An Overview of Management Compensation

7/30/2019 An Overview of Management Compensation

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An overview of management compensation

Luann J. Lyncha, Susan E. Perryb,*aDarden Graduate School of Business, University of Virginia, PO Box 6550,

Charlottesville, VA 22906-6550, USAb

McIntire School of Commerce, University of Virginia, Monroe Hall,Charlottesville, VA 22906-6550, USA

Received 1 November 2001; received in revised form 1 September 2002; accepted 1 October 2002

Abstract

Accounting curricula should change to meet the evolving needs of business, including needs of

the accounting profession. One increasingly complex element of the business environment is the

appropriate design of management compensation systems. Concerns regarding the level of execu-

tive pay, the debate over stock options, the emphasis by the International Accounting StandardsBoard on determining appropriate accounting for share-based compensation, and the lack of

current accounting standards regarding share-based compensation in most countries challenge our

thinking regarding the accounting for and the design and evaluation of compensation alternatives.

As future accountants, consultants, and financial managers designing and accounting for com-

pensation plans, students must understand both the broader business issues surrounding the use

of these contracts and the accounting, tax, and managerial issues associated with compensation

alternatives. We provide a general discussion of different compensation mechanisms, their bene-

fits and limitations, and their related financial, tax, and managerial accounting implications. In

addition, we provide technical references to enable students to conduct a detailed investigation of

each type of compensation to facilitate a rich, rigorous discussion in the classroom. We recom-

mend using this paper in financial, tax, and managerial accounting courses to broaden studentsunderstanding of all these issues beyond the more focused discussions typical in these courses.

# 2002 Elsevier Science Ltd. All rights reserved.

Keywords: Management compensation; Stock options; Executive compensation

1. Introduction

Accounting curricula should change to meet the evolving needs of business, inclu-

ding needs of the accounting profession (see, for example, Albrecht & Sack, 2000). One

J. of Acc. Ed. 21 (2003) 4360

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0748-5751/03/$ - see front matter # 2002 Elsevier Science Ltd. All rights reserved.

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* Corresponding author. Tel.: +1-434-924-3988; fax: +1-434-924-7074.

E-mail addresses: [email protected] (S.E. Perry); [email protected] (L.J. Lynch).
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increasingly complex element of the business environment is the appropriate design of

management compensation systems. Recently, there has been much controversy

surrounding executive and employee compensation that has challenged our thinking

regarding the accounting for and design and evaluation of compensation alter-natives. First, concern regarding the level of executive pay has continued to escalate

over recent years, and is particularly heated when pay does not appear to reflect

corporate performance (Bryant, 2000; Koudsi, 2000; Ozanian, 2000; Reingold,

2000). Second, the debate over stock options has intensified, as much of the increase

in pay levels has resulted from their use. Various parties have called for changes to

stock option accounting, restrictions on the tax deduction associated with stock

options, and tighter control of stock options granted to executives (Frangos, 2002;

Hitt, 2002; Ip, Kelly, & Lublin, 2002; Jenkins, 2002; Lagomarsino, 2002). Further,

the use of practices such as stock option repricing has posed accounting challenges.

Finally, the International Accounting Standards Board is currently debating appro-

priate accounting for share-based compensation. In recent years, the use of share-

based compensation has increased significantly in some countries, particularly in

Europe, yet little accounting guidance exists, as most countries do not have accounting

standards on share-based compensation (IASB, 2002).

The trend towards higher levels of pay and an increased use of stock options can be

partially explained by a number of factors. First, competitive labor markets have

made retention of employees a primary concern for companies. Compensation plans

with vesting periods or long-term performance incentives have evolved in response to

retention concerns. Second, the bull market of the late 1980s and 1990s led companiesand employees to increase their focus on equity-based compensation structures. Third,

many compensation plans have favorable financial accounting and tax implications

under US GAAP and US tax rules that reinforce their use. Fourth, since 1994, US tax

rules limit the corporate deduction for non-performance-based pay for the CEO and

each of the four other highest paid executives to $1 million.1 Since certain types of

performance-based compensation are excluded from this limit, an increase in empha-

sis on performance-based compensation has resulted. Finally, start-up firms, which

typically struggle for earnings, often are cash constrained and rely heavily on human

capital as their primary asset. In part, these firms have set the pace for equity-based

compensation schemes, which require little or no cash outlay, can be designed forfavorable accounting and tax treatment, and can be effective retention tools.

This paper provides a general discussion of different compensation mechanisms,

their benefits and limitations, and their related financial, tax, and managerial

accounting implications.2 We focus our discussion regarding financial accounting

and tax issues on US GAAP and US tax rules, for several reasons. First, much of

1 See Internal Revenue Code Section 162(m)(4)(c).2 The accounting and tax implications discussed are generally reflective of current practice. This paper

is designed to present a conceptual understanding of compensation systems, primarily for classroom use,

and is not recommended for authoritative accounting and tax guidance. For specific details on these

issues, the reader should consult relevant financial accounting standards and sections of the Internal

Revenue Code. In addition, we assume throughout this paper that the company uses accrual basis

accounting.

44 L.J. Lynch, S.E. Perry / J. of Acc. Ed. 21 (2003) 4360
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the controversy surrounding compensation practices has centered in the US and

stems directly from the favorable accounting and tax treatment that US GAAP and

tax rules afford some forms of compensation. Second, there currently is no inter-

national accounting standard for share-based compensation, so the USA serves asone of the best laboratories for considering issues related to accounting for various

compensation practices.

As educators, we believe that a basic understanding of the fundamentals of man-

agement compensation systems will improve accounting students effectiveness as

they move from the university into the business world. As future accountants

attempting to appropriately consider the accounting and tax implications for vari-

ous compensation contractual arrangements, students must understand the related

business issues so that accounting can properly reflect the substance of these con-

tracts. Likewise, as potential future financial consultants or managers, students must

understand the financial accounting, tax, and managerial issues associated with

compensation alternatives in order to implement compensation plans that effectively

motivate and retain employees while having a reasonable financial impact on the

organization.

Accounting textbooks typically include only one aspect (financial, tax, or manage-

ment accounting) of compensation decisions. However, in teaching the accounting

for and the design and evaluation of compensation packages, it is important to

realize that compensation decisions are not made by considering financial, tax, and

management accounting issues in isolation, but are made by considering these fac-

tors simultaneously. First, the economic effects of compensation plans may be sig-nificant, but measurement of these effects remains a difficult financial accounting

issue. At present, substantial portions of management compensation are not repor-

ted in the income statements or balance sheets for many companies. Additionally,

compensation systems may affect managers choices of financial accounting policies

(Watts & Zimmerman, 1986). When managers compensation is dependent on

reported accounting numbers such as earnings, those managers have incentives to

manage reported earnings to maximize their compensation, through discretionary

accruals or through the selection of alternative accounting methods such as depre-

ciation or inventory accounting methods.

Second, tax issues related to compensation schemes can have an impact on bothcorporations and employees (see Jones, 2003; Jones & Rhoades-Catanach, 2002;

Scholes, Wolfson, Erickson, Maydew, & Shevlin, 2001). The employer weighs after-

tax costs of compensation against perceived benefits, while the employees objective is

to maximize the after-tax value of their compensation. Therefore, compensation

schemes often are chosen after an evaluation of the tax consequences to both parties.

Third, there are management accounting issues associated with compensation plan

design. Agency theory suggests that separation of ownership and control leads to

issues that can be partially addressed through the design of management compen-

sation plans (Anthony & Govindarajan, 2000; Jensen & Meckling, 1976). Specifi-

cally, employees, as agents of the firm, are assumed to be risk-averse, with aninterest in increasing their own wealth. As a result, the interests of employees are not

always naturally aligned with interests of the shareholders. By linking pay with

L.J. Lynch, S.E. Perry / J. of Acc. Ed. 21 (2003) 4360 45


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performance, compensation contracts can be used to help align the interests of

employees with those of shareholders. In designing such contracts, one must consider

issues such as the inherent performance incentives, retention incentives, controll-

ability of the performance measures being used, and the effect on employees riskaverse behavior, each of which we discuss for each compensation mechanism.

We recommend using this paper in financial accounting or tax courses to broaden

students awareness and understanding of compensation issues beyond the more

focused financial accounting or tax implications typically discussed in these courses.

We also recommend using this paper in managerial accounting courses because not

only should students consider the managerial implications of various compensation

alternatives, but they should be prepared to consider financial accounting and tax

implications when designing and evaluating these plans. This paper can be used as

general background reading for a class discussion of compensation alternatives or as

a group exercise. If used as a group exercise, we suggest that the instructor divide the

class into groups of several students, request that students read the entire paper as a

general overview, and assign each group a specific component of compensation to

research more thoroughly and present to the class.3 We provide a table of technical

references in the Appendix to facilitate this exercise.

2. Components of compensation structure

2.1. Salary

Compensation packages can be viewed as comprised of two general components:

(1) a fixed or non-performance-based element (e.g. salary), and (2) a variable or

performance-based portion.4 One benefit of using salary as a compensation

mechanism is that employees have certainty about the payout of their compensation

package. In addition, since the payment with performance-based compensation is

less certain than the payment under compensation plans comprised only of a fixed

salary, plans with performance-based components place greater risk on the

employee than do plans without them. As a result, companies may have to pay a

premium to compensate employees for assuming this increased risk. Risk averse andundiversified executives will be willing to accept stock-based pay instead of cash

only if the value of stock-based pay is substantially greater than the value of the cash

foregone (Hall & Murphy, 2002).5 This suggests that the expected total compensation

cost is greater for plans that rely more heavily on performance-based compensation.

3 We thank an anonymous referee for this suggestion.4 While changes in salary from year to year may be influenced by performance, an employees salary at

the beginning of a period generally is set at a fixed level rather than allowed to vary based on performance

during the period.5 Hall and Murphy (2002) quantify the point of indifference between receiving all cash compensation

and receiving bonus compensation in restricted stock or stock options, for different levels of executive risk

aversion and different levels of executive wealth in company stock. They show that the point of indiffer-

ence results in a substantial premium being paid with stock-based pay as compared to cash compensation.

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Conversely, the expected total compensation cost usually is lower with plans relying

primarily on salary.6

Limitations of using salary as the only component of the compensation plan

include limited incentives for both short-term and long-term performance. As aresult, decisions regarding the proportion of compensation that should be perfor-

mance-based often involve a cost versus benefit assessmentwhether the benefits of

increased performance that come from using performance-based compensation

outweigh the additional compensation costs that arise from the risk premium the

company must pay the employee for accepting increased uncertainty associated with

performance-based compensation. When those costs outweigh the benefits, the sal-

ary component of compensation is likely to be high.

For financial reporting purposes, the company records compensation expense

during the period in which employees earn their salary. For tax purposes, employ-

ees pay ordinary income tax on the salary received during the year, and the

employer takes an equivalent tax deduction in the year the liability to pay the salary

is incurred.7

2.2. Annual performance bonus

An annual bonus is an award for performance during a pre-determined time per-

iod, typically one year. These bonuses usually are used to provide an incentive for

employees to focus on short-term performance. However, since bonuses typically are

based on accounting numbers, they can encourage manipulation of the accountingnumbers and a focus on short-term performance at the expense of long-term per-

formance, resulting in sub-optimal operating decisions.

Bonuses can be structured in a variety of ways. For example, bonuses can be

based on a strict formula or can be determined subjectively by the board of directors

or compensation committee. Bonus plans may have thresholds below which no

bonus is provided or ceilings over which no incremental bonus is paid. Bonuses can

be based on individual, business unit, or corporate performance. The more inter-

dependence the company has among business units, the greater the tendency for the

bonus to be based on corporate performance to encourage cooperation across busi-

ness unit boundaries and to better achieve corporate goals.For financial reporting purposes, the company records compensation expense dur-

ing the period in which the employee earns the bonus. For tax purposes, employees

pay ordinary income tax on the amount of bonus received during the year, and the

employer takes an equivalent tax deduction in the year the liability is incurred.

Example: Ace Plastics has a performance bonus plan based on the firms actual

net income compared to budgeted net income. If the annual actual net income

6 Clorox provides an example of a company that has made an explicit exchange of cash for stock-based

pay. As reported in its 1996 proxy statement, Clorox offered executive officers the opportunity to take all

or a portion of their annual bonus plan awards in stock rather than in cash. Those executives electing to

take stock instead of cash received a 20% premium on the bonus.7 This tax deduction is limited to $1 million for the CEO and the four other highest paid executives.



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is greater than budgeted net income, twenty percent of the excess of actual net

income over budgeted net income is put into the bonus pool for distribution to

employees. In 2000, Ace reported net income of $1,200,000 compared to budget

of $1,000,000. The amount in the bonus pool for 2000 is $40,000(($1,200,000$1,000,000)20%). Ace records compensation expense for finan-

cial reporting purposes and gets a tax deduction in the amount of $40,000 in

2000. Employees pay ordinary income tax on the bonus in the year in which

they receive the bonus payment.

2.3. Fringe benefits

Fringe benefits can include non-cash or other indirect forms of compensation.

Examples include employee food facilities, childcare, professional dues, and com-

pany cars, among others. These benefits can help in the attraction and retention of

employees, particularly if the employer can provide a benefit at a lower cost than the

employee would pay if he/she purchased it individually. The employer records an

expense for the cost of providing fringe benefits for financial reporting purposes,

and receives a corresponding tax deduction. However, for employees, the tax

treatment of fringe benefits varies. For example, personal use of a corporate plane

by top management is a taxable fringe benefit, but medical and life insurance, if

offered to all employees on a non-discriminatory basis, are not taxable to the

employee.

2.4. Stock

Stock can be granted to employees outright or can be granted with restrictions. In

addition, the granting of stock can be contingent on performance requirements. A

primary benefit associated with the use of stock as compensation is that it requires

no cash outlay by the company. In addition, if the employee retains ownership of

the stock after receiving it, the granting of shares for compensation purposes pro-

vides a long-term performance incentive since the employee gains the most when the

companys stock is performing the best.However, the use of stock as a performance incentive brings with it several con-

cerns. First, managers and employees may have limited ability to affect the com-

panys stock price. To the extent the stock price is less controllable, it is a less

effective performance incentive. Second, increased stock ownership by managers

may increase risk averse behavior. As their ownership in the company increases,

managers fortunes become more dependent on stock price performance and can

be highly affected by stock price declines. As such, managers may seek to reduce

this downside risk by avoiding risky projects that may be desirable to shareholders

(because they offer the potential for high returns) but that may lead to large stock

price declines if they fail (Kaplan & Atkinson, 1998). Third, shareholder dilution isa primary concern to existing shareholders. As employees receive more stock,

existing shareholders claims to the companys future value and dividend payments



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may decrease because the proportion of the company stock that they own

decreases.

2.4.1. Outright grant of stockOn occasion, companies grant shares of company stock to employees as a means

of compensation. With an outright grant of stock, for financial reporting purposes,

the company records compensation expense at the grant date based on the market

value of the stock.8 The employee pays taxes at ordinary income tax rates at the

grant date based on the market value of the stock, and the company gets an

equivalent tax deduction. The market value of the stock on the grant date becomes

the employees basis in the stock. When the employee sells the stock, he pays capital

gains tax on the difference between the market value of the stock on the selling date

and the market value of the stock on the grant date.

Example: Barnes Corporation distributed 1,000 shares of its stock to a key

executive as part of the compensation package in 2000. On the date of the

distribution, Barnes Corporations stock has a market price of $50 per share. In

2000, Barnes records compensation expense and gets a tax deduction of

$50,000. The executive pays ordinary income taxes on the $50,000 in 2000. The

executive sells the 1,000 shares of stock for $60 per share in 2002, and pays

capital gains tax in 2002 on the $10,000 capital gain (($60$50)1,000 shares).

2.4.2. Stock granted with restrictions

Restricted stock is an award of company stock to an employee that is subject to

return to the company if certain restrictions are not met. Restrictions most often

include the requirement that employees remain with the company for a specified

period or that certain performance goals are met.

Benefits of restricted stock include a retention incentive because employees must

remain with the company through the vesting period to be awarded the stock.9 In

addition, unlike stock options discussed below, after the vesting period, the

employee can sell the stock regardless of its value. Thus, restricted stock guarantees

holders some value even if the stock price drops. As with other stock compensation,managers risk averse behavior may increase with increased ownership as managers

attempt to avoid downside risk.


equal to the market value of the shares issued at the grant date. This compensation

expense is recognized over the employee service period.10 For tax purposes, the

employee is taxed at the vesting date at ordinary income tax rates on the market

8 In general, if the employee is required to pay some amount for this stock, then the expense is based

on the market value less the amount paid.9 The vesting period is the period of time after which the rights to the stock are transferred to the

employee and substantial risk of forfeiture of the stock no longer exists.10 In general, the employee service period is the period over which the employee earns the right to the

restricted stock, and is often the vesting period.

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value of the stock on that date, and the employer gets an equivalent tax deduction in

the same year.11 The market value of the stock on the vesting date becomes the

employees basis in the stock. When the employee sells the stock, he pays capital

gains taxes on the difference between the market value of the stock on the sellingdate and the market value of the stock on the vesting date.

Example: On December 31, 1995 Carlton Company awarded 500 shares of its

stock to a key employee, Casey Cantel. If Cantel quit his job before December

31, 2000, he had to return the 500 shares. On December 31, 1995 the stocks

market value was $50 per share, or $25,000 in total. The market value of the

stock increases to $75 per share, or $37,500, on December 31, 2000. Cantel did

not leave the firm and paid ordinary income tax on $37,500 income when the

restriction lapsed on December 31, 2000. Carton Company took a $37,500 tax

deduction in 2000 as well. For financial reporting purposes, Carlton Company

recognized a total compensation expense of $25,000 spread over the employee

service period. Cantel sells the stock for $85 per share in 2002, and pays capital

gains tax in 2002 on the $5,000 capital gain (($85$75)500 shares). (Alter-

natively, Cantel could have chosen to recognize $25,000 income and pay

ordinary income tax in 1995. If Cantel made this election, Carlton Company

would have recorded compensation expense and taken a tax deduction in 1995

for $25,000. When Cantel sold the stock in 2002, he would have paid capital

gains tax on the $17,500 capital gain (($85$50)500 shares). However, if

Cantel left the firm before December 31, 2000, he could not have recovered thetax paid on the forfeited shares.)

2.4.3. Performance shares

Performance shares are a specified number of shares that are awarded after

established performance goals are met, usually over several years. The benefits of

performance shares include a performance incentive and a retention incentive

because employees typically must remain with the company through the perfor-

mance period to be eligible for the award. The award is in the form of shares of

stock; however, the monetary amount of the award usually is determined by mea-sures other than the change in stock price, such as accounting earnings or return on

assets. This addresses the concerns of employees that controllability of stock price is

beyond their power. However, since the amount of the award typically is determined

based on operating results, performance shares can result in attempts by managers

to manipulate accounting numbers.


equal to the market value of the shares issued at the award date, which is allocated

11 Alternatively, the employee can choose to pay tax at the grant date on the value of the stock less the

amount paid. Then, future appreciation is taxed as capital gains in the year the employee sells the stock.

However, if restrictions are not met and the employee has to return the stock to the company, the

employee is not entitled to a refund of tax already paid. More complex alternatives can be used to defer

taxes in some circumstances.

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over the employee service period. At the award date, the employee pays taxes at

ordinary income tax rates based on the market value of the stock on that date, and

the company gets an equivalent tax deduction. The market value of the stock on the

grant date becomes the employees basis in the stock. When the employee sells thestock, he pays capital gains taxes on the difference between the market value of the

stock on the selling date and the market value of the stock on the grant date.

Example: Damon Inc. has an incentive plan that awards shares to employees

when the firm exceeds rolling three-year performance goals. If the return on

assets exceeds 10% for a three-year period, each employee covered under the

plan will receive 100 shares of company stock at the end of that three-year

period. Actual return on assets for the three-year period exceeded 10%. At the

end of the three-year period, the market value of stock is $15.00 per share. The

company records compensation expense over the three-year service period in

the total amount of $1,500 per employee. At the award date, each employee

pays ordinary income tax on $1,500, and Damon Inc. takes a tax deduction for

the same amount. One of the employees sold his 100 shares for $20.00 per share

two years after receiving it. During that year, he pays capital gains tax on the

$500 capital gain (($20$15)100 shares).

2.5. Stock options

Stock options are a right to purchase a specified number of shares of a companys

stock at a specified price (called the exercise or strike price) for a specified period of

time (called the option period, or life of the option). Companies typically grant fixed

options, where the exercise price is fixed and the number of shares can be determined

at the grant date.12 The exercise price usually is set equal to the market price of the

underlying stock at the grant date, and typically remains fixed over the life of the

option, although there are exceptions. Employee stock options often have a life of

510 years and a vesting period of several years before which the stock options

cannot be exercised.

Stock options are becoming a standard part of both executive and non-executivecompensation packages. A 1998 Towers Perrin study finds that 78% of US com-

panies provide stock options (Orr, 1999). Interestingly, non-top-five-executive

employees hold most stock options. A study of large firms over the 19941997 time

period finds that 75% of stock options are granted to non-top-five employees (Core

& Guay, 2001). Over a similar time period, a survey by ShareData finds that, of

companies with stock options plans and more than 5,000 employees, the percent

that grant options to all employees increased from 10 to 45%. In addition, 74% of

companies with less than $50 million in sales grant options to all their employees

(Morgenson, 1998).

12 In contrast, variable options either have an exercise price that varies over the life of the option, or the

number of shares cannot be determined at the grant date.

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However, the use of stock options is not without controversy. Several parties,

including Federal Reserve Chairman Alan Greenspan, have been very critical of

stock option accounting practices in the face of increasing use of this form of com-

pensation (see, for example, Frangos, 2002; Lagomarsino, 2002). Members of Con-gress have considered denying the tax benefits of stock options when related

expenses are not recognized in the financial statements (Hitt, 2002). Former SEC

Chairman Harvey Pitt suggested increased control over stock options used to com-

pensate executives (see, for example, Ip et al., 2002).

Stock options are a method of compensating employees that requires no cash

outlay by the company. Stock options create the incentive for managers to act in the

long-run best interest of the company since payout is linked to value creation as

reflected in the stock price. However, options suffer from the concern that stock

price fluctuation may be independent of management control. This is especially true

as stock options are issued to employees at lower levels in the organization because

they may have even less ability than executives to influence the stock price directly.

Stock options do provide the potential for capital infusion to the firm since

employees must pay to exercise their options. However, shareholder dilution raises

serious concerns. As employees exercise more options, existing shareholders claims

to the companys future value and dividend payments may decrease. Stock options

provide retention incentives since holders are subject to vesting period requirements

and may be motivated to stay with the company long enough to exercise their

options. In addition, employees holding stock options do not face the same increase

in risk aversion as employees with stock ownership, since with stock options there islimited down-side risk associated with stock price declines but unlimited upside

potential (Kaplan & Atkinson, 1998). In fact, options may lead to risk seeking

behavior by executives as they try to capture this unlimited upside potential by

aiming for larger gains (Casey, 2002).

A primary benefit of stock options is that, for US GAAP financial reporting

purposes, most companies do not have to record compensation expense. A com-

pany has two choices when accounting for stock options for financial reporting

purposes. Under the first alternative (known as the fair value method), the com-

pany records compensation expense equal to the fair value of the options at the

grant date, determined using an option pricing model. The expense is allocatedover the employees service period.13 Few companies elect to use this method.

Under the second alternative (known as the intrinsic value method), the company

records compensation expense equal to the difference in the market price of the

stock at the grant date and the exercise price of the options. The expense is

allocated over the employees service period. Since most companies issue fixed

price options and set the exercise price equal to the market price of the stock at

the grant date, this method typically results in no compensation expense being

recorded.14

13 The employee service period is often the vesting period of the option.14 An exception is variable options, for which companies are required to record compensation expense

in future periods based on the change in its stock price.

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2.5.1. Non-qualified options

For US tax purposes, there are two types of optionsnon-qualified options and

incentive stock options. Non-qualified or non-statutory options can be granted to

employees, directors, consultants, independent contractors, and others. For non-qualified options, taxation of compensation is deferred until the option is exercised.

At that time, the employee pays tax at ordinary income tax rates, and the company

is allowed a tax deduction on the difference between the market price of the stock at

the exercise date and the exercise price of the option. The amount the employee pays

to exercise the option (the exercise price) becomes the employees basis in the stock.

When the employee sells the stock, he pays capital gains tax on the difference

between the market value of the stock on the selling date and the exercise price of

the option.

Example: In 1996, Edwards, Inc. granted stock options to each employee under

a non-qualified stock option plan. When the options were issued, the market

price of companys stock was $12 per share. Each employee received an option

to purchase 100 shares of stock at an exercise price of $12 per share and a

vesting period of four years. Eric Eldo, an employee, exercised his options in

2000 when the market price of the stock was $30 per share and paid $1,200 for

stock valued at $3,000. He sold the 100 shares of stock for $40 per share in

2001. For financial reporting purposes, Edwards, Inc. records no compensation

expense related to the option.15 However, the company gets a tax deduction for

$1,800 (($30

$12)

100 shares) in 2000 when Eric Eldo exercises his options.Eric Eldo pays ordinary income tax on the $1,800 in 2000. When he sells his

stock in 2001, pays capital gains tax on the $1000 capital gain (($40$30)100

shares).

2.5.2. Incentive stock options

A much more restrictive type of option is the statutory or incentive stock option.

Incentive stock options can be granted only to current employees and have many

complex requirements. Incentive stock options are tax-advantaged for employees

instead of paying ordinary income tax, employees pay capital gains tax when thestock is sold on the difference between the market value of the stock on the selling

date and the exercise price of the option.16 However, employers receive no tax

deduction for the use of incentive stock options. As a result, incentive stock options

may be more advantageous for companies with low tax rates (like start up compa-

nies), and companies with net operating losses or net operating loss carryforwards.

Example: Assume the same facts as above, but now the stock options are not

from a non-qualified plan but instead are incentive stock options. Eric Eldo

15 This assumes that Edwards, Inc. chooses the second alternative (the intrinsic value method) when

accounting for stock options for financial reporting purposes.16 Capital gains tax rates usually are lower than ordinary tax rates.



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exercises his options in 2000 and receives 100 shares of stock. In 2001, Eldo sells

his shares when Edwards, Inc. stock has a market value of $40 per share. For

financial reporting purposes, Edwards, Inc. records no compensation expense

and gets no income tax deduction.17 Eric Eldo recognizes no income and pays notax when the options are exercised in 2000. However, when he sells the stock in

2001, Eldo pays capital gains tax on the gain of $2800 (($40$12)100 shares).

2.5.3. Recent issues

The use of options increased dramatically in the late 1980s and 1990s concurrent

with the bull market and other factors. However, more recently, as stock prices have

declined, options held by employees are increasingly out-of-the-money and have

little or no value.18 This can result in reduced retention and performance incentives

as employees begin to wonder whether their options will return to in-the-money

status. Several alternatives have surfaced for companies that are interested in pre-

serving the retention and performance incentives inherent in stock options. First,

some companies have repriced the options by adjusting the exercise price to the

lower stock price. A study of companies repricing stock options in 1998 finds that

they tend to be small, young, high-tech companies experiencing poor performance

and having options significantly out-of-the-money (Carter & Lynch, 2001). How-

ever, repricing options has been met with much opposition, as opponents of the

practice suggest that it rewards managers for poor performance. Further, companies

repricing options after 15 December 1998 must record an expense for financial report-

ing purposes, eliminating what was considered a benefit of stock options. As a result,repricing of stock options declined significantly in 1999 (Carter & Lynch, in press).

Second, companies can index stock options by tying the exercise price of the

option to some external benchmark, such as the S&P 500 index. If options are out-

of-the-money due to market downturns, this practice can insulate option holders

from market swings that are out of their control. However, companies that index

options are required to record an expense for financial reporting purposes. As a

result, few companies use this practice.

Other alternatives for addressing concerns about retention and performance

incentives include granting additional options or using other forms of compensation.

2.6. Stock appreciation rights and phantom shares

2.6.1. Stock appreciation rights

Stock appreciation rights (SARs) are a right to receive payments in cash based on the

appreciation in stock price (or increase in operating results) from the time of the award

until some specified future date. SARs can be tied to or granted with stock options so

that employees have enough cash to purchase those stock options upon exercise.

17 Again, this assumes that Edwards, Inc. chooses the second alternative (the intrinsic value method)

when accounting for stock options for financial reporting purposes.18 A stock option is out-of-the-money if the market value of the underlying stock is less than the exer-

cise price of the option.



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Like many other equity-based mechanisms, SARs provide an incentive for

employees to focus on long-term business results because employees compensation

is tied to long-term movements in the companys stock price. SARs provide an

employee a retention incentive since there often is a vesting period before whichemployees cannot exercise their SARs. However, as with other forms of equity

compensation, concerns regarding employees limited ability to affect the stock price

exist with SARs. An increase in risk averse behavior that can accompany employee

stock ownership is limited with SARs because, like stock options, they have limited

down-side risk and unlimited upside potential. An additional benefit of SARs is that

they can be used easily with private companies or when shareholder dilution or loss

of company control is of concern. Because the value of SARs depends on the com-

panys stock price performance, but stock need never be issued with SARs, they offer

the benefits associated with stock compensation without the potentially negative

impacts on shareholders. However, unlike stock options and stock, stock appreciation

plans require cash outlays by the company when the employee exercises them.

A company has two choices when accounting for SARs for financial reporting

purposes. Under the first alternative (known as the fair value method), the company

records compensation expense equal to the fair value of the SARs at the grant date,

determined using an option pricing model. The compensation expense is allocated

over the employees service period.19 Under the second alternative (known as the

intrinsic value method), the company records compensation expense equal to the

difference in the market price of the stock at the exercise date and the exercise price

of the SAR. This amount is estimated and allocated over the service period. For taxpurposes, the employee pays ordinary income tax during the year in which the SARs

are exercised. The company receives an equivalent tax deduction.

Example: In 1996, Franklin Enterprises offered Fred Farmer stock appreciation

rights (SARs) that allow him to benefit from the appreciation of 1,000 shares of

their stock. The SARs have a four-year vesting period after which time the SARs

can be exercised. On the grant date, the Franklin Enterprise stock was valued at

$15 per share. In 2000, after the SARs vest, Farmer exercised 500 SARs when the

market value of Franklin Enterprises was $25 per share. Franklin Enterprises pays

$5,000 cash (($25$15)500 shares) to Farmer. For financial reporting purposes,Franklin Enterprises records a total $5,000 in compensation expense, allocated

over the service period. Fred Farmer pays income tax on the $5,000 in 2000. Also

in 2000, Franklin Enterprises takes a tax deduction for the same amount.20

2.6.2. Phantom shares

Phantom share plans take on characteristics similar to other types of equity based

plans such as stock appreciation rights. A primary distinguishing feature of phan-

tom share plans is that, while most equity plans such as SARs are based on the

19 The employee service period is typically the vesting period of the SAR.20 This example assumes that Franklin Enterprises chooses the second alternative (the intrinsic value

method) when accounting for SARs for financial reporting purposes.

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change in value of a companys publicly traded stock, phantom share plans are

based on the performance of hypothetical stock. A primary advantage is that they

can be used for private companies or business units within a company that do not

have publicly traded stock, or for closely held companies whose stock is not fre-quently traded. Accounting and tax implications are similar to those inherent in

SARS.

2.7. Other deferred compensation

Full discussions of pensions and the intricacies of pension accounting are beyond

the scope of this paper. However, we briefly discuss deferred compensation since it is

a common component of the compensation structure. Deferred compensation refers

to an arrangement in which the employee earns the right to compensation but defers

income recognition for tax purposes until the compensation is received, often after

retirement.

2.7.1. Qualified retirement plans

A qualified retirement plan has fairly stringent rules to meet the statutory

requirements for federal tax purposes.21 A trust administers the plan and the

employer is required to make annual contributions to fund the plan. The plan also

must be equitable to all participating employees and may not discriminate in favor

of certain employees or groups of employees.

For financial accounting and tax purposes, the employer can deduct the amountof the annual contribution even though the employee defers recognition of the

income for tax purposes until the income is received.

2.7.2. Non-qualified retirement plans

While qualified plans provide positive tax benefits to both the employer and the

employee, the nondiscrimination requirement and the limited amount that employ-

ers can offer on a tax-deferred basis lead many employers to create non-qualified

deferred compensation plans. These plans may be offered to a select group of

employees and the dollar amount that can be deferred is not limited.

Employees do not recognize income for tax purposes until payment is received.The employer is not required to fund the plan but accrues a liability for financial

reporting purposes. For tax purposes, the employer deducts the nonqualified defer-

red compensation in the year the employee recognizes the income.

3. Conclusion

Recent controversy surrounding executive and employee compensation places

increased importance on understanding the financial, tax, and management account-

ing issues associated with alternative compensation plans. Concerns regarding the

21 See Internal Revenue Code Section 401-415 for requirements.

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level of executive pay, the debate over stock options, the emphasis by the Interna-

tional Accounting Standards Board on determining appropriate accounting for

share-based compensation, and the lack of current accounting standards regarding

share-based compensation in most countries challenge our thinking regarding theaccounting for and the design and evaluation of compensation alternatives.

We have discussed financial, tax, and management accounting implications of

some of the more popular types of compensation strategies observed in recent years,

including salary, performance bonuses, and equity-based compensation plans. Most

accounting resources focus only on one aspect (financial, tax, or management

accounting) of compensation decisions. However, decisions regarding compensation

result from a process of considering these factors in tandem. We have presented a

general integrated discussion of these factors as they relate to compensation alter-

natives and have provided a set of technical references that will facilitate more

detailed analysis and discussion of the benefits and limitations of these alternatives

in the accounting classroom.

As educators, we believe that a basic understanding of the fundamentals of com-

pensation systems will improve accounting students effectiveness as aspiring busi-

ness leaders, accountants, and financial managers. To effectively design and

implement compensation plans and to accurately reflect their economic impact when

accounting for those plans, students must understand both the broader business

issues surrounding the use of these contracts and the accounting, tax, and manage-

rial issues associated with compensation alternatives.

Acknowledgements

Luann Lynch gratefully acknowledges the financial support by the University of

Virginia Darden School Foundation. Susan Perry gratefully acknowledges the

financial support provided by the University of Virginia McIntire School of Com-

merce. We appreciate the helpful comments and suggestions by Sally Jones, Dave

LaRue, James Rebele (the editor), Tom Williams, an anonymous associate editor,

and two anonymous referees.



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Appendix. Technical references by type of compensation for financial accounting

treatment under US GAAP and tax treatment under US tax rules

Compensation

type

Financial

accounting technical

references (1)

Employer income

tax technical

references (2)

Employee income

tax technical

references (2)

Salary FASB Concept Section 162(a)(1) Section 61(a)(1)

Statement 6 Section 162(m) Reg. Sec.1.61-2(a)(1)

Section 263A

Annual performance FASB Concept Section 162(a)(1) Section 61(a)(1)

bonus Statement 6 Section 162(m) Reg. Sec. 1.161-2(a)(1)

Section 263AReg. Sec.1.62-27(e)

Fringe benefits FASB Concept Section 162(a)(1) Section 61(a)(1)

Statement 6 Section 162(m) Reg. Sec. 1.61-21

Section 263A Section 79

Section 105

Section 106

Section 129

Section 132

Outright stock FAS 123 Section 162(a)(1) Section 61(a)(1)

(unrestricted) APB 25 Section 162(m) Reg. Sec. 1.61-1(a)

Section 263A Reg. Sec. 1.61-2(a)(1)

Reg. Sec. 1.1032-1(a)

Restricted stock FAS 123 Section 162(a)(1) Section 83(a) and (b)

APB 25 Section 162(m) Reg. Sec. 1.83-1

Section 263A Reg. Sec. 1.83-2

Section 83(h) Reg. Sec. 1.83-3

Reg. Sec. 1.83-6

Reg. Sec. 1.1032-1(a)

Performance FAS 123 Section 162(a)(1)

shares APB 25 Section 162(m) Section 83(a) and (b)

Section 263A IRS Letter RulingSection 83(h) 7927021

Reg. Sec. 1.83-6

Reg. Sec. 1.162-27(e)(2)(vi)

Nonqualified stock FAS 123 Section 162(a)(1) Section 83(a) and (b)

options APB 25 Section 162(m) Reg. Sec.1.83-7

Section 263A

Section 83(h)

Reg. Sec. 1.83-6

Incentive stock FAS 123 Sections 421 and 422 Sections 421 and 422

options APB 25FIN 28

Repricing stock FAS 123 Reg. Sec. 1.162- No specific authority



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Compensation

type

Financial

accounting technical

references (1)

Employer income

tax technical

references (2)

Employee income

tax technical

references (2)

Options APB 25 27(e)(2)(vii)

FIN 44 Example 10

Stock appreciation FAS 123 Section 162(a)(1) Rev. Rul. 80-300,

rights and phantom APB 25 Section 162(m) 1980-2 C.B. 165

shares FIN 28 Section 263A Rev. Rul. 82-121,

Section 83(h) 1982-1 C.B. 79

Reg. Sec. 1.83-6

Qualified and non- FAS 35 Section 404 Section 72

qualified deferred FAS 106 Section 402

compensation FAS 87 Rev. Rul. 69-650,

1969-2 C.B. 106

(1) These references consist of the following: FASB Concept Statements, FASB

Statements and Interpretations, APB Opinions, AICPA Accounting Research Bulletins.

(2) These references are in the following: Internal Revenue Code, Treasury Reg-

ulations, Internal Revenue Service Revenue Rulings and Revenue Procedures,

Internal Revenue Bulletins.

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