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Review of Accounting Studies

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08.02.2020

The treatment of special items in determining CEO cash compensation

Erschienen in: Review of Accounting Studies | Ausgabe 2/2020

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Abstract

Prior literature documents that CEOs are rewarded for any positive component of income and are partially shielded from negative special items. However, the incidence of and rules pertaining to nonrecurring items significantly changed over the last two decades, calling for a reassessment of earlier research. This paper finds that executives now benefit less from positive nonrecurring items and are penalized more for negative special items, compared to earlier periods. The predictive value of the components of income helps explain this shift. Hand-collected data indicates that compensation committees are more likely to include a component of income that can predict future earnings in their CEO bonus performance measures. Changes in the predictive value of the nonrecurring components of income over time contribute to shifts in their treatment in calculating CEO pay.

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Current cash compensation is tied to accounting performance in many bonus plans, while the value of long-term noncash compensation is more clearly associated with market performance (e.g., Duru and Iyengar 2001). Also, this paper’s focus on CEO pay is driven by the closer connection between overall firm performance and pay for CEOs, compared to other types of managers.

U.S. Generally Accepted Accounting Principles do not define the term “special items.” Rather, academics use this label for the set of events and transactions U.S. GAAP defines as “infrequent or unusual.” Compustat provides the categories of special items (see Appendix 1).

Appendix Table 9 details the four samples used in this paper.

The inclusion of special item refers to instances in which an executive’s cash compensation can increase when positive special items are reported and decrease when negative special items are reported. The exclusion of special items refers to instances in which special items do not affect an executive’s cash compensation, because the earnings number used to calculate the bonus is some measure taken before the effects of special items. For example, imagine a firm has pretax income of $100 and special items of –$5. If the committee excludes special items, the income number used will be $100 – (−$5) = $105. If the committee includes special items, the income number used will simply be $100. Thus, when special items are negative (positive), it benefits a CEO to have them excluded (included).

The cash component of CEO pay remains important, because it is substantial in magnitude, can be easily understood by CEOs, provides liquidity, and is common in compensation contracts. The average CEO in my current large sample receives about half of his or her annual compensation in cash. According to Murphy and Jensen (2011), incentive plans are effective only if participants understand how their actions affect the payoffs they will receive. Those authors as well as Sloan (1993) claim that the ability of CEOs to adjust earnings is much greater than their ability to adjust stock price. Cash compensation provides more liquidity than restricted stock grants or options. Finally, cash compensation always links CEO pay to accounting earnings, but significantly fewer equity award performance measures do so (Bettis et al. 2015).

That paper uses the term “persistence” for a concept Jones and Smith (2011) later define as predictive value.

Theoretically, compensation committees could adjust for only portions of special items. For example, they could include the impact of one type of special item, like IPRD, but exclude another type, like restructuring. However, I find evidence that this occurs only in a small fraction of a percent of the instances in my hand-collected sample.

The choice of inflation-adjusted cash compensation allows for the most accurate comparison to the findings of Gaver and Gaver. Their data source provided total cash compensation only for most years and not bonus. Running their analysis on bonus alone, during my sample period, indicates no significant and consistent differences (untabulated); thus this switch between bonus and total cash compensation should not be problematic. Using non-inflation-adjusted numbers leads to qualitatively similar results (untabulated).

Given the skew in the distribution of cash compensation, the analysis is repeated after taking the log transformation of the dependent variable. This leads to qualitatively similar results (untabulated).

Special items are included on the basis of their before-tax values. A smaller subset of after-tax special items is available in Compustat, but this variable is significantly less populated than the pretax amount.

Results are qualitatively similar if the cutoff is 1992, the beginning of my current large sample period.

A number of earlier papers use the Cochrane-Orcutt procedure as a substitute for the full transformation (e.g., Natarajan 1996). However, that method would needlessly reduce the size of the sample, given other papers find both methodologies lead to the same results.

There are three main reasons I drop these observations. First, the exclusion of only noncash special items is very rare. Second, untabulated analyses, using a multinomial logit, reveal these are simply driven by industry membership. The remaining results are qualitatively similar. Finally, the results are qualitatively similar when these firms are defined as excluding special items.

Gaver and Gaver’s (1998) data is taken from the Forbes magazine CEO compensation survey of the top 500 firms in terms of either net income, total assets, revenue, or market value. The results from the current period are qualitatively unchanged if only the top 500 firms, as determined by those metrics, are included in the sample.

This requirement may introduce a survivorship bias. While this is not ideal, it is required by the methodology and has the benefit of exposing sustainable compensation decisions by firms.

The final sample also excludes outliers, in line with the methodology of Adut et al. (2003). On the basis of the results from equation 1, any firm with a coefficient on a nonrecurring component of income outside of three standard deviations of the median is eliminated. This method eliminates strong skews in the data. This removes six and 33 firms from the Gaver and Gaver large sample and current large sample, respectively. The percentage of data lost in eliminating the outliers similar to the loss of Adut et al. (2003).

Many firms provide reconciliations from GAAP to non-GAAP numbers used to calculate bonuses. For other firms, the paper uses the definition of income provided in the proxy statement and financial statement numbers to decide whether special items are included or excluded in determining executive compensation. This choice is not always clear and may introduce some noise; however, this is unlikely to bias the results. The dozen observations for which the inclusion or exclusion of special items is unclear are excluded from the sample.

This paper does not consider two types of nonrecurring items—extraordinary items and discontinued operations—given their relatively consistent exclusion from the definition of income used to calculate bonuses. Analyses using the current large sample show no significant link between these items and cash compensation.

The significant findings regarding negative special items only apply to instances when recurring income is positive (untabulated). Bonus plans typically reward CEOs only when firms are profitable. The finding that negative special items are only significant when recurring income is in a relevant range for bonus payouts is supported.

Gaver and Gaver (1998) indicate this finding is driven simply by negative recurring income, making a bonus unlikely. They find that a simple indicator for negative recurring income explains the significant coefficient. I find similar results (untabulated).

Adut et al. (2003) define their TREND variable in a number of ways. Their main analysis uses a growth index, calculated by dividing out-of-sample median compensation by median compensation in the first year. This paper uses their alternative measure, the percentage change in median compensation, relative to the prior year’s median compensation. This approach is necessary because this paper’s research design does not allow for out-of-sample data.

Almost all firms treat any special item reported during a given period in the same manner. The two observations with differential treatment of multiple special items do not allow for analysis and are excluded from the sample.

There is a noticeable increase in the predictive value of positive special items at the very end of the sample period. The question of whether this is sustainable trend or aberration to is left to future research.

Securities and Exchange Commission, Release Nos. 33–6962, 33–6966, and 34–32,723 and IRS Section 162(m).

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Titel: The treatment of special items in determining CEO cash compensation
Publikationsdatum: 08.02.2020
Erschienen in: Review of Accounting Studies / Ausgabe 2/2020
Print ISSN: 1380-6653
Elektronische ISSN: 1573-7136
DOI: https://doi.org/10.1007/s11142-019-09523-x

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