What is incentive compensation?

Definition of incentive compensation 

Incentive compensation is a type of compensation based on the performance of an entity. Often incentive compensation plans are designed to attract and retain key employees, identify with shareholders, and align interests of employees and the company. For instance, in the Unites States many corporations pay their executives and employees incentive bonuses based on multiple performance measures. Executives might receive the following forms of compensation: a base salary, annual bonus plan, stock options, and additional compensation (e.g., long-term incentive plan, retirement plan, restricted stock). Compensation plans are often based on net income and stock prices of the company or some other performance measure. 

Performance can be assessed using various measurements, both internal and external. Internal measurements might include financial indicators (e.g., stock price, earnings per share, net income, total shareholder return, return on equity, revenue growth) and non-financial targets (e.g., product quality, customer satisfaction, building excellent investor base, managing risk and reputation). Performance can also be evaluated in relation to the performance of a peer group of companies (e.g., earnings per share, total shareholder return).

There is a wide spectrum of incentive compensation arrangements: annual cash bonus plans, deferred bonus plans, stock grants, restricted stock grants, stock appreciation right plans, phantom stock plans, etc. For instance, under the stock appreciate right plan, a plan participant has the right to receive the appreciation in stock value. In restricted stock grants, employees are awarded company’s shares, subject to a vesting schedule.

The following criteria might be considered when drafting an incentive compensation plan:

• Performance measurements
• Eligibility
• Plan period
• Award size and frequency
• Vesting schedule
• Formal plan

Some of the advantages of incentive compensation may include the following:

• Aligns managers’ incentives with the objectives of the shareholders
• Tax deductible to the company
• Doesn’t dilute shareholder equity
• Either nontaxable to the individual or taxable but deductible
• Requires no investment by and downside risk to the individual

Some of the disadvantages of incentive compensation may include the following:

• Complexity. Many incentive compensation plans include multiple performance measurements as well as award types (e.g., short-term bonuses, long-term incentives, stock-based incentives, organizational awards) and target levels.
• Financial measures might not reflect the changes in the value of the company. For instance, a company with good accounting performance (e.g., earnings-per-share growth), at the same time, might destroy the value of the company to its shareholders through negative real returns (i.e., returns minus inflation) or real value losses (i.e., dividends minus capital losses).
• Create incentives for earnings management. Equity incentives might create a strong link between firm performance and executive’s wealth.
• Create incentives for excessive risk-taking.
• Create incentives for pursuing short-term profits.

Example of accounting for incentive compensation 

Let’s assume that each year Big Company (a fictitious entity) pays its executive John Smith an annual bonus of 4% of net income (before income taxes). At the year-end, the company determines its net income to be $1,000,000. Therefore, the company has to pay its executive $40,000 (i.e., $1,000,000 x 4%). The company would make the following journal entry to accrue the bonus liability:

Account Titles	Debit	Credit
Bonus Expense	40,000
Bonus Liability		40,000

When the company pays the bonus the following year, it would make the following journal entry:

Account Titles	Debit	Credit
Bonus Liability	40,000
Cash		40,000

Let’s assume that John Smith postpones the recognition of R&D expense of $100,000. In such a case, the net income before taxes would be $100,000 more (i.e., $1,100,000). As the result, John Smith would receive a larger bonus (i.e., $44,000 = $1,100,000 x 4%). As we can see from this example, incentive compensation plans might create an incentive to manipulate accounting information. As the result, it’s important to design appropriate compensation plans and establish strong internal controls.