Productivity and the Bonus Culture by Andrew Smithers;

Author:Andrew Smithers; [Smithers, Andrew]
Language: eng
Format: epub
ISBN: 9780192573124
Publisher: OUP Premium
Published: 2019-03-07T00:00:00+00:00

In Table 17 I use the ratio between these two measures to estimate the impact of inflation. As national account profits are measured in two ways I show the impact using both measures. (Inflation affects profits through the impact on inventories (IV) and on capital consumption (CC).)

Table 17. Extent to which US RoEs were boosted in the 12 months to Q1 2014 by using historic cost values for assets (Data sources: Federal Reserve Z1 Table B 103 and NIPA Table 1.14)

The bonus culture has given management a strong incentive to misrepresent the RoEs that their companies publish. Bonuses depend on changes in profits and share prices, compared to some previous level. In bad times it can therefore be in the interests of management to present abysmal profit figures, rather than merely bad ones. When things become so bad that management is changed, the new arrivals will want the level of profits when they take over to appear as low as possible, not only from a wish to blame their predecessors for the collapse but also to make subsequent profits look good. Even those managers who survive will wish to publish very bad profits in a poor year. They will then appear to have a strong case for scrapping the former profit targets and introducing new ones, in which success will be judged by the extent to which profits rise compared with their now heavily depressed level rather than with those published when things were going well. After a dramatic fall in profits, remuneration committees will think it only reasonable that bonus arrangements will not incentivise management if the profit targets appear to be out of reach. It thus seems sensible to reduce the level of profits which must be exceeded before future bonuses will become payable.

These arguments for scrapping previous targets are bogus, despite their proponents’ assertions. Making write-offs in bad years not only depresses the base from which future changes are judged but also makes subsequent profit increases much easier. When write-offs take place the effect is to reduce the book value of companies’ assets, such as their inventories, trade debtors and equipment. The lower the book values of inventories the greater will be the profits when they are subsequently sold, and the lower the book value of debts the greater will be the profits when payments are received from debtors. In the case of equipment, the lower its book value the lower will be the subsequent charge for depreciation—and again this will increase future profits. Write-offs are not just an admission that profits have been overstated in the past; they are also an implied promise that profits will be overstated in the future. This belongs to a rare group of management promises: those that are usually kept.

By exaggerating profit falls and their subsequent recoveries, the bonus culture encourages companies to publish profits which are much more volatile than before. This is exactly what has occurred. The increased volatility of published profits, which I illustrate in Figure 45, provides additional evidence of the impact of the change in management incentives on management behaviour.

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