Use Best Practices in Executive Compensation Plans

Companies encounter problems when their compensation programs motivate executives to act in ways that conflict with accurate financial reporting or to rely too heavily on stock price appreciation. Working with compensation committees, CPA consultants can design executive incentive packages that encourage management to improve corporate performance without losing sight of long-term objectives.

Here are some best practices CPAs can offer for compensation committee approval to address the role company performance and stock incentives should play in executive compensation programs.

Use accounting measures—such as earnings per share, return on investment or cash flow—in annual and long-term performance plans to make sure executives stay committed to operational excellence rather than to short-term stock price growth. To eliminate potential conflicts between management self-interest and accurately reporting financial results, committees should make sure accounting metrics reflect critical and achievable measures of operating performance. Compensation plans typically include two or three performance measures of results for which the participant is held accountable. (Once the executive has a target, he or she develops operational plans to achieve the accounting numbers.)

Have the external auditors confirm calculations to the compensation committee if executive payouts are to be based on pre-set formulas to ensure they are correct and to add credibility to the process.

Encourage accurate financial reporting; consider whether the company should reduce current incentive payments to executives who previously had benefited from inflated earnings in situations where it had to restate them.

Reduce payments in plan payout schedules when executives do not meet specified goals based on financial and nonfinancial performance measures. For example, if an executive is to receive $100,000 under a bonus plan, the committee could reduce the payment if the company failed its revenue growth target or did not meet new product introduction goals.

Evaluate overall corporate results and executives’ contribution toward achieving them; include strategic and qualitative performance measures, such as market share and customer satisfaction, in addition to financial measures. These measures also drive long-term shareholder value.

Raise standards of executive conduct beyond those required by law by using (or issuing) written policies on stock transactions including blackout periods and advance notification of sale.

Incorporate retention ratios for stock earned through incentive or equity plans. For example, encourage or require executives to retain 50% to 75% of the net shares they receive when they exercise their stock options to increase actual ownership in the company.

Prohibit executives from switching assets from company stock to other investment accounts under nonqualified deferred compensation plans based on inside information or during blackout periods.

Prohibit executives from obtaining company loans for the purpose of exercising options or purchasing company stock, and block them from buying company stock on margin or using it as collateral to diversify investment risk.

Establish a policy that forbids corporate-level executives and their families from participating in joint ventures or partnerships that have business dealings with the company or in compensation plans based on performance of pieces of the company rather than the whole.

Source: Adapted from “The Implications of ‘Enron’ for Executive Compensation,” Frederic W. Cook & Co., Inc., New York, 2002, .

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