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Compensation: disclosure urged for bonus formulas.

Compensation expert Bruce Ellig has a suggestion for companies seeking to practice good governance at bonus season: that they disclose all pertinent facts about their bonus payments. Specifically, he suggests disclosing the formulas used to determine the bonuses, and offers this advice:

* Many companies traditionally have used "net income" (income after taxes)--a formula that encouraged some to overstate revenue and understate expenses. It is important to beware of companies that use EBITDA (earnings before interest, taxes, depreciation and amortization). Almost as bad is the use of EBIT. These formulas do not hold the executives accountable for debt (interest), changes in retained earnings income (after taxes and paid dividends), capital investments (depreciation) and acquisition costs (amortization of goodwill).

* If some form of economic profit is used (such as net income less the cost of capital--both debt and equity), is the formula appropriate in terms of the current cost of capital? Low interest rates and dividends (plus a modest risk premium) will generate a higher return than if higher capital cost rates are used.

* If "cash flow" is used as the basis for the formula, it is important to disclose whether it is simply cash from the business or if capital and other investments have been included. Like economic profit, cash flow formulas could discourage executives from taking reasonable investment risks to grow their businesses.

Another possible formula is the "return formula." This includes: return on assets (ROA), return on equity (ROE), return on net assets (RONA) and return on sales (ROS). Again, the definition of numerator and denominator is critical.

A few other questions that Ellig recommends: Were non-financial statement formulas used? These might include: productivity (quality and quantity), new product success, market share and customer service. How were the measures defined?
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Title Annotation:BusinessBriefs; tips from compensation expert Bruce Ellig
Author:Heffes, Ellen M.
Publication:Financial Executive
Article Type:Brief Article
Geographic Code:1USA
Date:May 1, 2004
Words:292
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