solution Question 4 Bradford Inc. has operating income of $3,000,000 and is in a 30% tax bracket. The company has current debt of $1,000,000 and long-term debt of $14,000,000, which has interest of 9% and $6,000,000 of equity with a cost of equity of 12%, all of which approximate their respective market values. Determine the weighted average cost of capital and EVA for Bradford for the year. Solution file:///f /Courses/ /CGA/MA2/06course/m08selftest.htm (3 of 3) [09/09/2010 1:58:11 PM]

32 file:///f /Courses/ /CGA/MA2/06course/m08selftestsol1.htm Self-test 8 Solution ) 2. 1) 3. 1) 4. 1) 5. 3) Using the net method RI = $240,000 [($960, ,000) 10%] = $176,000 ROS = (75,000 72,000) 75,000 = 4%; Investment turnover = (75,000 25,000) = 3; ROI = (75,000 72,000) 25,000 = 12% Net income is translated at the average exchange rate for the current year as income is earned throughout the year ( ) 2 = 0.70 = C$1 and assets are translated at the time of purchase. ROI = [(35,000,000 22,000,000) 0.70] (40,000, ) = 27.9% file:///f /Courses/ /CGA/MA2/06course/m08selftestsol1.htm [09/09/2010 1:58:11 PM]

33 file:///f /Courses/ /CGA/MA2/06course/m08selftestsol2.htm Self-test 8 Solution 2 ROI is not comparable because Division I values property, plant and equipment at net book value while Division II uses gross book value. Add back accumulated depreciation in Division I to obtain its gross book value: $862,000 + $590,000 = $1,452,000. Total assets become $1,690,000 and ROI is $132,000 $1,690,000 = 7.81%. This is less than Division II's 8.97%, so Division II performed better on the basis of ROI. However, if the goal were to measure benefits to shareholders, it would be better to compare the divisions on the basis of residual income. RI is meaningful in this case because total assets are almost identical for both divisions on the basis of gross book value (GBV) ($1,690,000 and $1,650,000). RI calculations using GBV: Division I Required income = $1,690,000(0.05) = $84,500 Residual income = $132,000 $84,500 = $47,500 Division II Required income = $1,650,000(0.05) = $82,500 Residual income = $148,000 $82,500 = $65,500 Division II created more value for shareholders on the basis of RI. In this question, central management could direct divisions to use NBV or GBV, or at least would not be misled by alternative valuations. Other accounting manipulations, such as valuation of bad debts, may be harder to prevent or observe. file:///f /Courses/ /CGA/MA2/06course/m08selftestsol2.htm [09/09/2010 1:58:12 PM]

34 file:///f /Courses/ /CGA/MA2/06course/m08selftestsol3.htm Self-test 8 Solution 3 1. ROI of plant = $3,000,000 $25,000,000 = 12% Since the current ROI of Ontario division is 15%, it is unlikely the manager would purposefully reduce his or her ROI by accepting this new plant. Proof: 2. Since shareholders require a return of 11%, this new plant should be accepted, as the return is 12%. To ensure this, the managers compensation package should be changed to use RI. RI = $3,000,000 [$25,000,000 11%] = $250,000 Consideration should also take place as to whether the company required rate of return should be considered or if the Ontario divisional rate should be considered if Ontario division is either riskier or less risky than the company as a whole. file:///f /Courses/ /CGA/MA2/06course/m08selftestsol3.htm [09/09/2010 1:58:12 PM]

35 file:///f /Courses/ /CGA/MA2/06course/m08selftestsol4.htm Self-test 8 Solution 4 WACC = ($14,000,000 [0.09 (1 0.30)] + $6,000, ) $14,000,000 + $6,000,000 WACC = ($882,000 + $720,000) $20,000,000 = 8.01% EVA = ($3,000, ) [ ($21,000,000 $1,000,000)] = $498,000 file:///f /Courses/ /CGA/MA2/06course/m08selftestsol4.htm [09/09/2010 1:58:12 PM]

36 file:///f /Courses/ /CGA/MA2/06course/m08summary.htm Module 8 summary Outline the need for financial and nonfinancial performance measures Performance measurement is critical. Financial performance measures can be manipulated, and are not always complete. The Balanced Scorecard uses both financial and non-financial measures: Financial share price, net income, ROS, ROI Customer market share, customer satisfaction Internal business process efficiency of operations Learning and growth employee satisfaction, employee turnover Describe how accounting-based performance measures are designed 1. Choose the variables congruent with financial goals. 2. Determine the time horizon. 3. Define each variable. 4. Choose the measurement method 5. Choose a target to gauge performance. 6. Determine the timing of the feedback. Determine how different business units are evaluated Consider each segment separately. Divide costs into fixed and variable; and fixed costs into discretionary and non-controllable or committed. Use contribution margin for short-term decisions. Use variable and discretionary fixed costs to evaluate management in the short-term. Use all costs for evaluating long-term decisions. Recommend appropriate profitability measures based on an understanding of return on investment, residual income, economic value added, and return on sales ROI = Income/Investment. ROI = Income/Revenue x Revenue/Investment or profit margin x investment turnover. With the same profit margin, the higher the turnover, the higher the ROI. With the same turnover, the higher the margin, the higher the ROI. The return on investment becomes even higher if both factors are increasing. RI = income capital charge or income (Cost of capital x invested capital). EVA = Adjusted accounting earnings (weighted average cost of capital x (assets minus current liabilities)). Determine the effect of time horizon on performance measures A manager can manipulate short-term results. Multi-period analysis is necessary to evaluate managers, as some costs (such as research and development) do not immediately produce results. Calculate and analyze the impact of different measurement alternatives on performance measures. Long-term assets could be at net-book value or gross value. Calculate the effects on performance measures of different measurement alternatives for assets Alternatives for cost current cost, present value, current disposal cost or historic cost. Budgets and targets must be tailored to specific subunits and accounting systems. Comparing subunits with different historic cost based information can lead to erroneous decisions. Describe the effects of selecting performance goals and timing of feedback on performance evaluation file:///f /Courses/ /CGA/MA2/06course/m08summary.htm (1 of 2) [09/09/2010 1:58:13 PM]

37 file:///f /Courses/ /CGA/MA2/06course/m08summary.htm Continuous improvement targets allow management to look at year-to-year changes rather than absolute measures, which will prevent the pitfall of historical cost ROI. Timing of feedback in performance evaluation will depend on how critical the issue is. Describe the effects of performance measurement systems on subunits of multinational enterprises Differences in economic, legal, social and cultural systems make comparisons of subunits across international boundaries difficult. Translating foreign ROI and RI to domestic currency uses two exchange rates the average annual rate for income and the historic rate for assets. Describe how performance evaluation of managers relates to performance evaluation of organizational subunits Management compensation can be either salary and/or performance-based incentives. The more the compensation is performance-based, the higher the risk for the employee. Information asymmetry becomes a problem with performance-based compensation. A Balanced Scorecard can allow for nonfinancial measures that are tailored to the sub-unit and manager. Describe how salaries, performance incentives, and executive compensation affect an organization s strategy Compensation package design should focus on achievement of organizational goals, administrative ease, and ensuring the plan is perceived as fair. Multiple measures should be considered. Team members should be evaluated based on team results. Explain how moral hazard and adverse selection can result in performance measures that lead to management fraud, and describe the impact of IFRS on performance measurement Performance-based executive compensation that relies on financial information is easy to manipulate. Information asymmetry makes it difficult for owners to see what the management team is doing. Adverse selection means that managers have access to information that is not shared. Moral hazard means that managers actions are not readily visible; they could shirk. Earnings management often involves managers aiming earnings to an amount that maximizes their compensation package. Tools for control of earnings management include auditors, regulators, the board of directors, and the managerial labour market. Areas where managers are likely to manage earnings are to boost bonuses under bonus plans, to avoid violation of debt covenants, and to avoid political costs. IFRS use fair-value accounting methods which can lead to enhanced earnings management. file:///f /Courses/ /CGA/MA2/06course/m08summary.htm (2 of 2) [09/09/2010 1:58:13 PM]