Based on the research of Hariom Manchiraju, Susan Hamlen, William Kross, and Inho Suk
Firms use derivatives for hedging (reducing risk) and non-hedging purposes (possibly risky investments). These activities have a significant impact on the overall earnings of the firm. Should CEO compensation be based on such derivative gains/ losses? Hariom Manchiraju, Assistant Professor in the Accounting area at the Indian School of Business, and his co-authors examine whether derivative gains and losses affect the compensation of a CEO.
“Across the world, there are serious concerns about excessive CEO pay and CEO pay not being linked to performance,” says Professor Manchiraju. “Our study shows yet another instance where CEOs game the system. When dealing with complex financial instruments such as derivatives, CEOs are likely to attribute gains to their efforts and insights and thereby claim bonuses. On the other hand, when there is a loss, CEOs conveniently attribute it to complicated fair value accounting rules and get away with it.”
It is clear from the study that while gains are rewarded, losses are ignored when determining CEO compensation. Further, the compensation of a CEO is based not only on hedge derivative gains, but also on non-hedge derivative gains. This indicates that CEOs are being rewarded even when the company is taking excessive risks. “We recommend that firms involve an accounting financial expert in designing efficient executive compensation contracts,” says Professor Manchiraju.
Derivatives are financial instruments that have no tangible worth of their own but derive their value from the assets or liabilities to which they are linked. The linked asset could be a stock, a bond, a mortgage or a future sale, among others. According to the Bank of International Settlement (BIS), the national value of outstanding derivatives held by non-financial firms has increased from $9.4 trillion in 2000 to $44.4 trillion in 2009. This clearly indicates the extensive use of derivatives by firms.
Typically, firms use derivatives to hedge their risk. For example, an oil producer can fix the selling price of its future production by purchasing oil futures or options, and thereby insulate itself from subsequent price fluctuations. However, there have been several high-profile instances such as Enron and Metallgesellschaft, where firms have speculated on future prices and entered into these derivative contracts with the intention of making trading gains. Such speculative activities using derivatives are clearly risky and can be catastrophic for a firm. Thus, it is extremely important for the board of directors of a firm to monitor its derivative activities and design efficient compensation contracts for CEOs that reflect a sensible use of derivatives.
Professor Manchiraju and his co-authors examine how major components of CEO compensation are affected by derivative gains/ losses in the US oil and gas industry. “We chose this particular industry because of its extensive use of derivatives to manage the risks associated with fluctuations in oil and gas prices which affect cash flow,” explains Professor Manchiraju. The authors conducted the study for a period of five years, from 2007-2012, and it comprised of 445 firm-year observations for 87 unique firms. They manually collected information on derivative gains data for analysis. They obtained data on financial performance, leverage and cash holding from COMPUSTAT and on stock returns from the Center for Research in Security Prices (CRSP).
The authors find that derivative gains have a substantial impact on the earnings of the firm. Derivative gains also affect CEO compensation irrespective of the purpose for which they are used, i.e., CEOs are being rewarded both for hedging as well as speculating. The study further showed that CEO cash compensation is 70% and CEO equity compensation is 2.65 times more sensitive to non-hedge derivative gains than to non-hedge losses. Thus, CEOs are rewarded for derivative gains-irrespective of their source-and not penalised for derivative losses, possibly because they can attribute the losses to complex fair value accounting rules. Finally, the study examines the role of board independence and the value of an accounting financial expert in devising efficient compensation contracts. The results suggest that even where the board is independent, CEOs can easily exert influence on it if it is not well-informed about accounting techniques. Therefore, it is useful to have a financial accounting expert on the board to help determine the appropriate compensation for a CEO.
About the Researchers:
Hariom Manchiraju is Assistant Professor in the Accounting area at the Indian School of Business, Hyderabad.
Susan Hamlen is Chair and Associate Professor in the Accounting and Law Department at University at Buffalo, New York.
William Kross is Associate Dean for Research and Professor in the Accounting and Law Department at University at Buffalo, New York.
Inho Suk is Associate Professor in the Accounting and Law Department at University at Buffalo, New York.
About the Research:
Manchiraju, H, S Hamlen, W Kross, and I Suk. “Fair Value Gains and Losses in Derivatives and CEO Compensation”, Journal of Accounting, Auditing and Finance.
About the Writer:
Poonam Singhal (Ph.D) is a writer with the Centre for Learning and Management Practice at the Indian School of Business.