Executive Overcompensation

Paolo Quattrone, who holds the Chair in Accounting, Governance and Social Innovation at the University of Edinburgh, recently posted an interesting link on Facebook.

It was about an article in the Atlantic, in which authors William Lazonick and Matt Hopkins argued that executive compensation is drastically under-reported.

They are right.

Executive compensation is not just about salaries. Senior executives in very large corporations can, of course, make very large salaries. The CEO of the Walt Disney Company, Robert Iger, just to give one example, was paid a salary of $2,500,000 in 2015.

As with many top executives, however, this was just a small part of his compensation, He was also paid performance bonuses totaling $22,340,000. For one year of work.

And that's just the cash component. Iger was also given shares and stock options valued at $16,839,618. Stock options are the right to buy the company's shares at a specified price sometime in the future. The idea is that the executive then has an incentive to try to drive up the company's shares beyond the price specified in the stock option. The higher the share price goes, the more profitable the option is when it is exercised.

All told, in salary, bonuses and stock options, Iger's compensation in 2015 was almost $45 million. But Iger's compensation was dwarfed by that of executives from several other corporations. In fact, Iger was only the eighth highest paid executive in the US in 2015. I just picked on him because everyone loves Disney. The CEO of Expedia, Dara Khosrowshahi, led the list with compensation in the order of $94 million. The year before, two CEOs smashed the $100 million level. (In Canada, Blackberry CEO John Chen was paid CDN $89 million. It's not just a US phenomenon.)

But was the CEO of Expedia really the highest paid US executive in 2015? Bloomberg.com compiled a different set of figures, and concluded that Patrick Soon-Shiong, CEO of cancer research firm NantKwest Inc., topped the list with compensation worth $329.7 million. Most of this was in stock options.


What accounts for the discrepancy between these lists? The first list I cited, from the New York Times, was based on corporate proxy statements about expenses for executive compensation. These expenses are stated from the perspective of the corporation, so they disclose the value of executive stock options using estimated fair value. Because the options awarded this year won't be exercised until some time in the future, this requires building a complex probablistic model of future share prices and the likelihood of achieving certain performance targets.

The second list, the one in the Bloomberg article, was based on similar calculations, but used the total value of compensation if all the incentive targets were to be reached, regardless of the probability. Obviously, this means its figures would be higher.

Just because an accounting figure is accurate does not mean it is appropriate, or that it tells the whole story.

This is where the Atlantic article by Lazonick and Hopkins comes in. Both of these approaches are wrong, they say, because despite the huge figures being reported, both lists understate the compensation. Significantly.

The gist of their argument is that almost everyone, from union negotiators to the New York Times to Bloomberg, fixates on the value of executive compensation at the time the stock options are awarded. What people should be looking at, they argue, is the value of the compensation when the options are actually converted into shares. Often, they find, this value is much higher than initially expected. Share prices often rise far beyond the value anticipated in the company's original probablistic model (as in the New York Times article), and beyond even the target price where additional bonuses kick in (as in the Bloomberg article).

What senior executives actually pocket each year, in practice, is therefore far higher than the compensation expense reported by their companies.

Look at the compensation of Robert Iger at Disney again. Here is what Disney's 2015 proxy statement says about him on page 36:

The first amount is Iger's regular salary. The second, Stock Awards, is a straightforward payment of Disney shares worth almost $9 million, which was based on the company having achieved certain performance targets in 2015. The third, Option Awards, is the value of stock options, calculated as discussed above using a probablistic model. These options will vest over the next four years. The $8.4 million value shown is the expected cost to the company, not the amount Iger will necessarily receive. The fourth, Incentive Plan Compensation, is the cash bonus paid to Iger in 2015 for the company achieving performance targets. The fifth, Deferred Compensation, relates to pensions, and the sixth, Other Compensation, relates to perquisites, matching charitable donations, insurance premiums, vacation pay, and so forth.

But note that the $44.9 million total only includes the expected value of the stock options awarded this year. What about the actual value of previously awarded stock options that came to fruition for Iger this year? For that, we turn to page 44:

What this is saying is that, while the stock options awarded to Iger in 2015 had a value of $8,4 million, the stock options actually exercised by Iger in 2015 had a value of almost $32 million. In other words, the compensation expense reported by Disney for Iger in 2015 was much lower than Iger's actual compensation that year.

This pattern can be observed in the compensation of all the highest paid US executives, say Lazonick and Hopkins.

The Mind Boggles

Lazonick and Hopkins give the example of the well-known executive compensation list compiled by the AFL-CIO, a large labour union. The AFL-CIO list is based on CEO compensation expenses reported by the 500 largest US corporations, the data that Lazonick and Hopkins say are flawed. It shows that these CEOs made on average 373 times as much as the average US worker in 2015.

This is astonishing in itself. But it gets worse. The AFL-CIO only looked at CEOs. Lazonick and Hopkins look at all the highest paid executives in the US, regardless of whether they were CEOs. More importantly, they use the value of the options actually exercised by the executives in 2015, like we did above for Disney's Iger. If you use these figures, they say, senior executives made a mind-boggling 949 times as much as the average American worker.

Look, shiny thing!

Lazonick and Hopkins show us the importance of developing a deep understanding accounting information. Just because an accounting figure is accurate does not mean it is appropriate, or that it tells the whole story. The fair value of stock options that may be exercised several years from now is a problematic figure to begin with. But the real problem is, it's not necessarily even the figure we should be looking at. Think of it as the shiny thing a magician holds up to distract our attention from what is really happening.

Lazonick and Hopkins don't just teach us something about accounting. They teach us something about society. Perhaps we already suspected executive compensation was excessive, but the accounting figures, properly understood, show us that the situation is much more pronounced than we thought.

That's the point of this website, really. Accounting, if we look behind the numbers, tells us about society. Accounting is designed to create certain appearances. But if we stop to think critically about it, accounting hints at the structures behind those appearances. It points to who has the power to shape those structures and create those appearances.

To paraphrase Oscar Wilde, everything is about accounting. Except accounting. Accounting is about power.

Photos of  shiny classic convertibles taken in Toronto in 2016.

Photo of Langdon Hall taken in Cambridge, Ontario in 2014. The Langdon Wilks family began as fur traders, not stock traders.