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

com/locate/jaccedu

An overview of management compensation

Luann J. Lyncha, Susan E. Perryb,*
a

Darden Graduate School of Business, University of Virginia, PO Box 6550, Charlottesville, VA 22906-6550, USA b 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 executive pay, the debate over stock options, the emphasis by the International 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 the accounting for and the design and evaluation of compensation alternatives. As future accountants, consultants, and nancial managers designing and accounting for compensation 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 dierent compensation mechanisms, their benets and limitations, and their related nancial, 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 recommend using this paper in nancial, tax, and managerial accounting courses to broaden students understanding 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, including needs of the accounting profession (see, for example, Albrecht & Sack, 2000). One
* Corresponding author. Tel.: +1-434-924-3988; fax: +1-434-924-7074. E-mail addresses: sep4v@virginia.edu (S.E. Perry); lynchl@darden.virginia.edu (L.J. Lynch). 0748-5751/03/$ - see front matter # 2002 Elsevier Science Ltd. All rights reserved. PII: S0748-5751(02)00034-9

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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 alternatives. 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 reect corporate performance (Bryant, 2000; Koudsi, 2000; Ozanian, 2000; Reingold, 2000). Second, the debate over stock options has intensied, 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 appropriate accounting for share-based compensation. In recent years, the use of sharebased compensation has increased signicantly 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 companies and employees to increase their focus on equity-based compensation structures. Third, many compensation plans have favorable nancial 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 emphasis on performance-based compensation has resulted. Finally, start-up rms, which typically struggle for earnings, often are cash constrained and rely heavily on human capital as their primary asset. In part, these rms have set the pace for equity-based compensation schemes, which require little or no cash outlay, can be designed for favorable accounting and tax treatment, and can be eective retention tools. This paper provides a general discussion of dierent compensation mechanisms, their benets and limitations, and their related nancial, tax, and managerial accounting implications.2 We focus our discussion regarding nancial accounting and tax issues on US GAAP and US tax rules, for several reasons. First, much of
See Internal Revenue Code Section 162(m)(4)(c). The accounting and tax implications discussed are generally reective 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 specic details on these issues, the reader should consult relevant nancial accounting standards and sections of the Internal Revenue Code. In addition, we assume throughout this paper that the company uses accrual basis accounting.
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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 aord some forms of compensation. Second, there currently is no international accounting standard for share-based compensation, so the USA serves as one 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 management compensation systems will improve accounting students eectiveness as they move from the university into the business world. As future accountants attempting to appropriately consider the accounting and tax implications for various compensation contractual arrangements, students must understand the related business issues so that accounting can properly reect the substance of these contracts. Likewise, as potential future nancial consultants or managers, students must understand the nancial accounting, tax, and managerial issues associated with compensation alternatives in order to implement compensation plans that eectively motivate and retain employees while having a reasonable nancial impact on the organization. Accounting textbooks typically include only one aspect (nancial, tax, or management 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 nancial, tax, and management accounting issues in isolation, but are made by considering these factors simultaneously. First, the economic eects of compensation plans may be signicant, but measurement of these eects remains a dicult nancial accounting issue. At present, substantial portions of management compensation are not reported in the income statements or balance sheets for many companies. Additionally, compensation systems may aect managers choices of nancial 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 depreciation or inventory accounting methods. Second, tax issues related to compensation schemes can have an impact on both corporations and employees (see Jones, 2003; Jones & Rhoades-Catanach, 2002; Scholes, Wolfson, Erickson, Maydew, & Shevlin, 2001). The employer weighs aftertax costs of compensation against perceived benets, 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 compensation plans (Anthony & Govindarajan, 2000; Jensen & Meckling, 1976). Specically, employees, as agents of the rm, are assumed to be risk-averse, with an interest 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

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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, controllability of the performance measures being used, and the eect on employees risk averse behavior, each of which we discuss for each compensation mechanism. We recommend using this paper in nancial accounting or tax courses to broaden students awareness and understanding of compensation issues beyond the more focused nancial 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 nancial 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 specic 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 xed or non-performance-based element (e.g. salary), and (2) a variable or performance-based portion.4 One benet 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 xed 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 and undiversied 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.
We thank an anonymous referee for this suggestion. While changes in salary from year to year may be inuenced by performance, an employees salary at the beginning of a period generally is set at a xed level rather than allowed to vary based on performance during the period. 5 Hall and Murphy (2002) quantify the point of indierence between receiving all cash compensation and receiving bonus compensation in restricted stock or stock options, for dierent levels of executive risk aversion and dierent levels of executive wealth in company stock. They show that the point of indierence 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 a result, decisions regarding the proportion of compensation that should be performance-based often involve a cost versus benet assessmentwhether the benets 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 benets, the salary component of compensation is likely to be high. For nancial reporting purposes, the company records compensation expense during the period in which employees earn their salary. For tax purposes, employees 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 period, 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 accounting numbers and a focus on short-term performance at the expense of long-term performance, 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 interdependence the company has among business units, the greater the tendency for the bonus to be based on corporate performance to encourage cooperation across business unit boundaries and to better achieve corporate goals. For nancial reporting purposes, the company records compensation expense during 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 rms 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 oered executive ocers 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 nancial 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 benets Fringe benets can include non-cash or other indirect forms of compensation. Examples include employee food facilities, childcare, professional dues, and company cars, among others. These benets can help in the attraction and retention of employees, particularly if the employer can provide a benet 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 benets for nancial reporting purposes, and receives a corresponding tax deduction. However, for employees, the tax treatment of fringe benets varies. For example, personal use of a corporate plane by top management is a taxable fringe benet, but medical and life insurance, if oered 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 benet 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 provides 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 concerns. First, managers and employees may have limited ability to aect the companys stock price. To the extent the stock price is less controllable, it is a less eective 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 aected 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 oer the potential for high returns) but that may lead to large stock price declines if they fail (Kaplan & Atkinson, 1998). Third, shareholder dilution is a 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 stock On occasion, companies grant shares of company stock to employees as a means of compensation. With an outright grant of stock, for nancial 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 dierence 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 specied period or that certain performance goals are met. Benets 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. For nancial reporting purposes, the company records compensation expense 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
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 dierence between the market value of the stock on the selling date 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 rm 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 nancial 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). (Alternatively, 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 rm before December 31, 2000, he could not have recovered the tax paid on the forfeited shares.)

2.4.3. Performance shares Performance shares are a specied number of shares that are awarded after established performance goals are met, usually over several years. The benets of performance shares include a performance incentive and a retention incentive because employees typically must remain with the company through the performance 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 measures 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. For nancial reporting purposes, the company records compensation expense 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 the stock, he pays capital gains taxes on the dierence 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 rm 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 specied number of shares of a companys stock at a specied price (called the exercise or strike price) for a specied period of time (called the option period, or life of the option). Companies typically grant xed options, where the exercise price is xed 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 xed 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-executive compensation packages. A 1998 Towers Perrin study nds that 78% of US companies provide stock options (Orr, 1999). Interestingly, non-top-ve-executive employees hold most stock options. A study of large rms over the 19941997 time period nds that 75% of stock options are granted to non-top-ve employees (Core & Guay, 2001). Over a similar time period, a survey by ShareData nds 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).
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 compensation (see, for example, Frangos, 2002; Lagomarsino, 2002). Members of Congress have considered denying the tax benets of stock options when related expenses are not recognized in the nancial statements (Hitt, 2002). Former SEC Chairman Harvey Pitt suggested increased control over stock options used to compensate 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 reected in the stock price. However, options suer from the concern that stock price uctuation 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 inuence the stock price directly. Stock options do provide the potential for capital infusion to the rm 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 is limited 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 benet of stock options is that, for US GAAP nancial reporting purposes, most companies do not have to record compensation expense. A company has two choices when accounting for stock options for nancial reporting purposes. Under the rst alternative (known as the fair value method), the company records compensation expense equal to the fair value of the options at the grant date, determined using an option pricing model. The expense is allocated over 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 dierence 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 xed 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
The employee service period is often the vesting period of the option. 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-qualied options For US tax purposes, there are two types of optionsnon-qualied options and incentive stock options. Non-qualied or non-statutory options can be granted to employees, directors, consultants, independent contractors, and others. For nonqualied 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 dierence 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 dierence 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-qualied 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 nancial 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 the stock is sold on the dierence 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 companies), 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-qualied 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 nancial 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 nancial reporting purposes, Edwards, Inc. records no compensation expense and gets no income tax deduction.17 Eric Eldo recognizes no income and pays no tax 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 preserving 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 nds that they tend to be small, young, high-tech companies experiencing poor performance and having options signicantly out-of-the-money (Carter & Lynch, 2001). However, 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 nancial reporting purposes, eliminating what was considered a benet of stock options. As a result, repricing of stock options declined signicantly 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 outof-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 nancial 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 specied 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 nancial reporting purposes. 18 A stock option is out-of-the-money if the market value of the underlying stock is less than the exercise 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 which employees cannot exercise their SARs. However, as with other forms of equity compensation, concerns regarding employees limited ability to aect 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 benet 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 companys stock price performance, but stock need never be issued with SARs, they oer the benets 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 nancial reporting purposes. Under the rst 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 dierence 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 tax purposes, 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 oered Fred Farmer stock appreciation rights (SARs) that allow him to benet 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 nancial 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 phantom share plans is that, while most equity plans such as SARs are based on the
The employee service period is typically the vesting period of the SAR. This example assumes that Franklin Enterprises chooses the second alternative (the intrinsic value method) when accounting for SARs for nancial reporting purposes.
20 19

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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 frequently 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 briey 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. Qualied retirement plans A qualied 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 nancial accounting and tax purposes, the employer can deduct the amount of the annual contribution even though the employee defers recognition of the income for tax purposes until the income is received. 2.7.2. Non-qualied retirement plans While qualied plans provide positive tax benets to both the employer and the employee, the nondiscrimination requirement and the limited amount that employers can oer on a tax-deferred basis lead many employers to create non-qualied deferred compensation plans. These plans may be oered 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 nancial reporting purposes. For tax purposes, the employer deducts the nonqualied deferred compensation in the year the employee recognizes the income.

3. Conclusion Recent controversy surrounding executive and employee compensation places increased importance on understanding the nancial, tax, and management accounting 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 International 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 the accounting for and the design and evaluation of compensation alternatives. We have discussed nancial, 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 (nancial, 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 alternatives and have provided a set of technical references that will facilitate more detailed analysis and discussion of the benets and limitations of these alternatives in the accounting classroom. As educators, we believe that a basic understanding of the fundamentals of compensation systems will improve accounting students eectiveness as aspiring business leaders, accountants, and nancial managers. To eectively design and implement compensation plans and to accurately reect 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 managerial issues associated with compensation alternatives.

Acknowledgements Luann Lynch gratefully acknowledges the nancial support by the University of Virginia Darden School Foundation. Susan Perry gratefully acknowledges the nancial support provided by the University of Virginia McIntire School of Commerce. 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 nancial accounting treatment under US GAAP and tax treatment under US tax rules

Compensation type Salary

Financial accounting technical references (1) FASB Concept Statement 6 FASB Concept Statement 6

Employer income tax technical references (2) Section 162(a)(1) Section 162(m) Section 263A Section 162(a)(1) Section 162(m) Section 263A Reg. Sec.1.62-27(e) Section 162(a)(1) Section 162(m) Section 263A

Employee income tax technical references (2) Section 61(a)(1) Reg. Sec.1.61-2(a)(1) Section 61(a)(1) Reg. Sec. 1.161-2(a)(1)

Annual performance bonus

Fringe benets

FASB Concept Statement 6

Section 61(a)(1) Reg. Sec. 1.61-21 Section 79 Section 105 Section 106 Section 129 Section 132 Section 61(a)(1) Reg. Sec. 1.61-1(a) Reg. Sec. 1.61-2(a)(1) Section 83(a) and (b) Reg. Sec. 1.83-1 Reg. Sec. 1.83-2 Reg. Sec. 1.83-3

Outright stock (unrestricted)

FAS 123 APB 25

Section 162(a)(1) Section 162(m) Section 263A Reg. Sec. 1.1032-1(a) Section 162(a)(1) Section 162(m) Section 263A Section 83(h) Reg. Sec. 1.83-6 Reg. Sec. 1.1032-1(a) Section 162(a)(1) Section 162(m) Section 263A Section 83(h) Reg. Sec. 1.83-6 Reg. Sec. 1.162-27(e)(2)(vi) Section 162(a)(1) Section 162(m) Section 263A Section 83(h) Reg. Sec. 1.83-6 Sections 421 and 422

Restricted stock

FAS 123 APB 25

Performance shares

FAS 123 APB 25

Section 83(a) and (b) IRS Letter Ruling 7927021

Nonqualied stock options

FAS 123 APB 25

Section 83(a) and (b) Reg. Sec.1.83-7

Incentive stock options Repricing stock

FAS 123 APB 25 FIN 28 FAS 123

Sections 421 and 422

Reg. Sec. 1.162-

No specic authority

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Compensation type Options Stock appreciation rights and phantom shares

Financial accounting technical references (1) APB 25 FIN 44 FAS 123 APB 25 FIN 28

Employer income tax technical references (2) 27(e)(2)(vii) Example 10 Section 162(a)(1) Section 162(m) Section 263A Section 83(h) Reg. Sec. 1.83-6 Section 404

Employee income tax technical references (2)

Rev. Rul. 80-300, 1980-2 C.B. 165 Rev. Rul. 82-121, 1982-1 C.B. 79 Section 72 Section 402 Rev. Rul. 69-650, 1969-2 C.B. 106

Qualied and nonqualied deferred compensation

FAS 35 FAS 106 FAS 87

(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 Regulations, Internal Revenue Service Revenue Rulings and Revenue Procedures, Internal Revenue Bulletins.

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