Executive pay sometimes bloated by padded earnings

Posted: Friday, March 28, 2003

NEW YORK (AP) It's not just the excessive executive paychecks that are raising eyebrows. It's how those salaries got so big in the first place.

Compensation for top talent isn't driven just by competition in the marketplace, but by the methods companies use to determine who gets how much.

With a good portion of executive pay tied to earnings, what is and isn't included in calculating the bottom line can have great influence on what top managers make.

Executives have been rewarded on some factors that have nothing to do with the operations of the actual business,'' said Sumanta Ray, a senior analyst at the International Union of Electronic, Electrical, Salaried, Machine and Furniture Workers-Communications Workers of America who has been lobbying for changes in corporate compensation.

The pay going to top managers has soared in recent years, with many getting multimillion-dollar signing bonuses along with super-sized paychecks.

While executives usually get a salary upfront, their fortunes can rise through bonuses and other perks if they hit certain benchmarks generally tied to earnings, stock price and cash flow.

The problem comes in how earnings are calculated.

While companies may be following accounting rules when crunching earnings for their financial statements, those same earnings might not be the best gauge in determining compensation. That's because earnings sometimes include factors that have nothing to do with how businesses are being run.

Take pension income, for example. When added to earnings, it can pump millions, and sometimes billions, of dollars into the bottom line.

But while doing that is a proper accounting practice, pension income doesn't represent what is actually being earned on the investments in a pension plan, but rather shows a company's expected returns on its plan assets minus its costs.

Optimistic estimates, therefore, can boost reported pension income, even when plans are actually losing money. That then dramatically lifts profits and sometimes even turns losses into gains.

Whether companies deduct the cost of their stock options from earnings also can factor into compensation. Options are performance incentives that allow employees to buy shares and resell them at a profit if the company's stock rises.

As of now, companies are not required to subtract the cost of issuing options from earnings, though the issue is under review by accounting rulemakers.

These result in higher profits, which let executives hit their benchmarks to secure bigger bonuses.

Shareholders, frustrated by those lofty paychecks and the bite they take out of profits, have started pressing for change. Their intense lobbying has spurred a few companies to begin subtracting pension income from earnings when calculating executive compensation.

Starting this year, General Electric will not use pension income in determining senior executive long-term compensation. GE's pension income last year contributed about $1 billion after taxes to the $14.1 billion the company tallied in net earnings.

Verizon also won't include pension income when figuring bonuses paid to top management. Its pension income in 2002 added $971 million to net earnings of $4.1 billion, after excluding special items.

Both companies have also started deducting stock option costs from earnings, which will affect the profit base used in determining executive pay.

What they have been doing has been totally legal, but it hasn't made sense,'' said C. William Jones, a Verizon retiree who leads the Association of BellTel Retirees, which has been pressuring the communications company for the last three years on the pension-income change. Now, the climate has changed with what's considered acceptable.''

Curbing executive compensation won't come by just tying pay to performance, but by digging into what underlies that performance.

Rachel Beck is the national business columnist for The Associated Press. Write to her at rbeck(at)ap.org

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