Accounting-Based Incentive

What Is an Accounting-Based Incentive?

An accounting-based incentive is designed to compensate corporate executives based on performance measures such as earnings per share and return on equity. Other performance measures that companies commonly use to gauge executive performance include cash flow, return on assets, operating income, net income, and total shareholder return.

These widely-used incentive plans are based on the notion that the main goal of company management is to increase shareholder values to their highest possible levels.

Understanding Accounting-Based Incentives

Accounting based incentives typically reward performing executives with cash and company stock or employee stock options. In firms of all sizes, incentive pay commonly comprises a significant portion of an executive's compensation. Companies determine annual incentive awards for rank-and-file employees by using formulas based on the following three components:

  1. Individual salary level
  2. Firm-wide performance
  3. Performance of a particular business unit

Key Takeaways

  • An accounting-based incentive is designed to compensate corporate executives based on performance measures.
  • Companies can use a host of different metrics on which to base bonuses, including Individual salary levels, firm-wide performance numbers, and performance figured for a particular business unit.
  • Opponents to these programs believe they may present potential conflicts of interest, by tying the firm’s performance to an executive's paycheck, which could trigger high-risk decisions.

The Exponential Growth in CEO Compensation

Accounting-based incentives have been a topic of study for several decades, as businesses have evolved their definitions of what constitutes commercial success and how it may best be achieved. Aligning employee and executive goals with those of shareholders based on accounting measures is viewed as a straight-forward process for determining incentive compensation.

Critics have argued that as executives have increasingly been compensated with company stock incentives, they've been encouraged to focus on short-term impacts to share price rather than long-term planning and general business stability. According to the Economic Policy Institute, CEO compensation grew at 90 times the rate of typical worker pay from 1978 to 2014.

Advantages and Disadvantages of Incentive-Based Compensation

There any many cases to be made for this practice, including the following benefits:

  • The bonuses are tax deductible to the company paying them out
  • These events do not dilute shareholder equity
  • These programs align shareholder interests with a manager’s incentives

On the other hand, opponents of incentive-based compensation cite many disadvantages to this practice, including that fact that bonus calculations can be highly complex because compensation plans often rely on a multitude of performance measurements. Furthermore, there are many different types of awards, such as stock-based incentives, long-term incentives, and short-term bonuses.

Opponents likewise point to the fact that the financial metrics used may not necessarily reflect changes to a company’s value. For example, a company may exhibit substantial earnings-per-share growth, while simultaneously depressing the value of the company for shareholders, through real relative losses (dividends minus capital losses), or through negative real returns (returns minus inflation).

Finally, tying to an executives paycheck to the firm’s performance may foster high-risk decisions. If they fail, the executive may not win a bonus, but his or her base salary is spared. Meanwhile, the share price of the company may precipitously drop, thus hurting shareholders. 

[Important: Bonus incentives don't necessarily motivate all staffers to step up their game—especially those who believe they're already working at capacity.]

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