I have often started a class discussion with the following series of statements:
- We learned in Finance 101 that the value of a business is the present value of expected future distributions of cash to owners.
- Financial statements are the result of some guy with green eyeshades putting a debit in one account, and a credit in another.
- Cash available to pay owners is not affected by accounting entries.
- Therefore, accounting shouldn’t matter, right??
But accounting really does matter. Why? To cite just a couple of examples, executives would not have received so many stock options as compensation if it weren’t for the favorable treatment of stock options under APB 25; companies negotiate special deals with customers at the end of each quarter in order to be able to recognize revenue by the end of the period. Executives never adequately explain to shareholders those questionable decisions that merely lead to a cosmetic accounting result. That’s because the purpose of those decisions is to benefit the executives themselves, at the expense of shareholders. I conclude the class discussion by observing what should now be obvious: accounting rules should not make it easy for executives to reward themselves excessively at the expense of shareholders.
Now, finally, there is some explaining executives must do–the basis of their own compensation. For years, disclosure rules have made it too easy for executives to reward themselves excessively. There is no disputing that too many executive compensation decisions were motivated by inventing new ways to pay themselves without reporting the payment in proxy statements. The result for many companies has been rubber-stamped patchwork quilts of hidden payments passing for executive compensation packages. Here is a few of the more popular tricks:
- Bonus payments triggered by performance targets as easy to hit as the ocean with a beach ball.
- Multiple years of service credited in pension payment formulas for only one year of service.
- Perquisites ranging from family use of corporate jets to full-time chefs and servants.
- Undisclosed termination payments and golden parachutes.
- Engaging ‘independent’ compensation consultants to rig ‘benchmarking’ studies that were little more than cherry picking from executives packages at other companies that are already too rich.
Now comes the explaining for these abuses, because the SEC passed sweeping changes to its executive compensation disclosure rules that expand disclosures of who is getting paid, what is the form of payment, and most importantly, why particular forms of compensation were chosen.
The first wave of disclosure hit the EDGAR database during the past proxy season, and there have been a number of reports in the financial press (see, in particular, the feature articles by Eric Dash in the New York Times) of newly disclosed questionable compensation policies as well as examples of likely (I’m being kind here) non-compliance with the new disclosure regime.
The SEC staff has recently announced that its own reviews of executive compensation disclosures in proxy statements are well under way. However, consistent with their earlier promises to not skewer specific companies on their first go ’round, no comment letters have been issued–except for those disclosures contained in registration statements (i.e., prospectuses used for capital-raising transactions).
As one might expect, the SEC staff reports that there have been ‘numerous’ instances where CD&A (Compenation Discussion and Analysis–a new disclosure requirement focusing on the ‘why’ of executive compensation) could have provided a better analysis of compensation decisions. Whaddya know. I fully expect that a lot of the disclosure deficiencies are related to having to explain compensation decisions that defy explanation–the only plausible explanation being that they were specifically designed to avoid disclosure. I expect my point to be proven next year, when we see that companies will be taking the extra year they have been given by the SEC’s moratorium on comment letters to further simplify their executive compensation packages–so as not to be forced by the staff to explain that which defies explanation.
The SEC staff is also indicating that a common deficiency is insufficient disclosures of ‘benchmarking,’ when it is cited as a basis for determining compensation; the companies used for benchmarking must be named. Also, the issue of performance targets, another new disclosure, is a focus: whether targets are disclosed with sufficient specificity, omission of a target is legitimate(pursuant to a ‘competitive harm’ standard) , and probability of target attainment is disclosed if the target is omitted. The SEC is considering whether to issue guidance addressing the results of their compliance rules; I also expect this to happen.
The revamping of the SEC’s executive compensation disclosure rules may be the most significant financial reporting development of the past few years–not just for what the disclosures should reveal, but also for how the rules will change behavior. In other words, financial reporting and accounting do matter. As former Supreme Court justice Louis Brandeis wrote (years prior to the enactment of the federal securities laws), "Sunlight is said to be the best of disinfectants; electric light the most efficient policeman."
Here’s hoping the SEC will turn up the watts.