Executive Compensation Incentives Contingent on Long-Term Accounting Performance

Lingling Wang is Assistant Professor of Finance at Tulane University. This post is based on an article authored by Professor Wang and Zhi Li, Visiting Assistant Professor of Finance at Ohio State University. Related research from the Program on Corporate Governance includes Paying for Long-Term Performance by Lucian Bebchuk and Jesse Fried (discussed on the Forum here).

U.S. public firms increasingly tie CEO compensation to long-term accounting performance. The percentage of S&P 500 firms that adopt multiyear accounting-based performance (MAP) incentives has more than doubled from 16.5% in 1996 to 43.3% in 2008. In our paper, Executive Compensation Incentives Contingent on Long-Term Accounting Performance, forthcoming in the Review of Financial Studies, we offer the first large sample study that documents the use and design of MAP plans, investigates the determinants of plan adoption and structure, and analyzes the growing trend of MAP incentives.

MAP plans evaluate managers based on sets of predetermined targets, such as earnings, sales, cash flows, or efficiency measures like economic value added (EVA), over multiyear performance periods (generally three years). The final payment is contingent on firm performance during the performance period and the CEO would receive no payment from the plan if the firm misses the minimum criteria. For firms with MAP plans, the expected plan payouts have exceeded those of option grants and become the most significant component of CEO compensation.

We find that a firm tends to adopt MAP plans when its accounting performance has a better signal-to-noise ratio and is more informative about executive efforts than stock performance. Firms are also less likely to use long-term incentives like MAP plans when there are more short-term shareholders, suggesting that firms consider shareholders’ horizon preferences when design compensation contracts. In addition, firms with independent boards are more likely to grant MAP incentives, while CEO power does not increase the likelihood of adopting MAP incentives.

When designing MAP contracts, firms are more likely to choose an accounting performance measure when it is less volatile and is related to the firm’s strategic priorities. When firm performance comoves more with industry performance, firms use relative performance evaluation to filter out common exogenous shocks. Firms with volatile past performance and more long-term shareholders prefer longer performance evaluation periods. CEO power does not have much influence on the design of MAP plans. In general, the findings are consistent with the view that firms adopt and design MAP incentives to better align the CEO’s interests with the firm’s strategic priorities and shareholder preferences.

Much of the growth in the adoption of MAP incentives comes after 2002. Early adopters, firms that adopt MAP plans before 2002, have the highest stock to accounting volatility ratios, the longest shareholder horizons, and the most independent boards. Late adopters, firms that started granting MAP plans after 2002, trail behind in all three aspects, while firms that never adopt MAP plans come in last. These results suggest that companies that benefit the most from using long-term accounting signals adopt MAP plans first. Firms with short-term shareholders and weak accounting signals would not benefit from using accounting-based incentives, and thus choose not to adopt MAP incentives regardless of the shifting trend after 2002.

We further investigate what has swayed those “late adopters” toward MAP incentives after 2002. We identify three non-mutually exclusive factors in the changing macro environment. First, the technology bubble may have made shareholders more wary of the signal quality of stock performance, as they witnessed that stock prices can deviate from fundamental values for a prolonged period of time. Consistent with the view, firms that experienced elevated valuations during the bubble period (i.e., 1997 to 1999) are more likely to initiate MAP grants after 2002. Second, the trend to voluntarily expense options after 2002 and the subsequent 2005 FASB rule change that mandates option expensing create a more level playing field between stock options and other compensation incentives. Before 2002, firms that are barely profitable may have incentives to grant options to defer compensation costs. After the accounting treatment change, however, we find that they start switching to other types of compensation incentives and are more likely to adopt MAP plans. Third, the breakout of option backdating scandals in 2005 and 2006 has created negative public sentiment toward stock options. As a result, firms in industries with more incidences of option backdating are more likely to initiate MAP plans after these incidences are publicized.

Firms prefer to use MAP plans with stock-based payouts to cash-based ones to substitute option grants. Replacing stock options with stock-based MAP plans shows that firms do not shy away from equity-based pay in the post-bubble period. Instead, firms are switching from a purely stock-price driven approach to a combination of accounting and stock performance-based incentives to provide more balanced long-term incentives to executives.

This current change in CEO compensation design significantly differs from a previous noteworthy trend shift. In the late 1980s and early 1990s, firms started paying CEOs generous option grants in response to the shareholder activism that demanded higher pay-performance sensitivity. The increase in option grants did not substitute for other forms of compensation and significantly increased the overall pay level of executives. In contrast, the current shift toward MAP incentives is accompanied by a simultaneous reduction in option grants. As a result, CEOs with MAP contracts experience a change in pay structure, but do not receive higher pay compared with their matched peers without such contracts.

Our study helps researchers and practitioners piece together the recent regime change in executive compensation design in the United States. The evidence suggests that over the past decade, firms increasingly use MAP incentives in response to changes in contracting environment. However, firms do not blindly follow the trend of MAP adoption or use MAP incentives to enrich powerful CEOs. They adopt these incentives only when long-term accounting performance measures better match with firm characteristics and shareholder preferences.

The full paper is available for download here.

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