Managerial Accounting:
An Introduction To Concepts, Methods, And Uses
Chapter 14
Incentive Issues
Maher, Stickney and Weil
Learning Objectives




(Slide 1 of 3)
Describe key characteristics of divisional
incentive compensation plans.
Explain how incentive plans can affect the
development phase of the product life cycle.
Compare and contrast expectancy and
agency approaches to motivation.
Describe the balanced scorecard as a way to
tie performance measures to organizational
goals.
C14 - 2
Learning Objectives



(Slide 2 of 3)
Explain the importance of performance
measures for the four balanced scorecard
perspectives.
Explain what constitutes fraudulent financial
reporting.
Define the two most common types of fraud
and demonstrate their impact on financial
statements.
C14 - 3
Learning Objectives



(Slide 3 of 3)
Identify the incentives for committing
financial fraud.
Explain how environmental conditions
influence fraudulent conduct.
Identify controls that can be instituted to
prevent financial fraud.
C14 - 4
Divisional Incentive
Compensation Plans (Slide 1 of 4)

Nearly all managers of decentralized profit
centers are eligible for bonuses and other
nonsalary incentives


Often make up 25% to 50% of their salaries
Form of bonus plan varies with payments made in:
 Cash,
 Stock or stock options,
 Performance shares,
 Stock appreciation rights, and/or
 Participating units
C14 - 5
Divisional Incentive
Compensation Plans (Slide 2 of 4)

Bonus can be:
 Contingent on corporate or divisional
results
 Based on annual performance or on
performance over several years
 Paid out immediately, deferred, or spread
out over several years
C14 - 6
Divisional Incentive
Compensation Plans (Slide 3 of 4)

Most divisional incentive compensation plans have
the following characteristics:
 Cash bonuses and profit sharing plans reward
managers for short-term performance
 Deferred compensation arrangements give
manages incentive to take actions that increase
long-run share value
 Special awards may be given for certain
accomplishments or for extraordinary performance
C14 - 7
Divisional Incentive
Compensation Plans (Slide 4 of 4)

When designing incentive plans, management
must determine two things:



The behavior the system motivates
The behavior management desires
Some argue that incentive compensation
plans may motivate managers to take actions
that make the numbers look good but may
not benefit the organization in the long-run
C14 - 8
Incentives and the
Product Life Cycle

One problem with short-run incentive
plans is that managers can be penalized
for developing new products that could
produce long-run profits


New product development costs are
typically expensed as incurred, reducing
net income (and perhaps bonuses)
Incentive plans should encourage new
product development activities
C14 - 9
Views of Behavior

(Slide 1 of 2)
Expectancy theory view - maintains that
people act in ways to obtain rewards
and to prevent penalties, so incentive
plans should:


Provide rewards that are desirable
Provide a good chance that behaving as
the organization desires will lead to those
rewards
C14 - 10
Views of Behavior

Agency theory - focuses on:



(Slide 2 of 2)
Relations between principals and agents where principals
assign responsibility and agents work on behalf of the
principal
The cost of agents pursuing their own interests instead of
those of the principal
Agency theory views the objective of an incentive
plan as minimizing agency costs, essentially trading
off the costs of control and incentives against the
cost of agents pursuing their own interests
C14 - 11
Balanced Scorecard


(Slide 1 of 5)
The balanced scorecard is a model of
performance indicators that include both
financial and nonfinancial measures
Most companies use four categories or
“perspectives” of performance measures

A company can build an incentive plan around
these four perspectives
C14 - 12
Balanced Scorecard

(Slide 2 of 5)
Learning and growth perspective - indicates how
well the infrastructure for innovation and long-term
growth is working
 Focuses on developing the capabilities of
employees
 Key measures for evaluating manager
performance in this area might include:



Employee satisfaction
Employee retention
Employee productivity
C14 - 13
Balanced Scorecard

(Slide 3 of 5)
Internal business & production process
perspective - indicates how well internal business
processes are working
 Closely related to the learning and growth
perspective


Employees are the best source of better ideas for better
business processes
Supplier relations are critical for success

Company may provide incentives for good supplier
relations such as certification programs
C14 - 14
Balanced Scorecard

(Slide 4 of 5)
Customer perspective - indicates how the
company’s strategy and operations add value to
customers
 Focuses on how a company should look to its
customers for success
 Company should provide incentives to employees
to meet customer expectations
 Performance measures might include:



Customer satisfaction and retention
Market share
Customer profitability
C14 - 15
Balanced Scorecard

(Slide 5 of 5)
Financial perspective - indicates whether
company’s strategy and operations add value to
shareholders
 Performance measures include:


Net income
Return on investment
C14 - 16
Motivational Issues in
Designing Incentive Systems

When designing incentive systems, choices
must be made regarding whether rewards are
based on:






Current or future performance
Division or company-wide performance
Fixed formulas or subjective assessments
Accounting results or stock performance
Absolute or relative performance
Cash awards, stock awards, or prizes
C14 - 17
Problems With Incentive
Compensation Plans


Managers and other employees are many
times placed under great pressure to meet
short-term performance standards like profits
and return on investment
Employees may be tempted to “cook the
books” by:




Carrying obsolete inventory on the books
Overstating revenue,
Understating costs, or
Other methods
C14 - 18
Fraudulent Financial Reporting

Fraudulent financial reporting is
intentional conduct resulting in
materially misleading financial
statements

For financial reporting to be fraudulent


It must result from intentional or reckless
conduct
Resulting misstatements must be material to
the financial statements
C14 - 19
Types of Fraud

Two most common types of fraud

Improper revenue recognition


Example: reporting profit-increasing effects of
revenue in the wrong accounting period
Overstating inventory

Leads to overstated earnings
C14 - 20
Causes of Financial Fraud


Fraudulent financial reporting may occur
because of a combination of pressures,
incentives, opportunities, and environment
May result from:



High-pressure performance evaluation systems
The environment top management sets for dealing
with ethical issues
Lack of, or inadequate, internal controls
C14 - 21
Internal Controls

Companies establish internal controls to help
prevent fraud


Internal controls are policies and procedures
designed to assure management that actions
undertaken by employees will meet organizational
goals
A basic internal control would involve a separation
of duties so that one employee could not carry out
a series of tasks to commit fraud and take steps to
hide it
C14 - 22
Auditing


Internal auditors can deter fraud by reviewing
and testing internal controls and ensuring
controls are in place and working properly
Independent auditors provide an opinion on
the financial statements

Fraud detection is not their primary responsibility,
but presence of auditors and their review of the
internal control system should help to deter it
C14 - 23
If you have any comments or suggestions concerning this
PowerPoint Presentation for Managerial Accounting, An
Introduction To Concepts, Methods, And Uses, please contact:
Dr. Donald R. Trippeer, CPA
[email protected]
Colorado State University-Pueblo
C14 - 24