Compensation and management incentives
The compensation of managers can be structured to bring the interests of managers more into harmony with those of shareholders. Corporations usually tie the compensation of managers to the market success of the business. The salary increases and bonuses of most high-level managers are directly related to the firm’s profitability and the price of its shares. How important are these incentives? In recent years, salaries have constituted only about 10 percent of the compensation of chief executive officers (CEOs). The other 90 percent has been in the form of bonuses, often stock awards and stock options (the right to buy shares at a certain price). Both forms of payment have a “vesting period,” which means they will be granted only if the CEO stays with the firm for a certain amount of time and meets specific goals. Policies like these encourage corporate managers to maximize the the firm’s profits – and, not coincidentally, the value – of its shares both strongly in the interest of shareholders. Managers who develop a good track record of adding value to the firm gain not only more pay and greater job security, but also better job offers should they later decide to switch firms.
Incentive pay brings with it another unwanted incentive for managers, though: the incentive to gain personally by manipulating the firm’s accounting records to make its financial performance look better than it really is. However, stockholders and portfolio managers, and especially investors who specialize in selling stocks short when they think the firm is overvalued, will be scrutinizing the records to detect phony accounting designed to mislead investors.