I have made this document for learnings purpose for Incentives & Controls. The document contains the following:
- All lectures with information
- All papers discussed in lectures + extensive result description which is told in class
- All Papers discussed during Seminars (extensive solutions)
-...
Introduction to this document
THIS IS VERSION 2 OF THE SUMMARY – Corrected for the most grammatical/spelling mistakes.
This document contains all information with regards to the upcoming incentives & control exam (2021-
2022 UvA Master A&C). All the information is:
- All information covered in lectures
- All papers covered in lectures + detailed result description
- All papers covered in seminars + a detailed description of all questions asked
- All business case answers + calculation if needed + explanations
If there are questions, you are always able to contact me. Note that I did my best computing the answers
100% correctly with hearing back recordings. I also reread my answers so everything should be right.
Feel free to do additional work to the papers if you don’t understand them quite well. This is important
for the exam; we do not need to know who finds what. We need to understand what he/she found and
why they found that.
A summary of what we need to know from papers and business cases:
- You have to know business cases, e.g. EVA case, and you need to know how to compute it and what it
does.
- Why is EVA relevant?
- Why do they find results and what is the rationale? Understand stuff. Explaining findings of Core
papers.
- What are the three types of subjectivity for example?
- Only ask lists, because then you understand the topic or shortcoming in a certain concept, never asked
to just remember findings, understand them.
- Bank gift shop: what is target setting for example?
- You have to be able to calculate transfer prices
Note that these are just a few examples; the best way to practice for exam-like questions is the mock
exam which is posted on canvas!
Good luck with studying!
1
,Contents of the document:
1 Lecture 1 – Week 1 – Incentives & Controls ..........................................................................................................................................5
1.1 What is the scope of “Incentives & Control”? ............................................................................................................................7
1.2 Why do incentives & control problems emerge? .......................................................................................................................8
1.3 Framework of Merchant & Van Der Stede ...............................................................................................................................11
1.3.1 Illustration - Result controls - Paper: Albernety et al (2004) – Determinants of Control System design in Business Units. 12
1.4 Incentive and control problems at corporate level ...................................................................................................................15
1.4.1 Illustration – Problems at corporate level - Paper: Jensen & Meckling (1976) – Theory of the firm: Managerial behavior,
agency costs & Ownership structure ..............................................................................................................................................................15
1.5 Evaluation of incentive and control systems ............................................................................................................................18
1.6 Incentive and control system tightness ....................................................................................................................................18
1.7 Contingency Theory ..................................................................................................................................................................19
1.7.1 Illustration – Contingency Theory - Paper: Sandino (2007) – Introducing the First Management Control Systems: Evidence
from the retail sector. ....................................................................................................................................................................................19
2.5 Accounting performance measures ..........................................................................................................................................26
2.6 GAAP earnings (profit) ..............................................................................................................................................................26
2.7 Return on Investment (ROI) ......................................................................................................................................................27
2.8 Residual income (RI) .................................................................................................................................................................28
2.9 Economic Value Added (EVA, just a RI number) .......................................................................................................................28
2.9.1 Illustration: Indejejikian & Matejka (2012) – Accounting decentralization and performance evaluation of business unit
managers 29
3.1 Bouwens & Kroos - The effect of delegation of decision rights ...............................................................................................30
3.2 Campbell - Employee selection as a control system .................................................................................................................32
3.3 Wallace (1997) - Adopting residual income-based compensation plans: do you get what you pay for? .................................34
3.4 Business Case – Vyaderm ........................................................................................................................................................36
4 Lecture 3 – Week 3 – Incentives & Controls ........................................................................................................................................38
4.1 Non-financial performance measures ......................................................................................................................................38
4.1.1 Illustration: Ittner et al. (1997) – The choice of performance measures in annual bonus contracts ..................................38
4.1.2 Illustration: Banker et al. (2000) – An empirical investigation of an incentive plan that includes nonfinancial performance
40
, 4.4 Subjectivity performance measurements .................................................................................................................................44
4.5 Performance measurement systems (PMS)..............................................................................................................................45
4.6 Transfer pricing.........................................................................................................................................................................45
4.6.1 Market-based transfer prices ..............................................................................................................................................46
4.6.2 Cost-based transfer pricing .................................................................................................................................................46
5.1 Campbell et al. (2015) – Testing Strategy with Multiple Performance Measures: Evidence from a Balanced Scorecard at
Store24 48
5.2 Gibbs et al. (2014) - Determinants and Effects of Subjectivity in Incentives .............................................................................50
5.3 Business Case - Birch Paper ......................................................................................................................................................52
6 Lecture 4 – Week 4 – Incentives & Controls ........................................................................................................................................53
6.1 Target Setting ...........................................................................................................................................................................53
6.1.1 Illustration: Bol et al (2010) – Supervisor discretion in target setting: An empirical investigation ......................................55
6.2 Relative performance evaluation .............................................................................................................................................56
6.2.1 Illustration: Gong et al (2011)- Relative performance evaluation and related peer groups in executive compensation
contracts 56
6.3 Incentives .................................................................................................................................................................................57
6.3.1 Key choices to incentives ....................................................................................................................................................58
7.1 Kroos et al. (2021) – The relation between Internal Forecasting Sophistication and Accounting Misreporting .......................63
7.2 Cohen et al. (2008) – Real and Accrual-Based Earnings Management in the Pre- and Post-Sarbanes-Oxley Periods. ..............65
7.3 Kroos et al. (2018) – Voluntary Clawback Adoption and the Use of Financial Measures in CFO Bonus Plans...........................67
7.4 Business Case – Bark Gift Shop .................................................................................................................................................69
8 Lecture 5 – Week 5 – Incentives & Controls ........................................................................................................................................72
8.1 Equity incentives ......................................................................................................................................................................72
8.1.1 Coles et al. (2006) ...............................................................................................................................................................72
8.2 Dodd-Frank Act.........................................................................................................................................................................73
8.3 Equity incentives ......................................................................................................................................................................73
8.4 Dismissal ...................................................................................................................................................................................74
8.5 Promotions (based incentives) .................................................................................................................................................74
8.6 Labor Market Incentives ...........................................................................................................................................................75
8.6.1 Paper by: Ma et al. (2020) ...................................................................................................................................................75
9.1 Grabner & Moers (2013) – Managers’ Choices of Performance Measures in Promotion Decisions: An analysis of alternative
Job Assignments 82
9.2 Core et al. (1999) – Corporate Governance, chief executive officer compensation, and firm performance ............................84
9.3 Allee et al. (2020) – Private versus Public Corporate Ownership: Implications for Future Changes in profitability ..................87
10 Lecture 6 – Week 6 – Incentives & Controls ........................................................................................................................................89
10.1 Corporate governance ..............................................................................................................................................................89
10.1.1 Illustration: Ertimur et al. (2011) – Shareholder activism and CEO pay .........................................................................89
10.2 Corporate governance: Controversy remains ...........................................................................................................................91
10.2.1 Illustration: Eyring (2020) – Disclosing physician ratings: Performance effects and the difficulty of altering ratings
consensus 92
10.3 Alternative Theories .................................................................................................................................................................93
10.3.1 Illustration: Lourensco (2016) – Monetary incentives, feedback and recognition – complements or substitutes:
Evidence from a field experiment in a retail services company .....................................................................................................................94
10.4 Technology & Future of Finance ...............................................................................................................................................95
10.4.1 Illustration: Jans et al. (2014) – A field study on the use of process mining of event logs as an analytical procedure in
auditing 96
11 Seminar 5 – Week 6 – All Papers answers & additional work ..............................................................................................................98
11.1 Ittner & Oyon (2020) – Risk ownership, ERM practices, and the role of the finance function ..................................................98
11.2 Kim-Gina (2019) – External verifiability of accounting information and intangible asset transactions. ..................................101
11.3 Schloetzer (2012) – Process integration and information sharing in supply chain .................................................................103
11.4 Van der Stede et al. (2020) – An empirical analysis of employee response to bonuses and penalties ...................................105
4
,1 Lecture 1 – Week 1 – Incentives & Controls
Introduction into Economic Models
Most models are based on economic theory. But, which economic model and what economic theory?
For example, you are a sales representative with a choice of two alternative compensation contracts.
You can make a choice between two different contracts which are:
(1) First option = Fixed compensation of 200,000 euro
(2) Second option = Fixed compensation of 100,000 euro and possible bonus of 200,000 euro
Considering the options above, you have considerable influence on meeting the sales target, but external
factors also affect whether you are going to make the target (estimate: 50% likelihood)
This brings us to the two basic assumptions of economic models:
(1) Greed
o Greed relates to preferring more over less. Utility increases with each additional unit of income.
(2) Risk-aversion
o Utility increases at decreasing rate with each additional unit of income
These two basic assumptions can be illustrated through the concavity of a utility function
On the picture on the right, you see a concave function. Your utility
increases with more, but the increase starts to be smaller over time.
Looking back to first-choice between a fixed payment and a bonus. You see
if you take the direct line between 100k and 300k, it gives you a slightly
lower expected value. People dislike the decrease from 200k to 100k more
than the increase to 300k. That’s why we say that most people are risk-
averse.
Another assumption refers to information asymmetry. Information
asymmetry means that people have private information within an organization. Some people have an
informational advantage over other people. You can refer to this asymmetric information.
This brings us to Asymmetric Information Models; these models are used to present asymmetric
information within an organization.
(1) Moral Hazard (!!)
o Hidden actions/effort + uninformed party moves first
(2) Screening/Adverse Selection
o Hidden characteristics + uninformed party moves first
(3) Signalling
o Hidden characteristics + informed party moves first
Overview in a table:
The uninformed party moves first The informed party moves first
Hidden actions/effort Moral Hazard
Hidden characteristics Screening / Adverse selection Signalling
5
,(1) Moral hazard
Information: Moral hazard is about actions, in this case, the uninformed party moves first. In economics,
moral hazard occurs when one person takes more risks because someone else bears the cost of those
risks. With the agency theory, the agent acts on behalf of the principle. Thus, a principal appoints the
agent to act on their behalf and best interests.
An agent has private information about effort choices. Following this, there is a misalignment of interests
between principal and agent, because an agent may prefer leisure activities over productive (and costly)
effort. Principal elicits high effort and desired action choices by offering contracts contingent on
performance measures rewarding agents for productive effort (e.g. incentive compensation contracts)
Example incentive compensation contract:
An example is what happened at Wells Fargo. At Wells Fargo, millions of deposit and credit accounts were opened
without customer approval for the sole benefit of the incentive payments and career prospects of the employees
involved in the misconduct. This is a clear illustration of Moral Hazard because it concerns actions that employees
have performed, which the customers themselves knew nothing about.
(2) Screening / Adverse selection
Information: In the case of screening, the uninformed party makes an effort to obtain additional
information from the informed party about certain matters. So, screening and adverse selection is more
about characteristics, for example, someone who applies for a sale job, this person is not a top performer,
but it’s “ok”
An agent has private information about characteristics. Meanwhile, the principal induces agents to
truthfully reveal their private information about its type by offering contracts beneficial for high type,
but not for low type.
Examples of Screening / Adverse selection:
(1) A great example of this is the Health Insurance policy. The Health insurers providing plans with higher
premiums and coverage, only certain people self-select into those plans. Based on the choice the
customer makes (informed party) the insurance company (uninformed party) gets information about the
situation of this person.
(2) Firms provide strong incentive pay, only certain people self-select into those firms.
6
,(3) Signalling
Information: With signalling, the informed party wants to inform the uninformed party about her or his
qualities. So, now the informed party moves first. This only works if the strategy pays off for the high-
quality person but not for the low-quality person.
Agents communicate their type to the principal by taking actions less costly to the high type (relative to
the low type). Requirement for credible communication about its type (‘separating equilibrium’ instead
of ‘pooling equilibrium’)
Examples of signalling:
(1) Education as signalling device (abstract from an increase in marginal productivity)
(2) Higher education is more costly for low type, so for high type credible way of communication about
ability.
1.1 What is the scope of “Incentives & Control”?
- Many organizations are characterized by
• Asymmetric information (some members have an informational advantage).
• Some people have personal objectives that are not perfectly aligned with corporate objectives.
The focus of this course is on the contribution of various methods and techniques to the challenge of
aligning the interests of employees with the overall organizational objectives in settings characterized by
asymmetric information.
Why is this relevant for us?
From a business perspective: For example Wells Fargo.
Wells Fargo is a retail bank in the US. It has a strong performance-
oriented culture. They are very strongly focused on results, and also a
strong incentive to improve sales and being aggressive. The problem
was that at a certain point a too strong culture can backfire. What
happened, at a certain point the culture became too strong on results,
and in the end, you want sales for your paycheck. If you want to
advance in your career you need sales. At a certain point, they
committed fraud. They opened new bank accounts without the
approval of their customers (faking signatures) it started small and spread out. Risk management was
not very strongly implemented in the firm. At Wells Fargo, the sales culture was way stronger than the
risk management functions. In the end, the scale was enormous and millions of accounts were without
approval and they hit a record fine because of this. So, this is a business example where the incentive &
control system kind of backfired. In the beginning, it is balanced between controls and managing risk.
When one element becomes too strong then it gets out of balance and you get a problem like this.
7
,From the auditor's perspective: Auditors use
a questionnaire. Big audit firms say that
additionally the question is will assist in
engagement teams with documentation of
the risk assessment of fraud and non-
compliance with law and regulation. It’s a
tool where they can review and access the
potential risk of fraud. So incentives &
controls matter for the risk angle but also
matter for the auditing angle.
Quiz Question
In the case of Wells Fargo, where millions of deposit and credit accounts were opened without the
approval of customers only benefiting the incentive payouts and career prospects of the employees
involved in the misconduct represent an illustration of a moral hazard?
Answer: Yes, this is an example of Moral Hazard. Why? It’s about actions, Employees take actions in
terms of opening customer accounts, credit card accounts, and superiors do not know, because the CEO
didn’t know exactly that there was fraud going on. The CEO likes high sales but if it is like this, it going to
be a disclosure of this and this person’s career is terminated. It involves actions, private information
(secretly by employees) it has to do with the incentive plan, and their preferences are incentivized by the
chief of sales. In the end, the incentive kind of system provides behavior which is not in best behavior
long time of the firm. Their preferences are not in line with the long-term view of the firm. Misalignment
of preferences so, moral hazard.
Quiz Question related to the exam: It’s important for the exam, always look to both components! Do
people tell something about the actions they take and the preferences of their benefits (bonus etc.) but
it doesn’t align with the long-term interest of the firm. Thus, look from both sides.
1.2 Why do incentives & control problems emerge?
Why do we have these I&C problems? The first question is, where do they come from? Then we are
going to talk about delegation of decision rights. If there is no delegation, there is no I&C problem. If you
are the only person working at your firm, there is no I&C problem.
First, we talk about knowledge. Knowledge is valuable in decision-making. Co-locate decision rights
with knowledge important for making those decisions. You always need decision rights and knowledge.
The CEO has all the decision rights, but maybe he does not know about all markets (knowledge is often
dispersed throughout the organization).
This brings us to the problem that people, who make decisions, often do not have enough experience
about a certain point of interest. This is because knowledge is spread around the whole entity and every
person has their specialty.
8
, Example of the Asian Market:
Maybe you have a part of your firm located in Asia which you don’t have a lot of knowledge about. A
way to solve this is to put someone from the Asian market in a higher department. This is called KTC,
knowledge transfer costs. The more volatile a market is, the more information you have to record, which
is very difficult. The problem is if you make decision rights to the Asian market you have (CC) Control
Costs.
From above we conclude that there are two important aspects in decision-making:
(1) Knowledge
(2) Rights and obligations to make decisions.
So, there are two alternatives to manage knowledge and decisions.
• Moving knowledge to those with decision rights (KTC)
• Moving decision rights to those with knowledge (CC)
o Knowledge transfer cost (KTC) depends on the nature of
knowledge, organizational volatility, technology, etc.
What is the nature of the knowledge? We make a distinguish between:
• Specific knowledge => costly to transfer, if you need to do advertising in China, but you work in
Europe. It is hard to know what works in China. This is knowledge of local preferences and what works
and not works. What products are most valued by local customers? This is specific knowledge.
• General knowledge => inexpensive to transmit, this is pretty easy information to gather.
Specific knowledge is hard to transfer using KT, while general knowledge is easy to transfer. This
difference in knowledge creates two problems for a firm:
(1) Rights assignment problem
Which person in an organization gets the rights and obligation to make decisions?
(2) Control / agency problem
How can account for the fact that the employees who get the rights and obligations to make
decisions, initially make the right decisions and do not think about their interests.
So, what can we learn from outside markets?
Markets have a system of private, alienable rights (Alienability is the right to sell/transfer rights and the
right to pocket the proceeds). The rights are now acquired by those who value the rights the most
Market prices reflect the present value of future cash flows from current utilization and thus provide
rewards and punishment as a result of their decisions
This is not applicable for firms as e.g., employees do not receive rights to alienate decision rights
under their control
o Question becomes to what extent firms should decentralize decision rights?
9
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