ETHICS in the Real World
The boards of directors of most major U.S. companies have established executive compensation plans that base executive pay on some measure of company performance. While these plans differ widely across companies, a large percentage use some form of reported earnings as the measure of performance. Recognizing that there are many different ways to measure earnings, these compensation contracts must be very specific about which earnings measure is used. Pillsbury, for example, bases its formula on operating earnings, the result of subtracting operating expenses from operating revenues, excluding such items as interest expense, interest income, gains and losses on asset sales, extraordinary gains and losses, and the effects of accounting changes. Other companies, such as DuPont and Ashland Oil, base their formulas on net income after such items—the “bottom line.”
Consider a company that has a compensation plan like that of DuPont, where compensation is a function of earnings after interest expense, and assume that management is analyzing how to finance a particular capital investment—that is, should it be financed with debt or equity? Management knows that if debt is chosen, net income and its compensation will be reduced by the interest expense recognized on the debt. On the other hand, if management chooses equity, there will be no interest expense to reduce its compensation amount.
ETHICAL ISSUE Is it ethical for management to consider the impact of the financing decision on its compensation amount, or should such impact be completely ignored when choosing between debt and equity?