Amsterdam Business School
The effects of the financial crisis, CEO ownership and
non-financial performance measures on abnormal CEO compensation
Name: Wouter Beijer Student number: 1029410 Date: 18-1-2014
Supervisor: ir. drs. A.C.M. de Bakker Wordcount: 15.425
MSc Accountancy & Control, specialization Accountancy Faculty of Economics and Business, University of Amsterdam
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Statement of originality
This document is written by student Wouter Beijer who declares to take full responsibility for the contents of this document. I declare that the text and the work presented in this document is original and that no sources other than those mentioned in the text and its references have been used in creating it. The Faculty of Economics and Business is responsible solely for the supervision of completion of the work, not for the contents.
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This master thesis researches what the effects of the financial crisis, CEO ownership and the presence of non-financial performance measures in the annual bonus contract of the CEO are on abnormal CEO compensation. The research is produced on S&P 500 firms during the period 2006-2012 excluding the industries services, finance, insurance and real-estate. We have defined three research periods, pre-financial crisis (2006-2007), financial crisis (2008-2009) and post-financial crisis (2010-2012). We have determined abnormal CEO compensation with the model of Agrawal & Walkling (1994) for this research which is our dependent variable and is tested with three independent variables, namely the financial crisis, CEO ownership and the presence of non-financial performance measures in the CEOs annual bonus contracts. For each regression analysis control variables were included. The research shows that abnormal CEO compensation does not have a significant negative relation during the financial crisis in relation to the other two defined periods. Also no significant positive relation was identified between abnormal CEO compensation and CEO ownership. Furthermore, no significant positive relation was found between abnormal CEO compensation and the presence of non-financial performance measures during the financial crisis. The conclusion of this research is that the effects of the financial crisis, CEO ownership and the presence of non-financial performance measures in the CEOs annual bonus contracts on abnormal CEO compensation are not significant.
Key words: Abnormal CEO compensation; Financial crisis; CEO ownership; Non-financial performance measures; Volatility.
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Table of contents
1 Introduction ... 7
1.1 Background ... 7
1.2 Motivation ... 7
1.3 Contribution and research question ... 8
1.4 Research method ... 9 1.5 Report Structure ... 9 2 Theoretical Framework ... 10 2.1 Theoretical outline ... 10 2.2 Explanatory Theories... 11 2.2.1 Agency Theory ... 11 2.2.2 Informativeness theory ... 12
2.2.3 Managerial power theory ... 13
2.3 Relevant aspects ... 14
2.3.1 CEO compensation ... 14
2.3.2 CEO Risk taking, Incentives and CEO compensation structure ... 15
2.3.3 Financial performance measures ... 16
2.3.4 Non-financial performance measures ... 17
2.3.5 The weight of performance measures in CEO bonus contracts ... 18
2.3.6 Financial crisis ... 19
3 Hypotheses development ... 22
3.1 Hypotheses & Research model ... 22
3.2 Expectations ... 23
3.2.1 Financial Crisis ... 23
3.2.2 CEO Ownership ... 24
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4 Data & Measures ... 26
4.1 Research model and variables... 26
4.1.1 Abnormal CEO compensation ... 26
4.1.2 Financial Crisis ... 28
4.1.3 CEO Ownership ... 28
4.1.4 The presence of Non-Financial Performance Measures ... 29
4.2 Data sources ... 29
4.3 Sample Selection ... 31
4.3.1 Data Gathering ... 31
5 Results... 37
5.1 Determining Abnormal CEO compensation ... 37
5.2 Descriptive statistics ... 38
5.2.1 Core figures ... 38
5.2.2 Correlation matrix ... 40
5.2.3 Multicollinearity ... 41
5.3 Hypotheses testing ... 42
5.3.1 Test results hypothesis 1 ... 42
5.3.2 Test results hypothesis 2 ... 44
5.3.3 Test results hypothesis 3 ... 45
6 Conclusions and recommendations ... 47
6.1 Conclusion... 47
6.2 Limitations... 48
6.3 Suggestions for further research ... 49
Bibliography ... 51
Appendix 1, market value of equity per industry. (*1,000 $) ... 54
Appendix 2, observed firms hypotheses 1 and 2 ... 55
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1 Introduction
1.1 Background
CEOs are typically evaluated based on financial and non-financial performance measures. On average, financial performance measures are still the most important measures in CEO bonus contracts (Ittner, Larcker, & Rajan, 1997). Evaluating the performance of a CEO during an economic crisis by means of financial performance measures, however, is hampered because economy-wide factors largely influence these financial performance indicators. Non-financial performance measures such as customer satisfaction, on the other hand, are more firm-specific and less subject to changes in the macro-economic environment. As a result, it can be expected that non-financial performance measures provide a more accurate assessment of CEO-performance during an economic crisis. Firms are increasingly implementing non-financial performance measures into their CEO bonus contracts. Placing relative weight on non-financial performance measures such as customer and employee satisfaction, quality, market share, productivity, and innovation, increases returns on assets and market returns according to the research of Said, Elnaby, & Wier (2003).
1.2 Motivation
This research is mainly motivated by two aspects, first there is a lack of recent research on the use of non-financial performance measures and second is the financial crisis. The main research on the use of performance measures was conducted by Ittner, Larcker & Rajan (1997) and Davilla & Venkatachalam (2004). After these studies on the main drivers on the use of non-financial performance measures little research has been done on this subject. Secondly the Declaration of bankruptcy of Lehman Brothers (15 September 2008) was the beginning of a global phase of panic and considerable shrinkage of economic activity (Cordemans & Ide, 2012). As researched by Stock (2012) the economic crisis created financial shocks which are based on the macroeconomic dynamics of the 2007-09 recession in the United States. These financial shocks during the financial crisis created noise in financial performance measures. This because financial performance measures are often based on accounting (summary) measures. Fair value accounting, legislated by IFRS and US GAAP, had company’s assets to be valuated at the amount of expected future returns on those assets. During the financial crisis, a great amount of these assets had to be devaluated and these negative results had to be taken through profit and loss or in equity. These devaluations dramatically impacted the accounting & equity measures upon which the CEO bonuses were based (Laux & Leuz, 2009). Considering this knowledge and
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the lack of recent research it is interesting to analyze the use of non-financial performance measures and abnormal CEO compensation1 during the financial crisis.
1.3 Contribution and research question
The contribution of this research goes two ways. First it will provide empirical evidence on abnormal CEO compensation before, during and after the financial crisis. Secondly it will provide evidence on explanatory factors which influence the abnormal CEO compensation for the period 2006 till 2012. The factors we investigated are the financial crisis (a worldwide macroeconomic event), CEO Ownership and the performance measures used in the CEO’s
annual bonus contracts for S&P 500 firms. The main research question for this research is:
What are the effects of the financial crisis, CEO ownership and non-financial performance measures on abnormal CEO compensation?
As can be determined from the above stated research question it contains four subjects which are, abnormal CEO compensation, financial crisis, CEO Ownership and non-financial performance measures. Abnormal CEO compensation is the amount of compensation received by the CEO in a certain period which deviates from the expected compensation. The abnormal compensation component will be estimated by the model of Agrawal & Walkling (1994). The financial crisis is a large event with many influences on business & financial economics. Since it will be too extensive to assess all influences of the financial crisis individually, we will only analyze the abnormal compensation during crisis and non-crisis periods to find a relation between the two variables. Further on we will try to determine if powerful CEOs gain more compensation or have higher abnormal compensation then less powerful CEOs. The reason to include this factor in this research is to determine if powerful CEO’s can influence their compensation during times of economic downfall. For the last subject non-financial performance measures we will try to explain the question if non-financial performance measures explain abnormal CEO compensation in a volatile market. Some of the leading economic scientists have performed research on the determinants of including non-financial performance measures in CEO bonus contracts during the period 1997-2004. Ittner, Larcker & Rajan (1997) has shown that that noise (volatility) in financial performance measures stimulates the use of
1 Abnormal CEO compensation is the part of compensation received by the CEO for a certain period which is not explained by the model used in this research and designed by Agrawal & Walkling (1994). This variable is estimated by this model described in chapter four and will be used to identify anomalies in the compensation of CEOs.
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non-financial performance measures in CEO bonus contracts. Davilla & Venkatachalam (2004) found similar results in the airline industry. It is therefore interesting to investigate if firms during a volatile market with high abnormal CEO compensation have non-financial performance measures included in their CEO’s compensation plan.
1.4 Research method
To answer the research question, quantitative research will be conducted by determining abnormal CEO compensation in a pre-crisis, crisis and post-crisis period using the CompuStat and ExecuComp databases. After determining the abnormal CEO compensation this sample will be analyzed by gathering data from the proxy statements2 available in the Lexis/Nexis databases. The companies in the population are the S&P 500 for the years 2006-2012. All Data will imported in SPSS and statistical analysis is conducted by regression and correlation analytics.
1.5 Report Structure
In chapter two the theoretical framework is described covering all relevant theories and aspects of the research questions. In chapter three the hypothesis will be developed based on the theoretical framework and underlying expectations. In chapter four will be described how these hypothesis will be tested. Finally in chapter five the test results will be discussed and chapter 6 will include the concluding analytics of results and recommendations for future reference. The report is ending with a bibliography and the appendices.
2 Proxy statements: A document containing the information that a company is required by the SEC to provide to shareholders so they can make informed decisions about matters that will be brought up at an annual stockholder meeting. Issues covered in a proxy statement can include proposals for new additions to the board of directors, information on directors' salaries, information on bonus and options plans for directors, and any declarations made by company management.
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2 Theoretical Framework
In this chapter the background and theoretical framework of the research is discussed. Started with a theoretical outline of the main topics and relevant theoretical concepts. After that the main aspects of the research question and a description used are theoretically assessed for their content and validity to be used in this research.
2.1 Theoretical outline
Most firms use short-term or annual bonus plans in their executive compensation programs3 to provide incentives for CEO’s to act in the best interest of the shareholders of the firm (Ittner, Larcker, & Rajan, 1997). Performance measures are incorporated into these bonus plans to measure the performance of the CEO. These performance measures are based on financial and non-financial metrics to assess and reward the performance of the CEO over a certain period. Traditionally the emphasis of these performance measures lies with financial performance measures since they are perceived to be a reflection of the financial performance of the firm. Nowadays firms are increasingly using non-financial performance measures on their CEO bonus plans to provide the CEO’s with other incentives to increase firm value. The discussion on the use of performance measures is mostly based on well-researched agency conflict (Jensen & Meckling, 1976) (Eisenhard, 1989) and the informativeness hypothesis which suggests that financial measures alone may not provide the most efficient means to motivate managers to act in the best interest of the firm (Banker & Datar, 1989) (Feltham & Xie, 1994) (Hölmstrom, 1979).
This study is focused on abnormal compensation for CEO’s which we will try to explain by the performance measures used in CEO bonus contracts. Additionally we will investigate how the financial crisis influences the Abnormal CEO compensation. To do this we will have to know the determinants for incorporating non-financial performance measures into CEO bonus contracts and the different aspects of the financial crisis on CEO compensation and these performance measures. Secondly we will need to understand which factors are the determinants of the normal part of CEO compensation to determine the abnormal or excessive part of CEO compensation. Regarding CEO pay, only the salary and the cash bonus aspect will be considered since stock returns and other income gained from equity investments are not directly related to
3 The analysis in this paper only considers the choice of performance measures in for the annual bonus plan, and not whether it is optimal to include annual bonus plans in compensation packages.
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CEO’s performance but to the firm’s performance. Besides this it is considered that if we want to measure if the CEO has an influence on its compensation package and or if powerful CEOs gain more cash compensation we will have to remove any disruptive factors from the research model. Another factor considered is that equity based compensation contains has too many influences which cannot be accurately analyzed for this master thesis. Therefore it is considered sufficient to focus on cash compensation only to be able to reach plausible conclusions.
Further on this study is focused on a set of S&P 500 firms which includes 500 leading companies and captures approximately 80% coverage of available market capitalization. The S&P 500 have been chosen since under SEC legislation these companies are obligated to file their annual proxy statements which are needed to determine the performance measures used in the CEO compensation schemes. All the aspects regarding CEO compensation, performance measures, the financial crisis and relevant theories will be discussed in the following paragraphs.
2.2 Explanatory Theories
In the following paragraph we will describe some relevant theories and articles to outline the main issues in conducting the research. These theories are the agency theory, the informativeness theory and the managerial power theory. These three perspectives gives us some relevant angles to examine the results we have described in chapter five.
2.2.1 Agency Theory
As a starting point for the theoretical framework to the agency theory or the theory of ownership structure of the firm created by (Jensen & Meckling, 1976) is used. In this paper elements from the theory of agency theory of property rights and the theory of finance are used to develop the theory of ownership structure of the firm. The agency theory explains the relationship (contract) when one or more persons (the principal(s)) engage another person (the agent) to perform services on their behalf which involves delegation of decision right to this agent. The main problem “the agency problem” is that the agent will not always act in the best interest of the principal(s) since he wants to maximize his own utility. In the case of a publicly held firm the shareholders delegate decision rights to the CEO to create and increase firm value. To align the interests of the shareholders and the CEO, the shareholders create incentives for the CEO to act in the best interest of the shareholders. These incentives are typically bonuses granted in the form of cash or equity grants which are agreed in CEO bonus contracts. The variety of incentives and their goals are further discussed in paragraph 2.3.
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The validity of using the agency theory in this particular setting has been illustrated by (Eisenhard, 1989). She argues that the agency theory offers insight into information systems, outcome uncertainty, incentives and risks and is an empirically valid perspective, especially when used with related perspectives on the organizational structure. By conducting a review on several agency theory studies she showed the validity of this theory and therefore it is able to use this theory in this study of the principal-agent issue to measure the performance of CEOs and provide accurate incentives. Some researchers, for example Barkema & Gomez-Mejia (1998) argued that it would be more interesting to use different theoretical perspectives like the stakeholder theory when conducting research on incentives and compensation. However, since the agency theory is proven to be a valid perspective when researching compensation policies, this perspective is maintained in conducting this research on the expected change in the relative weight placed on non-financial performance measures in CEO bonus contracts as result of the financial crisis.
2.2.2 Informativeness theory
Multiple signals are commonly available for evaluating managerial performance (Banker & Datar, 1989). These signals such as profit numbers, market share price and customer satisfaction provide information about the managers performance. These information providing signals are necessary to address the agency problem of information asymmetry between the principal and the agent. When incorporating the signals as performance measures in compensation plans, incentives can be provided to the agent so that they act in the way the principal desires. A critical implementation issue that arises when incorporating multiple performance measures in compensation plans is determining the relative weights to place on the various measures when determining bonuses. Much academic research has been conducted on the determinants of performance measures in these compensation plans. Agency theory predicts that a particular performance measure will be included in a portfolio of performance measures if and only if it has information content about a manager's actions over and above other measures in the portfolio (see, for example, Holmstrom, 1979). Further academic research shows that both financial metrics and non-financial metrics provide information on the performance of CEO’s. Besides this, it is suggested that incorporating non-financial metrics in compensation plans, gives the CEO incentives to act in the best interest of the firm and that these metrics have information content on the performance of the CEO (Ittner et al, 2003; Bushman et al, 1996 Davilla et al, 2004; Feltham et al, 1994). Based on the knowledge that non-financial performance measures provide information content about the CEO’s performance and actions it is interesting to conduct research on the use of these measures during the financial crisis. Since the financial crisis
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obligated CEO’s to take actions concerning the going concern and financial performance of the firm.
2.2.3 Managerial power theory
In addition to the agency and the informativeness theory the institutional theory called managerial power explains internal compensation schemes. Lambert, Larcker & Weigelt (1993) define the managerial power theory as the ability of managers to influence the remuneration decisions made by the Board of Directors. In general, the higher in the hierarchy, the more power they have. Bebchuk, Fried & Walker (2002) state in addition that the power of the executives mainly depends on the ownership structure of the company. In their paper they give an example of the dominant position of the CEO in combination with the ownership structure of the company. The more power the CEO has, the more he will be able to affect its own compensation/bonus. This also has to do with the securities held by the CEO, the more shares, the more power the CEO has in the composition of the Board. Ferri & Maber, (2013) and Ertimur, Ferri & Muslu, (2011) included CEO ownership as the percentage of total shares held by the CEO to determine if this was related with excessive CEO pay. In both studies it is shown that higher CEO ownership is positively related to excessive CEO pay. There are other factors which influence the power of the CEO but since these factors will not be included in the research design no further information on these factors are provided in this research. The measure that will be included in the research design to measure CEO Power is CEO ownership measured as the number of shares held by the CEO offset to the total amount of shares.
With respect to the performance measures in the annual bonus contracts, the research of Ittner, Larcker & Rajan (1997) indicates that non-financial performance measures provide a mechanism for increasing the level of CEO compensation. This indication is based on the fact that non-financial performance measures are potentially more prone to manipulation by the CEO and are rarely subject to public verification. Non-financial measures such as internal customer satisfaction survey results, employee satisfaction, workforce diversity or efficiency and productivity figures are easily manipulated and for example are not audited by the external auditor. Eccles & Mavrinac (1995), for example, find that many investors and market analysts believe that reported non-financial performance measures may be biased and their computation may change over time. Although the research of Ittner et al. (1997) showed that CEO power is not a significant determinant of non-financial performance measures, we will still want to determine if powerful CEOs are related with higher abnormal CEO compensation. In our research we have not come across any studies which have analyzed the relation between these
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two variables. Therefore we concluded it relevant and interesting to see if these two variables are related and how they react during the financial crisis.
2.3 Relevant aspects
2.3.1 CEO compensation
Recent research of Murphy (2012) has documented the current state of executive compensation and showed the level and current state of CEO pay over the past century. In his study he has given a body of facts to guide future theoretical and empirical research on executive compensation. The research is mostly focused on the level of CEO compensation and in which way in which period this compensation is given. To determine abnormal compensation we will first need to determine how total executive compensation and normal executive compensation are determined.
According to Murphy (2012) executives receive compensation in a dizzying array of forms, including base salaries, annual bonuses, long-term incentives, restricted stock, performance shares (i.e., restricted stock with performance-based vesting), stock options, retirement benefits, and perquisites ranging from health benefits to club memberships and personal use of the corporate jet. Many of these forms of compensation depend on performance measured over a single or multiple years, and it is not obvious how (or when) to measure them. For example, stock options (which give the executive the right, but not the obligation, to buy a share of stock at a predetermined price) typically have terms of up to ten years. This raises the question should stock options be “counted” as compensation when granted, or only when exercised? Concluding, CEO total compensation is complex to determine for a certain period of fiscal year.
Avoiding that the determination of abnormal compensation will become too complex in this research, only the base salary and annual cash bonus will be included in determining abnormal compensation. According to Agrawal & Walkling (1994) the base salary and cash bonus are also applicable to the industry peers of the firm. Besides this the salary and the annual bonus component are directly related to the appliccapble performance meausures included in the proxy statement for that specific year. Therfore in this research only the base salary and annual cash bonus will be included in determining abnormal compensation, controlling for industry tendencies. Other studies, for example Ertimur, Ferri, & Muslu (2011), did include all the annual grants of the CEO in determining total compensation. Since their study was focused if total compensation is influenced by shareholder activism and not on the performance measures
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included in the proxy statements for that exact year, it was possible to use this meausure. For this study including als these items will bring many complications in comparing data, and therfore only the base salary and annual cash bonus are used in this study. This choice is supported by Murphy (2012) who states that most bonus plans are settled in cash soon after the results are tallied (e.g., after the year-end audited financials). The immediacy and tangibility of these cash awards may well provide stronger incentives than the distant and uncertain paper gains in unvested equity plans.
2.3.2 CEO Risk taking, Incentives and CEO compensation structure
The differences in the preferences of shareholders and CEO’s regarding risk taking creates a moral hazard in the perception of the agency theory (Jensen & Meckling, 1976). Moral hazard is a situation where the CEO behaves without keeping the negative aspects of its actions under consideration. That is because the CEO does not have to bear any consequences on the actions taken. To mitigate this moral hazard incentives are provided to the CEO by the shareholders in the form of fixed and variable compensation. Coles, Navveen & Navveen (2006) provided empirical evidence of a strong causal relation between managerial compensation and investment policy, debt policy and firm risk. This is to be interpreted as when CEOs receive more compensation on forward-looking performance measures they tend to be more risk adverse in their decision making concerning investment policy, debt policy and firm risk. Concluding that incentives provide positive stimulants to CEOs to align their interests with those of the shareholders.
To assure that the incentives provided by the shareholders don’t have the opposite effect, the compensation structure in the CEO bonus contract needs to be thoroughly determined. Mehran (1995) suggests that the form rather than the level of compensation is what motivates managers to increase firm value. In his research he finds that firm performance is positively related to the relative amount of equity held by managers and to relative weight of their compensation that is equity-based. Murphy (2012) describes the developments in CEO compensation during a period from 1992-2011 in S&P 500 Firms. This research shows that during the years the compensation structure of CEOs drastically changed. The most recent significant changes are between 2001 and 2008 when stock options become largely replaced by restricted stock and between 2006 and 2009 when total compensation decreases significantly. After 2009 the total compensation amount increases to its former level of 2006 which could indicate a change in either performance measures used for compensation or an increase in financial performance of the firm. Besides that the research of Murphy shows that shareholders
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are always, by means of other sets of incentives, searching for instruments to align the interests of the CEO to the value of the firm.
This study will try to answer the question if abnormal CEO compensation before, during and after the financial crisis changes and if this is related to the use of several forms of performance measures in CEO bonus contracts. Hereby the following subjects are discussed; financial performance measures 2.3.3, non-financial performance measures 2.3.4, the relative weight of these measures in CEO bonus contracts 2.3.5 and the different influences of the financial crisis 2.3.6. In these paragraphs the questions, how and based on which performance metrics do we measure the performance of CEOs, to provide incentives which align the interest of the CEO with the Shareholders and mitigate the moral hazard of the CEO are theoretically assessed.
2.3.3 Financial performance measures
Firms have traditionally measured and rewarded CEO performance based financial performance metrics upon which the CEO compensation is based (Ittner, Larcker, & Rajan, 1997). Each financial performance measure has other information content, but they all focus on the financial outcomes of the CEO’s actions. In the research of Bacidore, Boquist, Milbourn & Thakor (1997) several financial performance measures are assessed and they argued that financial performance measures have information content regarding the shareholder value of the firm and therefore provide information about the actions taken by the CEO and their financial outcomes.
Financial performance measures can be divided into two main types, namely 1) market measures and 2) accounting measures. 1) Market measures are based on the stock price of the firm which under the efficient market theory should reflect all future cash flows and future risks which are incorporated in the discount factor. These market measures represent forward looking measures which incorporate anticipated effects of current actions taken by the CEO and may reward them for anticipated rather than realized performance. The positive side of these market measures is that they are very congruent4 with the objective of the shareholders namely increasing firm value. On the down side these measures are relatively noisy because there is a strong impact on the market measures by external factors. 2) Accounting measures are based on figures in the financial statements like ROA, ROI, ROE and EBIDTA. These performance measures are deemed backward looking since they reflect results of economic decisions made in
4 As an abstract term, congruence means similarity between objects or in terms of management accounting it means that performance measures are highly related with the objectives of the firm. As an example when a firm wants to reach higher markets shares and the performance of the CEO is measured based on the relative growth in market share per year.
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the past. These measures are less susceptible to noise since they are based on internally based figures but are less congruent with firm value. The financial crisis of 2008 and 2009 created noise in market measures and accounting measures as result of impairment of assets and dropping stock prices and interest rates. So when the performance of CEOs is measured by market or accounting measures this phenomena noise created by the financial crisis influences CEO’s compensation. The influence of financial crisis distorts the information content of the financial performance measure on the actual performance of the CEO. Thus it is expected when the performance measures used are less susceptible by noise, the influence on the CEO pay is lower and the abnormal CEO pay calculated would be higher compared to industry peer firms. Concluding we want to analyze if there is an indication that higher abnormal CEO compensation is related to the use of non-financial performance measures in CEO contracts.
2.3.4 Non-financial performance measures
In an article on Oct. 16, 2000, in the Financial Times’ Mastering Management series, Wharton accounting Professors Christopher Ittner and David Larcker suggest that financial data have limitations as a measure of company performance. This article describes the advantages and disadvantages of non-financial performance measures. According to this article there are four main advantages of non-financial performance measures over financial performance measures. First of these is a closer link to long-term organizational strategies. Second, critics of traditional measures argue that drivers of success in many industries are “intangible assets” such as intellectual capital and customer loyalty, rather than the “hard assets” allowed on to balance sheets. Although it is difficult to quantify intangible assets in financial terms, non-financial data can provide indirect, quantitative indicators of a firm’s intangible assets. Third, non-financial measures can be better indicators of future financial performance since for example: research and development expenditures and marketing costs must be charged for in the period they are incurred, so reducing profits. But successful research improves future profits if it can be brought to market. Finally, because many non-financial measures are less susceptible to external noise than accounting measures, their use may improve managers’ performance by providing more precise evaluation of their actions. This also lowers the risk imposed on managers when determining pay. Besides these advantages, in the article are five primary limitations described which are related to high costs, time consuming activities, a lack of common denominators, causal links and statistical reliability. These advantages and disadvantages are taken into consideration in conducting the analysis of the results.
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Previous research of Ittner, Larcker & Rajan(1997) suggest that the use of non-financial performance measures is motivated by two explanations. First they provide information about managerial actions which are not captured by financial measures. Secondly non-financial performance measures enable CEOs to inflate their compensation, given that they are relatively manipulable and rarely subject to public verification. In the study of Ittner & Larcker(1998) modest support is found that customer satisfaction measures are leading indicators of customer purchase behavior, growth in the number of customers, and accounting performance. Or in other words, the non-financial performance measures provide information content about the manager’s actions to increase firm value. And Sliwka(2002) finds that non-financial performance measures are important to measure actions taken by the manager related to the corporate strategy which are not captured by financial performance measures. In the research of Ittner, Larcker & Rajan(1997) they also find that the relative weight placed on non-financial measures increases with the level of regulation, the extent to which the firm follows an innovation-oriented strategy, the adoption of strategic quality initiatives, and the noise in financial measures. Davilla & Venkatachalam(2004) show that noise in financial metrics influences the relation between non-financial performance measures and cash compensation in the airline industry. Since the financial crisis as described further on, created noise and volatility on the stock market and in accounting measures. It can be expected that the total CEO compensation is higher in a financial crisis year when non-financial performance are included in the annual bonus contract of the CEO. If CEOs are aware of the consequences of the financial crisis on the financial performance measures the can also convince the Board to be appraised based on non-financial performance measures.
2.3.5 The weight of performance measures in CEO bonus contracts
Previous theoretical research on performance measures and performance evaluation using multiple signals in different agency settings (e.g., Holmstrom 1979; Banker and Datar 1989; Feltham and Xie 1994), shows that financial performance measures alone will not always provide the most efficient ways align the interests of shareholders and CEO’s. In theory, the bonus contract should place a non-zero weight on any performance measure that gives information about the performance of the CEO on those actions of the CEO that the shareholders wishes to motivate to align the interest of the CEO with the firm’s objectives. The relative weight on these relevant performance measures should be related to the information content that performance measure has about the actions of the CEO. If in this manner non-financial performance measures give material information content about the CEO’s actions in reaching the objectives of the firm a material relative weight of the total performance measures should be based on the
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relevant non-financial performance measures. In particular, when changes in the actions taken by the CEO have a greater impact on realizing a non-financial performance measure instead of a financial performance measure, it is more efficient to place a greater relative weight on the non-financial performance measure in the annual bonus contract. Moreover. Feltham and Xie (1994, 447) show that, "Barring exceptional circumstances, a second-best incentive contract requires that the (stock) price be supplemented with other measures, even though those measures are impounded in the price." This result is based on the fact that performance measures related to determinants of the stock price (financial performance measures) is based on their implications for future cash flow instead of the informativeness about the actions taken by the CEO. This means, when non-financial performance measures provide information about the desired actions taken by the CEO, they should be included in the annual CEO bonus contract to provide incentives for the CEO to reach the objectives of the firm.
2.3.6 Financial crisis
The Declaration of bankruptcy of Lehman Brothers (15 September 2008) was the beginning of a global phase of panic and considerable shrinkage of economic activity (Cordemans & Ide, 2012). As from this point the interest rates of the Federal Reserve dropped from 5.1% at the beginning of 2008 to the bottom rate of 0.1% at the end of 2009. Also the inflation and the gross domestic product dropped significantly. After the bankruptcy of Lehman Brothers a number of major financial institutions failed, world trade collapsed, unemployment soared, and global output registered a dramatic decline (Gourinchas & Ayhan Kose, 2011). According to Stock(2012) the economic crisis created financial shocks which are based on the macroeconomic dynamics of the 2007-2009 recession in the United States. Based on this it can be expected that these financial shocks followed by drops in revenue, profit, and stock price affected the financial performance measures in CEO contracts. This expectation is also substantiated with the results of (Murphy, 2012) where he showed that financial crisis impacted the compensation of CEO’s in a negative way. Since traditionally CEO compensation is mainly based on financial performance measures (Ittner, Larcker, & Rajan, 1997), the drop in total compensation is positively related to these financial performance measures. Evaluating the performance of a CEO during an economic crisis by means of financial performance measures, however, is hampered because economy-wide factors largely influence these financial performance indicators. Furthermore, financial performance measures proved to be volatile during the financial crisis (Manda, 2010; Schwert, 2011) which makes such measures less useful for performance evaluation. Non-financial performance measures such as customer satisfaction, on the other hand, are more firm-specific and less subject to changes in the macro-economic environment. As a result, it can be expected
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that non-financial performance measures provide a more accurate assessment of CEO-performance during an economic crisis.
In previous research evidence is obtained that noise in financial performance measures as a result of volatility in the financial performance metrics and other effects are related with placing a greater weight on non-financial performance measures in bonus plans (Davilla & Venkatachalam, 2004) (Ittner, Larcker, & Rajan, 1997). These researches are based on the noise hypothesis developed by Banker & Datar (1989) and states that the relative weight placed on a performance measure is influenced by the noise inherent in that measure. In the research of Ittner, Fischer z-scores are calculated to create a proxy for noise and shows that the use of non-financial performance measures is positively influenced by noise in non-financial metrics. Davilla (2004) shows that stock return volatility as proxy for noise is positively related to the use of the non-financial measure passenger load factor in the airline industry. The financial crisis created a large amount of volatility on the financial market, which creates noise in financial metrics according to Schwert (2011) & Manda (2010). Refer to Figure 1, stock volatility index S&P 500 for an overview of stock volatillity during the financial crisis for S&P 500 firms. Here it is visible that the financial crisis created large volatility in the period 2008 – 2009. Since volatility creates noise in the financial performance measures it could be expected that abnormal CEO compensation during this period is strongly influenced. Theoretically it could also be that due to this phenomenon, CEOs with compensation based on non-financial performance measures will receive more compensation relative to their peers.
Figure 1, stock volatility index S&P 500 2006-2012, Source: Yahoo Finance
As described above the financial crisis created exogenous factors which create noise in financial performance measures. Exogenous factors are those external items or developments which influence the firm’s performance. Examples of these external factors are, changes in
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regulation, innovative new technologies, and changes in consumer taste and in this case a large scale depression followed by dropping stock market values, interest rates and asset values. These factors also influence the financial performance measures in such a way that it loses information content and precision about the actions taken by the CEO (Banker & Datar, 1989) and (Feltham & Xie, 1994). In theory, when a performance measure has more precision or less noise about the actions taken by the CEO the relative weight on such a performance measure should be higher than performance measures with lower precision or more noise. So when during the financial crisis noise increased in financial performance measures they lost precision and information content about the actions taken by the CEO. Since non-financial performance measures are less impacted by the accounting effects incurred during the financial crisis it is logical that a relative higher weight is placed on non-financial performance measures in CEO bonus contracts. Ittner Larcker & Rajan (1997) and Davilla & Venkatachalam (2004) discuss the choice of performance measures in these contracts. In their studies they found some evidence that as the noise in financial performance measures increases, firms tend to place more weight on non-financial performance measures in CEO bonus contracts.
During the financial crisis numerous firms reached a point of financial distress (Stock, 2012). The definition of a financially distressed firm according to (http://www.investopedia.com, n.d.) Is “a condition where a company cannot meet or has difficulty paying off its financial obligations to its creditors”. The chance of financial distress increases when a firm has high fixed costs, illiquid assets, or revenues that are sensitive to economic downturns. Gilson & Vetsuypens (1993) find that compensation policy is often an important part of a firm's overall strategy for dealing with financial distress. In such situations, CEO bonuses are often tied to short-term outcomes related to bringing the firm out of distress and successfully completing the restructuring. The ability to increase (short-run) cash flow, as well as other financial indicators of firm viability, is an important factor in the negotiations required to avoid the legal fees and other costs associated with financial restructuring or bankruptcy. Thus, short-term financial measures should provide more informative signals of the managerial actions desired by shareholders in these situations.
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3 Hypotheses development
In this chapter the hypothesis will be developed, based on the theoretical framework discussed in chapter two. The findings and expectations reached during the literature study are used to develop and formulate the research hypotheses.
3.1 Hypotheses & Research model
Based on the findings from the theoretical research we have created the following three hypotheses.
H1: Abnormal CEO compensation is negatively related to the financial crisis. H2: Abnormal CEO compensation is positively related to CEO ownership
H3: Abnormal CEO compensation is positively related to the presence of non-financial
performance measures in CEO bonus contracts
For these hypotheses we have created the following conceptual model to provide a schematic view of the research question and the sub questions. Refer to figure 3 for the conceptual model. As visible in figure 3 all aspects from the research question are captured by the conceptual model. The research question of the thesis is:
What are the effects of the financial crisis, CEO ownership and non-financial performance measures on abnormal CEO compensation?
Figure 2 Conceptual model
To test the hypotheses we first need to determine abnormal CEO compensation. We will use the research model of Agrawal & Walkling (1994) to estimate the variable abnormal compensation with regression analytics. Secondly we will have to determine the exact period of
1-Abnormal CEO
Compensation CEO Ownership
Presence of non-financial performance measures 3 + 2+ Financial Crisis
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the financial crisis. To assess if abnormal CEO compensation is related to the financial crisis two dummy variables will be made for the years 2006-2007 (before financial crisis), 2008-2009 (during the financial crisis) and 2010-2012 (after the financial crisis). Based on the data we are able to answer the second hypothesis, Abnormal CEO compensation is negatively related to the financial crisis. The variable of the second hypothesis, CEO ownership is determined as the percentage of total shares held by the CEO. Finally for the third hypothesis we will have to gather data on the measures upon which CEOs are assessed and upon which their cash bonus is determined. This data is contained in the bonus plans which are available in the proxy statements of SEC listed firms. The research area will be S&P 500 firms since the data needed for the research is accessible and reliable. We will collect data on the performance measures from the proxy statements of the firms filed in the Lexis/Nexis database for the 25 firms with the largest and the 25 firms with the smallest abnormal CEO compensation to answer the third hypothesis, Abnormal CEO compensation is related to non-financial performance measures in the annual CEO bonus contract. In the following paragraph we will explain our expectations and out hypotheses development as described above.
3.2 Expectations
Based on the agency theory (Jensen & Meckling, 1976) it is to be expected that there will be a change in the compensation schemes of CEOs since the financial crisis had firms moving their point of focus from growth to survival. The Informativeness theory (Hölmstrom, 1979) says, that performance measures that have information content on the desired actions of the CEO, should be included in the compensation schemes. Since the desired actions of CEOs during the financial crisis changed from creating firm value to going concern it is also to be expected that there will be a change in the compensation scheme of the CEO. Further on, as a result of the different compensation schemes and the different performance measures we expect that CEOs with higher abnormal compensation have non-financial performance measures included in their compensation during times of economic downfall. These general expectations based on two main theories will be further discussed in this chapter. Including the relevant aspects of chapter two the expectations will lead to the hypothesis.
3.2.1 Financial Crisis
Based on the theoretical framework we know A) non-financial performance measures are less susceptible by noise created by a macroeconomic effect and B) the financial crisis created noise in financial performance measures as a result of volatility in stock prices and financial
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metrics in the financial statements of the firms. The volatility mentioned, led many firms all over the US to present losses or lowered income in their financial statements and taking large losses in terms of stock value. Since traditionally the CEOs of these firms are mostly compensated based on market measures and accounting measures, these effects are directly resulting in lower compensation for CEOs (Murphy, 2012). Refer to figure 3 included in the research of Murphy for an overview of CEO compensation levels for the period 1992-2011 regarding S&P 500 firms. It is observed that for the years 2008 and 2009 the annual compensation of the CEOs in the S&P 500 index is significantly lower than the compensation in the 2 years before and after the financial crisis. This was because of the financial crisis and the reaction of the public on excessive compensation of executives. These results lead to the first expectation that the financial crisis has a negative effect on abnormal compensation.
Figure 3 Median CEO Compensation 1992 – 2011 (Murphy, 2012)
3.2.2 CEO Ownership
In subparagraph 2.2.3 we discussed the managerial power theory and previous research linking CEO power to the use of non-financial performance measures in annual bonus contracts. We also discussed the fact that CEO compensation is influenced by the power of the CEO and the ownership of the CEO. The studies of Ferri & Maber, (2013) and Ertimur, Ferri & Muslu, (2011) included CEO ownership as a determinant of CEO compensation. In these articles and the research of Bebchuk, Fried & Walker (2002) CEO ownership is determined as the sum of several variables. In this study we want to determine if the variable “percentages of total shares held by the CEO” is positively related to abnormal CEO compensation. By doing this we deviate
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from earlier models but because of the small time frame of this research and the amount of work it will costs to gain all data we chose to stick to the one variable as described above. This could be determined a limitation to this research. Based on the managerial power theorie and previous studies we expect that CEO ownership is positively related to abnormal CEO compensation.
3.2.3 Non-financial performance measures
In chapter two we have discussed the character of non-financial performance measures and their determinants. According to Ittner, Larcker & Rajan (1997) the main determinants of the presence of non-financial performance measures are the level of regulation, the extent to which the firm follows an innovation-oriented strategy, the adoption of strategic quality initiatives, and the noise in financial measures. The research of Davilla & Venkatachalam (2004) also show that noise in financial performance measures is positively related with the adoption of non-financial performance measures in annual bonus contracts of CEOs. In this research we want to analyze if the presence of non-financial performance measures is related to high abnormal cash compensation of CEOs during the financial ciris. Since the financial crisis created heavy volatillity and noise in financial performance measures it can be expected that CEOs with high abnormal compensation during this financial crisis period during 2008 and 2009 are receiving cash compensation based on non-financial performance measures. This expectation leads us to the following hypothesis; Abnormal CEO compensation is positively related to the presence of non-financial performance measures in CEO bonus contracts during the financial crisis.
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4 Data & Measures
In this chapter the variables abnormal CEO compensation, the financial crisis, CEO ownership and the presence of non-financial performance measures in annual bonus contracts of CEOs are central in this research. To test the hypotheses described in chapter three, quantitative research will be performed. In this chapter the sample (size) selection, data sources, data collection and the measures for testing are described. The first step in this chapter will be an explanation of the research models which are used in testing of the hypotheses and determining the variables used in these models. After that we will describe how and where we gathered the relevant data and determined our sample size.
4.1 Research model and variables
This paragraph describes which measures are used to test the hypothesis. The measures used are Abnormal CEO Compensation, financial crisis, CEO Power and presence of non-financial performance measures.
4.1.1 Abnormal CEO compensation
To determine the dependent variable. Abnormal CEO compensation, the model used in the research of Agrawal & Walkling (1994) has been used. A small modification has been made to the model. In the model of Agrawal & Walkling the variable salary plus bonus and market value of equity are transformed into a logarithm. We have not transformed these variables into logarithms since the predicted value by this model will be used for further hypotheses testing. Since using a dependent variable partially based on logarithmic predictor variables for hypotheses one and two brings up several difficulties, we chose not to transform these variables. Hypothetically this would raise a problem in the population regarding the normal distribution of the observations. Based on the research performed by Agrawal & walking we have reason to expect that this issue will not be significant for our research. This statement is based on the following statement included in their paper on abnormal compensation.
Log values are used to normalize the distribution of both compensation and firm size, although results are similar without the transformation. (Agrawal & Walkling, 1994, p. 1011)
This model was chosen since it incorporates the cash bonus which is based on performance measures and because of its relative simplicity. Furthermore it does not incorporate receivables from stock options, restricted stock or other equity based bonuses and only focusses on the
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salary and cash bonus component of the total CEO compensation. Therefore we deem the model suitable for testing the hypotheses, without making it too complex for this research. 𝜀𝜀𝑖𝑖, is a measure of unexplained salary and bonus based on the following model
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑖𝑖 = 𝑏𝑏0+ 𝑏𝑏1𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑖𝑖+ 𝑏𝑏2(𝑅𝑅𝑖𝑖− 𝑅𝑅𝑚𝑚) + 𝑏𝑏3𝑆𝑆𝐴𝐴𝐸𝐸𝑖𝑖+ � 𝑏𝑏𝑗𝑗+3𝐷𝐷𝑖𝑖𝑗𝑗 3 j=1 + � 𝑏𝑏𝑗𝑗+6𝐷𝐷𝑖𝑖𝑗𝑗𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝑖𝑖 3 j=1 + 𝜀𝜀𝑖𝑖
Where SALB is based on annual salary and bonus, AGE is the age of the firm's CEO at year end, and EQUITY is the market value of equity at year end. Ri and Rm are the annual holding period stock returns of target firm i and the market (S&P 500 value weighted composite index), measured over year T. To calculate the ratio annual period stock returns we have used the following model included in Figure 4 Annual Stock Returns Ratio.
Figure 4 Annual Stock Returns Ratio
D1 to D4 are binary dummy variables that equal 1 if a firm's industry is, respectively, mining and construction (SIC = 1), manufacturing (SIC = 2 or 3), transportation and utilities (SIC = 4), or trade (SIC = 5); they equal zero otherwise. The omitted industry is banking, insurance, and services (SIC = 6, 7, or 8). The reference group for these dummy variables is manufacturing since this is the largest industry measured by the market value of equity. Refer to appendix 1 for a histogram of the market value of equity per industry. The dummy variables are names Mining & Construction Dummy, Transportation & Utilities Dummy and Trade Dummy. The final variables included are interaction terms of the industry dummies multiplied by EQUITY to permit the slope and intercept to vary per industry. We estimate this model for the entire population of S&P 500 firms. The predicted value resulting from this model are the abnormal compensation components per observation. These variables will be used in testing hypothesis one, two and three and will be called ABNCOMP.
The rationale for use of these variables is as follows. Empirical evidence indicates that executives of larger firms are paid more. The market value of equity is used as a measure of firm size. Log values are used to normalize the distribution of both compensation and firm size. Older executives are likely to have greater firm-specific human capital and receive higher
P0 = Initial Stock Price
P1 = Ending Stock Price (Period 1)
D = Dividends Paid
(P1 - P0) + D
P0
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compensation. Compensation is also expected to be positively related to firm performance. We use the difference between the 12-month return of the firm's stock for the year t and the corresponding 12-month return on the market as a measure of firm performance.
4.1.2 Financial Crisis
To test the hypothesis that the financial crisis is negatively related to abnormal CEO compensation, We have created 2 dummy variable to distinguish three periods, 2006-2007 (pre-crisis), 2008-2009 (during crisis) and 2010-2012 (post-crisis). Since the financial crisis started in 2008 (with the bankruptcy of Lehman Brothers) and was reached its peak during 2009, these two years are used as the financial crisis period. Because we want to test if abnormal CEO compensation is significantly lower during the crisis period in relation to the other two periods we have determined that the financial crisis period is our default group. We will analyze if the test results show that the other two periods have a significant positive relation with abnormal CEO compensation which will indicate that abnormal CEO compensation is significantly lower during the crisis period. The post-crisis period is used as the dummy variable POSTFINCRISIS and the pre-crisis period is used as the PREFINCRISIS Dummy.
As control variables we will use ROA (return on assets) and ROE (return on equity) as measures of performance, log total assets as a measure of firm size, leverage (book value of debt/book value of total assets) as a measure of solvency. These control variables are based on the research of Agrawal & Walkling (1994) and (Ertimur, Ferri, & Muslu, 2011) which both research abnormal and respectively excessive CEO compensation.
Together with the financial crisis dummy variables these are the independent variables for the first hypothesis, abnormal CEO compensation is negatively related to the financial crisis. We have created the following research model based on the variables described above.
𝑆𝑆𝑆𝑆𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝑖𝑖 = 𝑏𝑏0+ 𝑏𝑏1𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑅𝑅 𝑎𝑎𝑎𝑎𝑎𝑎𝑅𝑅𝑅𝑅𝑎𝑎 + 𝑏𝑏2𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑅𝑅 𝐸𝐸𝐸𝐸𝑅𝑅𝐸𝐸𝑅𝑅𝐸𝐸 + 𝑏𝑏3𝑆𝑆𝑜𝑜𝐿𝐿 𝐸𝐸𝑜𝑜𝑅𝑅𝑎𝑎𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑅𝑅𝑅𝑅𝑎𝑎
+ 𝑏𝑏4𝑆𝑆𝑅𝑅𝐿𝐿𝑅𝑅𝑅𝑅𝑎𝑎𝐿𝐿𝑅𝑅 + 𝑏𝑏5𝐷𝐷𝑅𝑅𝐷𝐷𝐷𝐷𝐸𝐸 𝑝𝑝𝑅𝑅𝑅𝑅 𝑓𝑓𝐸𝐸𝑅𝑅𝑎𝑎𝑅𝑅𝑓𝑓𝐸𝐸𝑎𝑎𝑇𝑇 𝑓𝑓𝑅𝑅𝐸𝐸𝑎𝑎𝐸𝐸𝑎𝑎
+ 𝑏𝑏6𝐷𝐷𝑅𝑅𝐷𝐷𝐷𝐷𝐸𝐸 𝑝𝑝𝑜𝑜𝑎𝑎𝑅𝑅𝑓𝑓𝐸𝐸𝑅𝑅𝑎𝑎𝑅𝑅𝑓𝑓𝐸𝐸𝑎𝑎𝑇𝑇 𝑓𝑓𝑅𝑅𝐸𝐸𝑎𝑎𝐸𝐸𝑎𝑎 + 𝜀𝜀𝑖𝑖
4.1.3 CEO Ownership
We use an indicator variable to examine the hypothesis that CEO ownership (denoted CEOPOWER) is positively related to Abnormal CEO compensation. In the research of Tosi and Gomez-Mejia (1989), Wade et al. (1990), Finkelstein (1992), Lambert et al. (1993), Core (1996), and Core et al. (1996) five indicators of the relative power of the CEO are defined namely: (1) the proportion of external board members appointed by the CEO , (2) the
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proportion of internal board members appointed by the CEO, (3) a dichotomous variable indicating whether the CEO also holds the additional title or position of Chairman of the Board , (4) the number of outstanding shares and exercisable options held by the CEO divided by the total number of outstanding shares and exercisable options, (5) the number of outstanding shares held by institutional investors divided by the total number of outstanding shares and exercisable options. For this research we want to determine if CEO Ownership measured as the number of outstanding shares held by the CEO divided by the total number of outstanding shares are positively related with abnormal CEO compensation. Since this variable is accessible in the data sources used and the other variables mentioned above are very time consuming to collect we have chosen this variable to reflect the ownership of the CEO over the company. The percentage of shares held by the CEO will be regressed against the abnormal compensation variable to test the second hypothesis, abnormal CEO compensation is positively related to CEO ownership. For this research model we have include the same control variables as described in the paragraph above which results in the following research model.
𝑆𝑆𝑆𝑆𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝑖𝑖 = 𝑏𝑏0+ 𝑏𝑏1𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑅𝑅 𝑎𝑎𝑎𝑎𝑎𝑎𝑅𝑅𝑅𝑅𝑎𝑎 + 𝑏𝑏2𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑜𝑜𝑅𝑅 𝐸𝐸𝐸𝐸𝑅𝑅𝐸𝐸𝑅𝑅𝐸𝐸 + 𝑏𝑏3𝑆𝑆𝑜𝑜𝐿𝐿 𝐸𝐸𝑜𝑜𝑅𝑅𝑎𝑎𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑅𝑅𝑅𝑅𝑎𝑎
+ 𝑏𝑏4𝑆𝑆𝑅𝑅𝐿𝐿𝑅𝑅𝑅𝑅𝑎𝑎𝐿𝐿𝑅𝑅 + 𝑏𝑏5𝐴𝐴𝐸𝐸𝐴𝐴 𝑜𝑜𝑜𝑜𝑅𝑅𝑅𝑅𝑅𝑅𝑎𝑎ℎ𝐸𝐸𝑝𝑝 + 𝜀𝜀𝑖𝑖
4.1.4 The presence of Non-Financial Performance Measures
The independent variable is the presence of non-financial performance measures in the CEO's annual bonus contract. The variable is called non_fin_measure and is expressed as present or not-present in the annual bonus contract retrieved from the proxy statements. In this research we will test if the determined dependent variable for the 25 observations with the highest abnormal compensation and the 25 observations with the lowest abnormal compensation is explained by the presence of non-financial performance measures. These two groups of observations will be compared with the abnormal CEO compensation variable with a Chi-squared test. This test will provide us information on the third hypothesis, Abnormal CEO compensation is positively related to the presence of non-financial performance measures in CEO bonus contracts.
4.2 Data sources
In performing this research several databases containing information on S&P 500 need to be used to gain all relevant data. To test and answer the hypotheses, the relevant data needed from these databases will be gathered. The databases used for this research are ExecuComp, CompuStat, CRSP and Lexis/Nexis. Refer to Table 1 Variables per data source for an overview
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of all relevant variables and the database used to gain the variable or components to determine the variable.
Table 1 Variables per data source
The CompuStat, ExecuComp and CRSP databases are made available by Wharton Research Data Services (WRDS). The Lexis/Nexis Database is publicly available and accessible through the website.
Variable Dataset Purpose
Company ID Number ExecuComp & Compustat Combine databases.
CEO Name ExecuComp Informational
Fiscal Year ExecuComp Informational
CEO Salary ExecuComp Determine SALB
CEO Bonus ExecuComp Determine SALB
Market Value of Equity CompuStat Determine EQUITY
Stock price t-1 CompuStat Determine Ri
Stock price t CompuStat Determine Ri
Dividends per share CompuStat Determine Ri
Market annual stock returns S&P 500 Value weighted Index
CRSP Determine RM
CEO Age ExecuComp Determine CEO Age
SIC Industry Code ExecuComp Create industry Dummy's
Financial Year Compustat Crisis Dummy's
Shares Held by the CEO ExecuComp Determine CEO ownership Total Shares Issued by the company CompuStat Determine CEO ownership Presence of non-financial
performance measures.
Lexis/Nexis Presence of non-financial performance measures.
Total assets CompuStat Determine firm size, return
on assets and leverage
Total debt CompuStat Determine leverage
Shareholder equity CompuStat Determine return on equity Institutional shares & options CompuStat Determine institutional
ownership
Net income CompuStat Determine return on equity
and return on assets Control variables
Performance measures CEO Ownership
Financial Crisis
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Compustat North America is a database of U.S. and Canadian fundamental and market information on active and inactive publicly held companies. It provides more than 300 annual and 100 quarterly Income Statement, Balance Sheet, Statement of Cash Flows, and supplemental data items. Execucomp is a sub database from Compustat which contains all information on the compensation of the directors of companies. It tracks executive compensation in S&P 1000 firms and contains top executives' salary, bonus, and stock option data since 1992. The database also has company-specific financial statement information to supplement the compensation data. The Center for Research in Security Prices (CRSP) maintains the most comprehensive collection of security price, return, and volume data for the NYSE, AMEX and NASDAQ stock markets. Additional CRSP files provide stock indices, beta- and cap-based portfolios, treasury bond and risk-free rates, mutual funds, and real estate data. The Lexis/Nexis database is made available by the LexisNexis Group. This is a corporation providing computer-assisted legal research as well as business research and risk solution services. During the 1970s, Lexis/Nexis pioneered the electronic accessibility of legal and journalistic documents as of 2006, the company has the world's largest electronic database for legal and public-records related information. Relevant for this research it contains the proxy statements from which we can collect the bonus schemes of the CEOs containing information on the performance measures. The above mentioned databases give us all relevant variables to use in testing our hypotheses.
The Sample selection is discussed in the following paragraph, the main issues in this paragraph is gathering sufficient data for the sample from all databases, matching the data from the different databases and gaining a large enough sample to gain external validity.
4.3 Sample Selection
4.3.1 Data Gathering
The number of observations in the sample is determined by extracting relevant data from the ExecuComp, CRSP and CompuStat databases and then combining these three databases to create the dataset to be used for the sample. The data regarding non-financial performance measures is gathered after determining abnormal CEO compensation. It is obtained from the proxy statements in the Lexis/Nexis database. During this process several steps had to be taken to separate the relevant and usable data from the excess data. This section will describe the process and the steps taken.
The starting point of the data gathering activities is gathering the data on CEO compensation from the ExecuComp database. This data is needed to determine abnormal
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compensation and when this information is missing no connections can be made to the other databases. The population used in this research is S&P 500 firms for the years 2006 – 2012 so this is the main range used in gathering the relevant data. The year 2005 was also included in the search to provide information on lagged variables. Since it was unclear in the ExecuComp search tool to extract only S&P 500 firm data, data from all S&P indexes were gathered. In table 2 a summary of the data gathered from the ExecuComp database and its usability is given. All data was exported to Excel to combine this data with the data from the CompuStat database as described below.
Table 2 Data gathered from the ExecuComp database
After the data gathering from the ExecuComp database was completed the data from CompuStat was gathered. This data shown in table 3 is primarily used to determine firm performance by determining the sample firm’s annual stock returns and their size by using the total market value variable. The annual stock returns are determined by calculating the stock mutation including dividends paid during the year. This will be offset with the average S&P 500 annual stock returns to determine the firm’s performance in compared to the market performance. This S&P 500 average weighted index is gathered from the CRSP database as described in the following paragraph. Secondly the CompuStat database is used to determine the
Data gathered Data usabillity
Full Name Used for identification of CEO ID number for each
executive/company combination Used for identification of CEO Company Name Used for identification of the Firm
Salary ($) Used in the abnormal compensation calculation Bonus ($) Used in the abnormal compensation calculation Shares Owned - Options
Excluded Used to determine CEO Power
Percentage of Total Shares Owned
- Options Excluded Used to determine CEO Power
Executive's Age Used in the abnormal compensation calculation Company ID Number Used to link Database to Compustat
Executive ID number Used for identification of CEO Fiscal Year Used to determine the data Period First Name Used for identification of CEO Present Age Used for identification of CEO CUSIP and Issue Number Used to link Database to Compustat S&P Index Used to determine S&P 500 firms
