Better Carrots?

Big changes are under way in long-term incentive compensation, a new survey finds. But they may not be big enough.

Expecting a revolution in long-term incentive pay? Don’t hold your breath.

Change, to be sure, is occurring. And more is inevitable, if the Financial Accounting Standards Board finally succeeds in requiring the expensing of at least some employee stock options, as a rule it has proposed would do beginning in 2005. Although they agree on little else, advocates and opponents of expensing do agree on one thing: if companies have to expense options, most will use fewer of them. In fact, companies have already curtailed their use of options, partly because boards are anticipating the new rule and partly because the recent stock-market slump made options far less attractive to managers.

Expensing should also prompt companies to look seriously at ways to link long-term incentives to performance goals. Companies currently have to expense performance shares, since the exemption applies only to options whose exercise price and quantity are fixed on the grant date. Require the expensing of all compensation, though, and boards will no longer have an accounting reason to dismiss options with a performance component. Expecting that the expensing rule will take effect next year, a number of companies have already started using performance-based options.

A survey by CFO magazine of 131 companies suggests that these changes will accelerate if FASB gets its way. This is good news for those who think that options contributed to the excesses of the 1990s. But there are reasons to doubt that expensing of options will magically produce better alignment between executive pay and shareholder wealth. That is because the basic governance problems that allowed compensation committees to dole out questionable incentives to managers still exist. Unless boards show true independence, there’s a good chance that top managers will continue to receive pay that isn’t tightly hitched to performance, and that shareholders will once again be left paying the consequences.

The Trouble with Options

When stock options first took off in the early 1990s, many investors greeted them as the answer to a long-standing problem: how to make managers act like owners without rewarding them even if they botched the job. Compensation committees embraced options for another reason: granting them incurred no charge to earnings.

But fixed-price options created perverse incentives. Because there are no restrictions on when an executive can unload options upon vesting, they invite steps to fuel a short-term rise in stock price, even if the decision doesn’t make long-term sense. CFO found that 23 percent of finance executives at public companies think stock options have led to such actions at their companies.

A number of academic studies have established a link between options and earnings manipulation. One new paper, by Jap Efendi, Anup Srivastava, and Edward P. Swanson of Texas A&M University, shows that the likelihood of an accounting restatement is higher at companies where CEOs have large holdings of in-the-money options. The study also found that these CEOs realized more cash from their options in the two years preceding a restatement than did their counterparts in other firms.

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