Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
Chapter 20
Management Compensation, Business Analysis, and
Business Valuation
Learning Objectives
LO 20-1 Identify and explain the types of management compensation
LO 20-2 Identify the strategic role of management compensation and the different types of
compensation used in practice
LO 20-3 Explain the three characteristics of a bonus plan: the base for determining performance, the
compensation pool from which the bonus is funded, and the bonus payment options
LO 20-4 Describe the role of tax planning and financial reporting in management compensation
planning
LO 20-5 Apply the different methods for business analysis and business valuation.
New in this Edition
Four new Real World Focus (RWF) items: one is an update pay for performance, one focuses on
different uses for bonuses, one comments on retention plans, and the fourth presents a
commentary on valuations
Eleven new or revised brief exercise, exercises or problems that focus primarily on ratio analysis
and executive compensation
Teaching Suggestions
This is a new and unique chapter on two of the emerging issues in cost management – management
compensation and the valuation of the firm. Management compensation is an important part of the
strategy for most firms, because of the increasing competition for top executives. Our coverage presents
the strategic objectives, as well as many of the operational issues of implementing compensation plans,
including the different types of bonus plans, tax issues, and financial reporting issues. Also, the valuation
of the firm is increasingly important both as a means to evaluate the firm’s management, and as a basis
for investors to assess the value of the company. We cover several of the common valuation methods.
If you cover both topics in this chapter, you will probably use one class meeting for each topic. It may
be that you spend as much as two class meetings on compensation when teaching an advanced course. In
that situation, you would devote the second day entirely to a comprehensive case such as Midwest Petro-
Chemical (Case 20-1). Also, it is possible to spend two days on the valuation of the firm. Given the
growing importance of this topic, it is likely 2 day coverage could become commonplace. In that
situation you might devote the second class meeting entirely to a comprehensive case such as Outsource
Inc. (Case 20-3).
Management Compensation. The coverage of management compensation is based on the main theme
of the two previous chapters, that is, the three-fold objective of management controlmotivation,
decision making, and fairness. In addition, this is a good topic to develop ethical issues, and you may
spend a few minutes of class time to discuss the issue of rapidly increasing executive pay. You could
prepare handouts for executive pay based on recent articles from Business Week, The Wall Street Journal,
or The New York Times. All three publications of frequent articles on executive pay and often an annual
review of executive compensation. The compensation of executives during the recent economic
recession might be a topic of particular interest. An important additional aspect of compensation, as for
20-1
Education.
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
transfer pricing in the previous chapter, is the effect of taxes on the net after-tax compensation to the
manager, and the net after-tax cost to the company.
Valuation of the Firm. Consider beginning this coverage by explaining the importance of firm-level
evaluation – both for the individual managers and for the shareholders and owners. Increasingly,
managers are being evaluated on how well they have increased the overall value of the firm, typically, in
terms of shareholder’s value. Moreover, as new firms are started and others are acquired by larger firms,
there is an increasing need for management accountants and others to assess the value of the entire firm.
Many of the concepts and techniques in this part of the chapter are covered, sometimes in great detail, in
the finance course, so consider a straight-forward approach, possibly presenting the different methods in
simple form and go through a few short examples. If there is time, I like to do Case 20-2 (Example
Company) in the Cases and Readings Supplement which is based on the W. T. Grant company that failed
in 1976. The case is a good illustration of the inadequacy of many common liquidity measures in this
context, and the importance of considering cash flows from operations.
The section of the chapter on the valuation of the firm is divided into two parts: the first part, business
analysis, uses financial ratio analysis, the balanced scorecard (BSC) and economic value added to
measure the value of the firm from the firm’s financial and operating data. These business analysis
methods provide an indirect measure of the changes in the value of the firm. The second part, business
valuation, provides a direct measure of the value of the firm, using a variety of methods including
discounted cash flow and the earnings multiple. Both types of methods can be useful to the management
accountant in valuing the firm as a whole.
20-2
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
Assignment Matrix
End-of-Chapter Exercises & Problems Learning Objectives Text Features
7e
EOC
6e
EOC
Transition
6e to 7e
X = included in Connect
Time
1.
Management compensation: types
2.
Strategy role of compensation
3.
Characteristics of a bonus plan
4.
Tax planning and financial reporting
5.
Business analysis and business valuation
Strategy
Service
International
Ethics
Sustainability
Brief Exercises
20-16 Moved to 20-22
20-17 Moved to 20-23
20-16 New question X 05 min. X
20-17 New question X 05 min. X
20-18 20-18 X 05 min. X
20-19 20-19 X 05 min. X
20-20 20-20 X 05 min. X X
20-21 20-21 X 05 min. X X
20-22 20-16 Moved X 10 min. X
20-23 20-17 Moved X 05 min. X
20-24 New question X 05 min. X
Exercises
20-25 20-22 Moved to 20-25 –20 min. X X X
20-26 20-23 Moved to 20-26 v15 min. X X X
20-27 20-24 Moved to 20-27 –20 min. X X X X X
20-28 20-25 Moved to 20-28 –20 min. X X
20-29 20-26 Moved to 20-29 –20 min. X
20-30 New question 10 min. X
20-31 20-27 Moved to 20-31 –20 min. X X
20-32 20-28 Moved to 20-32 –15 min. X X
20-33 20-29 Moved to 20-33 –15 min. X
20-34 20-30 Moved to 20-34 –15 min. X
20-35 20-31 Moved to 20-35 X 20 min. X X
20-36 20-32 Moved to 20-36 X 30 min. X
20-37 20-33 Moved to 20-37 X 30 min. X
20-38 20-34 Moved to 20-38 –15 min. X
20-39
20-40
New question X 15 min. X
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
Assignment Matrix continued
End-of-Chapter Exercises & Problems Learning Objectives Text Features
7e
EOC
6e
EOC
Transition
6e to 7e
X = included in Connect
Time
1.
Management compensation: types
2.
Strategy role of compensation
3.
Characteristics of a bonus plan
4.
Tax planning and financial reporting
5.
Business analysis and business valuation
Strategy
Service
International
Ethics
Sustainability
20-40 New question X 10 min. X
20-41 New question X 15 min. X
Problems
20-42 20-35 Moved to 20-42 25 min. X
20-43 20-36 Moved to 20-43 20 min. X X
20-44 20-37 Moved to 20-44 20 min. X X X
20-45 20-38 Moved to 20-45 30 min. X X
20-46 20-39
20-40
Moved to 20-46 40 min. X
20-47 20-40 Moved to 20-47 25 min. X X X
20-48 20-41 Moved to 20-48 30 min. X X X
20-42 Removed
20-49 20-43 Moved to 20-49 30 min. X
20-50 20-44 Moved to 20-50 20 min. X X
20-51 20-45 Moved to 20-51 45 min. X
20-52 20-46 Moved to 20-52 20 min. X
20-53 20-47 Moved to 20-53 50 min. X
20-54 20-48 Moved to 20-54 30 min. X X
20-49 Removed
20-55 20-50 Moved to 20-55 45 min X X
20-4
Education.
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
Lecture Notes
A. Types of Management Compensation. Effective management compensation plans are an important
and integral part of the determination of a strategic competitive advantage and are important concerns of
the management accountant. Management compensation plans are policies and procedures for
compensating managers. Compensation includes one or more of the following:
Salary: a fixed payment.
Bonus: based on the achievement of performance goals for the period.
Benefits: any other extras paid for by the firm (travel, life insurance, etc.)
Compensation can be paid currently or deferred to future years. Salary and benefits are typically awarded
currently; bonuses are either paid currently or deferred. The compensation plans for high-level managers
are generally explained in the firm’s proxy statements and must be approved by the shareholders. Base
salary and benefits are negotiated when the manager is hired and when compensation contracts are
reviewed. They are not commonly influenced by the manager’s current performance, as is bonus pay.
B. Strategic Role and Objectives of Management Compensation. The strategic role of management
compensation has several aspects:
1. Design the Compensation Plan for Existing Strategic Conditions. The compensation plan
should be grounded in the strategic analysis of the firm. As the strategic conditions change over time, the
compensation plan should also change.
2. Risk Aversion and Management Compensation. Compensation plans can manage risk aversion
effectively by carefully choosing the mix of salary and bonus in total compensation. The higher the
proportion of bonus is in total compensation, the higher the incentive for the manager to avoid risky
outcomes. To reduce the effect of risk aversion, a relatively large portion of salary should be in total
compensation.
3. Ethical Issues. Two ethical issues must be addressed when designing and implementing
compensation plans:
a. The overall level of compensation. There is a common concern that executive pay is too high and
that lower-level employees are not properly compensated relative to the very high salaries and
bonuses of top executives. Whether executive pay is too high varies from person to person; for
example, shareholders who see their investments grow and attribute this to the executive are likely to
see the compensation plans as just and ethical. The IRS can deny a firm’s right to deduct
compensation that is determined to be unreasonable. The U.S. Tax Court analyzes 14 compensation
factors to determine whether the compensation is reasonable.
b. Unethical actions. Sometimes the management compensation plan provides incentive for
unethical actions. A lack of top management emphasis on ethics and accounting controls can
contribute to fraud. Also, the presence of a very strong motivation due to a compensation plan
without compensating accounting controls designed to detect and prevent fraud can lead to unethical
behavior.
4. Objectives of Management Compensation. The firm’s key objective is to develop management
compensation plans that support its strategic objectives, as set forth by management and the owners. The
objectives of management compensation are therefore consistent with the three objectives of management
20-5
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
control (these were defined in Chapter 17). The first objective is to motivate managers to exert a high
level of effort to achieve the firm’s goals. A performance-based compensation plan is best for this
purpose. The second objective is to provide the appropriate incentive for managers to make decisions that
are consistent with the firm’s objectives, from which its CSFs are derived. Therefore, firms attend to
CSFs by making them part of the manager’s compensation. In developing compensation plans, the
management accountant works to achieve fairness by making the plan simple, clear, and consistent.
Fairness also means that the plan focuses only on those controllable aspects of the manager’s
performance. Similarly, the manager’s performance should be separate from that of the unit because
economic factors beyond the manager’s control are likely to affect the unit’s performance. Fairness in
this sense is often achieved by basing the manager’s compensation on performance relative to prior years
rather than on comparison to the performance of other managers.
5. Bonus Plans. Bonus compensation is the fastest growing element of total compensation and often
the largest part. A wide variety of bonus plans can be categorized according to three key aspects:
a. Base of compensation. The base of compensation is how the bonus pay is determined. The three
most common bases are stock price, SBU-based performance, and the balanced scorecard. When
stock price is used, the amount of the bonus depends on the amount of the increase in the stock price
or whether the stock price reaches a certain predetermined goal. The bonus can be determined in
three ways. It can be based on a comparison of current performance to prior years, a budget or pre-
determined target, or the bonus awarded to other managers. By using a budget or a comparison to
prior years, firms avoid the influence of uncontrollable factors. The choice of a base comes from a
consideration of the compensation objectives. A common choice is to use SBUs because they are
often a good measure of economic performance.
b. Compensation pools. Compensation pools are the source from which the bonus pay is funded. A
manager’s bonus can be determined by the so-called unit-based pool that is based on the performance
of the manager’s SBU. The appeal of the unit-base pool is the strong motivation for effective
managers to perform and to receive awards for their effort; the upside potential to the individual
manager is very motivating. Alternatively, the amount of the bonus available to all managers is often
a firm-wide pool set aside for this purpose. When the bonus pool is unit-based, the amount of the
bonus for any one manager is independent of the performance of the other managers. In contrast,
when a firm-wide pool is used, each manager’s bonus depends in some pre-determined way on the
firm’s performance as a whole. Therefore, the firm-wide pool provides an important incentive for
coordination and cooperation among SBUs.
c. Bonus Payment options. Payment options are how the bonus is to be awarded. The four most
common methods:
1. Current bonus (cash and/or stock) based on current performance
2. Deferred bonus (cash and/or stock) earned currently but not paid for two or more years.
Deferred plans are used to avoid or delay taxes or to affect the manager’s future total income
stream in some desired way.
3. Stock options confer the right to purchase stock at some future date at a predetermined price.
They are used to motivate managers to increase stock price for the benefit of the shareholders.
4. Performance shares grant stock for achieving certain performance goals over two years or
more.
C. Tax Planning and Financial Reporting. In addition to achieving the three main objectives of
compensation plans, firms attempt to choose plans that reduce or avoid taxes for both the firm and the
manager. By combining salary, bonus, and benefits, accountants can maximize potential tax savings for
20-6
Education.
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
the firm, and delay or avoid taxes for the manager. Firms also attempt to design compensation plans that
have a favorable effect on the firm’s financial reports.
D. Management Compensation in Service Firms and Not-for-Profit Organizations. Although most
compensation plans are used by manufacturing or merchandising firms, an increasing number of service
firms are using these plans. Possible methods of performance measurement and compensation in service
firms include:
1. Profitability can be measured by a profit multiplier, the ratio of net revenues to direct labor
dollars.
2. Efficiency can be measured by staff utilization, which is determined from the ratio of direct
labor-hours chargeable (to the client) to total hours worked less vacation and holiday time.
3. A collection of accountants can be measured by two ratios: the percentage of accounts
receivable over 90 days or the average days of unbilled work outstanding.
E. Business Analysis. The goal of strategic cost management is the success of the firm in maintaining
competitive advantage, so we must evaluate the firm’s overall performance as well as the performance of
individual managers. The three principal approaches for business analysis are the balanced scorecard,
financial ratio analysis and economic value added.
1. The Balanced Scorecard. The use of the balanced scorecard to evaluate the firm is similar to
the use of CSFs in evaluating and compensating the individual manager. When evaluating the firm using
CSFs, the management accountant uses benchmarks from industry information and considers how the
CSFs have changed from prior years.
2. Financial Ratio Analysis. Financial ratio analysis uses the financial statement ratios to evaluate
the firm’s performance. Two common measures are a firm’s liquidity and profitability. Liquidity refers to
the firm’s ability to pay its current operating expenses and maturing debt. The five key measures of
liquidity are the accounts receivable turnover, the inventory turnover, the current ratio, the quick ratio,
and the cash flow ratio. The higher these ratios are, the better, and the higher the evaluation of the firm’s
liquidity. The four key profitability ratios are the gross margin percent, the return on assets, the return on
equity, and the earnings per share.
3. Economic Value Added (EVA). EVA is a business unit’s income after taxes and deducting the
cost of capital. The cost of capital is usually obtained by calculating a weighted average of the cost of the
firm’s two sources of funds, borrowing and selling stock. EVA focuses managers’ attention on creating
value for shareholders. By earning higher profits than the firm’s cost of capital, the firm increases its
internal resources available for dividends and/or to finance its continued growth.
F. Business Valuation. An intuitively appealing performance measure for the firm is its market value.
Market value is an objective measure that clearly shows what investors think the firm is worth. It also has
the advantage of being consistent with the objective of top management to add shareholder value.
Success in the market is achieved by taking a value-oriented approach within the firm—orienting the
firm’s strategy to shareholder value. This can mean the spin-off of certain business units, financial
restructuring, and outsourcing of certain activities. The four methods for directly valuing a firm are
market value, asset valuation, the discounted cash flow method, and earnings-based valuation.
1. The Market Value Method. In this method, the firm’s value is determined by multiplying the
number of outstanding shares by the current market price of the shares:
Number of shares × Share price
20-7
Chapter 20 – Management Compensation, Business Analysis, and Business Valuation
The market value method is the most direct and objective measure of the shareholder’s assessment of the
firm’s performance and its success in creating value for the shareholders. It is a measure of the equity
value of the firm, and the value derived is often called “market capitalization.”
2. The Discounted Cash Flow (DCF) Method. The DCF method measures the firm’s value as the
discounted present value of its net cash flows. Cash flows a year or more into the future are discounted to
consider the time value of money. Since it is based on cash flows, the DCF method has the additional
advantage of not being subject to the bias of different accounting policies for determining total assets and
net income, as are the asset valuation and the financial analysis methods. The DCF method is commonly
used when the share price is not available or unreliable. The DCF distinguishes two types of value in
determining a firm’s value. The first is the value of the cash flows for the planning period (usually a
three- to five-year period), and the second is the value of the cash flows beyond three to five years.
3. Multiples-Based Valuation. A firm’s value can be estimated based upon a simple multiple of
some significant financial aggregate such as total assets, total sales, total earnings, etc. The earnings
based multiple is the most common. The earnings-based valuation method computes value as the product
of expected annual accounting earnings and a multiplier. The multiplier is often estimated from the P/E
ratios of the stocks of comparable publicly held companies. The earnings multiplier has important
limitations. The accounting treatment of inventory, depreciation and other components of earnings might
not be comparable to that of other firms in the industry. When earnings are not comparable for these
reasons, determining a relevant and useful multiplier is difficult. The P/E ratio measures the amount the
investor is willing to pay for a dollar of the firm’s earnings per share. If the P/E ratio is not available for a
given firm, an average or representative value is taken from the P/E ratios of other firms in the industry.
In practice, the management accountant commonly uses two or more of the valuation techniques and
evaluates the assumptions in each to arrive at an overall valuation assessment.
An Illustration of Strategic Decision Making in the Valuation of a Fashion Retailer
Arizona Sunrise Inc (ASI) is a retailer of women’s fashion clothing with 455 stores in the U.S. and
55 in Canada, an increase of 62 stores over the prior year. The company is growing fast because of its
unique fashion styles and the quality of its clothing. ASI products are priced at levels slightly higher than
competitive brands, but production and selling costs are somewhat higher as well, thus sales have grown
very fast, but earnings and cash flows have trailed behind. In some recent quarterly periods, cash flow
from operations has been low and in some cases even negative. Bettman, PLC, a similar retailer located
in London, is also known for its fashion-wise designs and product quality. Bettman has expressed an
interest in buying ASI, both because of ASI’s recent success and because the fall in the dollar relative to
the British pound in recent years has effectively reduced the purchase cost in U.K. currency. Bettman
would maintain the ASI brand name for at least a few years and at least initially would maintain the local
store management. In the longer term, Bettman’s plan is to integrate the two products lines into a single
global brand. Bettman plans to purchase ASI in a cash transaction, but is not sure what value to place on
ASI.13
The Five Steps of Strategic Decision Making for Bettman, PLC.
1. Determine the Strategic Issues Surrounding the Problem.
Both firms involved in the case are differentiators based on quality and style. The key business issue
is how the combined firms will be more or less competitive than the separate firms. Bettman’s plan to
move the two firms to a larger, global brand, could help the firm establish a presence globally, thereby
improving its opportunity for further growth. The immediate issue is to determine the purchase price of
ASI.
20-8
Education.
2. Identify the Alternative Actions:
Bettman can use a variety of methods to value ASI, as described above: discounted cash flows,
multiples of earnings or other measures, and enterprise value, among other methods.
3. Obtain Information and Conduct Analyses of the Alternatives
Bettman performs a discounted cash flow analysis based on ASI’s projected free cash flow for the
next 5 years and projects a value of $24 billion. A valuation based on the earnings multiple yielded a
smaller value of $14 billion, the current market value of ASI’s equity was $16 billion, and the Enterprise
Value was calculated to be $15 billion.
4. Based on Strategy and Analysis, Choose and Implement the Desired Alternative
The analysis produced a wide range of valuations, but a cluster of them was around $15 billion.
Moreover, Enterprise Value is particularly appropriate for valuing a purchase because it takes into account
ASI’s debt and cash equivalents available to the purchaser. Bettman also considers the strategic
advantages and disadvantages of the purchase, and is persuaded to make an offer of $15 billion because
the acquisition of ASI could help Bettman establish a stronger brand globally, thereby improving its
opportunity for further growth and profitability.
5. Provide an On–going Evaluation of the Effectiveness of implementation in Step 4.
If Bettman purchases ASI, it will need to complete the implementation through a plan for
integrating the two businesses, operationally, financially, and strategically. This will be a key
management goal for the first few years after the acquisition. Bettman is required by International
Financial Accounting Standards to regularly assess the value of the acquisition, and if the value of the
acquisition should fall, Bettman must write the asset down to the new fair market value.
If the purchase is not completed, Bettman should continue to look for firms like ASI that would
help Bettman obtain the global presence that is central to its strategy.
20-9
Education.