Sometimes things become so commonplace that people stop giving them a second thought, even though they deserve one, or even more than one.Like a great many others, recent events have caused us to realize that we may have become complacent about the magnitude of executive compensation. Those at the top rung of corporate America make what seems to everyone but them to be truly staggering amounts of money each year.

So how does this happen, and what, if anything, needs to be done about it?

There are at least two sides to this issue, and the two of us might not see eye to eye on it, and each of us has mixed feelings, too.

On one hand, it can be argued that the free market for executive talent has produced such lofty pay simply in response to supply and demand. On the other hand, a closer look at the power of entrenched management reveals that this market is not free at all, but is actually rigged to steer large amounts to executives who not only control the flow, but are dysfunctionally addicted to high wages.

Regulation

The history of federal securities regulation clearly reflects the philosophy that it is better to facilitate the market's ability to control the greed through disclosure than to empower the government to impose political criteria that define the difference between acceptable and exorbitant compensation.

We are inclined to go along with the disclosure strategy, except that financial statements prepared in accordance with generally accepted accounting principles have proven to be terribly inadequate for revealing the amount of the compensation, with the ultimate consequence that the free market is left groping in the dark.

What is needed, perhaps, is a bank of floodlights that expose the truth for all to see.

In late July, the Securities and Exchange Commission published a rules proposal,

"Executive Compensation and Related-Party Transactions" (www.sec.gov/rules/proposed/33-8655.pdf) in an effort to respond to growing unrest about both the exorbitant amounts and the apparent impunity of those who set up their compensation plans.

This 370-page document goes into many topics, but we were drawn to the perennial bone of contention: compensatory stock options.

Although the proposal goes to great lengths to describe new disclosures about options and their value, this effort would not be necessary if accepted practice for reporting this compensation was up to the crucial task given to it.

Bad accounting

In other words, we're confident that one reason for the prevalence of excessive compensation is the lack of a full and fair accounting for what was paid. Although many seem to think that SFAS 123R would clarify who got how much and when, the truth is simply not being put into the statements.

The omission of the full compensation cost from the income statement disables or at least diminishes the ability of financial reporting to fulfill its important role of providing a check against managers' seemingly irrepressible addiction to enriching themselves at shareholders' expense. That check is a critical ingredient for any effective system of corporate governance.

How does compensation paid to executives avoid showing up on the income statement? It's quite simple if the compensation is in the form of stock options. Until this year, most managers simply chose to not expense the options they received, after an embattled Financial Accounting Standards Board gave them that prerogative back in the early 1990s. It didn't take a prophet to anticipate that options would get completely out of hand when their economic value wasn't reported in the financials.

While executives no longer have the loophole of simply not expensing options, FASB injudiciously provided another loophole that hides the total cost of option-based compensation. This happened because the board focused all its political energy on merely valuing options at the grant date, while paying no attention to what happens afterwards. It is afterwards, of course, that all the action occurs and the really big bucks can pile up.

Under the grant-date model, options that get exercised produce an expense equal only to their value on the day that they're awarded. Of course, at the time that the options are granted, they aren't worth much because they're so speculative. If stock prices rise, the executives reap the benefits and the shareholders bear the cost, but the GAAP income statement never moves beyond the initial state of ignorance. We can be sure that the result is a gross understatement of reported compensation.

Is it just a game?

Beyond this glaring weakness, SFAS 123R's grant-date fixation also enables managers to indulge their addiction by playing games, such as backdating and spring-loading, both of which select a grant date with a stock price lower than the one in place when the options are actually authorized.

In addition, accounting mayhem follows when management fiddles with the value estimation parameters. For example, biasing the volatility index can lower the estimated option value and reduce the reported compensation expense without diminishing the real amount.

These devious behaviors would accomplish nothing if options were accounted for as derivative liabilities and marked to market from the grant date until the end of their lives. Under this complete model, reported compensation would grow dramatically when the stock rises, and fully reflect all lofty payouts.

We believe that a deep-down fear of negative publicity motivates much of the corporate opposition to market value accounting in general, and for stock options in particular.

Stated simply, we place much responsibility for the compensation explosion squarely at FASB's feet. Our claim is confirmed by disclosures of executive pay packages. In a recent Business Week interview, Bob Nardelli, chief executive officer of Home Depot, said this about his own pay package (earned despite a 30 percent decline in the stock price): "First of all, let me say that of the $245 million reported, over 80 percent of that is tied directly to equity that is still held by the company, and of the 80 percent of equity, 60 percent is related to stock options."

Those who claim that Nardelli needs $120 million of options to focus his attention on increasing the stock price are missing two points: Why didn't it work, and wouldn't some smaller amount have accomplished the same bad result?

How much is too much?

We find immense irony in the fact that stock options have created so much wealth for executives that they won't ever be able to spend it. If so, the shareholders have to wonder what they have to do to get managers to pay any attention to their work. How can you possibly motivate someone with additional wealth when they already have more than they can ever use? It makes more sense to replace them with someone who's hungry!

We find it puzzling that more and more executives are making plans to give away some of this vast wealth. Apparently they see themselves as some sort of Robin Hoods, taking money from shareholders to support their own pet causes. As quoted in the same Business Week mentioned earlier, Oracle CEO Larry Ellison pathetically lamented to reporters who were guests on his 452-foot yacht: "You can't spend it even if you try. I've been trying."

He went on condescendingly to describe vague plans to eventually give "almost everything" away to charity. We think it would make sense for Ellison to stop taking any more compensation and pay a dividend to the shareholders, so they could decide how to donate their money, instead of giving it to him!

Besides that, with all the time and effort it must take to manage and flaunt his own incredible wealth, Oracle shareholders ought to be wondering how much time Ellison actually devotes to managing the business.

(We can't leave this topic without applauding Warren Buffett for (a) not ever taking an option, (b) holding onto his stock for decades, * living modestly, (d) taking down only $100,000 of salary, and (e) delegating the task of managing his charitable contributions to someone else. We can't help laughing at the contrast between his humility and the money-grubbing greed of virtually all other CEOs.)

Can it be fixed?

We're pleased that the commission has tackled the compensation problem, although we're skeptical that disclosures will pry managers' avaricious fingers from their imperial scepters and suddenly produce correlations between effort and reward.

Without doubt, improved disclosures would have a better chance of changing things if option accounting were to be improved simultaneously. Even then, we don't know whether it would be enough, because the addiction to excessive compensation is very well established.

Hope for a cure is a pipe dream unless and until the financial statements openly declare this dysfunctional behavior for all to see.

Paul B. W. Miller is a professor at the University of Colorado at Colorado Springs and Paul R. Bahnson is a professor at Boise State University. The authors' views are not necessarily those of their institutions. Reach them at paulandpaul@qfr.biz.

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