The Advisors' Blog

– Fred Whittlesey, Buck Consultants

With ARRA’s prohibition on “any compensation plan that would encourage manipulation of the reported earnings to enhance the compensation of any of its employees” there’s finally a legislative impetus to deal with one of the real problems with executive pay. This has received scant attention, however, given the media focus on simpler and politically-sexier provisions such as the $500,000 pay cap. Who really wants to read about financial performance measures when we can debate whether $500,000 is a lot of money?

As a consultant, it’s easy to shoot at the simplistic knee-jerk TARP and ARRA pay provisions but I have to say that I appreciate the government’s institutionalization of an idea that many of us have been harping about for (I hate to admit) decades. While we don’t yet know exactly what that sentence in the legislation really means, allow me to speculate on the potential it holds.

Much research and a basic knowledge of financial accounting indicate the potential issues with a large percentage of executive incentive programs using earnings per share (EPS) and other potentially flawed measures as a primary measure of company performance. Many research studies show no relationship between EPS and shareholder value creation so we must ask why such a measure should be the basis for short-term cash-based awards to senior executives. The lack of relationship between some measures and value creation should be enough to end the use of such, but it has not been. The far bigger problem is the ease with which such measures are manipulated. Now these programs may be in direct violation of the new prohibition for TARP companies and raise questions for all companies as other TARP provisions have.

This blog posting could easily be a chapter and that chapter could easily be a book. It’s a deep and difficult aspect of compensation design that has been given too little attention for three reasons:

1. It’s a deep and difficult aspect of compensation design. It takes more analysis, more understanding of both accounting and finance, and a thorough understanding of the firm’s business strategy. That’s a lot harder than looking in a survey. Peter Drucker was not exaggerating in his comment that “fundamentally, businesspeople are financially illiterate.” There are some Compensation Committee members in that category. Why, EPS is right there at the bottom of the income statement. The FASB requires reporting it. It must be good. Next slide please.

2. The most “popular” measures are the most easily manipulated. Surprise! Anyone with a basic understanding of accounting knows that the accrual-based income statement is nothing more than one possible and very subjective version of business performance resulting from hundreds of decisions. It’s the set of numbers that the company chooses to report. LIFO or FIFO? Black-Scholes or binomial? Exactly when it that piece of machinery going to wear out? Is all that inventory in the warehouse really saleable? What about all that goodwill on our balance sheet, it’s still valuable, right? Let’s do a value-for-value option exchange. There we go, a nice big fat EPS number. Bonus time!

3. The survey says. How can a company be wrong if it’s doing what 70% of the peer group is: determining incentive compensation based on EPS. Well, I think we have seen an answer to the “everybody’s doing it” rationale.

It has always annoyed me that there are surveys, and annoyed me more that companies reference those surveys, measuring “what other companies do” in terms of prevalence of performance measures. That’s about as meaningful as deciding what to have for dinner based on a survey of what other people on my street are eating tonight.

A few years from now we’ll look back on this economic crisis and likely try to ferret out the good that came from the economic devastation, misguided government efforts, and associated effects. I am hopeful that a survey will show that this period created a new attention to short-term and long-term performance measurement and that no one got in trouble for manipulating reported earnings to enhance their compensation.