Management Accounting and Control System

1. Management Accounting and Control System Management accounting and control system (MACS) provides information to monitor and assess whether the corporate objectives are being achieved.

2. Design of MACS Technical and behavioural considerations in MACS • Technical considerations: • Quality of information • Comprehensive and include all activities across the value chain (traditional vs. ABC)

3. Design of MACS • Behavioral considerations • Effectiveness of MACS: design based on the scientific management school or the human relations movement • MACS needs to play a behavioural-influencing role through: • Comprehensive code of ethics (based on legal rules, societal norms, professional memberships, organizational or group norms, and personal norms. • A mix of short- and long-term qualitative and quantitative performance measures ( “What gets measured gets done”, but need to choose measures very carefully). • An appropriate incentive system to reward performance.

4. Incentive System to Reward Performance:Linking Rewards to Performance REWARDS (to attract and retain talented employees) PERFORMANCE Organizational Goals & Objectives Measurement of Results or Outcomes

5. The Expectancy Theory • The expectancy-valence theories (Atkinson, 1957; Vroom, 1964) are frequently cited to explain the influence of incentives on human behaviour. • Monetary rewards or incentives increase the valence (desirability) of successful task outcome (or task performance). • The higher the valence of successful task performance, the greater will be the motivational force or push to achieve success. • The increase in motivation increases the willingness to expend time and/or effort to attain the task (organization’s) goal. • The effectiveness of incentives, however, is a function of the skills and knowledge of the decision-maker.

6. Agency Theory • An agency relationship occurs when the principal hires the agent to perform a service that requires the principal to delegate certain decision-making authority to the agent. • In an organization, there may be two levels of principal-agent relationships: • The agency theory assumes: • Agent seeks to balance return from, and cost of, his/her efforts • Agent bears no moral burden • Incentive compensation plans are to align agents’ interests with those of the principals, and to minimize agency (monitoring) costs. 1 BOD Top-mgt team 2 Decentralized unit managers

7. Intrinsic Rewards • Intrinsic rewards come from within an individual and arises from satisfaction from a job well-done or from doing things that are consistent with one’s beliefs or values. • According to cognitive evaluation theory (Deci & Ryan, 1980), the innate psychological needs for competence and self-determination are the basic determinants of intrinsic motivation. • Interesting and challenging tasks provide high intrinsic rewards.

8. Extrinsic Rewards • Extrinsic rewards are rewards received from others, such as cash bonuses, prizes, awards and course grades for jobs well-performed (i.e., wages compensate minimum acceptable efforts, rewards are used to motivate additional efforts). • McGraw (1978) concludes that extrinsic rewards would facilitate tasks that are boring or monotonous and require straightforward and mechanical solution procedure, but could be detrimental to tasks that are interesting or challenging.

9. Extrinsic Rewards In most compensation system designs, the type of incentives considered are generally extrinsic in nature. Where people are adequately compensated financially, designing jobs and establishing an environment and culture that lead employees to derive intrinsic rewards just by working become a challenging task for management. Providing recognition awards or medals is a way to satisfy the ego of employees and hence, the rewards may be intrinsic in nature.

10. Performance-based Rewards • Performance based rewards are awarded on achieving or exceeding some measured performance. • Absolute performance, e.g., quantity produced, profit achieved, share price performance. • Relative performance, e.g., favourable variance, EVA, above-average performance. • Organizations’ information systems provide relevant and reliable performance information or indicators.

11. Effective Performance Measurement and Rewards (and Compensation) Systems Appropriately chosen job or operations-related performance measures to signal which aspect(s) of the job is (are) important. A mix of measures may be necessary. Employee must be able to see the relationship between effort, performance and rewards, i.e., system is fair and predictable or transparent. Standards set must be acceptable (controllable outcomes) and measurement system must be reliable. The performance measures leads to behavioural changes beneficial to attainment of organizational objectives.

12. Effective Performance Measurement and Rewards (and Compensation) Systems must understand the organization’s goals and strategies and how individuals in the organization must act or behave to attain those goals. performance measures must be transparent and within the control of the individual employee; rewards must be equitable to all level of employees, rewards must be given on a timely basis to reinforce behaviour.

13. Effective Performance Measurement and Rewards (and Compensation) Systems • Accounting system collects the data, analyse and report the measures for determination of the rewards due. • Incentive compensation systems work best in organizations in which employees have the skill and authority to react to environmental conditions and according make the appropriate decisions. Where employees merely follow rules and procedures, the systems are enforcement systems.

14. Types of Incentive Compensation Plans • Types of Rewards/Incentive & compensation systems: Basis of Award. • Based on business unit/department’s attainment of financial targets – possible to cause goal incongruence. • Based on corporate (current or average over 4 to 5 years) financial results or performance – lead to better team spirit and long-term view of performance • Based on both financial and non-financial (operational measures)performance measures (Bonuses can be in cash or in stock options, and paid immediately, deferred or over 3-5 years) • Individual or Group performance for awarding incentives ? • Group-based rewards encourage team work and cooperation – but may encourage free-riding on efforts of others. • Combination of group and individual-based rewards system. • Rewards or incentives can be paid immediately or deferred;cash or equity; monetary or non-monetary (fringe benefits or awards)

15. Types of Monetary Compensation Plans Cash or stock bonus or profit sharing (e.g., % of profits for bonus) • One-off payment based on individual or group performance. • May have no clear link between individual’s efforts and organization’s financial performance; problem with free riders. • Stock bonus imposes a need for cash to pay taxes and possible risk-adverse behaviour. • Consider using EVA measure for determination of bonus payments. • Gain-sharing distributes cash bonuses based on gains or savings arising from performing better than the target and such system promotes employee participation, teamwork and innovations.

16. Types of Monetary Compensation Plans • Stock options • Would dilute EPS. • Lack direct relationship between stock performance and staff contributions. A lavish reward during the bull market.

17. Types of Monetary Compensation Plans • Deferred bonus and compensation (e.g., golden handshakes) • Mainly aim at tying senior executive to organization, or to ensure continual efforts to sustain organization’s performance. • Performance shares (for achieving some long-term performance growth objectives or targets. • More long-term oriented, but suffers weaknesses of accounting-based measures • Stock Appreciation Rights and Phantom Stock • Essentially deferred cash bonuses dependent on future share price • Participating Units – payment is linked operating results (accounting-based) rather than to share price.

18. Agency Costs and Incentive Compensation Plans • Agency costs comprise cost of incentives, monitoring cost through periodic reporting and cost of other actions diverge from owners’ interests. • Problems with Incentive Compensation Plans: • Stock options: lack of direct causal relationship between share price and management actions due to many uncontrollable external factors; too much firm-specific risk (high risks for their reputation,bonuses & wealth) – risk adverse actions by agents that are perceived as too conservative by principals. • Accounting-based measures: leads to possible dysfunctional behaviours (short-term outlook) and “creative accounting” to manipulate profits. • Could BOD impose rules for measuring profits? Yes, but uncomfortable to use income numbers that are different from those reported to shareholders for rewards. • Compensation committees are not truly independent of top management.

19. Bonus Pool and Allocations • Normally a pre-determined % of the excess of after tax profit over the required return on investment or capital employed, with perhaps a limit based on dividends paid. • Danger of use of low capital base (consequences of past losses, ‘big bath’ approach, debt instead of equity financing and non-price-adjusted capital base) • During boom times, the lavish bonuses may not justify the relative poor performance. • Allocation of bonuses is normally proportionate to salary, and this gives rise to free-rider problem. Allocation should be based on the perceived importance of the job and the success achieved in the assigned task.

20. Models for Incentives Contracts Problems of using budgets or standards as benchmarks for performance evaluation: • Moral hazard problem as a consequence of the individual manager to intentionally misrepresent his/her specialised or private information to result in an understatement of budget or standard. • Information impactedness that results in a manager not conveying truthfully the valuable, and perhaps unique, information about the environment, due to self-interest.

21. Models for Incentives Contracts General conclusions: • A flat wage is not effective because the employee (the agent) will not keep his/her promise by providing a lower level of effort than expected under the contract. • Compensation package must tie rewards to performance (performance contingent rewards): • A risk premium for risk-adverse employee • Truth-inducing incentive for accurate (private or specialist) information, say for forecasting or budgeting. • Total rewards comprise a flat wage plus a profit sharing scheme based on the total corporate expected profits and the profit variance in the manager’s division).