Archive for September, 2010

(Commentary by David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program, And Brian Tayan, MBA ’03, Stanford GSB; Date: 9-23-2010)

A new paper by Barth, Gow, and Taylor (2010) calls into question the practice of excluding stock options from reported earnings per share (so-called “non-GAAP” earnings).

Under U.S. accounting rules, companies are permitted to report adjusted financial results, so long as they disclose at the same time the most directly comparable GAAP figure and a table that reconciles the two. Experts have long clashed over the value of these adjustments. On the one hand, adjustments may be done to improve earnings quality when one-time items distort the long-term profitability of a company. In this case, excluding these items would improve the information quality of the reported figures. On the other hand, earnings adjustments may be made opportunistically by management to boost short-term results and beat Wall Street estimates. In this case, excluding certain items reduces earnings quality by misrepresenting the company’s underlying profitability. The evidence suggests that both can occur, depending on the circumstances.

In their paper, Barth, Gow, and Taylor (2010) examine the practice of excluding stock option expenses from quarterly earnings. They find that this practice does not improve earnings quality. Instead, they find that excluding stock options is done opportunistically “to increase earnings, smooth earnings, and meet earnings benchmarks.”

Technology companies tend to be the most enthusiastic practitioners of stock option non-expensing. This may be because they rely heavily on options in employee compensation packages, particularly when the companies are still in high-growth phase. For example, in Q2 2010, Google reported non-GAAP EPS of $6.45 compared with GAAP EPS of $5.71. VMware reported non-GAAP EPS of $0.34 versus $0.18 GAAP EPS. And Salesforce.com reported non-GAAP EPS of $0.29 versus $0.11 GAAP EPS. These are not small differences.

How does such a practice persist, particularly in a circumstance where it is clearly shown to reduce earnings quality? Isn’t this what governance systems are expected to prevent? And yet with stock option expensing, it seems that many members of the system are complicit: the board that approves the exclusion, investors who value the company on that basis, analysts who provide the research, and regulators who write the rules.

Source: Barth, Mary E., Gow, Ian D. and Taylor, Daniel J., Non-GAAP and Street Earnings: Evidence from SFAS 123r (September 2010). Rock Center for Corporate Governance at Stanford University Working Paper No. 88. Available at SSRN: http://ssrn.com/abstract=1681144

See also: David F. Larcker and Brian Tayan, “Pro Forma Earnings: What’s Wrong with GAAP?” CGRP-09.

Professor Larcker defines five corporate governance related terms. Article including definitions are found here.

Terms defined: corporate governance, proxy access, rating agencies, risk management, and executive compensation.

Performance-Based Incentives for Internal Monitors
Posted by Professor David F. Larcker, Stanford Graduate School of Business.

Note: This was originally posted on The Harvard Law School Forum on Corporate Governance and Financial Regulation on Friday, March 12, 2010 at 9:04 am

In the paper, Performance-Based Incentives for Internal Monitors, which was recently published on SSRN, my co-authors (Christopher Armstrong and Alan Jagolinzer) and I investigate the choice of performance-based incentives for the general counsel (GC) and chief internal auditor (IA) and assess whether these incentives enhance or impair monitoring.

We use proprietary and public data that provide details about the incentive-compensation contracts of the GC and the IA to identify the determinants of performance-based incentives of internal monitors. More importantly, we also examine the impact these incentives have on either alleviating or exacerbating agency problems within the firm. We draw inferences regarding the implications of compensating internal monitors with performance-based incentives using a propensity score matched-pair research design, which helps address econometric concerns related to the endogenous design of compensation contracts.

We find that internal monitors receive greater incentives when their job duties contribute more to the firm’s production function. Internal monitors also receive greater incentives when they are more highly ranked within the firm and when the firm’s CEO receives greater incentives, consistent with standardization in compensation contracts within the executive suite. In addition, monitors receive lower incentives at firms with greater ex ante litigation risk, consistent with risk-averse monitors demanding less risky compensation when their human capital is more at risk. Finally, we find some evidence that incentive levels are greater when there is more demand for internal monitoring.

To better understand the implications of internal monitor incentives, we examine the association between internal monitor incentive levels and the frequency of adverse firm outcomes, which we use to proxy for unresolved agency problems within the firm. After matching monitors on observable characteristics of their contracting environments using a propensity score approach, we find a lower frequency of adverse outcomes (e.g., regulatory enforcement actions and internal-control material-weakness disclosures) at firms that provide their monitors with greater performance-based incentives. These results are consistent across a variety of alternative measures of incentives and outcomes and appear to be generally robust to omitted variable bias.

Overall, our results support the notion that performance-based incentives enhance the internal monitoring function, perhaps by providing incentives for better monitoring efforts or by facilitating the selection of more talented monitors. These results may allay concerns raised in the economics and legal literatures regarding whether performance-based incentives are an appropriate form of compensation for internal monitors. These results also provide new insights into the implications of providing management with incentive-based compensation by focusing directly on the implications of providing incentives to corporate officers who are responsible for overall governance within the firm.

The full paper is available for download here.

Closer Look Series: Topics, Issues and Controversies in Corporate Governance, No. CGRP-10, By David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program And Brian Tayan, MBA ’03, Stanford GSB; Date: 9-15-2010

• Sensitivity of CEO Wealth to Stock Price: A New Tool For Assessing Pay for Performance (PDF)

In recent years, there has been considerable debate as to whether CEO compensation is actually correlated with performance in U.S. companies. This issue is known as “pay for performance.” While the debate is often heated, there tends to be little in the way of concrete analysis to inform conclusions.

We explain an important new method for measuring pay for performance. This involves examining the sensitivity of CEO equity ownership to potential large-scale changes in the stock price. We explain how the convexity of this relationship can give shareholders and stakeholders a better understanding of the incentives that the company is offering to its CEO. We also explain that it is important to review this information in the context of the company’s strategy to determine whether potential payments are appropriate and whether they encourage “excessive” risk taking.

The Corporate Board, September/October 2010 — Vol. XXXI      No. 184

by Stephen A. Miles, Heidrick & Struggles  and Professor David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program, and Senior Faculty, Rock Center for Corporate Governance at Stanford University

Many boards have done shockingly little on CEO succession. Some of our largest public companies harbor a dirty little boardroom secret—their boards of directors have done shockingly little to assure sound, effective CEO succession. Research by Heidrick & Struggles and Stanford University finds boards often have vague succession “plans,” or are overly optimistic about the ability of CEO prospects to step up to the role. Plus, their top candidates may not even know about (or want) the job.

(Commentary by David F. Larcker, James Irvin Miller Professor of Accounting, Director of Stanford Graduate School of Business Corporate Governance Research Program, and Brian Tayan, MBA ’03, Stanford GSB)

Compensation Committee – Merits of Shareholder-Sponsored Proxy Proposals requesting that boards disallow more than one current or former CEO from serving on compensation committee

Source: Time Warner Inc., Form DEF 14A, Filed April 9, 2009

This proxy season, the AFL-CIO has submitted shareholder-sponsored proxy proposals to companies including Eli Lilly, Goldman Sachs, and Time Warner that would disallow more than one current or former CEO from serving at the same time on the compensation committee.

According to the AFL-CIO, the proposals were based on academic studies that suggest that companies with more than one CEO on the compensation committee tend to have higher pay than companies that do not. In theory, when CEOs serve on the compensation committee, they engage in “back scratching” and other forms of reciprocity by approving larger pay packages with the expectation that other CEOs will do the same for them. As a result, compensation negotiations are not an arms-length negotiation and pay packages artificially rise.

This is likely a simplistic view. Most academic studies on the relation between board structure and executive compensation have weak or inconclusive findings. (One exception is that boards with “busy” directors who serve on multiple boards do tend to award larger compensation on average. These results are robust and widely accepted. [See: Core, J., Holthausen, R., Larcker, D. (1999), "Corporate governance, chief executive officer compensation and firm performance", Journal of Financial Economics, Vol. 51 pp.371-406.]

Still, let’s see how the AFL-CIO proxy proposal would apply to a company such as Time Warner. Last fiscal year, the compensation committee comprised Frank Caufield (co-founder of venture capital firm Kleiner Perkins), Mathias Dopfner (CEO of Axel Springer), Michael Miles (former CEO of Phillip Morris), and Deborah Wright (CEO of Carver Bancorp). If the proposal were accepted and passed, two of these individuals would have to step down. Who would replace them? Only three directors qualify: Robert Clark (professor at Harvard), Jessica Einhorn (professor at Johns Hopkins), and Kenneth Novack (former vice chairman of AOL). Is there any evidence to suggest that these individuals would be more qualified than those who step down? Robert Clark is a professor of corporate governance. Does that make him more capable of setting compensation? Jessica Einhorn serves on the boards of four other organizations, making her a “busy director.” As we just noted, busy directorships are correlated with elevated compensation. Kenneth Novack is a former employee of the company. Insiders are correlated with lower governance quality in certain areas, such as mergers and acquisitions.

When we attach names to the committee, the complexity of the decision becomes clear. Rather than arbitrarily restrict the committee structure, investors should evaluate committee members on a case-by-case basis taking into account their qualifications, objectivity, and independence of judgment. This is likely to lead to much better outcomes than establishing one-size-fits-all restrictions that ignore the importance of relevant details.