Why Compensation Committees Need Your Help

EXECUTIVE SUMMARY

WHETHER WORKING IN THE FINANCE DEPARTMENT of a public company or advising that company as an outside consultant, CPAs are in a unique position to guide compensation committees in their role as corporate overseers and to help them better align compensation practices with shareholder interests. CPAs CAN ADD VALUE TO COMPENSATION COMMITTEES in these four areas: helping to ensure compliance with relevant laws and regulations, setting performance goals and benchmarks for the incentive portion of executive pay packages, calculating the value of stock options where companies treat options as expenses on income statements and evaluating alternatives to traditional stock option payouts. CPAs WON’T BE ABLE TO ADVISE some clients on compensation matters. The Sarbanes-Oxley Act of 2002 prohibits CPAs from providing many nonaudit services to their audit clients, including management or human resources functions, appraisal or valuation services, “expert services” unrelated to the audit and any other service the soon-to-be-created oversight board finds impermissible. CPAs CAN HELP COMPENSATION COMMITTEES set the performance goals to which incentive pay is linked. CPAs also can assist in calculating any adjustments to bonus payouts that may be required due to circumstances outside the CEO’s control. THE INTERNATIONAL ACCOUNTING STANDARDS BOARD has already proposed that companies using its standards start expensing stock options in 2004, and FASB said it will consider revisiting the issue and produce its own proposal.

RANDY MYERS is a freelance financial writer who lives in Dover, Pennsylvania. His e-mail address is randy@randymyers.net .

ompanies have yet to solve the riddle of executive compensation—at least to the satisfaction of investors and legislators. Dismayed by reports of CEOs cashing in stock options worth millions of dollars amid a tumbling stock market and a rash of corporate scandals, Congress and financial market regulators have introduced new rules designed to make it harder for top executives at public companies to reap windfall profits at shareholders’ expense .

Executive stock option programs—hailed in the 1990s as the best way to align the interests of executives with those of shareholders—face a growing public outcry. This new climate presents a raft of challenges for board members who serve on compensation committees and for the CPAs who advise them. Whether working in the finance department of a public company or acting as an outside consultant, CPAs are in a unique position to guide compensation committees in their role as corporate overseers and to help them design and implement pay packages more in line with shareholder interests.

CPAs who advise compensation committees can add value to these undertakings in four distinct areas:

Helping to ensure the committee acts in compliance with the latest laws and regulations.

Setting the performance goals and benchmarks that are the basis for the incentive portion of most executive pay packages.

Calculating the value of traditional stock options for the growing number of companies electing to treat the issuance of options as an expense on their income statement.

Considering alternatives—in terms of their costs and tax implications—to traditional stock option awards.

FOLLOW NEW LEGISLATION
Compensation committees work in a complex and ever changing environment and need expert accounting and legal advice. Thus a critical task for CPAs who counsel them is to keep abreast of pertinent laws and regulations. Compensation committee conduct became even more sharply circumscribed on July 30 when President Bush signed the Sarbanes-Oxley Act of 2002. Besides sweeping reforms affecting public company audits and how such companies conduct business, the act bans a formerly common practice whereby companies granted, and their boards approved, loans to executives. (For more information see “ Regulations Under the Sarbanes-Oxley Act, ” JofA , Oct.02, page 33.)

Under section 402(a) of the act, it is illegal for public companies to extend credit, directly or indirectly, to directors or officers, except for certain loans available to the general public in the ordinary course of the company’s business. (A bank, for example, can still provide mortgages to its officers and directors.) But virtually all of the loans commonly found in executive compensation packages appear to be prohibited, such as those made to help an executive purchase company stock, fund a split-dollar life insurance arrangement, meet an extraordinary expense or relocate. Because the specific intent of the act is unclear in this area, CPAs must wait for interpretive guidance from regulators.

If a company must restate its financial statements due to its failure to comply with disclosure requirements, section 304 of the act requires the CEO and CFO to forfeit any bonuses, incentive or equity-based compensation, as well as any profits from the sale of the company’s securities, within the year after the company issues any noncompliant financial statement.

Other new regulations are on the horizon. In August the New York Stock Exchange filed proposed new “corporate accountability” rules with the SEC. (For more information on the new NYSE listing standards, see www.nyse.com/about/report and “ NYSE Sets Audit Committees on New Road, ” JofA , Nov.02, page 51). These amendments to its listing requirements—if the SEC approves them—would

Require public company boards to have a compensation committee that is composed entirely of independent directors, with tough new definitions for what constitutes independence.

Mandate the committee have a written charter and produce an annual report on executive compensation for inclusion in the company’s annual proxy statement.

Specify that compensation committees must consider their companies’ performance and relative shareholder returns when setting executive pay.

Provide shareholders the opportunity to vote on all equity compensation plans, except inducement awards and option plans in a merger or acquisition. In situations where equity-based compensation plans don’t require shareholder approval, the compensation committee must OK them.

Give the compensation committee the sole authority to retain and terminate any compensation consulting firm and approve its fees and contract terms.

Congress has still more legislation in mind. Senators Carl Levin (D-Michigan) and John McCain (R-Arizona) have sponsored a bill (S 1940) that would require a company to treat stock options on its tax returns the same way it treats them on its financial statements. (Currently, companies can take a tax deduction for the value of options without recording them as an expense on their income statement.) “It’s a new ball game,” concludes Jim Reda, a principal and compensation practice leader with Buck Consultants in Atlanta. With all of the new rules and pending legislation, “there are a lot more things CPAs need to be knowledgeable about.” (See “ Where to Go for Help, ” at the end of this article.)

Foremost on that list is understanding that CPAs won’t be able to advise some clients on compensation matters. Sarbanes-Oxley prohibits CPAs from providing many nonaudit services to audit clients, including management or human resources functions, appraisal or valuation services, “expert services” unrelated to the audit and any other service the Public Company Accounting Oversight Board (PCAOB) finds impermissible. Given the vagueness of that language, says Steven Schaffer, a partner with the law firm Powell Goldstein Frazer & Murphy LLP in Atlanta, it’s difficult to say with certainty the degree to which the new law prohibits CPAs from advising audit clients on compensation issues. This provision of Sarbanes-Oxley won’t take effect until 180 days after the PCAOB is up and running—which isn’t expected until April of 2003. “In the current climate, and with the volatile issues facing the accounting profession right now, I think CPAs have to be very circumspect in rendering these additional services,” Schaffer says.

Of course, CPAs who work for audit firms would still be able to provide consulting services to companies that are not audit clients, as would CPAs who work for compensation consultants and in corporate finance departments.

SET GOALS AND BENCHMARKS
Most public company CEOs and other senior executives have four components to their pay packages: an annual salary, an annual incentive bonus pegged to short-term corporate performance, a long-term incentive program typically structured around the issuance of stock options and a nonqualified deferred compensation program which supplements qualified retirement plan benefits. CPAs can help compensation committees establish the performance goals incentive pay is linked to, says Mike Kesner, CPA, an executive compensation consultant and managing partner of the Chicago office of Deloitte & Touche. For example, suppose a company wants to pay its CEO a bonus only if the company’s performance exceeds a specified measure such as the average earnings-per-share gain of comparably sized companies in the same industry. CPAs can advise the compensation committee on which companies to include in that peer group and also handle the calculations necessary to figure out how the client company performed relative to the peer group.

CPAs also can help calculate any adjustments to bonus payouts that may be required due to circumstances outside the CEO’s control, such as a fire in a major production facility that had a negative impact on earnings. Because a company’s directors are responsible for making such decisions, “whether the CPA has any business opining on making the adjustment is debatable,” Kesner says. “However, these bonus plans often provide for many discretionary adjustments and a lot of financial analysis needs to be done as a result; somebody has to objectively handle those adjustments.” He also says that under IRC section 162(m)(4)(C)(iii), compensation committees, in awarding a performance-based bonus, must certify the company met the relevant performance goals. Here, too, CPAs can be of service. “Compensation committees don’t crunch the numbers themselves,” Kesner explains. “They typically use an internal CPA to calculate the numbers and then the compensation committee signs off on them.”

CALCULATE STOCK OPTION VALUES
The vast majority of public companies follow APB Opinion no. 25, Accounting for Stock Issued to Employees, in accounting for employee incentive stock options. Under Opinion no. 25, as subsequently clarified by FASB Interpretation no. 44, Accounting for Certain Transactions Involving Stock Compensation, a company calculates the cost of those options based on their intrinsic value—the difference between the strike price of the option and the market value of the stock. Since most options are issued “at the market,” they have no intrinsic value on the date of issuance, so the cost to the company is zero.

In 2002, however, bowing to pressure from shareholder activists and high-profile leaders such as Warren Buffet, several dozen companies announced they would begin to voluntarily count the fair value of stock options, not the intrinsic value, as an expense on their income statement. They include Coca-Cola, General Electric, Citigroup and Procter & Gamble. FASB Statement no. 123, Accounting for Stock-Based Compensation, recommends this approach but allows companies that comply with Opinion no. 25 and Interpretation no. 44 to merely disclose in the notes to the financial statements what the effect on net income and earnings per share would have been if they had expensed the options at fair value.

Many accounting experts think it is only a matter of time before companies will have to report stock options as an expense at fair value. The International Accounting Standards Board (IASB), for example, has already proposed that companies using its standards start expensing stock options in 2004, and FASB said it will consider revisiting the issue and produce its own proposal. In any event the current trend already is creating demand for the services of CPAs who can calculate the value of executive stock options and suggest economically viable alternative compensation strategies now that some companies have decided to expense options.

Unfortunately, compensation experts find valuing executive stock options isn’t as straightforward as valuing options traded in the financial markets. The Black-Scholes model is the most commonly used strategy to value exchange-traded options, but that method doesn’t factor in some of the complicating features of executive options, such as their illiquidity and the vesting requirements most incorporate. Partly for that reason, Coca-Cola, in announcing it would expense stock options beginning in the fourth quarter of 2002, also said it would not use Black-Scholes. Instead, the company said it would hire two independent financial institutions to calculate, as best they could, a fair market value for the options.

Whatever method financial advisers use, a company’s decision to expense stock options at fair value immediately raises another issue for the compensation committee: what alternative pay programs it should consider. “The primary reason stock options became so popular was because of the lack of an accounting charge,” observes James Scannella, a CPA and associate principal with Buck Consultants in New York City. “Once you’ve accepted the accounting charge, that puts options pretty much on a level playing field with other incentives. The tax field is also quite level, meaning companies that expense options will be free to pick the incentive that makes the most sense for their business. That’s the way it should be, with tax and accounting issues very much in the background,” says Scannella.

EVALUATE ALTERNATIVES
CPAs can recommend an alternative to issuing plain vanilla options—options with a fixed strike price equal to the market price on the date of issue—by suggesting a company issue options indexed to the performance of a stock-market benchmark, whether a custom index of peer group companies, a third-party industry index or a broad-market measure such as the S&P 500. With this type of option, the strike price—the price at which the executive can exercise the option—moves up in lockstep with the specified index. Accordingly, the option becomes worth exercising only if the company’s stock outperforms the index. This eliminates complaints from investors and corporate governance experts that even mediocre corporate performance can result in handsome rewards for stock-option recipients when the stock market as a whole is rising.

To date, relatively few companies have issued indexed options because of their accounting treatment. APB no. 25 requires charging the intrinsic value of indexed options against the issuing company’s earnings each year. However, if companies adopt the preferred method under Statement no. 123 and expense options in the year they issue them, the variable accounting requirement is eliminated. With that concern out of the way, employers and shareholders find they generally prefer performance-linked options, since they pay only for exceptional, above-market results. For that reason these options also have less value upon issuance and result in a lower charge to earnings than fixed-price options. Companies can choose to issue standard fixed-price options with a strike price higher than the stock’s current market price—postponing the point at which variable accounting treatment is required.

Yet another compensation alternative is to issue stock itself rather than options. Although there is no universal agreement on the matter, many shareholder activists and corporate governance gurus argue that stock, especially restricted stock (the recipient cannot sell it for a predetermined period of time), better than options aligns the interests of executives and shareholders. Their argument is that options present the executive only with upside potential, since they either go up in value or expire worthless, while stock offers both an upside and a material downside. With stock the executive “feels the pain” of a declining stock price along with other shareholders. On a share-for-share basis, restricted stock will have far greater value than any type of stock option. CPAs advising compensation committees will want to point this out so companies switching to restricted stock awards can reduce the size of the award, on a per-share basis, by an appropriate amount.

RIDE HERD ON CHANGE
CPAs who stay on top of changing rules and shifting public opinion will find they can help compensation committees with what John Boma, CPA and senior vice-president at Mullin Consulting, a Minneapolis-based benefits consultant, says may be their biggest challenge—simply to take advantage of the new climate to better adjust compensation philosophy with corporate culture. “Take the issue of stock options,” says Boma. “Three years ago companies often had to dump options on people just to attract and retain key executives. For many it was more a matter of keeping up with the Joneses than an expression of corporate culture. Now they have a chance to make compensation programs fit corporate goals.” One example: A high-tech company subject to volatile year-over-year performance may favor stock options with strike prices well above the current market price as a way to encourage management to meet lofty goals. A more conservative company in a less volatile industry may prefer to issue either options priced at the market or restricted stock.

“Compensation committees really have to take a step back and ask themselves what is reasonable for the company to pay its executives,” says Judy Thorp, a CPA and Chicago-based partner of KPMG LLP in charge of the firm’s Midwest compensation and benefits practice. “The whole concept of reasonableness has gotten little attention in the last several years.”

Boma, like many other compensation experts, does not foresee a material decline in what CEOs and other top executives receive in the form of salary over the next few years. But he does anticipate a decline in total compensation for two reasons: The weak economy likely will lead to lower incentive-linked bonus payouts, and outstanding stock options are less likely to produce outsized gains now that the stock market no longer is banging out double-digit returns.

DRIVING FORCE
By helping compensation committees understand the issues that are driving executive pay trends today, as well as the alternative solutions available, CPAs can guide them through this new and rocky terrain in 2003 and beyond. This is an important task because the stakes are so high. Investor confidence in management depends on setting compensation at fair levels. And compliance with new laws and regulations is crucial as Congress, the SEC and other regulators focus increased attention on corporate governance, of which compensation is only one small, albeit very important, part.