Page 78 - Bruce Ellig - The Complete Guide to Executive Compensation (2007)

64 The Complete Guide to Executive Compensation

Some of the aforementioned “creative accounting” actions affecting the income state-
ment, cash flow statement, and balance sheet are counter to FASB and SEC requirements,
and those that are not inappropriate are still not consistent with the spirit of the rules.
Because FASB is essentially a rule-oriented body, some companies will take action unless
someone can point out where they are in violation of those rules. For that reason some argue
that the IASB (International Accounting Standards Board) has a better approach—it is
principle-, not rule-oriented in its issuance of standards. Creative people will always find the
gaps in GAAP.
Within GAAP there is a sufficient gray area for more creative accounting than many
people might believe exists. The FASB and SEC are continually changing the gray areas into
either black or white, but it would be unrealistic to believe there are not still areas where
chicanery can occur. The probability of this is greatly increased if the CEO and CFO can see
how certain interpretations will increase their incentive pay.
Combination Formulas. As indicated at the beginning of this chapter, there are four
categories of measurement: (1) relative return on a financial measurement expressed in per-
centage terms, (2) increase or decrease in absolute dollars; (3) relative value of percentages
other than returns on income; and (4) various combinations of the first three. For example,
two relative return formulas could be selected (e.g., ROA and ROE), with performance meas-
ured in terms of which was greater or which was less. An absolute increase formula (e.g., net
income) could be combined with a relative return (e.g., ROE) to determine performance,
defined as the extent to which net income exceeded a prescribed ROE minimum.
Permutations and combinations abound and more will be illustrated later in this chapter.
Relevance of Financial Measurements. Whereas old economy companies have relied on
traditional financial measurements more than new economy companies, how important are
earnings in determining a company’s stock price? Some will argue that the stock price is the
present value of future earnings. Others will argue that it accounts for less than 20 percent.
The new economy provides many examples to validate this view.
While financial measurements are commonly used in short-term and long-term incen-
tive plans, do they really reflect the way an organization measures its performance? They
account for financial stewardship, but do they measure value added? Furthermore, they are
backward looking not forward focused and therefore do not highlight important changes
until after the fact. For these reasons, exclusive use of financial measurements is probably
inappropriate. There are nonfinancial performance measurements that, although more
difficult to quantify than financial measurements, may be more appropriate in indicating
how an organization is truly performing. However, such measurements lack the definition of
consistency of financial measurements, which are prescribed by GAAP.
Other Key Measurements Within the Company As we have seen, there are a number
of financial measurements available; however, they exclude a host of other items that could,
and maybe should, be measured. Financial measurements do not include all factors that man-
agement looks at when running the company. These factors include nonfinancial assets and
processes that led to the creation of value and execution of strategy. Often these are grouped
in a category called goal sharing since eligible persons share credit for the extent to which the
goal has been achieved. When including nonfinancial measurements, it is important that
each be clearly defined in terms of output and time. Needless to say, the objective must be
important to the organization and it must be attainable. Here are some possibilities: