Page 56 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

42 The Complete Guide to Executive Compensation

statement or the balance sheet, they are all historical numbers and not by themselves
predictive of future performance. Nonetheless, they are undoubtedly the most common
performance measurements for executive pay purposes.

Two Sets of Books

We’ve all heard about the illegal practice of keeping one set of books for the auditors and
another that reflects the true status of the business. This practice is not only illegal, it will get
one a rent-free accommodation in a confined facility. However, the company does maintain
separate records for bona fide reasons.
Accounting vs. Tax Requirements. Accounting records are driven by Generally Accepted
Accounting Principles (GAAP) and statements by the Financial Accounting Standards Board
(FASB). Tax records reflect the Internal Revenue Code (IRC) and proclamations by the
Internal Revenue Service (IRS). A reconciliation of the two is called deferred taxes, which
appears on the accounting balance sheet.

Accrual vs. Cash Accounting. Another difference in financial reporting appears when an
action is reflected on a financial statement. Under accrual accounting, a sale is realized when
the product is shipped or the service performed; under cash accounting, it is reflected when the
cash is received. The same is true for items purchased by the company. Under accrual account-
ing, they are recognized when ordered; under cash accounting, they are recognized when paid.
Executive Pay Considerations. Given these differences, it is important to know what
records are being used as measurements for executive pay. Typically, accrual accounting is
used, and that is where most of the emphasis will be in this chapter.
Financial Measurements within the Company

Numerous financial measurements can be used in the design of executive pay plans, especially
short- and long-term incentives. They fall into various categories: (1) relative return on a finan-
cial measurement expressed in percentage terms, (2) increase or decrease in absolute dollars,
(3) relative value or percentages other than returns on income, and (4) various combinations of
the first three.
There are three financial statements that are the source of most of the financial measure-
ments of a company. They are the income statement, the cash flow statement, and the bal-
ance sheet. Each of these will be examined, and then various measurements from them
will be identified and described. The balance sheet reportedly has been in existence for over
one hundred years, the income statement for little less than half that time, and the cash flow
statement of rather recent origin. However, double-entry bookkeeping goes back some
500 years and is attributed to Luca Pacioli, a Venetian mathematician and monk (a little
something for your trivia data bank).
Income Statement. This is a statement of income and expenses for a prescribed period of
time. It is prepared monthly and usually issued to shareholders on a quarterly and year-end
basis. The three-month statements are both self-standing and cumulative year-to-date. Thus,
the fourth quarter will show the full year results in addition to the fourth quarter only. For
most companies, the business year is the same as the calendar year; however, some compa-
nies have a fiscal year with a different 12 month period (e.g., July 1 through June 30). Such
companies select the 12 month period most representative of their business year.