CHAPTER 1
WHY WE NEED A NEW COMPENSATION PARADIGM
“All significant breakthroughs are significant break-‘withs’ old ways of thinking.”
—Thomas Kuhn
If you are reading this book, you are likely only somewhat satisfied or even dissatisfied with your firm’s current owner compensation system and you are wondering how to make it better. Or perhaps you want to benchmark your current compensation system against firms that are known for their best practices. Whatever your reasons for reading this book, you can make your current compensation system more effective, and perhaps even fairer, than it is today.
While the world in which the professional works today is vastly different from the traditional environment during the first 90 years of the twentieth century, compensation systems have not changed much during the same period. Practicing in the twenty-first century poses significant challenges to accounting firm owners in the areas of leadership, management, risk vs. reward, recruitment and retention, succession, and compensation.
This chapter discusses paradigm shifts in the accounting profession and paradigm shifts in owner compensation.
PARADIGM SHIFTS IN THE ACCOUNTING PROFESSION
No one can predict the future with accuracy, but we know what has worked in the past often no longer suffices in the new world order of the twenty-first century. We base this statement on our observations of the public accounting profession for more than 25 years, and we recognize the following realities:
▮ Global outsourcing
▮ Competitive landscape
▮ Increased regulation
▮ Advancements in technology
▮ Global economy
▮ Fee pressure
▮ Client demands
▮ Firm leadership
▮ New metrics
▮ Compensation
▮ Workplace diversity
▮ Work-life balance
▮ Generational differences
▮ Talent shortage
A discussion of each paradigm shift in the profession follows.
Global Outsourcing
The professional services sectors (law, accounting, and medicine) in the United States are beginning to feel pressures of the global economy. Accounting and tax preparation work is now outsourced to India or other countries, legal research is often contracted, and various activities such as medical practices are performed in locations far removed from the patient.
Competitive Landscape
In the first few years of the twenty-first century, the accounting profession faced some of its darkest hours. It is no exaggeration to state that the profession was shaken to its core. Arthur Andersen, one of the premier international accounting firms, was not only disgraced but destroyed. Never in the history of the accounting profession had one of the big international accounting firms gone out of business in this fashion. The catastrophic events of an Enron, WorldCom, or Adelphia; advances in technology; and increased client sophistication have contributed to the current environment in which accountants must now work and compete.
Increased Regulation
Public company auditors are now regulated by the Public Company Accounting Oversight Board (PCAOB) an agency created under the Sarbanes-Oxley Act (SOX), the 2002 corporate governance reform act. SOX was passed not only to oversee the auditors of public companies, but also to protect the interests of investors and further public interest in the preparation of informative, fair, and independent audit reports.
Advancements in Technology
Technology, such as the use of Web-based accounting and payroll solutions, plays an increasingly important role in today’s public accounting practice, regardless of the size of the firm. Technology allows any firm to have tax returns, write-up, and other backroom procedures processed in India, another low-cost country, or even a low-cost area in the United States. In his groundbreaking book, The World Is Flat: A Brief History of the Twenty-First Century, Thomas L. Friedman shares, “In 2003, some 25,000 U.S. tax returns were done in India. In 2004 the number was 100,000. In 2005, it is expected to be 400,000. In a decade, you will assume that your accountant has outsourced the basic preparation of your tax returns—if not more.”1
Global Economy
The United States and other developed countries of the world are feeling the impact of a global economy. Many industries (such as automotive, manufacturing, and textile) have undergone, or are undergoing, widespread economic restructuring. Accounting firms of all sizes are beginning to feel some of the same global pressures. Like other businesses, they have no choice—they either generate a profit or they go out of business.
Fee Pressure
Fee pressure on basic or commodity services, such as bookkeeping or simple tax compliance, will increase over the next decade. Firms that are unable to maintain acceptable profit margins on commodity work, especially when commodity work comprises a large percentage of their practices, may have insufficient cash to allocate to owners. This will only cause more owner dissention and place additional pressure on owners to create compensation systems that reward for performance rather than entitlement.
Client Demands
We recently conducted a survey of more than 100 accounting firms for the Association of Accounting Firm Administrators. The survey showed that clients of the very smallest to the very largest firms are more sophisticated today than ever before. Clients continue to become more sophisticated in basic tax and financial issues. They have access to an overwhelming abundance of data and online resources that deal with business operations, taxes, and finance. As a result, the days of the generalist are, perhaps, short lived. While clients are willing to pay for value-added services, it may be harder to demonstrate the added value your firm can provide. The traditional business model of the professional adviser as the expert is not where future demand will lie. While this model has well served the service professions (such as legal, medical, and public accounting), today’s clients no longer see themselves as humble individuals asking experts for their “worldly advice.” Professionals today collaborate with their clients to create exact solutions to individual and organizational problems. This requires the professional to have deeper knowledge and greater skills than ever before. The future, we believe, will require accountants to have specialized knowledge in industries and specific practice areas as well as greater consulting skills.
Firm Leadership
Firms run the gamut from great leadership to poor leadership. Great leadership is often expressed in the achievement of the firm’s goals and mission, and translates itself into higher productivity and profitability. While firm leadership has been shown as a major differentiating factor among certified public accounting firms, few firms invest in developing good, much less great, leaders. Worse yet, some professional services firm leaders may have outdated concepts about authentic leadership. According to Bruce J. Avolio and Fred Luthans in “The High Impact Leader,” authentic leadership is a process that combines positive leader capacities and a highly developed organizational context.2 The authentic leader is confident, hopeful, optimistic, resilient, moral/ethical, future-oriented, and gives priority to developing associates to be leaders. Authentic leaders are true to themselves and their behaviors positively transform or develop their associates into leaders themselves.
New Metrics
Forward-thinking leaders are embracing modern management techniques, such as the balanced scorecard, to manage and lead their firms. They realize that focusing on economic and financial indicators (measures) alone are insufficient to maintain a competitive edge and achieve desired levels of profitability and client service. They realize the need to focus on client service and loyalty, employee growth and learning, business development, and internal systems development indicators as well.
Compensation
Compensation and reward systems for employees and owners are being modified. At a time when many believe Generation Y maintains a strong sense of entitlement, there is also a growing trend in the corporate world to move from entitlement to performance-based compensation systems. Even older public accounting firms with entrenched beliefs are beginning to reward their top performers—those owners and employees who help the firm achieve its strategic vision. They are also beginning to let non-performers and underperformers go. Employment for life, even for public accounting firm owners, is no longer guaranteed.
Workplace Diversity
The AICPA’s Diversity Statement provides firms a clear vision of today’s and tomorrow’s workforce:
The American Institute of Certified Public Accountants is committed to being recognized as the premier national professional organization. To achieve this status, it must lead in encouraging, valuing and fostering diversity in its membership and in the workforce. The AICPA has decided to reaffirm the importance of diversifying the accounting profession and promoting work-force diversity by making these objectives among the AICPA’s highest priorities. Therefore, in principle and in practice, the AICPA will identify, recognize, and support strategies and efforts within the organization and profession that are dedicated to achieving the AICPA’s diversity objectives.
The AICPA will begin by increasing its efforts to continue to recruit and maintain a diverse professional staff. In addition, it will continue to actively recruit and maintain diverse membership in all AICPA committees.
The AICPA encourages all state CPA societies and related organizations to adopt similar diversity statements.
Many firms are embracing the Institute’s diversity statement. For example, in 2006 Ernst & Young LLP was honored as one of the “Top 50 Companies for Diversity” by Diversity Inc magazine. In recognition of the firm’s commitment to workplace equity, Ernst & Young ranked 24 overall and ranked sixth on the magazine’s “Top Ten Companies for GLBT [gay, lesbian, bisexual, and transgender] Employees” list. The firm also appeared for the eighth consecutive year on both the 2006 Fortune “100 Best Companies to Work For” list and Working Mother’s “100 Best Companies for Working Mothers” list.
According to a recent study (“A Decade of Changes in the Accounting Profession: Workforce Trends and Human Capital Practices”) conducted by the AICPA’s Work-Life and Women’s Initiatives Executive Committee, women now account for 19 percent of all public accounting firm owners. This is a 58 percent increase over the last 10 years. This trend will only increase based on the number of women graduating with degrees in accountancy. The report concluded that the accounting workforce is changing faster than human resources policies can adjust, noting significant gaps between what firms think motivates and retains people and what is effective in actual practice. (A copy of the report is available from the AICPA’s Web site, www.aicpa.org/members/div/career/wofi/research.htm.)
Work-Life Balance
Market dynamics—single parents, children caring for aged parents, and children—are forcing firms to address the work-life balance. Both men and women in public accounting firms are taking advantage of alternative career paths now being offered by firms. These include flex time, part-time, and shared positions. A few firms are also offering part-time partnership positions to employees they want to keep.
The need for work-life balance, along with the overall shortage of qualified staff, has caused more firms to abandon their “up or out policy.” According to the AICPA work-life study, 38 percent of firms surveyed offer some kind of alternative career path that does not lead to an owner position.
Generational Differences
According to Rick Telberg, Editor at Large at the AICPA, “It is well established that there are distinctly different personal preferences and work habits among the four generations in the workplace. For instance, as we reported in ‘What Your Workforce Really Wants,’ the generations fall in a few basic categories, the so-called Mature Generation, born before 1946; Baby Boomers, born between 1946 and 1964; Generation X, born between 1965 and 1980; and Generation Y, born after 1980.”
According to Leslie Murphy, Former AICPA Chair, “In the next 15 years, 75 percent of current AICPA members will be reaching or approaching retirement age.” The accounting profession’s future will be controlled by the tail end of the Baby Boomers, those born after 1960, and Generation X. With four different generations currently in the ranks of all firms, it is inevitable that generational conflicts arise as the older generations try to hold onto what they have achieved and the newer generations strive to build for the future.
Talent Shortages
It was the best of times and it was the worst of times. If only Charles Dickens were writing today. Every firm in the country could use more people, especially experienced ones. Even though enrollment is up in accounting programs, it will be a few years before graduates enter the job market. Jerry Love, chairman elect of the Texas Society of Certified Public Accountants, captured the current environment when he said in a March 2006 article in the Austin Business Journal, “Right now we are just trading people. The shortage is not going to go away anytime in the near future. As the Baby Boomer generation begins to retire in increasing numbers in the coming years, firms will continue to strain to fill positions.”
New paradigms are replacing old ones, and when there is a paradigm shift of this magnitude, massive change generally follows. The factors discussed in this chapter have caused firms to look differently at their resources and reward systems.
Joel Arthur Barker observed that “when a paradigm shifts, everyone goes back to zero.”3 By “zero,” Barker meant that no matter what your position before the paradigm shift, you are back at the starting line. Everyone who is affected by the shift is starting over. No one has an advantage over anyone else. The old laws and rules no longer apply.
We maintain a paradigm shift is currently taking place in the area of firm compensation systems. Some firms will see it and embrace it, others will see it and laugh at it, and still others will not see it until it may be too late. Paradigm shifts generally do not happen overnight; they evolve as we receive new information or more complete information, and there is usually a transition period between the old and new paradigms. However, those firms that see the shift early and embrace it can gain competitive edge over those who laugh or do not see it until it is too late.
Living through a paradigm shift, whether you see it or not, generally results in change—either small or large—and some pain. To give you an idea of what firms are going through today, we share the statement of a managing owner of one of our client firms after his firm made changes to its owner compensation system: “I will say this—change is chaotic, painful, unsettling, and hard.” Need we say more?
PARADIGM SHIFTS IN OWNER COMPENSATION
Based on our consulting with firms and the 2006 compensation survey we conducted with the AICPA PCPS Division, we have identified 11 specific paradigm shifts taking place in public accounting firm owner compensation plans. These paradigm shifts are outlined in Exhibit 1–1, “Old Versus New Compensation Paradigms for Owners.” A discussion of our observations follows.
Evaluating Based on Customized Criteria and Goals
In the old paradigm, firms often tended to evaluate all owners on the same criteria—business development, billable hours, and origination, to name a few—regardless of each owner’s competence in these areas. Everyone was, in essence, put into the same mold.
Owners with valuable competencies outside of these criteria often were not motivated to exercise them since there was no reward for doing so. The old paradigm also paid little attention to managing the practice or to building future capacity in the firm. There were few, if any, incentives for an owner to cooperate with other owners, to develop future leaders, or to build new niches and services.
Owners focused on how they could achieve their own individual goals. Hence, firms created a culture of independence and competition: “I win and I do not care whether you win or lose,” or worse, “I win, you lose.” Success today is contingent upon the owners acting interdependently rather than independently.
The new paradigm takes into consideration the strategic and operational goals of the firm. It encourages the accomplishment of current production goals as well as goals that build the firm’s ability to get even better results in the future—developing “capacity.” These goals (for example, improving staff skills and creating more effective business systems) keep the firm capable of future growth. The ultimate, long-term success and viability of a firm depend upon the accomplishment of these two types of goals.
One chief operating officer (COO) of a Top 100 Accounting Firm compared his firm to a sports team: “The team has an overriding vision and mission and needs to fill various spots with people who have different but complementary competencies. The more members work together, the more successful the firm becomes.”
Using Win-Win Agreements
Under the old paradigm, compensation was often allocated based on a pure formula calculation, some combination of formula and subjective evaluation or relative determination. The results of our 2006 Compensation Survey show that firms will be moving away from the formula compensation plan to the pay-for-performance approach.
The new paradigm requires each owner and the firm to determine mutually agreed upon expectations at the beginning of the year, and to identify what it means if the owner meets expectations. This is often called a “win-win agreement” because owners are generally focusing on goals that allow the owner to focus on his or her talents, passion, and activities (a win for them) that drive both short-term and long-term growth and profitability (a win for the firm). There is no confusion about what needs to be done by when or by whom.
Focusing on Current Production and Future Capacity
We often tell our clients that no margin means no mission. There certainly is nothing wrong with focusing on current production. After all, that is what helps to create profits today. That focus can become dysfunctional, however, when current production is the only or primary focus.
The new compensation paradigm suggests a firm needs to focus equally on current production as well as building capacity for future production, developing new services, creating future leaders, and training employees. Client needs are constantly changing and, in today’s environment, clients will surely look to another firm if your firm cannot satisfy their needs.
Providing a Solid Safety Net
Under the old paradigm, many owners were left to swim or sink. Even if they were given goals at the beginning of the year, they were often left on their own to achieve them; they generally received no coaching, no mentoring, and no quarterly performance reviews. In short, firm management did not support its owners.
Under the new paradigm, for the firm to win, owners must be great swimmers. As a result, more resources may be provided to help owners achieve goals. This does not mean the firm will “carry” unproductive owners. Rather, it must provide them an environment in which they can succeed with the resources they need, and if they are unable to achieve their goals, they may be counseled graciously to find other opportunities.
Rewarding Performance
“What did you do for me today?” may be the new mantra. Seniority, equity, and business origination no longer count as much as they once did in the scheme of total compensation.
The worst case scenario under the old paradigm of entitlement is one in which owners are compensated solely based on seniority, equity, and even origination without regard to current production. For example, Owner Jones has 40 percent ownership. The firm’s current compensation system provides for each owner to take out a draw of $100,000 and then profits are allocated based on ownership. Jones’ other founding owner, Smith, has 38 percent ownership, and the four remaining owners have 7 percent, 6 percent, 5 percent, and 4 percent. Jones and Smith work the fewest hours and have the least billable time. Since a large portion of their compensation is based on ownership, they are able to remain the two highest-paid owners without contributing much to the firm today. Younger owners could rightfully argue that both Jones and Smith have effectively retired from the firm, but have failed to inform fellow owners.
The new paradigm shifts a greater percentage of total compensation from entitlement to performance. We see some firms limiting the percentage of total compensation based on seniority, equity and origination to as low as 10 percent. Several firms are between 10 percent and 20 percent.
Including At-Risk Compensation
A natural consequence of the current environmental and economic realities is that a lesser percentage of total compensation is being guaranteed to owners. In the old paradigm an owner could often draw 90 percent or more of his or her total compensation. For example, an owner making $250,000 per year would be guaranteed $225,000. The amount at risk ($25,000) would be insufficient to motivate the owner to perform at a high level or even worry about performance.
Under the new paradigm, that same owner might be guaranteed 60 percent or less of the total compensation or $150,000 ($250,000 × 60 percent). In fact, some of the most profitable firms pay owners 25 percent of their potential compensation during the year. The remainder is at risk.
In one firm with which we are familiar, the average owner total compensation was over $400,000 in 2003. Yet, owners were only allowed to draw $100,000 during the year. The rest was allocated as a performance bonus.
Ensuring Fairness
We cannot tell you how many owners have pulled us aside to talk about the perceived lack of fairness of their current compensation systems. While some of this complaining may be “sour grapes,” there is proof that older systems were often not designed to be fair, and owners do indeed have a legitimate complaint. In our 2006 Compensation Survey, we asked, “To what extent is the owner compensation system designed to be fair to each owner in the firm?” Here are the responses:
Fifty-one percent believe their systems were designed to be very fair.
Forty-one percent believe their systems were designed to be somewhat fair.
Eight percent believe their systems were not designed to be fair at all.
We asked a follow-up question as to how fairly the compensation system is applied.
▮ Sixty percent said very fairly.
▮ Thirty-five percent indicted somewhat fairly.
▮ Five percent reported not applied fairly at all.
A reliable compensation system not only needs to be understood by the owners, it also needs to be designed in a fair manner and then applied fairly. If owners do not understand how the compensation system works or, even worse, if they do not know what to do during the year to earn their compensation or increase it, a feeling of unfairness can permeate the firm. This is often a root cause for many owner problems.
Under the new paradigm, the compensation system is perceived to be more fair when each owner understands it and knows exactly what he or she must do to in order to earn his or her compensation. This transparency leads to trust and better morale among the owners.
Agreeing Upon Goals
In the old paradigm, goals were not clearly stated. In our 2006 Compensation Survey, we asked the question, “Do owners in your firm have written goals?” Eighty percent responded negatively. If a goal is not written down, how can owners be held accountable? And 74 percent of the firms responding to our survey indicated they had either no evaluation or only an informal evaluation for owners. Only 10 percent of the respondents said they use a formal evaluation method. Under the new model goals are clearly developed and documented at the beginning of the year, and there is mutual agreement between the owner and firm management about the reward. While management may suggest goals to owners, individual owners must take responsibility for them. This requires commitment and buy in. The win-win agreement allows this to happen. Unless owners are involved in setting their goals, there will likely be no commitment to them.
Creating a New Culture
During the Clinton-Bush Presidential race in 1992, the Clinton team came up with a brief but effective winning theme: “It’s the economy, Stupid.” Our winning theme for the new compensation paradigm is “It’s the culture, Stupid.” Culture is simply the collective behaviors of everyone in your firm. Albert Einstein is often quoted as saying if you keep doing what you always have done, you will continue to get the same results. In short, if behaviors do not change, you cannot expect different results.
The new paradigm requires an examination and evaluation of the results that are being produced and an exploration of the individual behaviors that are causing those results. Then, you must explore why people behave the way they do. Generally, it is because they have found personal success with these behaviors in the past. When their behaviors, however, do not get the desired results, you must explore even more deeply why they engage in behaviors that do not get desired results. This is generally due to incomplete or inaccurate beliefs (paradigms). Remember, behaviors will only change when individuals change their beliefs. For example, if as a professional service provider, you believe business development is a noncore or uncomfortable activity, you will likely not engage in business development activities. The results will be pretty evident: very little or no business development.
Exercising Courage
Under the old paradigm, owners were seldom formally evaluated by management. According to the results of our survey, while 81 percent of the respondents believe that owners should have written goals, 80 percent of the firms indicated that their owners do not have any written goals. Because of this, it is extremely difficult to have formal evaluation.
Underperforming owners were often retained because of close friendships or other emotional or subjective reasons. Under the old standard, it was easier for management to simply turn away than to make a hard decision regarding the underperformer. Sadly, both the firm and the individual owner were often dissatisfied. In the new environment, underperformers have no place to hide. They have only three choices: They can (1) accept compensation system changes and strive to increase their performance, (2) be asked to leave the firm, or (3) elect to leave on their own accord. Remaining as an underperformer is no longer an option.
Balancing Individual and Firm Benefits
Too often, under the old model owners focused only on their own enrichment and betterment. As long as they won, they did not care if anyone lost. The goals of each owner were independent rather than interdependent.
The focus of the new compensation model has changed. Firms are moving toward interdependent goals that develop a culture of cooperation, teamwork, and abundance. Studies have shown, and as Stephen R. Covey points out in The 7 Habits of Highly Effective People,4 a philosophy of abundance rather than one of scarcity produces more for everyone.
FINAL THOUGHTS
While your old compensation system may not have been perfect, it had some good points and probably served you well in the old environment. Times are changing, and now is the time to change your views on compensation and income allocation so you can make needed changes to the compensation system. Will the new system be perfect? We doubt it. Your paradigms will always be incomplete.
The best advice we can offer you is to identify which of the old paradigms we’ve described are prevalent in your firm today. They could be standing in the way of growing the compensation pie and using it as a true strategic asset. When you identify the old paradigms as well as the negative effects they are having on your firm, you can begin to make the shift to developing a new and more effective compensation system.
EXHIBIT 1–1 Old Versus New Compensation Paradigms for Owners
| Old Compensation Paradigm | New Compensation Paradigm |
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