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07.10.2023

Properties of accounting performance measures used in compensation contracts

verfasst von: Oktay Urcan, Hayoung Yoon

Erschienen in: Review of Accounting Studies

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Abstract

This paper examines the properties of accounting numbers used in compensation contracts for S&P 500 firms from 2006 to 2017. Our data reveal wide variation in the accounting performance metrics used in compensation contracts, with some recent movement from bottom-line earnings-based measures to top-line measures. Investigating specific exclusions made to GAAP-based financial measures to arrive at realized compensation performances, we identify 27 different types of exclusions and document significant heterogeneity in tailoring across firms. We test whether exclusions are made to remove noise in performance measures and better isolate managerial effort (efficient contracting theory) or to camouflage managerial rent extraction (managerial power theory). We find evidence consistent with both explanations.

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Fußnoten
1
GAAP-based financial measures include not only reported net income but also various other measures that are reported in or can be calculated directly from financial statements (e.g., sales, EBITDA, and cash flows from operations).
 
2
We are not interested in the choice of GAAP-based benchmark. Instead we examine economic implications of exclusions in fine-tuning the GAAP-based benchmark once it is chosen. Bloomfield et al. (2021) provide evidence that boards choose a particular accounting performance measure in a bonus plan to mitigate underinvestment problem and insulate newly hired managers from the sunk costs incurred by the previous executives. However, accounting performance measures are noisy and therefore may not insulate managers from factors beyond their control. For example, boards might choose sales as an accounting performance measure to completely shield managers from any types of costs and expenses. However, sales are, for example, affected by foreign exchange differences, making them a noisy performance measure. Boards can fine-tune accounting performance measures to increase their effectiveness.
 
4
For example, Eli Lilly & Co.’s 2012 annual meeting and proxy statement has the following quote about the firm’s use of non-GAAP performance measures in executive compensation: “2011 bonus were determined to eliminate the distorting effect of certain unusual income or expense items on year-over-year growth percentages. The adjustments are intended to: 1. align award payments with the underlying performance of the core business, 2. avoid volatile, artificial inflation or deflation of awards due to the unusual items in either the award year or the previous (comparator) year, and 3. eliminate certain counterproductive short-term incentives—for example, incentives to refrain from acquiring new technologies, to defer disposing of underutilized assets, or to defer settling legacy legal proceedings to protect current bonus payments.”
 
6
We focus on these measures as they together comprise over 90 percent of all accounting measures used by our sample firms. The next two frequently used measures after the top seven measures we examine are operating expense and capital expenditure, which comprise 1.12% and 0.79% of the total sample, respectively.
 
7
The SEC only recently clarified that firms must provide reconciliations to comparable GAAP financial measures for non-GAAP financial measures used as compensation targets (https://​www.​sec.​gov/​corpfin/​non-gaap-financial-measures). Moreover, Robinson et al. (2011) find that compliance with compensation disclosure requirements is incomplete. Therefore some CD&A of proxy statements do not have information on adjustments to GAAP-based financial measures.
 
8
Appendix A provides an example proxy statement disclosure on the types of accounting performance metrics, the realized performance measures, and the exclusions from GAAP-based financial measures to arrive at the realized measures. In this example, realized earnings per share (EPS) is $1.55 for compensation contracting purposes, and GAAP-based benchmark EPS is $3.23, suggesting that the amount of exclusions per share is $1.68 ( $3.23 – $1.55).
 
9
In unreported analyses, we line up the future performance measures with the independent variables (e.g., future sales as the dependent variable and the sales compensation performance measures and its exclusions as the independent variables) and find qualitatively similar results.
 
10
It is theoretically unclear whether an exclusion that helps the manager meet or beat a target is of low quality. While compensation contracts are designed to motivate managers, boards contract with managers at a higher expected compensation because effort is unobservable, performance measures are noisy, and managers are risk averse. Therefore exclusions that remove noise in the performance measure, reduce the risk that the manager is unrewarded despite putting in the effort, and help the manager meet and beat the compensation benchmark could be of high quality. In contrast to this theoretical possibility, Curtis et al. (2021) find (and we confirm) that managers compensated on adjusted earnings are paid more.
 
11
Our results in this section should be interpreted with caution. The sample size for the target beating analysis is smaller due to missing data on performance targets in companies’ disclosures. In our data, this occurs for two main reasons: 1) the company does not have all three performance targets (threshold, target, and maximum), and 2) incomplete disclosure. This sample attrition can affect our results. In particular, firms may strategically not disclose compensation benchmark information when exclusions are driven by opportunism.
 
12
We manually examine the nature of items classified as other and observe that they are generally transitory. Examples of other adjustments include impacts of law and regulation changes, transaction costs, charitable contributions, environmental charges, insurance recoveries, and other generic terms, such as “certain items” or “nonrecurring items.”.
 
13
We confirmed the categorization of each type of exclusion by reading the descriptions from the proxy statements. To do so, for each exclusion type, we read five examples with the largest magnitude of the adjustment.
 
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Metadaten
Titel
Properties of accounting performance measures used in compensation contracts
verfasst von
Oktay Urcan
Hayoung Yoon
Publikationsdatum
07.10.2023
Verlag
Springer US
Erschienen in
Review of Accounting Studies
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI
https://doi.org/10.1007/s11142-023-09806-4