Earlier this week I explained how enterprise software company Technology One (ASX: TNE) had engaged in some creative accounting.
By adopting a more aggressive accounting policy in relation to the treatment of research and development (R&D) expenses, TNE was able to almost completely offset the hit to its revenue from changes to the accounting standard for revenue recognition and thereby keep its estimated 2019 NPBT at around $74m.
This pleased shareholders, with TNE’s shares rising 15%, to $5.04 at the time of writing, since TNE updated the market on its accounting changes.
But it’s not just shareholders who will benefit from this creative accounting.
TNE executives’ fixed remuneration is a relatively smaller percentage of their total annual compensation compared to its peers. As the company notes in its 2017 Annual Report: “executives have [a Short Term Incentive (STI)] set at the start of their contract which is typically approximately 33% of their total targeted remuneration compared to only 15% for our ASX-listed peers”.
And to be fair, Long Term Incentives (LTI) also represent a higher portion of TNE’s executives’ total compensation (typically 33% at the start of the executive’s tenure) than that of its peers (at around 15-20%).
On the face of it, this is a good thing.
All things equal, I’d prefer a company’s executives have minimal fixed compensation and instead have compensation that is “at risk” ie linked to how shareholders fare – both on the downside as well as the upside – to the greatest extent possible.
But, as they say, the devil is in the details.
The STI portion of TNE executives’ total compensation actually rises the longer they stay at TNE: “the STI increases to approximately 50% of their targeted remuneration compared to 15% for our ASX-listed peers”.
Even better, there is no cap on the amount of STI that can be awarded.
This is in contrast to LTI compensation, which does have a cap (at 100% of target). Moreover, while STI is paid in cash, from 2016 LTI is paid in options, which are obviously only worth something if TNE’s share price is higher than the options’ exercise price when they vest.
(To top it off, LTI is measured over three years, whereas the Australian Shareholders Association, who do God’s work on behalf of retail investors, recommend a minimum of four years).
So practically speaking, this means that STI is the largest component of executives’ total compensation.
This is where I have concerns.
While it Is true that TNE’s 99% customer retention rate means that new customers added in a particular year lead to strong growth in recurring revenue going forward, as the STI is based on just one-year’s performance and paid in cash, it doesn’t exactly encourage long-term thinking on behalf of management.
The greater the percentage of their total compensation that it is represented by STI, the more it encourages management to run the business for the short-term rather than the long-term, particularly as only 20% of STI is deferred and potentially subject to clawback, and that only for three months after TNE’s year end.
This also creates the incentive to game the calculation of STI, and this appears to be one of the reasons behind the change in accounting policy in relation to R&D.
STI is based on improvements in net profit before tax (NPBT), either for the group as a whole or for the relevant executive’s business segment.
The changes to the recognition of revenue forced on TNE by the accounting regulators would have led to NPBT falling by around 36% in 2019.
This would likely have resulted in substantial falls in executives’ STI in 2019.
However, as I’ve noted previously, the inherent flexibility in the accounting standard in relation to R&D expenses provided a way out.
And not just for 2019.
R&D expenses are projected to grow at 8% per year (before capitalisation and amortisation) but until the yearly amortisation charge is large enough, this accounting change also benefits executives’ STI for a number of years beyond 2019.
Of course, this accounting change also benefits executives’ LTI by, amongst other things, pushing up earnings and hence also likely pushing up TNE’s share price, making executives’ options more valuable.
The power of incentives
Now, it is true that directors – particularly Executive Chairman Adrian Di Marco and John Mactaggart – hold large shareholdings in TNE. But to me that is all the more reason not to engage in these accounting shenanigans, take the hit from the change in accounting standards in relation to revenue recognition, and move on.
Moreover, executive incentives are just one thing to consider when analysing a company, and I haven’t done enough research to conclude whether TNE is – or isn’t – good value at current prices.
Yet all this does indicate the power of incentives to shape executives’ – and for that matter, all humans’ – behaviour.
No wonder Charlie Munger, Warren Buffett’s long-time confident and partner at Berkshire Hathaway, remarked in 1994 (when he was a spritely 71 years old): “I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.”