Xu Yue

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					The Nature of Employee Stock Option Costs and Other Major
 Expenditures: An Empirical Examination of Their Link to
                 Executive Compensation




                     Thesis Proposal by


                          Xu Yue




             Faculty of Business Administration
              National University of Singapore




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                                   CHAPTER 1
                                 INTRODUCTION

1.1 Background of the Study

Many generally accepted accounting principles (GAAPs) result in accounting
treatments in conflict with the underlying economic reality. Employee stock options
are one glaring example. Many investors and analysts including the famed Warren
Buffet have pointed to the continuing treatment of the cost of employee stock option
grants as a non-expense as one of the biggest failures of the accounting profession and
regulators. As another example, many including Stern Steward of the EVA fame have
argued that R&D expenditures should not be treated as an expense, since such
expenditures provide future benefits and should be treated as an asset.

The confusion created by the criticism against certain accounting principles and the
reporting of income numbers based on different rules raises an interesting question:
where do firms themselves stand on the issue?

1.2 Objective of the Study

This study attempts to find out the TRUE position taken by the companies themselves
on the issue: whether employee stock option and R&D expenditures should be
accounted as the cost of the period they happen? I use chief executive officer (CEO)
compensation as a tool and try to find out whether firms determine executive
compensation based on income number before these controversial items or after them.

I focus on the CEO compensation because prior research documents a strong
empirical relation between top executive compensation and earnings (Lambert and
Larcker, 1987, Defeo et al., 1989, and Sloan, 1993). CEO is responsible for the firm
performance, including accounting earnings. To fairly reflect CEO’s effort on firm
performance, most firms relate earnings with CEO compensations.

However, the earnings used by firms for compensation may be different from the
earnings shown in the income statement. For those items controllable by CEO, only
when firms do not consider some items in income statement as a true cost of the same
period, are their effect eliminated from establishing CEO compensation plan. In this
sense, from the relationships between CEO compensation components and the
controversial items, we can find out whether firms consider employee stock option
and R&D as true cost or not, even though they are expenses against profits in the
income statement complying with accounting principle. The negative relationship
would tell us firms do think the item as true cost of the current year, vice versa.

While agency theoretic models related total pay to performance, my study focuses on
the components of total compensation. Compensation agreements with executives



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may be structured and administered so that components of total pay, such as salary,
bonus and stock-based awards, respond differently to observable performance
measures, such as market and accounting returns. Thus, I estimate an empirical model
that relates CEO compensation to firm performance through bonus, cash
compensation as well as total pay.

1.3 Potential Contributions of the Study

By finding out whether controversial items affect CEO compensation, this study can
disclose the firms’ true standpoint about whether these items are cost or not. Their
support or objection for the current accounting measurement would be clear. This may
give accounting regulators and researchers some useful information about the firms’
attitude about financial disclosure. They could find whether information about those
items has relevance for financial statement users and thereafter better improve
accounting reporting principle.

Another contribution of the study is to start a new way to do accounting research on
firms’ position on some controversial items. It could be useful in promoting future
research in this area.

Finally, the study expends the research on executive compensation. Prior research
usually examines the relationship between executive compensation and firm
performance and their mutual effects. This study further discovers something new by
using the same modeling.

1.4 Organization of the Thesis

The remainder of the paper is organized as follows: Chapter Two gives an overview of
the accounting treatments for the two special items and their corresponding
controversy. A review of empirical research on the executive compensation factors’
effects are also presented in this part. Chapter Three identifies the development of
model conducted in this study and several hypotheses are put forward. The empirical
research methodology, data sources, and sample selection procedure are outlined in
Chapter Four. Chapter Five will present the empirical findings and analyze research
results. Finally, Chapter Six will sum up the main findings in this thesis, present the
implications of the study, explain the weakness of the study, and suggest areas for
future research.




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                                           CHAPTER 2
                                       LITERATURE REVIEW

2.1 Overview

This chapter starts with a review of the two special items: employee stock option and
R&D expenditures. Their accounting treatments and the corresponding controversy
are presented. This is followed by a review of empirical research on the factors
affecting executive compensation.

2.2 Employee Stock Option

2.2.1 Incentive Compensation Plans

A stock option is a right to buy a number of shares of stock at or after a given date in
the future (the exercise date) at a price agreed upon at the time the option is granted
(usually at the current market price or less). Employee stock options provide a
non-cash substitute for part of the wage compensation the firm must provide to attract
and retain employees. Especially, those new entrepreneurial firms may not be able to
provide enough cash for compensation. Instead, they can offer stock options (Malkiel
and Baumol, 2002).

The major motivational benefit of stock option plans is that they direct managers’
energies toward the long-term, as well as the short-term, performance of the company.
Given that agency problems1 exist, the principal’s concern is to devise an appropriate
incentive and monitoring system that induces the agent to act accordingly to the
principal’s desire (Starks, 1987). Stock compensation gives executive incentive to
keep stock price high. Haugen and Senbet (1981) also showed that the use of
executive stock options in executive compensation may emerge as solutions to the
agency problems analyzed by Jensen and Meckling (1976).

Stock option is also a way to motivate employees. Businesses that want to attract and
retain top-notch talents look at options as a primary vehicle. By stock options, they
can accomplish this goal with limited cash resources but significant stock appreciation
potential --- including startups and turnaround situations (Plishner, 1993). In
price-declining stock market, many stock options are for restricted stock (stock that
vests over a period of time) as a tool to retain employees (Kroll, 2002). Option
incentives have been widely used by new companies and innovative managements.

1
  Jensen and Meckling (1976) defined an agency relationship as a contract under which one or more persons (the
principal(s)) engage another person (the agent) to perform some service on their behalf which involves delegating
some decision making authority to the agent. The separation of ownership and control in corporations produced a
condition where the interests of the owner and that of the ultimate manager might and often did, diverge (Berle and
Means, 1932). As the managers in the pursuit of self-interest would not always act in the interests of the
shareholders, agency costs arise. Another source of agency cost might come from the divergence between
managers and shareholders in risk preference. Because of the decreasing utility for wealth and the large amount of
agent capital that is dependent on the company, managers are assumed to be risk averse. On the other hand, the
owners can easily diversify away risk and are risk neutral.



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According to reports “The State of Employee Stock Options - 2002”, an electronic
survey conducted jointly by WorldatWork and Sibson Consulting/The Segal Co, stock
options are alive and well at least for now. Two major examples:

“The goals of option programs are unchanged. Most of the nearly 300 companies
responding to the survey report they use option programs to attract and retain talent,
motivate performance, focus employee attention on organizational performance, and
create a culture of ownership, just as their peers in 2000 did.”

“The specific employee groups eligible for options, the percentage of the firm's
employees eligible for options, and the value of options in the overall compensation
mix changed relatively little in the past three years.”

2.2.2 Accounting Measures for Employee Stock Option

Accounting for employee stock options remains a highly emotive issue and the
self-interest based lobbying that was evident in the US in the early 1990s continues
internationally today.

Issued in October 1995 by Financial Accounting Standards Board, Statement of
Financial Accounting Standards (SFAS) No. 123, "Accounting for Stock-Based
Compensation" established a fair value based method of accounting for stock-based
compensation plans and encourages entities to adopt that method of accounting for
their employee stock compensation plans. This pronouncement also allows an entity
to continue to measure compensation cost for those plans based on Accounting
Principles Board Opinion No. 25 (APB 25) (issued in October 1972), "Accounting for
Stock Issued to Employees" and disclose the pro forma net income and net income
per share in footnotes as if the fair value method had been applied in measuring cost.

The fair value of a stock option (or its equivalents) of a publicly-traded company shall
be estimated using an option pricing model (e.g., Black-Scholes2), which includes
expected volatility on prices of the underlying stocks. However, SFAS 123 does not
provide specific guidance on the methodology for determining fair value for such an
arrangement or the measurement date on which the fair value of the equity instrument
is determined.

Under APB 25, compensation cost is determined based on the market value of the
stock and is recognized for awards of shares of common stock or stock options to
directors, officers and employees of the Company and consolidated subsidiaries only

2
  A model for pricing call options based on arbitrage arguments developed by Fischer Black and Myron Scholes in
1973. Black-Scholes Option Pricing Model is the basic instrument used for the determination of a stock option's
estimated value at grant. It uses the stock price, the exercise price, the risk-free interest rate, the time to expiration,
and the expected standard deviation of the stock return. Some of the assumptions of the model are: the price of the
underlier is lognormally distributed with constant mean and volatility; there are no transaction costs or taxes;
markets trade continuously, i.e. there are no sudden jumps in prices; the risk-free rate is constant and the same for
all maturities.



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if the quoted market price of the stock at the grant date (or other measurement date, if
later) is greater than the amount the grantee must pay to acquire the stock.

2.2.3 Controversy on the Accounting Measurement

Under current accounting rules, companies do not have to count the cost of stock
options against profits as compensation costs. Instead, the costs of such option grants
-- as calculated using standard pricing models -- must merely be cited in a footnote in
companies' annual financial reports.

The footnotes were the result of heated battles between options-inclining technology
companies and accountants. In 1995, accounting regulators tried to force companies
to expense employee stock options against profits. However, the complaint and
objections from companies made the regulators retreat and only require companies to
disclose the "pro forma" effect of options on earnings in a footnote.

Some firms have elected to apply APB 25 and related interpretations in accounting for
their employee stock options, only disclosing the pro forma net income in footnotes as
if compensation cost had been determined based on SFAS 123. Very few companies
will voluntarily adopt the fair-value method, as it always results in compensation
expense. They believe that the models available to estimate the fair value of employee
stock options do not provide a reliable single measure of the fair value of employee
stock options. Moreover, such models required the input of highly subjective
assumptions, which can materially affect the fair value estimates. Therefore, they
measure compensation cost using the intrinsic value method3 and do not recognize
compensation expense on the issuance of its stock options because the option terms
are fixed and the exercise price equals the market price of the underlying stock on the
grant date.

Some support the SFAS 123: Because employee stock options have value for
employees, they represent a cost to employers, and thus should be recognized as an
expense in the financial statements. As famous Warren Buffet said, "If options aren't a
form of compensation, what are they? If compensation isn't an expense, what is it?
And, if expenses shouldn't go into the calculation of earnings, where in the world
should they go?"

Though Warren Buffett and other critics suggest that the income statement should
reflect an "expense" to the firm measured by the cash-equivalent value of the options,
Malkiel and Baumol (2002) point out two problems with this view. They said that
firstly there is no way to measure that "cost" -- the value of the options at the time
they are issued -- with reasonable precision. Even the Nobel Prize winning
Black-Scholes formula does not provide reliable estimates for longer-term options,

3
  The intrinsic-value method under APB 25: Compensation costs attributable to stock option and similar plans are
recognized based on any difference between the quoted market price of the stock on the date of grant and the
amount the employee is required to pay to acquire the stock.



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such as those lasting six months to one year, and market prices often differ
substantially from predicted values. The second problem with "expensing" stock
options is that they can have both positive and negative effects on share prices. They
tend to reduce earnings per share when measured on a "fully diluted basis." On he
other hand, stock prices preponderantly benefit from the issue of employee options.
Because the market believes that the positive benefits of the options make the “pie”
grow faster than the dilutive effect that shrinks current shareholders' percentage piece
of the “pie”.

Quinn (2002) refutes Malkiel and Baumol’s points in arguing that stock option would
be accounted for similarly to salary compensation. He objects unscrupulous use of
options, earnings timing, and opaque accounting standards and argues that if options
are good in the long run for corporations, they will still be good when accounted
appropriately.

The controversy that attends the share-based payment debate centers largely on when
this expense should be recognized in the accounts, and the basis on which
measurement should be made, that is the how. The problem is that there is no clear,
objective method by which to calculate fair value. Typically firms use a (traded)
options pricing model such as the Black-Scholes to estimate employee stock option
expense, but employee stock options are quite different to traded options in that they
cannot be transferred and they have characteristics that may well lead to early
exercise.

Currently, most stock options are treated as a gift from the gods; that is, as entailing
no "cost". The employee is richer, but the company, without recording an expense, is
none the poorer. The "costless" compensation has hardly discouraged boards from
ladling out options (Lowenstein, 1995). Accounting analysts estimate that option
grants issued by high-tech companies in 1997 would have slashed net income at those
companies anywhere from 10% to 100%, if they were expensed. As MacDonald and
McGough (1999) pointed out, if Wall Street started paying more attention to options'
implicit cost, stock prices of some companies could come under pressure.

It has been argued that a requirement to charge employee stock options to the profit
and loss account could hit US company profits by approximately 9%, the impact on
the high-technology alone being closer to 33% (Grey, Cotter and Barnes 2002). A
new study by Bear Stearns & Co, similarly, indicates that option grants would
completely wipe out corporate profits and operating income at some fast-growing
high-technology companies, which tend to rely heavily on generous option grants to
attract top talent. For example, counting the cost of stock-option grants would have
erased fiscal 1997 operating income at companies such as Silicon Graphics and
Digital Equipment.

According to Grey, Cotter and Barnes (2002), the accounting treatment of employee
stock option also has implications for wider corporate finance issues. "As companies


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increasingly rely on stock options to compensate workers, not expensing them inflates
corporate earnings and thus overstates companies' performance, which leads to higher
stock prices, which leads to more valuable options," says Pat McConnell, senior
managing director at Bear Stearns. Firms that grant employee stock options and thus
avoid a charge against income, artificially boost earnings. Managers may favor share
repurchases over conventional dividend payments as they buoy up share price with
positive implications for the fair value of managers' stock options. Forcing firms to
expense employee stock option costs could affect the roles of dividend, compensation
and financing policies. If volatile share prices, short vesting periods and low
revenues/large losses are typical of high-technology firms in general, it is not
surprising that reporting firms are vigorously opposed to recognizing employee stock
option expense. Even for firms without the twin characteristics of share price
volatility and low revenues/incomes, expensing employee stock options is likely to
impact on reported earnings substantially.

Broadly speaking, the spirit of the responses to the FASB is that preparers are
opposed to recognition of employee stock option expense, and users may favor it.
Recognition of share-based payments is currently the subject of much debate. An
important dimension to the discussion is whether the benefits to users of expensing
employee stock options are greater than the possibility that firms would be
constrained from using them to attract and retain employees (especially for higher risk
and emerging firms) (Zeff, 1978). This is a key issue worth addressing. “Although its
decision should rest --- and be seen to rest --- chiefly on accounting considerations, it
must also study --- and be seen to study --- the possible adverse economic and social
consequences of its proposed actions”.

2.3 R&D Expenditures

2.3.1 R&D and Its Accounting Measurement

Research and development (R&D) is defined in the Federal Acquisition Regulation
(FAR) in terms of four elements:

1. Basic research is directed toward increase of knowledge in science; it seeks a fuller
knowledge or understanding of the subject under study, rather than any practical
application.

2. Applied research attempts to exploit the potential of scientific discoveries or
improvements in technology, materials, processes, methods, devices, or techniques,
and to advance the state of the art.

3. Development is the systematic use of scientific and technical knowledge in the
design, development, test, or evaluation of a potential new product or service or of an
improvement in an existing product or service.



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4. Systems and other concept formulation studies are analyses and study efforts either
related to specific R&D efforts or directed toward identifying desirable new systems,
equipments or components, or modifications and improvements to existing systems,
equipments, or components.

Professional accountants have tried to determine how to treat research and
development (R&D) expenditures for many years. At first, the accepted practice was
to defer R&D costs, but with changes in revenue laws in the 1950s, many companies
began to write off R&D expenditures immediately. Based on the belief that a direct
relationship between R&D costs and specific future revenue generally has not been
demonstrated, the Financial Accounting Standards Board issued SFAS No. 2,
"Accounting for Research and Development Costs" in 1974, specifies that all R&D
charges should be written off immediately. This preserved the standard that most US
companies use today. GAAP require that R&D costs be expensed in the period
incurred. Some costs can be appropriately capitalized, carried as assets, and
depreciated to research expense. They include research facilities, equipment, and
machinery.

2.3.2 Controversy on the Accounting Measurement

The controversy about the accounting measurement of R&D still exists. The point lies
in whether R&D should be considered as a kind of investment or an expense. National
Association of Insurance Commissioners (NACI) supports R&D costs to be expensed,
“because the future benefit is rarely certain or measurable and the future period over
which deferred costs might be allocated is usually arbitrary, deferral is not consistent
with the conservatism concept included in the Statement of Concepts.”

By contrast, many persons look R&D as one form of investment. Newman (1988)
argued that at the macroeconomic level, the large amounts of money spent on R&D
each year enhance profits for companies in later years; therefore, costs should
somehow be matched against future revenues.

Horwitz and Ronald Zhao (1997) examines whether the capital market ignores the
mandated expensing of firms' R&D to make its own judgments about current and
future cash flows. The study finds that cash flow statements reconstructed to assume
different proportions of expensed and capitalized R&D can result in a better
association of cash flow variables with security returns than that provided under the
GAAP requirement of 100% expensing. That is, the market does regard a good
amount of R&D outlays as investments, even though these outlays are actually
classified as operations expenses under U.S. GAAP.

Another question arisen now is the inconsistency on accounting for costs required
completing a purchased R&D program after it is acquired. It makes little sense to
capitalize and amortize the acquisition costs of R&D while expensing the subsequent



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costs of completion. The lack of consistency is likely to cause confusion among
investors. If companies that purchase R&D programs capitalize and amortize these
projects while other companies immediately expense internal R&D activities,
earnings for the two companies are not comparable. Thus, differential treatment of
R&D based on internal programs versus external purchases potentially confuses
interpretation of operating results.

In a word, as Clem and Jeffrey (2001) indicated, the key point in the controversy is
whether R&D meets the definition of an asset, and, if so, whether information about
that asset has relevance for financial statement users. R&D is undertaken with the
expectation that it will provide future benefit to the firm. While not every R&D
project initiated generates benefits, the expectation is that on average some will,
resulting in assets for the firm. Yet meeting the definition of an asset and
demonstrated relevance are not adequate for recognition in the financial statements.
To be recognized, an item must have a relevant attribute that is reliably measurable.
Widely accepted valuation models for R&D have not been developed, and questions
about valuation approaches are critical to current deliberation.

2.4 Executive Compensations

2.4.1 Components of Executive Compensations

In the organization of a public company, control rights are vested with the directors
who authorize the exercise of control rights by the chief executive officer (CEO) and
other top executive officers. The board of directors develops a compensation policy
that enables the firm to attract, retain and motivate the CEO and other top executives
through negotiated compensation agreements. Thus, compensation can be used to
motivate directors and other senior executives towards meeting a company's or its
shareholders' goals.

The chief executive officer’s compensation is usually discussed by the compensation
committee of the board of directors. The percentage of incentive compensation
applied to the CEO compensation is an important signal about how the board regards
the CEO’s performance. Forbes magazine publishes annually a list of the
compensation of hundreds of CEOs, compared with the profits for which they are
presumably responsible. The general message is that compensation is indeed highly
relative to performance.

An executive’s total compensation package consists of three components: (1) salary,
(2) benefits (principally pension and health benefits, but also perquisites of various
types), and (3) incentive compensation. The three components are interdependent, but
the third is specifically related to the management control function and approved by
the board of directors according to the executive’s performance.




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Incentive compensation plans can be divided into (1) short-term incentive plans,
which are based on performance in the current year, and (2) long-term inventive plans,
which relate compensation to the longer-term accomplishments. The representative of
the former one is bonus, and the representative of the latter is stock option.

Much empirical research investigating relations between executives’ compensation
and their firms’ market and accounting performance has focused on the cash
components (which is defined as base salary plus annual bonus) of total compensation
because cash compensation represented a material portion of a CEO’s yearly
compensation and dominated other forms of compensation during the periods studied
(Murphy 1985, Lambert and Larcker 1987). In recent years, the stock-based share of
total compensation has increased significantly and now makes up about one-third of
executives’ total compensation.

2.4.2 Executive Compensations Determinants

CEO compensation is related with his/her performance. How to measure CEO
performance? How do these measurements determine the compensation? A variety of
factors have been investigated to find their roles in determining executive
compensations.

   Firm Performance

Accounting researchers are interested in the information properties of market and
accounting performance measures in the context of executive performance evaluation.
Empirical research has investigated how the sensitivity and precision of the
performance measures (Banker and Datar, 1989) influences the relative weights
placed on market and accounting returns (Lambert and Larcker, 1987, Sloan, 1993),
whether the relative influence of accounting returns has changed over time (Bushman,
Engel, Milliron, and Smith 1998a), how the properties of reported earnings affect
pay-performance sensitivities (Bushman, Engel, Milliron and Smith 1998b), and
whether relative performance evaluation (Holmström, 1982) is used to remove noise
in the performance measures (Antle and Smith, 1986; Gibbons and Murphy, 1990;
Janakiraman, Lambert and Larcker, 1992). The evidence is that both security returns
and accounting earnings are used to set compensation contacts. Both measures are
informative of the agent’s unobservable actions in the agency context.

Lambert and Larcker (1987) document a positive association between the cash
compensation of CEOs and their firms' contemporaneous earnings performance. In his
research, he uses accounting return on equity (ROE) and security market return (RET)
as performance measures. Sloan (1993) provides evidence in support of the
hypothesis that earnings-based incentives help shield executives from fluctuations in
firm value caused by market-wide factors that are beyond their control. The paper
demonstrates that earnings reflect firm-specific changes in value, but are less sensitive



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to market-wide movements in equity values. The hypothesis is shown to explain
cross-sectional variation in the use of earnings-based incentives.

Researchers have found that accounting returns have significant incremental
explanatory power to market returns in estimations that relate cash compensation to
performance. Bushman et al. (1998a) found that, while the weight placed on earnings
in determining cash compensation has not declined over time, the importance of
earnings relative to other information captured by stock returns has declined over time.
He also found that changes in pay-earnings sensitivities are positively associated with
changes in price-earnings sensitivities (earnings response coefficients) and the noise
in market returns and negatively associated with the noise in earnings (Bushman et al.,
1998b).

Most of these studies consider only cash compensations. Very few studies have
examined relations between total compensation or non-cash components of
compensation and firm performance measures. Murphy (1985) found significant
positive relations between the change in total compensation and stock returns and
between the change in cash compensation and stock returns, but he found no
relationship between the change in stock-based compensation and stock returns.
Baber et al. (1996) found significantly positive coefficients on market return in their
total pay, cash (salary and bonus), and long-term pay (option, restricted stock and
LTIP pay-outs) equation, but they found a significantly positive coefficient on
accounting return in their cash equation only. Veliyath (1999) examines the linkage
between two separate components of executive compensation (i.e. cash compensation
and stock options) and market return performance, among a selected sample of US
pharmaceutical company CEOs and COOs. The study finds that market returns were
not instrumental influences on the levels of both compensation components.

Cash Flow and Accruals

As for accounting-based performance, the investigation of the degree to which
components of earnings are informative about managerial actions, and therefore
priced in the managerial labor market, parallels the inquiry into the role of cash flows
and accruals in firm valuation.

Clinch and Magliolo (1993) examine the possibility that components of earnings
relate differently to the CEO’s performance and do not enter into the compensation
function in the same way. Results indicate that income from discretionary transactions
accompanied by cash flow effects is reflected in the CEO compensation function.

Natarajan (1996) investigates the role of components of earnings in CEO
compensation contracts. It argues that shareholders will use components of earnings
as additional performance measures whenever the components provide information,
over and above earnings, about managerial decisions. Results indicate that earnings
and cash flow measures together have a better association with cash compensation


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paid to CEOs of U.S. companies than aggregate earnings alone. The evidence also
suggests that current accruals and cash flows from operations are aggregated for
performance evaluation.

The study by Gaver and Gaver (1998) also investigates the role of alternative earnings
components in the CEO cash compensation function. It finds that cash compensation
is significantly positively related to above the line earnings, as long as results are
positive. Similarly, nonrecurring transactions that increase income flow through to
compensation, while nonrecurring losses do not. In a word, compensation committees
distinguish among the transactions comprising net income in determining executive
pay.

However, accounting numbers can be “managed” or “manipulated” via changing
accounting methods and can be subject to falsification by management. Discretion
reduces the effectiveness of accounting-related transactions as performance measures
(Firth, Tam, and Tang, 1999).

   Size

Murphy (1998) provides a review of the compensation literature. Many studies,
including most of those cited above, report a strong link between firm size and
managerial rewards (Roberts, 1956; Ciscel and Carroll, 1980; and Agarwal, 1981),
and size (book value of total assets) is a major determinant of executive
compensations (Chung and Pruitt, 1996 and Veliyath, 1999)

Ryan and Wiggins (2001) find that the executive compensation has a positive relation
with firm size. Bliss and Rosen (2001) provide several theoretical explanations for
this positive correlation. Compensation can be used to motivate effort among
lower-level managers who view the top job as spoils that go to the winner of an
intra-firm tournament (Nalebuff and Stiglitz, 1983; Rosen, 1992). A bigger firm
represents a larger tournament, and therefore demands a commensurate high prize.
Also, managing a bigger firm might involve more skill and job complexity than
managing a smaller firm. Compensation is thus used to solve the adverse selection
problem in choosing a competent manager. These explanations for the correlation
between compensation and size imply that better managers control bigger firms rather
that making a firm larger should increase the compensation of an existing manager.

   CEO Age

The age of executives, as a proxy variable for general training levels and/or
experience, may affect their remuneration. However, the direction of this relationship
cannot be determined with certainty. The relationships are also different among the
components of compensations.




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Bryan, Hwang, Lilien (2000) find an unexpected negative relationship between CEO
age and stock option. One potential explanation is that older CEOs facing imminent
retirement prefer to minimize the uncontrollable effects of the market-wide factors on
their wealth. Another explanation is younger CEOs are frequently found in
high-growth firms that tend to rely heavily on stock option awards.

Under the premise that older and younger CEOs have the incentives to focus on
short-term outcomes, Ryan and Wiggins (2001) find a concave relation between cash
bonus and age, suggesting that firms pay the youngest and oldest managers less
short-term bonus. They also find a negative linear relation between options and age,
but a concave relation between restricted stock and age. On the surface, these two
relations seem counterintuitive since firms appear to be reinforcing short-term
tendencies of older CEOs in the case of options and both older and younger CEOs in
the case of restricted stock.

In contrast, Chung and Pruitt (1996) cannot find any effect of CEOs age on their
compensation, which rejects the hypothesis that age, as a proxy variable for general
training or experience, affects executive compensation. It seems that the positive
relationship between age and income does not apply to executive labor market.
Executive positions are characteristically different from other jobs and general
experience may not increase a CEO’s total productivity.

   CEO Tenure

CEO's tenure, defined as the number of years he has been CEO, is considered to be
related with incentive compensations. However, prior researches have got different
conclusions about the relationship.

Consistent with previous research (Murphy, 1986; Barro and Barro, 1990), Clinch and
Magliolo (1993) observe that for operating earnings and the discretionary
cash-flow-based earnings component, the length of CEO tenure is negatively
associated with the strength with which these items enter the compensation function.

Chung and Pruitt (1996) find the number of years as CEO is significantly and
positively related to executive stockholding. This is consistent with the view that the
cumulative value of incentive compensation received in the form of stock options may
be larger for executives with longer employment histories. Large tenure means more
experience, which deserves greater levels of compensation.

Ryan and Wiggins (2001) find CEO tenure is negatively related with stock options at
the 10% significance level. This finding is inconsistent with an entrenchment
argument, but consistent with the premise that CEOs with long tenures have
accumulated more stock and therefore require less equity-based pay than newer
CEOs.




                                                                                     14
   Ownership Structure

When CEOs hold a large fraction of their firm’s equity, their demand for further
stock-based compensation is like to be reduced, since the interests of CEOs and the
shareholders are already relatively aligned (Jensen and Meckling, 1976). Furthermore,
CEOs are typically unable to diversify the risk associated with their wealth (Smith
and Watts, 1992). The constraint affects their tolerance for additional risk, that is, they
prefer cash compensation to stock option.

Bryan, Hwang and Lilien (2000) find a significant negative relationship between CEO
stockholding and stock option, and the negative association is somewhat stronger for
mid-cap and small-cap firms. Ryan and Wiggins (2001) use the percentage of a firm's
shares held by the chief executive to measure CEO stock ownership, and find a
negative relation with all forms of incentive compensation. It is consistent with the
notion that as CEOs own more stocks, their interests become more aligned with
shareholders and there is less need for incentive compensation.

   Growth

Many prior papers have documented that high-growth firms are more likely than
low-growth firms to use stock-based compensation rather than salary and bonus
compensation in the pay packages of their senior executives (Lewellen, Loderer, and
Martin, 1987; Clinch, 1991; Smith and Watts, 1992; Gaver and Gaver, 1993).

Growth firms are expected to have high investment opportunities. Gaver and Gaver
(1995) use market-to-book assets, market-to-book equity, R&D expense to assets, and
total return variance to measure the investment opportunity and find that firms with
abundant investment opportunities pay higher levels of total compensation to their
executives. Moreover, executives of growth firms receive a larger portion of their
compensation from long-term incentive compensation (such as performance awards,
restricted stock grants, and stock option grants), while those of non-growth firms
receive a larger portion of their pay from fixed salary. They conclude that higher
manager-shareholder information asymmetry in growth firms leads these firms to
emphasize long-term incentive compensation in order to motivate managers to act in
their shareholders' interests and reduce agency costs. It is also consistent with
long-term incentive contracts motivating managers to take actions to seek out and
exploit new investment opportunities.

   Industry

Industry also has considerable effect on the structure of executive compensations.
Smith and Watts (1992) examine industry-level data and find that high-growth firms
are more likely than low-growth firms to use stock-based compensation plans.
Executive compensation studies suggest that many of these same factors are also
associated with the relative weight placed on accounting measures. Ely (1991) finds


                                                                                         15
that the choice between alternative accounting measures varies by industry,
suggesting that these measures must be tailored to reflect industry-specific value
drivers and competitive environments.




                                                                                16
                                CHAPTER 3
                            MODEL DEVELOPMENT

3.1 Overview

This chapter introduces the development of model conducted in this study. The
variables measures and hypotheses development are also described in detail.

3.2 Model Development

The confusion from the criticism against certain accounting principles is pervasive in
the accounting research field. This raises a question: where do firms themselves stand
on the issue? My way to test the firms’ position is to find whether firms determine
executive compensation based on income number before these controversial items or
after them.

I focus on the CEO compensation because early research documents a strong
empirical relation between top executive compensation and earnings (Lambert and
Larcker, 1987, Defeo et al., 1989, and Sloan, 1993). CEO is responsible for the firm
performance, including accounting earnings. To fairly reflect CEO’s effort on firm
performance, most firms relate earnings with CEO compensations.

However, components of earnings relate differently to the CEO’s performance (Clinch
and Magliolo, 1993; Natarajan, 1996; and Gaver, 1998). The earnings used by firms
for compensation may be different from the earnings shown in the income statement.
One reason is firms may not consider some items in income statement as a true cost of
the same period. As a result, these items are not taken into consideration when
evaluating CEO performance, even though they are expenses against profit in the
income statement complying with accounting principles. Another reason is these
items are uncontrollable by CEO and thus not related with CEO performance. Option
cost and R&D expenditures do not belong to this type of items, since CEO is involved
in deciding employee stock option as well as the R&D project of the firm.

In this sense, we can find out whether firms consider employee stock option and R&D
as true cost or not through the relationships between CEO compensation and these
controversial items. A negative relationship may tell us that firms do think the item as
true cost of the current year. On the other hand, if significant negative association
does not exist, one big possibility is that firms do not look the item as an expense.

3.3 Measures and Hypotheses Development

3.3.1 CEO compensations

The agency theoretic models that motivate empirical research in executive



                                                                                      17
compensation derive total compensation as a function of available performance
measures (Holmström 1982, Banker and Datar 1989). Total compensation paid to an
executive includes cash payments such as salary (fixed cash payments) and bonus
(variable cash payments), and the ex ante or grant date value of stock-based awards
including stock options and restricted stock. James Cathro (1996), a principal with the
international compensation consulting firm William M. Mercer, commented: “There
seems to exist a public perception that option grants are made over and above what is
already adequate compensation in the form of salary and bonus. This is rarely the case.
Typically, today’s compensation committee will establish a mix of pay that includes
the estimated value of the long-term incentives as part of a total compensation
package.”

When compensation is paid in two or more forms, their relative mix depends on
factors that influence the marginal costs and benefits to the firm and the marginal
utility to the employee (Woodbury, 1983). In prescribing an approach for
compensation committees, William White (1992), National Director of Compensation
Services for Ernst and Young, stated: “Determine the overall pay philosophy that
underlies the company’s pay mix and levels, its pay-for-performance guidelines and
the use of various vehicles, balancing executive safety and risk factors. …Once this
assessment has been made, pay specific attention to the level of predictable pay (base
salary) versus that of variable pay (annual and long-term incentives).”

These observations suggest that firms determine the total compensation required to
satisfy the executive’s reservation utility (based on alternative opportunities in the
executive labor market) and the mix of compensation components that will provide
appropriate incentives to motivate and retain the executive. Compensation agreements
with executives may be structured and administered so that components of total pay,
such as salary, bonus and stock-based awards, respond differently to observable
performance measures, such as market and accounting returns. Thus, I estimate an
empirical model that relates total compensation to firm performance through the cash
bonus and stock-based shares, as well as total pay.

3.3.2 Independent Variables

My independent variables determining executive compensation are divided into three
parts. Executive compensation should be determined by the costs and benefits of the
executive's actions during a period. I thus first measure the costs by employee stock
option and R&D expenditure. I pick them up from profit in order to find their links
with compensation. Corresponding to the cost, I also need to include benefits of the
executive's actions during the same period. I measure the benefits by such accounting
measures as cash flow (before R&D expenditure) and accruals, and such
market measures as shareholder returns in one (shorter term) and three years (longer
term).




                                                                                    18
My cost part of independent variables includes only employee stock option cost and
R&D expenditure. There are other cost items such as goodwill amortization,
restructuring charges and extraordinary item that may affect executive’s compensation
in different ways. I drop them from my list of cost variables due to a desire to obtain a
large sample because not many firms have those cost items at the same time. They are
not the objects in this study and their influences on the CEO compensation have been
incorporated in the benefits items.

Other than the costs and benefits, compensation is supposed to be determined by the
personal characteristics of the executive and firm characteristics. This forms the third
part of independent variables. The personal characteristics that I include in my study
are CEO age, CEO tenure and CEO ownership. The firm characteristics are size,
growth opportunities and industry.

   Employee Stock Option

The share-based payment debate centers largely on whether this is an expense and
should be recognized in the accounts of the current period. If firms consider option as
a true cost of the current year, they would reduce the option from the profit when
determining CEO compensation. As a result, there should be a negative relationship
between CEO compensation and the option cost. Otherwise, no significant
relationship will be found. Since till now, most firms would not like to expense
employee stock option (only two companies in the S&P 500 include employee stock
option grants as an expense in their income statements), I make the following
hypothesis:

H1: There is no significant negative relationship between employee stock option and
the bonus or the total compensations.

   R&D Expenditures

The controversy about the accounting measurement of R&D lies in whether R&D
should be considered as a kind of investment or an expense. If firms think the R&D
expenditure is related with future benefit and should be looked as one kind of
investment, they would like to capitalized it rather than expense it in the current year.
Even though GAAP asks firms to expense the R&D, firms may not consider it as a
true cost when evaluating CEO’s performance. Consistent with the objections to
implemented GAAP, the hypothesis is:

H2: Firms look R&D as investment and do not expense it when determining CEO
compensations.

   Performance of the Firm




                                                                                       19
To reduce the biases for the relationships between CEO compensation and
controversial items, I control for as many other factors that may also affect executive
compensation as possible. The intention is to control the effects from other factors and
capture the true effect of items examined.

Both accounting-based measure and market-based measure have conceptual and
methodological weaknesses as measures of performance. Accounting measures are
subject to management manipulation and may not correlate significantly with firm
value (Lubatkin & Shrieves, 1986). On the other hand, a company's stock market
performance is also sensitive to numerous factors beyond the control of management,
and so market-based measures may also be an inadequate indicator of CEO
performance (Jensen & Murphy, 1990). To avoid the biases inherent in using either
method alone, we used both accounting-based and market-based measures of
performance in this study. Both measures were based on rates of return to facilitate
comparisons to each other.

Operating cash flow and accruals represent main part of accounting earnings.
Although CEO compensation is positively related with earnings according to previous
empirical analysis, components of earnings do not enter into the compensation
function in the same way (Clinch and Magliolo, 1993; Natarajan, 1996; Gaver, 1998).
Since accruals can be “managed” or “manipulated”, it may play a less important role
to the CEO’s performance than cash flow. It leads to the following hypotheses:

H3a: CEO compensation increases with cash flow and accruals.

H3b: Cash flow has more weight than accruals in determining CEO compensation.

To measure the market-based performance, I use one-year and three-year market
return to shareholders. The return includes stock price appreciation and dividends. I
expect higher market return is one indication of CEO good performance and therefore
a higher compensation could be observed.

H4: CEO compensation increases with market return.

   Growth Opportunity

Previous research documents greater use of stock-based pay for firms with more
extensive growth opportunities in their investment opportunity set (Smith and Watts,
1992; Gaver and Gaver, 1993). According to Gaver and Gaver (1995), the investment
opportunity set is unobservable, and it is likely to be imperfectly measured by any
individual proxy. Therefore, they use an ensemble of variables to measure the
investment opportunity. I follow the approach and include the market to book ratio of
equity and sales growth rate as proxies for growth opportunity in this study. Market to
book ratio is the growth measures used most frequently by earlier researchers in



                                                                                      20
previous studies. It is the ratio of the market value of the firm (share closing price
times outstanding shares) to the book value of its equity and relies on current stock
price to assess the firm’s growth potential. Another growth measurement is firm’s
growth rate in net sales (Bathala and Rao, 1995). I use 3-year least-squares4 growth
rate of sales. According to prior research, I predict:

H5: CEO compensation is positively related with firm growth opportunity.

    Other Factors Determining CEO Compensations

Other exogenous variables are included in the compensation equations based on
economic theory and prior empirical research. They include firm size (sales revenue
in the fiscal year), CEO age and tenure, CEO ownership (the percentage of a firm's
shares held by the chief executive), and industry effect (industry dummy variables are
used to control for the possibility of spurious correlations among the variables
operating through industry effects).




4 The least-squares trend is a commonly used growth indicator. It has the following advantages: firstly, it takes
into account each of the observations under consideration, unlike geometric (or compound) growth rates, which
only consider the first and last observations; secondly, it measures the stability of observed growth; finally, unlike
the arithmetic average of annual growth rates, it takes into account the sequence of different growth rates over
time.



                                                                                                                   21
                                       CHAPTER 4
                                RESEARCH DESIGN AND DATA

4.1 Methodology

4.1.1 Basic Regression

Many researches (Lambert and Larcker, 1987; Sloan, 1993 and Dechow et al., 1994)
have documented a positive association between the cash compensation of CEOs and
their firms’ contemporaneous earnings performance. Accordingly, to examine the
relationships between CEO compensations and the controversial items, the following
cross-sectional OLS regression is estimated for the CEO compensation of 1999 on the
contemporaneous firm performance of 1999.

      CEOCOMP99   0  1OPT99   2 RD99   3CF99   4 ACCRUAL99   5 MRKYR1
                             6 MRKYR3   7 MBV   8 SALESGROWT   9 SIZE  10 AGE
                                                                  H
                            11TENURE  12CEOSH  13 IND1  ...  20 IND8  
                                                                                                 <Equation 1>

Since the effect of factors may be varied among the different components of CEO
compensations, I examine the components of CEO compensations separately. The
CEOCOMP99 has three conditions: (1) Cash compensation: Salary + Bonus; (2)
Stock Option; and (3) Total Pay: Salary + Bonus + Stock Option + Other Annual Pay.

The description of independent variables:

OPT --- Option Cost. The fair market value of all awards of stock-based
compensation at the grant date, computed as the difference of pro forma net income
and reported net income, deflated by total assets5.

RD --- Annual R&D expenditure to book value of total assets, deflated by total assets.

CF --- Cash flow before R&D expenses, deflated by Total Assets.

ACCRUAL --- Total accruals defined as income before extraordinary items minus
operating cash flows, deflated by Total Assets.

MRKYR1 --- 1-year market return to shareholders, used to measure market
performance of the firm.

MRKYR3 --- 3-year market return to shareholders, used to measure long term market

5
  In my regression, the option cost, R&D expenditure, cash flow and accruals are deflated by total assets in order
to enhance cross-sectional comparability and reduce heteroscetisticity.



                                                                                                                 22
performance of the firm.

MBV --- Growth or investment opportunities, measured by market value of the firm to
the book value of its total assets.

SALESGROWTH --- 3-year least-squares growth rate of sales, used to measure firm’s
growth opportunities.

SIZE --- Firm size, measured by the natural logarithm6 of the sales of the fiscal year.

AGE --- Age of CEO who is in office.

TENURE --- Number of years since the time of CEO appointment.

CEOSH --- CEO ownership, measured by the percentage of a firm's shares held by the
chief executive.

IND1~8 --- Industry dummy variables are used to control for the possibility of
spurious correlations among the variables operating through industry effects. The
number of dummy variables is decided by the number of industries my sample
belongs to. According to four-digit SIC codes of 10 industry categories7, all sample
firms come from 9 categories.

4.1.2 Sensitivity Tests

4.1.2.1 Time-series Relations

Murphy (1985) observed that cross-sectional differences in characteristics of firms
and their executives are likely to influence relations between compensation and
performance. Failure to control for these factors would cause an omitted variable
problem and lead to biased estimates in empirical models that relate compensation
levels to performance. He controlled for this problem by using a first-difference
specification of the compensation variable, reasoning that the lagged compensation
values would be informative about the characteristics of the firm and the executive.

In the first difference model, changes in compensation are related to surprises in
performance. It suggests that the changes in compensation persist over time. While
there may be a dynamic response of pay to surprises in performance, it does not imply
a permanent change in pay except under the assumption that the manager’s true
productivity evolves as a random walk. Anderson et al. (1999) included the lagged
value of total pay as an independent variable in the pay-performance equation and

6
  The objective of taking the natural logarithm of sales is to mitigate the influence of extreme observations.
7
  Four-digit SIC codes partition firms into 10 industries: 1. Agriculture, Forestry, and Fishing; 2. Mining; 3.
Construction; 4. Manufacturing; 5. Transportation, Communications, and Utilities; 6. Wholesale Trade; 7. Retail
Trade; 8. Financial, Insurance, and Real Estate; 9. Service; 10. Public Administration.



                                                                                                            23
found that compensation responses to performance shocks are not persistent. Baber et
al. (1999) found that the sensitivity of compensation to earnings levels is concave in
persistence. These findings indicate that earnings changes are essential to properly
specify relations between CEO compensation and earnings performance.

To specify the relations between CEO compensation and controversial items as well
as resolving the missing variable problem sited by Murphy (1985), I regress the
change of compensation on the change of option cost, change of R&D, and change of
performance for year 1999 and 1998.

CEOCOMP   0  1OPT   2 RD   3 CF   4 ACCRUAL  5 MRKYR1
                  6 SIZE  


                                                                          <Equation 2>

Similar to the first equation, I examine three conditions of CEOCOMP change: cash
compensation, stock option and total pay.

4.1.2.1 One-year Lagged Relations

One possibility is that the actual reward is based on the degree to which company
financial goal and individual performance objective established early in the fiscal year
have been achieved. Accordingly, the bonus and stock-based compensation are paid at
the beginning of the next year for each eligible executive. It implies that earnings
performance relative to bonus plan bounds can be inferred from ex post bonus
payments in the following year (Holthausen, Lacker and Sloan, 1995). Therefore, I
regress the current year’s bonus and stock option on the previous year’s performance.
The model examined represents a one-period lagged relationship in which company
performance in 1998 is the independent variable and the CEO compensation (bonus
and stock option) from 1999 is the dependent variable.

BONUS 99  OPTION99   0  1OPT98   2 RD98   3CF98   4 ACCRUAL   5 MRKYR1
                                                                      98

                    6 MRKYR3   7 MBV   8 SALESGROWT   9 SIZE  10 AGE
                                                         H
                   11TENURE  12CEOSH  13 IND1  ...  20 IND8  
                                                                          <Equation 3>

4.2 Sample Selection and Data Sources

I use cross-section data for the study. In this session, the sample selection method and
data are explained. I present the data sources and selection method in the first part. It
is then followed by descriptive statistics on the executive compensation, controversial
items, and firm and industry characteristics.




                                                                                       24
4.2.1 Data Sources

I use US publicly held companies for my sample. CEO compensation data and CEO
information are collected from the COMPUSTAT Executive Compensation files.
Except option cost, all the company information and financial statement data are
obtained from the COMPUSTAT annual industrial files with supplements from
DATASTREAM for missing data. Option costs of the companies are obtained from
SEC online EDGAR (Electronic Data Gathering, Analysis, and Retrieval system)
archives.

Some selection criteria are considered when collecting data:
(1) The firm has both accounting data and CEO compensation data reported in
COMPUSTAT files.
(2) The firm has a December fiscal year-end each year. This criterion is used because
Smith and Pourciau (1988) show that firms with December fiscal year-end and
non-December fiscal year-end have significant differences in financial characteristics.
(3) SEC online EDGAR archives contain the firm’s annual report (10-K form), from
which employee stock option cost data are collected8.
(4) The firm has both employee stock option cost and R&D expenditure different
from zero for the sample year.
(5) For sensitivity tests of Time-series Relations and One-year Lagged Relations, the
firm must have the same CEO who was in office for both 1998 and 1999.

Finally, 407 firms are included in the cross-sectional regression, and 301 firms are
included in the sensitivity tests.




8
  Most companies choose to apply APB 25 and disclose the pro forma net income in footnotes as if compensation
cost had been determined based on SFAS 123. Since the option prices were greater than or equal to the market
prices at the date of grant, most companies have not recognized the compensation cost for stock options. Thus, the
difference between pro forma net income and net income as reported in income statement can be considered as
compensation expense for stock option (after-tax effect) amortized in the current period. In this study, I use this
difference from 10-K form to approximate the employee stock option cost of a company.



                                                                                                                25

				
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