EXECUTIVE
SUMMARY |
RECENT SCANDALS HAVE
CREATED A PUBLIC perception
that corporate executives are putting
their own interests ahead of shareholders’
concerns. While the Sarbanes-Oxley Act of
2002 does not directly mandate changes in
compensation methods beyond placing
restrictions on personal loans to
executives, its emphasis on corporate
governance has been a catalyst for public
companies to reexamine how they pay their
top executives.
IT’S NOW UP TO COMPANIES
TO REVISE THEIR pay methods
with CPAs’ assistance. On a practical
level, greater duties for board
compensation committees and a
reconsideration of companies’ use of
stock options will have the greatest
impact on how companies compensate their
executives.
FOR COMPENSATION
COMMITTEES SEEKING GUIDANCE
on how to begin, CPAs can
recommend a list of best practices
developed late in 2003 by the National
Association of Corporate Directors’ blue
ribbon commission on executive
compensation. Executive Compensation
and the Role of the Compensation
Committee suggests compensation
committees maintain their independence,
create fair pay packages, focus on
long-term shareholder value, link pay to
performance and encourage transparency.
CPAs CAN HELP
COMPENSATION COMMITTEES CAREFULLY
examine how stock options
should fit into the mix. Option grants
became less appealing after the market
boom ended. They also were perceived as
encouraging executives to focus on
short-term results that would cause a
temporary stock surge and raise the
option value just in time for exercise.
FASB has introduced mandatory expensing
of stock options, which may diminish
their appeal for some companies.
| ANITA
DENNIS is a JofA contributing
editor and a freelance business writer.
|
n a speech last fall, PCAOB Chairman
William McDonough said many members of Congress
had asked him whether he could “figure out a way
they could pass a law controlling compensation.”
In expressing his doubts to the National
Association of Corporate Directors annual
corporate governance conference, McDonough said he
didn’t believe any one law could fit each
company’s unique situation, though “that doesn’t
mean that one won’t get passed if the American
people stay angry enough.” Regulators and
Congress have begun to scrutinize how public
companies pay their executives; the subject
remains a sore spot for investors as well.
“Something has gone wrong with executive
compensation in the United States,” Sean Harrigan,
president of the California Public Employees’
Retirement System—the country’s largest public
pension system and a powerful institutional
investor—told Congress last year. Harrigan said it
was “shocking” to see top corporate executives
insulating themselves from any risk while
shareholders are losing value. This
article identifies some of the key concerns on
which CPAs—in their capacity as CFOs, human
resources professionals, financial managers or
consultants—can advise companies as they seek to
revise their pay practices. CPAs also can offer
important advice on tax, financial reporting and
compensation issues. In addition, the information
in this article will be helpful to the CPAs who,
because of their financial expertise, are
increasingly being asked to serve on corporate
boards (see “
CPAs as Audit Committee Members, ” JofA
, Sep.03, page 32).
Practice Makes Perfect
In a 2003 study,
48.9% of corporate
board directors believed compensation
practices at their own companies were
“very good,” if in need of a few
changes. Most ( 55.1% )
thought U.S. compensation practices were
“good” but in need of more extensive
change. Source: Corporate
Board Member magazine and Towers
Perrin, www.towersperrin.com
.
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THE CPA’s ROLE
“CPAs employed by companies can
take a proactive role in advising their boards on
compensation practices,” says Roselyn Morris, CPA,
associate dean of the McCoy School of Business
Administration, Texas State University at San
Marcos. Depending on the CPA’s position, “this may
even be part of his or her job.” A CFO, for
example, could offer advice and opinions when
dealing with the board and other executives. CPAs
in other areas of the organization not directly
involved in compensation can direct governance
issues, shareholder advocacy concerns and other
questions to the company’s ethics hot line.
For CPAs seeking to guide employers or clients
through the compensation minefield, Morris says
openness will be a key concern. “Today, a company
wants to be more transparent rather than less,”
she says. That may mean going beyond minimum
disclosure rules to consider what information an
investor might want. For example, from a financial
reporting standpoint, “in an audit, if something
is not material, you don’t have to be
transparent.” But, Morris notes, “what may not be
material to a company may be material to creditors
and investors. If you’re doubling someone’s salary
and paying them $1 million in cash and $1 million
in stock options, I don’t care if it’s immaterial
to General Motors. If you don’t tell investors or
creditors about it, they feel you’re playing games
with them.” CPAs can help companies understand the
value of exceeding basic requirements to satisfy
creditor and investor concerns. “Even if it’s
possible to avoid disclosure, you may want to do
so anyway,” she says. In working with or
serving on compensation committees, CPAs are in an
excellent position to help the committee
understand various pay options. On some committees
not all members will be familiar with different
pay strategies, so CPAs can help fill the gaps in
their knowledge. CPAs also can offer valuable
perspective—for example, ERISA laws prohibit
companies from offering executives benefits
packages that are unavailable to other employees.
“Compensation committees need to start asking
whether they would be willing to pay all their
employees the way they are paying top executives,”
Morris says. A CPA can provide the answers.
CPAs also can play a role based on their more
traditional areas of expertise. They are in the
best position to advise human resources executives
and the board of directors on the financial
reporting and tax implications of new compensation
strategies. Before a board adopts a new incentive
plan it will need to know what impact the plan
will have on the company’s balance sheet. A new
strategy is worthless if it will require changes
to the financial statements that are even more
detrimental than the old one. Board members,
particularly compensation committee members, also
will want to know the tax effect—to the company
and to individual recipients—of switching, for
example, from stock options to restricted stock.
CPAs can provide the necessary reassurance that
the tax consequences will not be harmful to the
company or act as a disincentive to executives.
A FOCUS ON CORPORATE GOVERNANCE
The changes companies make in
their pay strategies will be effected in large
measure by new approaches in two key areas:
greater duties for board compensation committees
and a reconsideration of the use of stock options.
According to Tom Wamberg, chairman and CEO of
Clark Consulting in Barrington, Illinois, 2003
“was the culmination of watershed events for
executive compensation.” Wamberg says boards of
directors’ compensation committees are under
tremendous pressure to meet and even exceed
shareholder expectations by putting a proper
compensation structure in place. Recent
scandals have left the impression that corporate
executives are putting their own interests ahead
of shareholders’ concerns. To address this issue,
the major U.S. stock exchanges established new
rules in 2003 requiring shareholder approval of
all equity compensation plans. As a result, during
the 2003 proxy season, Home Depot asked
shareholders to approve the terms of
performance-based compensation payable under the
company’s management incentive plan. In 2004
Hewlett-Packard asked its stockholders to approve
its stock incentive plan. Other companies are
putting forth similar resolutions.
Meanwhile, although the Sarbanes-Oxley Act of
2002 did not mandate changes in compensation
methods beyond placing restrictions on personal
loans to executives, its strong focus on corporate
governance issues has been a catalyst for
companies to reexamine standard operating
procedures—including how they pay top executives.
A STRONGER ROLE FOR COMPENSATION
COMMITTEES
In any public company
responsibility for changing pay practices
generally rests with the board of directors’
compensation committee—a body CPA directors may be
asked to serve on or advise in their capacity as
the executive charged with overseeing
compensation. “We’re seeing these committees doing
a lot more work,” says Joseph Sorrentino, managing
director of compensation consultants Pearl Meyer
& Partners in New York City. In its 2004 proxy
statement, Massachusetts-based EMC Corp. said its
compensation committee met 12 times during 2003.
CPAs advising compensation committees on how
to begin changing pay structures can take
advantage of a list of best practices put together
in 2003 by the National Association of Corporate
Directors’ blue ribbon commission on executive
compensation. In Executive Compensation and
the Role of the Compensation Committee ( www.nacdonline.org
), the commission recommends these principles
and practices CPAs can use to advise employers and
clients on executive compensation.
Independence. Compensation
committee members not only should be independent
(as they must be under new stock exchange listing
requirements) but also should consider engaging an
outside consultant—as necessary—to help develop an
overall compensation philosophy and specific pay
packages for company executives. (NYSE’s corporate
governance rules also mandate an independent
compensation committee have a written charter and
make an annual report to the SEC. CPAs can find
these rules at www.nyse.com/pdfs/finalcorpgovrules.pdf
. The American Stock Exchange rules are at www.amex.com/?href=/atamex/news/press/sn_CorpGovRules_091302.htm
and the Nasdaq’s rules can be found at
www.nasdaqnews.com/news/pr2002/ne_section02_141.html
. In the past top managers often were
involved in hiring compensation consultants to
craft their own pay packages. A 2003 survey by
Corporate Board Member magazine and
Towers Perrin found management hired 25.1% of
executive compensation consultants while the
board, with management’s input, hired 55%. Nearly
70% of those surveyed expected retention of
consultants in the future would involve greater
director participation—with continued management
involvement. Many compensation consultants say
that from an ethical standpoint, they prefer the
compensation committee hire them.
Fairness. The blue ribbon
commission recommends against wide gaps between
the CEO’s pay and the pay of other senior
managers—or between executives and other
employees—without reasonable justification.
Long-term shareholder value.
The commission believes executives
should be rewarded for meeting short-term targets,
“but companies also should award additional
variable compensation based on achieving key
metrics over an extended period of time, using
company performance measures, rather than stock
price, as criteria.”
Link pay to performance.
Managers should have a long-term
stake in the company through stock ownership
requirements and stringent holding periods. In
light of this recommendation CPAs should advise
the full board to participate in setting
performance objectives rather than delegating this
responsibility to the compensation committee. “Pay
should be linked to performance as reported, and
performance metrics should not be changed after
the fact to compensate for failure to meet stated
objectives,” the report says.
Transparency. Every
element of compensation should be clearly
disclosed to investors—even when the company is
not required to do so. “Coupled with a
spirit of courage and rigor, these practices can
help ensure that we motivate and retain the best
talent while minding the long-term interest of the
organization and its shareholders,” said Barbara
Hackman Franklin, cochair of the blue ribbon
commission, who also is a corporate director and
former U.S. Secretary of Commerce. Given
such principles as a basis for compensation
decisions, CPAs should remind compensation
committees they face the practical task of
figuring out specifically what to pay their
executives. The committee’s job will be a juggling
act in which it will rely on some established
benchmarks in crafting a program that is unique to
the company and includes a mix of external and
internal points of reference. “A lot of
compensation committees are starting with a blank
slate”—building a tailor-made plan that is not
based on past practices, says Donald Sagolla, a
principal of Mercer Human Resource Consulting in
Los Angeles. “They’re looking not only at the cost
of their compensation program but also at the
return on their compensation expense.” Committees
are scrutinizing the dilution and “overhang”
effect of various strategies on share value, as
well as how compensation decisions mesh with the
corporate culture and the business plans of the
company and its parent. (As used here dilution
is the reduction in stock value and earnings
per share when an employee exercises stock
options; overhang is stock options
granted, plus any remaining promised options still
to be granted, that can depress the company’s
stock price if an employee sells them.) In
some cases apparently successful companies with
seemingly competitive pay strategies continue to
see turnover at the top. These businesses, Sagolla
says, need to gain a perspective on succession and
leadership issues—as well as define overall
performance measures both qualitatively and
quantitatively—with compensation as only one
factor in their analysis. Sagolla says as
a result of recent trends, CPAs involved in
crafting compensation programs will see a new
externalized element in the approach companies
take to compensation. In the past an executive who
met his or her business-plan targets might have
been well-rewarded automatically. Today, companies
also want to know how their own performance
stacked up against the competition before they
hand out rewards. If the company did well but not
nearly as well as its competition, it may factor
that in to reduce the executives’ final payout.
But while companies should examine the
competition’s performance, they will likely place
less emphasis on duplicating its pay packages. In
the past corporations often sought to set
executive pay based on compensation surveys. But
that approach will no longer work. “Everybody
can’t be paid at the 75th percentile,” Sagolla
says, referring to a former goal for executive
pay. CPAs should recommend that companies that
once scrambled to keep up with their peers’ pay
packages now set aside the benchmarking surveys
and take a closer look at their own performance
and how their executive has influenced it, then
use those results as a basis for compensation.
At the same time, companies still will want
to know how their pay packages compare with those
of their competitors. According to Pearl Meyer’s
Sorrentino, that will mean a greater effort to
define the business’s proper peer group. Issues
CPAs should consider when companies ask them to
help make this determination include not only the
company’s size and industry but also what
businesses it competes with for revenues and for
talent, which ones usually serve as the recruiting
grounds for top talent and which lure away
departing leaders. Beyond paying and
retaining executives, companies also should
consider how to let them go. Given the number of
cases where an executive was terminated for poor
performance but still got a whopping severance
package, “this issue is definitely on
institutional shareholders’ radar screen,” says
Sorrentino. The board of directors may ask CPAs in
finance and payroll functions to help it determine
how much it will cost the company if an executive
leaves under a variety of scenarios. CPAs
typically can consult the executive’s contract and
make “what-if” calculations under different likely
termination scenarios so the board can consider
potential severance costs in making personnel
decisions.
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PRACTICAL TIPS TO
REMEMBER
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CPAs should
advise public companies that
their compensation committee
members should be independent.
It’s also a good idea for them
to consider engaging an
independent consultant to help
develop an overall
compensation philosophy and
specific executive pay
packages.
When recommending
corporate pay strategies, CPAs
should suggest companies set
aside benchmarking surveys.
Instead, they should look
closely at their own
performance and how the
executive influenced it and
use those results as a basis
for compensation.
The specific
business performance metrics
CPAs should advise public
companies to use when
developing compensation
strategies depend on the
company itself. For example, a
retailer might use return on
sales as a basis for ongoing
compensation, while an
investment bank might rely on
return on equity or capital
employed.
Given the bright
light investors and regulators
are shining on corporate
compensation practices, the
best advice CPAs can offer a
company is that it be more
transparent rather than less
in what it discloses. That may
mean going beyond minimum
disclosure rules.
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STOCK OPTION ALTERNATIVES
One critical step for any board
committee charged with setting executive
compensation is to examine how stock options fit
into the mix. During the boom of the late 1990s,
many companies handed out options as a cheap form
of compensation. Executives welcomed the chance to
own options on stock that—it seemed during the
market’s headiest days—would only increase in
value. The practice became less attractive,
however, when the market tanked, leaving many
options essentially worthless. Worse yet, option
ownership seemed to encourage executives to focus
on short-term results that would cause a temporary
stock price surge and raise the value of their
options just in time for exercise. In 1995
FASB issued Statement no. 123, Accounting for
Stock-Based Compensation, which introduced
the concept of voluntarily expensing stock options
and required new disclosures. More recently, as
part of its ongoing equity-based compensation
project, FASB released an exposure draft,
Share-Based Payment, an Amendment of FASB
Statements No. 123 and 95, in March 2004.
Under the ED companies would have to treat all
forms of share-based payments to employees,
including stock options, the same as other forms
of compensation by recognizing the related cost in
the income statement. Companies clearly
have begun to make changes. A study released in
April 2004 by Pearl Meyer & Partners found
that the average value of options granted to CEOs
fell to $3.2 million in 2003, a 38% decline from
the prior year. Approximately two-thirds of the
companies paid their CEOs more cash in 2003 than a
year earlier, while less than 20% provided options
with a higher grant value. Company boards and
their compensation committees are seeking
alternatives—or at least complements—to stock
options. Investors want other changes as
well. At its 2004 annual meeting, Hewlett-Packard
faced a shareholder resolution that would have
required the company to expense all future stock
options in its income statement. The inevitable
result would have been the granting of fewer
options to avoid too large a drain on earnings.
Stockholders in other companies proposed similar
measures during this year’s proxy season in
advance of a final FASB statement that is likely
to require essentially the same treatment.
Mercer’s Sagolla predicts CPAs will see
companies making greater use of restricted stock.
Under this scenario a company might make an
outright grant of stock rather than an option, but
with some strings attached. For example, the stock
may have a vesting schedule to compel the
executive to stay with the company for a certain
period or it may vest based on the achievement of
certain goals. In the Mercer survey, among
companies that recently had introduced a new
equity plan, two-thirds used service-based
restricted stock and one-third used
performance-based restrictions. Whether
combined with restricted stock or in another
strategy, tying pay to performance definitely has
gained in popularity. “One way to link
compensation to performance that shareholders care
about is to pay executives based on key business
performance metrics,” says Sorrentino. “We’re
going to see fewer discretionary annual incentive
awards. There will be a stated formula, based on
key performance drivers, using criteria tied not
just to profits but also to key business
requirements.” His firm recommends long-term
incentive packages have a mix of some stock
options as well as a plan that focuses on business
performance rather than stock price. The
specific business metrics CPAs should recommend
depend on the company. For example, a retailer
might use return on sales as a basis for ongoing
compensation, while an investment bank might rely
on return on equity or capital employed, according
to Sorrentino. “Then we would design a three-year
plan based on the company’s financial projections,
determining the targets and payout based on
performance over that period. The goal is to
improve long-term shareholder value.” The
three-year horizon helps build a better foundation
for business decisions and planning. If the
company doesn’t meet the set thresholds at the
target dates—or if it exceeds them—the executive’s
compensation varies accordingly. According
to Sagolla, companies will “no longer use a bunch
of performance measures the competition uses or
that they read about in a book. CPAs should
encourage them to consider their own business
model and how the metrics relate to their own
goals or to those of their parent. And the most
important question will be, what performance
creates value for shareholders?” Stock
appreciation rights (SARs), which give executives
the chance to benefit from stock price increases
without having to actually pay the exercise price
of a stock option, also will gain in popularity as
a way to reward and retain employees, says
Sorrentino. (If an employee has 100 SARs, for
example, and the stock’s price rises by $5 a share
during a specified period, he or she receives an
award of $500 in either cash or stock.) Although
businesses must treat an SAR’s value as a
compensation expense, this drawback will be less
of an issue when companies are required or choose
to expense stock options. In addition, they don’t
require the employee to lay out cash and, if paid
in the form of company stock, don’t dilute share
values the way stock options can. They also don’t
require a loan to purchase the shares, as is the
case with stock options; companies thus can avoid
the Sarbanes-Oxley restriction on loans to
executives.
Other “options.” There are
other alternatives CPAs can encourage employers to
consider. In February IBM became the first large
U.S. company to adopt a program that grants senior
managers stock options at a price higher than what
the shares are selling for at the time of the
grant. Under the program IBM shares must rise 10%
or more before the options have any value. At
present the new terms apply to IBM’s chairman and
CEO and to 300 of the company’s most senior
executives. IBM expects to expand it to 5,000
executive-level employees in the next year.
This and other new programs signal a shift in
how companies compensate their top executives. “In
recent years the stock market and the competition
for talent drove compensation,” Sorrentino says.
“Companies were afraid to lose skilled executives
to Internet start-ups, hedge funds or investment
banks, so they provided ‘upside’ opportunities in
the form of stock options or equity to try to
retain them. However, the economy and the labor
market have changed.” While the stock market has
come off its lows, Sorrentino does not believe
companies will relapse into their former
practices. “I think we’ll see more customized
compensation programs,” he says. “Options won’t go
away but will be used selectively to provide
upside leverage. When they have to expense
options, companies will look at them more
critically.”
WHAT’S BEST FOR SHAREHOLDERS?
As governance issues become more
of a priority, corporations are reexamining
executive pay and the role it plays in achieving
shareholder goals. CPAs need to encourage their
employers and clients to put on their shareholder
hats and ask, “What would bother me about this
approach? Does this method send the right
message?” Shareholders understand that strong
performance is rewarded with salary or other
incentives, Sagolla notes, “but companies are now
saying, ‘Let’s define the purpose of each element
of pay.’ That helps refine a cost-effective way of
deploying compensation.” The bottom line will be
fairly paid executives who align their long-term
goals with shareholder needs. In the end both
parties will come away happy. |