Investigating Ceo Compensation and How

Abstract:

The purpose of this paper is to gain a further understanding into how CEO's get compensated, and how they use accounting choices to maximize their compensation, often at the expense of shareholders. It is based off the findings of a paper by Fields, Lys and Vincent on accounting choice, which covers the issue of earnings management and executive compensation. My paper aims to look at the different types of accounting choices, and means of manipulation that CEO's use to influence their compensation. Although I have done no quantitative analysis to prove it, I have attempted to acquire sufficient information to show that there are incentives for CEO's to manipulate earnings for personal gain.

Introduction:

Throughout our Seminar in accounting course, we have frequently come across the issue of management compensation and accounting choice. One area that stirred a lot of interest, particularly with me, was that of CEO compensation. Are CEO's really out there for the shareholder, or are they mainly trying to satisfy their own interest? There may be a conflict of interest, as the CEO is supposed to maximize shareholder value, but at the same time, by having incentives to increase his/ her compensation, they do not have their shareholders' interest at heart. This paper will look at how CEO's are compensated, and analyze those components of CEO compensation contracts that most influence the extent of analyst guidance (in particular stock and option ownership). The paper will also examine how CEO's manage to manipulate earnings, and how this is done.

How are CEO's compensated?

In order to fully understand how the CEO's manage to manipulate earnings, it is important to first understand how they get compensated, and where there are incentives to manipulate earnings by using accounting choice.

According to the SEC , here are some of the main compensation methods for CEO's. In order to help the reader understand areas focused on in my paper, I have expanded some of the methods mentioned below:

* Salary: CEO salaries are usually set on an annual basis. Moreover, it is a stylized fact that firm's size is associated with base salary (Murphy, 1999).

* Bonus: These are a highly firm-specific and evaluate performance measures, performance standards, and the structure of the pay-performance relation (Murphy, 1999)

* Perks and other personal benefits, securities or property

The following are most subject to earnings manipulation, and will be the focus of my paper:

* Stock: above-market or preferential earnings paid (or payable but deferred at the election of the executive officer) on deferred compensation,

Restricted stock: restricted stock award is an outright grant of shares of stock by a company to an individual, usually an employee, without any payment by the recipient or for only a nominal payment.

Generally, the shares of stock are subject to a contractual provision under which the granting company has the right (but not the obligation) to repurchase or reacquire the shares from the recipient upon the occurrence of a specified event (such as termination of employment). This right of repurchase or reacquisition expires after a specified period of time, either all at once or in increments. The expiration of this right is referred to as "vesting." During the period that the shares of stock may be repurchased or reacquired, the recipient is prohibited from selling or otherwise transferring the shares. (Thus, why the shares are called "restricted" stock)

Stock appreciation rights: A stock appreciation right ("SAR") is a contractual arrangement between a company and an individual, usually an employee, in which the recipient has the right to receive an amount equal to the appreciation on a specified number of shares of stock over a specified period of time

* Stock Options: A stock option is a contractual arrangement between a company and an individual, usually an employee, where the company offers the recipient the opportunity to purchase a specified number of shares of stock of the company at a specified, pre-determined price (typically, the market price of the company's stock on the date of grant) for a specified period of time. There are two different types of stock options: (1) incentive stock options -- options that meets the requirements of Section 422(b) of the Internal Revenue Code and, therefore, enable the recipient of the option to qualify for preferential tax treatment under the federal income tax laws, and (2) non-qualified (or "non-statutory") stock options -- options that do not satisfy the requirements of a statutory stock option under the Internal Revenue Code and, therefore, do not qualify for any special tax treatment.

* Earnings paid on Long-Term Incentive Plan compensation.: These are usually based on a three to five-year moving average of firm's performance

Manipulating Stock prices and analyst predictions:

Fig 1. Diagram showing generally how CEO's stock compensation works .

One of the most significant trends in the last two decades was the extent to which CEO compensation via equity has accelerated at a rapid rate. As is documented in Hall (2002) the amount of equity-based pay (as a fraction of total top executive pay) at the beginning of 1990 was less than 10%. By 1992 this fraction was about 30% and by the end of the decade had reached over 60%. The vast majority of this trend was accounted for by increases in the use of executive stock options. Stock-based compensation comprises the fastest-growing component of executive compensation. Jensen and Murphy (1990) find that on average, CEO wealth changes by $3.25 per $1, 000 of shareholder value. Most of these performance-related payments are in the form of executive stock holdings.

Also, in their research, Hall and Liebman (1998) found a stronger relationship between firm performance and CEO compensation. They credit stock option grants for this change.

By the end of the 1990s, stock-based pay peaked at over 60% of total executive pay (Hall 2002). CEO's use these stock options as one of the main ways they can maximize their compensation. By aiming to reach analysts predictions and performing better than the market expects, CEO's will be able to acquire greater wealth when they exercise their stock options. The problem though is that they