Executive Compensation

Gary Girous

• Publisher: Business Expert Press
• Year: 2014
• Print ISBN: 9781606498781
• eBook ISBN: 9781606498798
• Topic: Business
• Subtopic: Contabilità finanziaria
• Index: Business

The chief executive officer (CEO) of a corporation and his or her executive team are responsible for the management of the business and its continued operating and financial success. The CEO and executive team are almost always highly compensated and the relative total compensation has mushroomed over time. Most of the compensation now is designed to be performance-based, but leading to charges that executives have incentives to manipulate corporate earnings and stock price in the short-term for their own self interests. The compensation at some companies became so egregious that compensation again became a major public policy issue subject to federal regulation. Executive Compensation focuses on the major topics related to executive compensation—present, past, and future. First, is understanding what executive compensation is, including composition and objectives of pay contracts. Second, how do specific compensation agreements affect corporate behavior and performance? Third, what are the major components, including how and what are accounted for and disclosed? How is compensation, especially executive compensation, accounted for—that is, what are the calculations and journal entries required? Fourth, what does historical analysis tell us about the topic, especially how contractual decisions have been made and what has worked. Finally, what is in store for the future—both expected compensation agreements and what the compensation incentives suggest for future corporate decisions on operations and accounting manipulation.

CHAPTER 1

Introduction to Executive Compensation

Too often, executive compensation in the U.S. is ridiculously out of line with performance.

—Warren Buffet

The chief executive officer (CEO) of a corporation and his or her management team are responsible for the operations of the business and its continued financial success. The CEO and executive team are almost always highly paid and their relative total compensation has mushroomed over time. Most of the compensation is now designed to be performance based because of the charges that executives manipulate their earnings and stock price for their own self-interest. The compensation at some companies became so egregious (Enron and other tech-bubble failures or Citigroup and other banks during the subprime meltdown) that it again became a major public policy issue subject to federal regulation. Popular outrage and calls for government action against well-paid CEOs have been common at least since the 1930s.

Questions about this vital topic abound: Are executives paid more than they are worth? Are compensation incentive structures effective in motivating executives to promote the interests of investors, employees, customers, and other stakeholders? Do current accounting and reporting standards provide adequate information on the effectiveness of compensation? Does economic theory and empirical evidence provide the appropriate framework for evaluating compensation decisions? Would a historical analysis provide a useful perspective for current and future requirements?

This book focuses on the major topics related to executive compensation—present, past, and future. (1) What is executive compensation, including composition and objectives of pay contracts? (2) How do specific compensation agreements affect corporate behavior and performance? (3) What are the major components, including how and what are accounted for and disclosed? (4) What does historical analysis tells us about the topic, especially how contractual decisions have been made and what has worked? Part of the historical analysis is regulation, which has a long, complex history—usually fueled by public outrage. Regulation often resulted in unintended consequences. Chapter 5 focuses on academic research, which studied the issues for decades, and has a set of theories, models, and empirical tests. Chapter 6 analyzes international comparisons, because U.S. results differed from those of other countries. Finally, what is in store for the future—both expected compensation agreements and what the compensation incentives suggest for future corporate decisions on operations and accounting manipulation.

Three key points are emphasized. First is the role of accounting and disclosure in the process. Transparency has increased over time and compensation components seemingly are accounted for more effectively. Research analysis based on these disclosures suggests certain overall results about the composition and reasonableness of executive pay, although alternative perspectives have different interpretations. Second is the importance of a historical (or chronological) perspective. Business cultures and institutional frameworks have changed dramatically since the 1930s, with important ramifications. The role of the Securities and Exchange Commission (SEC) has been important since the 1930s and the Financial Accounting Standards Board (FASB) for the last 40 years. Types and amounts of executive pay have bounced up and down based partly on tax laws and regulatory changes—often because of unintended causes, as executives found new ways to be paid more. The timeline at the end of the book is quite useful putting this changing framework in perspective. Third is the importance of theory (especially economic) and empirical findings that help explain what is happening. Researchers have been investigating compensation worldwide and their findings are often different from those of the popular press. Overall, for example, compensation may be less egregious than previously thought. Finally, executive compensation continues to be the leading incentive structure driving a short-term financial focus and potential accounting manipulation by public corporations.

What is Executive Compensation?

The major corporate executives are usually considered the CEO and the CEO’s top lieutenants, including the chief financial officer (CFO), president, and chief operating officer (COO). However, according to Ellig, executives can be defined by “salary, job grade, key position, job title, reporting relationship or a combination.”1 So, a bit of care must be taken in the analysis. The SEC requires considerable disclosure for the CEO, CFO, and other executives with the highest compensation—called the “named executive officers” (NEOs). The SEC definition will be the one used most of the time.

The SEC Proxy Statement is the place to turn to define executive compensation. The summary compensation table has the following categories for the most recent three years: salary, bonus, stock awards, options awards, nonequity incentive plan compensation, change in pension value plus deferred compensation, and all other compensation. The sum of these seven columns is the total compensation. Summary compensation table for Microsoft, 2013 is a reasonable place to start an analysis, although there are many more disclosures and complex reporting. The details (and there are many) are described in the SEC’s S-K Regulations.2

Table 1.1 shows the summary executive compensation of Microsoft for fiscal year 2013. (A more complete disclosure of Microsoft’s Proxy Statement information on executive compensation is presented and analyzed in Appendix 1.) Although CEO at the time Steve Ballmer (a multibillionaire with wealth estimated at $20.7 billion, number 32 on the Forbes 400 list) made less than $1.3 million, other senior executives were quite well paid. The remaining five received huge stock awards up to $7.5 million and cash bonuses up to over $2 million.

Table 1.1 Summary compensation table for Microsoft, 2013

The base salary is the cash compensation figure the executive expects to receive no matter what. Basic pension benefits and perquisites also usually are paid under all circumstances. Most of the remaining components are “performance-based,” meaning that the amounts presumably will rise and fall as corporate performance changes, usually one or more measures of accounting earnings and stock performance as specified in the compensation contract. Specific terms can be complex and often require multiyear measurements and vesting periods. More coverage on this point in upcoming chapters.

Paying Executives What They Are Worth

What could a CEO or any other executive actually be worth? Many of them are paid a lot, but not all. Steve Jobs, as CEO of Apple Computer and arguably one of the best CEOs of all time, was often paid a dollar a year. Conveniently, he was a billionaire, but certainly not overpaid most years. Warren Buffett, head of Berkshire Hathaway, had a long-time annual salary of $100,000 a year (also a billionaire and one of the richest men in the world).

On the other hand, many executives received unbelievable sums. Larry Ellison, CEO of Oracle (another billionaire), received a pay package of $96.2 million in 2012 (up 24 percent from 2011), even though total returns for Oracle fell 22 percent.3 A pay survey by GMI ratings indicated that Mark Zuckerberg, CEO and founder of Facebook, received $2.3 billion in compensation thanks to exercised options and Richard Kinder of Kinder Morgan, $1.1 billion. Billion dollar pay is rare and the average executive pay is much lower. On the other hand, pay increases tend to be generous for executives, while raises for average workers typically stingy. The median pay increase was 8.5 percent across over 2,200 North American CEOs, 19.7 percent for the S&P 500.4

Equal public outrage involves the exit packages of CEOs fired for mediocre performance or worse. The record for outrageous termination pay is still held by former Disney CEO Michael Eisner, receiving a $550 million exit package after being canned in 1997. Eisner had plenty of competition including Michael Ovitz’s severance, also from Disney in 1995 (ironically fired by Eisner—Disney apparently had plenty of funds to pay for bad management), at $130 million; Richard Grasso forced out from the New York Stock Exchange (NYSE) presidency after receiving $140 million (the NYSE was a nonprofit organization at the time); Robert Nardelli with an exit package from Home Depot of $210 million, Hewlett-Packard’s Carly Fiorina ($21 million); and numerous others. Enron executives received some $500 million in total pay in the second half of the 1990s, enough to encourage ongoing deceit through the end of that decade.

A number of CEOs were paid gigantic salaries and likely well worth it. Robert Goizueta, long-time CEO of Coca-Cola, became the first nonowner of a public company to receive more than a billion dollars in total compensation over his career (1981 to 1997). Jack Welch of General Electric (GE) was well compensated over a long career at GE, including 20 years as chairman and CEO (1981 to 2001). The market value of GE increased over 30 times while he was CEO (from $14 billion to more than $400 billion), although he earned the epithet Neutron Jack for terminating thousands of employees. His retirement/severance package was later valued at $420 million, enough to tarnish his reputation—in part because parts of it were hidden (until disclosed during a nasty divorce). Other large retirement packages from major corporations included Lee Raymond of Exxon (2005, $321 million) and Louis Gerstner of IBM (2002, $189 million).

The Economics of Labor and Compensation

Executive pay has long been an important part of labor economics and economics in general. Labor is one of the factors of production (inputs), along with capital, land, and (in some models) entrepreneurship. Other factors such as natural resources, technology, infrastructure, or capital stocks can be considered separately or as parts of the major factors of production. Output is usually measured as finished goods. Labor in economic terms measures the work done by humans, including issues associated with the demand and supply of labor; skill levels; and impact on wages, incomes, and overall employment. In neoclassical economics, the demand and supply of labor markets determine prices (wage rates) and quantity (employment). Labor behaves differently from other production factors. If supply is greater than demand, the result is unemployment (a problem of public policy, not necessarily business). If demand is greater (overall or for specific skills), additional supply is not easily generated as wages rise. Labor markets within firms focus on how firms set up, maintain, and end employment relationships, while providing incentives to maintain efficiency and avoid employee shirking.

Executive compensation models in economics generally are based on an agency framework. Agency is a branch of law where a principal authorizes an agent to create legal contracts/relationships with third parties. This is a fiduciary relationship requiring the agent to be loyal to the principal. A corporation is a legal entity relying on human agents. Although based on legal terms, economic agency theory was developed by Jensen and Meckling in a 1976 paper. Underlying assumptions are that corporations (and other organizations) seek profit; principals and agents are rational; agents seek additional returns (rent seeking); principals are risk neutral but agents are risk adverse; and agency costs are major factors to consider in writing contracts. As in most economic models following neoclassical assumptions, the results are mathematically elegant but not especially realistic.5

During the Roaring Twenties, the very rich reached the pinnacle of wealth. As the Great Depression hit, Congressional hearings and various investigations discovered million-dollar salaries of a few at the top, tax cheats, and rampant fraud. An outraged public demanded action and federal regulators gathered compensation data of the top executives—which has continued to this day. With this growing database, economists could develop and test various hypotheses about compensation and its impact on firm behavior. Early studies were descriptive, such as John Baker’s Executive Salaries and Bonus Plans published in 1938. New Deal legislation, high tax rates and World War II wage controls held executive compensation in check—a period called the Great Compression, which lasted into the 1980s.

In a pair of 1990 articles, Robert Jensen and Kevin Murphy laid out an economic argument for performance-based compensation based on an agency framework and a wealth of data.6 The more influential article was published in Harvard Business Review, which claimed that CEOs were paid like bureaucrats without regard to actual corporate performance. Their empirical analysis showed that CEO compensation in the 1980s (adjusted for inflation) was actually less than that in the mid-1930s (during the middle of the Great Depression). Based on agency incentives, Jensen and Murphy claimed that CEO stock ownership was too low for efficient contracting based on pay-performance sensitivity. Their su...

Table of contents

• Cover
• Halftitle
• Title
• Copyright
• Contents
• Chapter 1: Introduction to Executive Compensation
• Chapter 2: Compensation Basics
• Chapter 3: Accounting for Executive Pay
• Chapter 4: Historical Perspective on Executive Pay
• Chapter 5: Economic Theory
• Chapter 6: International Comparisons
• Chapter 7: The Future of Executive Compensation
• Appendix 1: Microsoft Proxy Disclosures, 2013
• Appendix 2: Microsoft 10-K Stock Compensation Disclosures, 2013
• Appendix 3: Pfizer 10-K Disclosures, 2012
• Timeline
• Glossary
• Notes
• References
• Index
• Ad Page
• Backcover