Page 380 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

366 The Complete Guide to Executive Compensation

Bonus Found $ Nondeductible Formula Limitation
(A% Net Income)

Deductible Formula Formula
X % Net Income – Y%
Common Stock Equity

Figure 7-4. Bonus fund formulas (deductible—nondeductible—limitation)

permits) whether to return to net income or carry over a portion to the next year. The
rationale for the carryover provision is to offset extraordinary circumstances (a real concern
if the formula is especially “tight”); the danger is that such an approach may result in
paying out almost as much in mediocre years as in outstanding periods—giving confusing
signals to both executives and shareholders.
Conversely, such deductible formulas cause problems if the company has a loss year.
The issue is not with the bonus that year, for obviously there is no bonus (assuming no
carryover from previous years). However, since a loss reduces the company’s net worth, it
thereby lowers the deductible the following year. Thus, the company pays out a greater-
than-planned portion of earnings during profitable years following loss years. To illustrate,
assume the formula is 10 percent of the amount by which net income exceeds 6 percent of
shareholder equity. At the end of the first year, shareholder equity is $100 million, net
income is $7 million, and the bonus fund equals $100,000. The second year, the company
experiences a $1 million loss, thereby reducing shareholder equity to $99 million, and the
bonus fund is, of course, zero. The third year, the company returns to its profitable ways
with an $8.5 million net earnings figure. Assuming no dividends paid during the period
(simply to uncomplicated the example), net worth is now $107.5 million and the bonus
fund equals $205,000 (i.e., 10 percent of the amount that $8.5 million exceeds 6 percent of
$107.5 million). This is $6,000 more than if the previous year had been a no-earnings-
no-loss year. Even more dramatically, if the company had a 10 percent increase in both the
second ($7.7 million) and third ($8.5 million) year, the bonus fund for year two would
have been about $124,000, but the bonus fund the third year (because net worth would be
$118.2 million, not $107.5) would be $141,000—$64,000 less than the $205,000.
Some will argue that it is more difficult to show such a turnaround after a loss year; be
that true or not, this type of formula encourages a cyclical earnings pattern rather than steady
growth. It is certainly to management’s advantage to ensure that all costs that can be taken
are taken in a year that earnings will not exceed 10 percent of shareholder equity.
For this reason, the limitation or tandem type of formula seems more appropriate (e.g., a
percentage of net income, or X percent of net income minus Y percent of common stock
equity, whichever is lower). As shown in Figure 7-4, a limitation formula protects against
payout at low net-income levels and tempers runaway conditions at high net-income levels.