Incorporating Tax into Finance Executives’ Compensation Plan: Does It Benefit or Hurt Innovations in Management Accounting?

Abstract

Finance executives often do not pursue innovations in management accounting that can improve long term profits because these innovations can lead to increases in short term tax liabilities. To focus finance executives on pursuing innovations, common wisdom would suggest shielding their compensation from tax considerations. In this study, finance executives make decisions about an innovation in a costing system that has potential to improve sales managers’ future pricing decisions, but at the same time increases the firm’s external tax liability. Contrary to using before-tax compensation that shields their compensation from tax, our results show that compensating finance executives on after-tax profit increases their propensity to choose the innovation in the costing system over the existing system, especially when their compensation is deferred. The results show that this is optimal from a firm perspective as sales managers making pricing decisions using the innovation in the costing system realize higher profits that outweigh the tax liability increase. Our results offer important new insights for practice. After-tax compensation that explicitly incorporates conflicting considerations into executives’ compensation contracts can stimulate finance executives to better scrutinize their decisions provided that the compensation rewards long-term profits more heavily.

Keywords: Tax difference, Costing system, Compensation plan, Conflict, Analytic thinking

JEL Classification: C91, D83, M40