Fair Value Gains and Losses in Derivatives and CEO Compensation

Abstract

This study examines the sensitivity of CEO compensation to fair value gains and losses in derivatives for firms in the U.S. oil and gas industry. Our evidence indicates that firms use derivatives for both hedging and non-hedging purposes and that the derivative gains have a substantial impact on firms' overall earnings. We find that CEOs are rewarded for hedge derivative gains, more so in firms facing high financial contracting costs. However, we find that non-hedge derivative gains are also rewarded. Furthermore, the CEO compensation is more sensitive to non-hedge derivative gains than it is to non-hedge derivative losses. This is surprising because non-hedge derivatives often relate to speculation or inefficient hedging. Overall, our results suggest that the board does not fully distinguish between the nature of derivative activities and rewards all gains in a similar fashion. The presence of accounting financial expert on the compensation committee, however, does improve efficient contracting.

Compensation Committee Quality and the Relationship between CEO Cash Compensation and Accounting Performance—Evidence From Taiwan

“…Wang, Xie, and Zhu (2015) indicate that directors with corporate financial expertise on a firm' compensation committee decrease CEO excess compensation. Hoitash et al (2012) and Manchiraju et al (2016) also provide some evidence that CC financial expertise is associated with higher compensation committee quality. Kim, Mauldin, and Sukesh (2011) find that both firm-specific knowledge and individual financial expertise are negatively associated with excess CEO compensation, a measure of the board's compensation monitoring role.…”

“…Particularly, individual directors' profession is considered in this paper. Recently whether individual directors' profession could affect the effectiveness of boards of directors or committees has garnered a great deal of interest in both the regulators and academic researchers (e.g., Hsu, Huang, & Lai, 2019;Manchiraju, Hamlen, Kross, & Suk, 2016;Wang, Xie, & Zhu, 2015;Hsu, Huang, & Lai, 2015;Hoitash, Hoitash, & Johnstone, 2012;Brickley & Zimmerman, 2010). In 2009, the U.S. Securities and Exchange Commission (SEC) released its final proxy disclosure enhancement rules.…”

Level 3 Income and CEO Cash Compensation in the Financial Industry

“…Darrough et al (2014) find that CEO compensation is reduced when the FVs of acquired business units are written down. More recently, Manchiraju et al (2016) find that boards treat derivative gains similar to other earnings components when designing executive compensation. The current evidence is consistent with the informativeness principle (Holmstrom, 1979), which posits that any informative signal measuring management action, regardless of how noisy it is, will be used in a compensation contract.…”

“…where Following prior literature (Livne et al, 2011;Manchiraju et al, 2016), CEO cash compensation (Ln.Cash.Comp) is the natural logarithm of CEO salary plus bonus. Income.Adj is the income before extraordinary items less Level 3 gains or losses divided by total assets at the end of the fiscal year.…”

Derivative disclosures and managerial opportunism

“…Previous literature documents that derivatives used for hedging reduce cash flow volatility (Froot et al, 1993), heighten earnings predictability (DeMarzo & Duffie, 1995), alleviate financial distress, and lower expected tax liabilities (Smith & Stulz, 1985). However, derivatives also serve nonhedging purposes, such as earnings management and speculation (Brown, 2001;Chernenko & Faulkender, 2011;Faulkender, 2005;Géczy et al, 2007;Manchiraju et al, 2016Manchiraju et al, , 2018, giving rise to information uncertainty and/or asymmetry faced by investors. Unfortunately, different managerial incentives for using derivatives cannot be easily distinguished by investors, especially absent associated disclosures made in an adequate manner.…”