Consider the Risks When Rewarding Success

Source: AICPA CPA Insider

The following includes excerpts, reproduced with permission, from an article by Robert Torok.

A key driver of risk is the incentive that an individual may have to achieve a certain result. This situation is further amplified by four factors:

1. The relatively short tenure of an executive in any given position;
2. The very substantial incentive award that can be earned for single period results;
3. The long-term nature of many business decisions, such that a potential risk may not materialize for several years; and
4. The irreversibility of past-period compensation payments.

Fundamentally, the problem is that individuals earn rewards based on business results for a single period, receive those rewards immediately and cannot ‘lose' the reward virtually no matter what happens in the future.

These factors can be overcome through the use of a multi-period and multi-metric set of performance incentives that meets three objectives:

1. Balance risk over multiple periods, with rewards earned in each period but adjusted and paid over time, reflecting the fact that business decisions may deliver positive results in the short term while creating risk in future years.
2. Force the organization to consider multiple conflicting metrics when making decisions.
3. Take a long-term view, which may be 15 years or 20 years for a public utility, but only two years for a high-technology or software company.

To do so, organizations must:

• Utilize a balanced scorecard, one that recognizes both financial and other performance targets, with portions of incentive compensation tied to each element, thus meeting the second objective above; and
• Implement an incentive pay-out structure that reflects the occurrence of a risk event, driven even in part by decisions of prior years, thus meeting the first and third objectives.

For the complete article, read “Incentive Compensation and Risk Management.”

From AICPA CPA Insider, May 9, 2011, http://www.CPA2biz.com.