Chief financial officers could breathe easier last year, as the performance goals set for them in their compensation plans got a little easier to achieve, according to new research by Michal Matejka, an accounting professor at the W.P Carey School of Business.
During the financial crisis and the resulting recession, companies set tough targets for their CFOs, refusing, in some cases, to give bonuses unless companies reported positive earnings, Matejka says. In a time when a lot of firms were reporting losses by no fault of their own, that meant that some CFOs probably didn't see the sorts of bonuses that they were accustomed to -- and that they might have deserved.
"There was a substantial increase in the importance of financial performance indicators in compensation plans during the recession," he says. "That makes sense. Companies were struggling for survival, so things like cash flow were really important. In 2011, they're dialing back that emphasis. We're getting back to normal."
Matejka does a bi-annual survey and analysis of CFO compensation in cooperation with the American Institute of Certified Public Accountants. For this year's study, he surveyed about 1,000 AICPA members -- CFOs, CEOs and other executives, mostly at privately held firms -- to identify trends in corporate compensation. His work provides a benchmark by which companies can assess their compensation practices and by which investors and other stakeholders can assess the efficacy of pay plans.
The well-designed compensation plan
The idea of companies de-emphasizing financial measures in CFO pay plans may seem odd -- after all, these executives oversee the financial side of businesses. But even for a CFO, a well-designed compensation plan should include both financial and nonfinancial measures, Matejka says. A CFO is typically part of the executive team and thus will be expected to participate in decision-making and strategy-setting that reaches beyond financial matters, he says.
"When you talk to people at companies, regardless of size, a common theme is, 'We don't just want a bean counter. We want someone who's involved in the operations.'" To encourage broader thinking, companies must create appropriate goals and incentives. A firm might, for example, also evaluate its CFO based on measures like customer satisfaction and market share. "You can have nonfinancial measures of performance with objective targets," he points out.
A company shouldn't lean too heavily on financial targets because the CFO has disproportionate influence on the firm's financial results. For example, he makes judgments about the right amount to put in reserve accounts, like the allowance for doubtful accounts receivable, and the rate at which property is depreciated. By nudging those numbers one way or another, he can influence the bottom line. Too much stress on financial targets might tempt him to make decisions that lead to short-term financial gains at the expense of longer-term corporate goals.
Matejka learned that, in 2010, CFOs earned just about half of their bonuses by meeting financial targets and the rest through a combination of nonfinancial targets and subjective evaluation. "CFOs of larger companies had more of their bonus contingent on meeting financial performance targets -- the bonus weight was 58 percent in the largest companies (with sales greater than 500 million) and 42 percent in the smallest (with sales below $25 million)," he writes in the study.
In 2010, nonfinancial targets played roughly the same role in bonus plans regardless of company size. Smaller firms tended to give them a little more heft and larger ones a little less, but on average, they accounted for about 10 percent of CFO bonuses.
In contrast, subjective evaluations showed greater variance, with the smallest companies stressing them far more than largest ones did. Specifically, 44 percent of the bonus for the average CFO of a company with less than $25 million in sales was tied to a subjective evaluation, while only 30 percent of the bonus of the average CFO at a company with more than $500 million in sales was set that way.
Matejka hasn't done any surveys on why smaller companies might favor subjective targets, but he suspects that it reflects the entrepreneurial nature of these firms, where a founder-CEO is often in charge. "You get these strong CEOs who are used to pulling all of the strings," he explains. "And you do lose some control when you use objective targets. So if you like to be in control, you're less likely to rely on objective evaluation."
Subjective evaluations aren't bad, Matejka adds. They have their place in pay plans alongside objective measures. A company doesn't want to lean too much toward either extreme. "You don't want to go 100 percent objective or 100 percent subjective," he cautions. Objective targets make a CFO's goals clear but can backfire during a crisis. Imagine, for example, that a bank CFO's pay was tied only to profitability measures during the recent financial crisis. That CFO might have worked hard to ensure that his bank survived. But if his bank lost money, as many of them did, he wouldn't have received a bonus. Subjective targets can be ideal at a time like that, Matejka says.
Setting the bar
Another key element in designing a compensation plan -- for a CFO or any executive -- is correctly setting the difficulty of the targets. A company can perfectly balance financial, nonfinancial and subjective assessments of performance and still undercut its incentives by making one or more of the factors too hard or too easy to achieve.
"You want Goldilocks targets -- neither too hard nor not too easy," Matejka says. "If you make them too hard, people give up, but if they're way too easy, they don't try. If the difficulty of the targets is misaligned, then the whole package is misaligned."
There's no perfect level of difficulty, but a reasonable one for many companies would be in the range where a CFO had a 60 to 80 percent probability of achieving the goal.
Interestingly enough, the companies in Matejka's study managed to land within that range in setting their 2011 targets. The executives surveyed estimated that they had a 64 percent probability of meeting their earnings targets this year, up from 48 percent in 2009. In contrast, their average estimate of the probability of meeting nonfinancial targets dropped slightly -- to 64 percent, from 68 percent -- but still fell within the sensible range.
Matejka sees these findings as complementary -- and also as welcome signs that business has returned to normal. "The difficulty of nonfinancial targets and earnings targets was better balanced in 2011, and companies were less likely to rely on nonfinancial targets to offset difficult earnings targets," he writes.
In other words, post-downturn, companies have tweaked their targets, just as they should. "In the recession, executives were asked to focus on a few key financials that were difficult to achieve," he says. "And in a recession, it wasn't necessarily wrong to set challenging targets. If times are bad, companies may not want to pay bonuses. That idea is ingrained in business. And maybe if you're not willing to take risks, perhaps you shouldn't be a CFO.
"But you can't stick to that forever because then managers don't ever make any bonuses."