The Secrets of CEO Performance and Integrity Hidden in Accounting Data

Shane Dikolli:

Firms disclosed measures that signal to capital market participants what the goals of the firm are and also what the benchmarks are for evaluating how well the CEO's performed. These disclosures are in proxy statements that firms release each year that talk about how firms design their compensation contracts for executives. I just think there's just a wealth of information in there that we're only scratching the surface of so far.

Sean Carr:

CEOs get paid a lot. That's hardly news, but depending on one's point of view, they're either being paid fairly based on what the market will bear or they're using their outsized influence to extract more than the world. According to Shane Dikolli at the University of Virginia Darden School of Business, the truth is somewhere in the middle and perhaps surprisingly, the tools of accounting can help us address some of the perplexing issues that link CEO, performance, integrity, and compensation. I'm Sean Carr, and welcome to Darden Ideas to Action. Shane, thank you for joining us on the podcast.

Shane Dikolli:

My pleasure. Thank you for having me.

Sean Carr:

You have looked at CEO compensation and CEO performance through a long stretch of your academic career. I'm interested to know how did you get started? Why did that become an area of focus for you?

Shane Dikolli:

CEOs is high stakes because boards make decisions about CEO contracts, investors make decisions about whether or not they want to invest in a firm that's led by a specific CEO. And so I was really curious about, well, how do you provide incentives for the CEO to do the things that would align the firm's interests with, say, investors of the firm?

Sean Carr:

Can you just give us a quick snapshot of some of the angles that you've examined to unpack that CEO performance versus compensation conundrum? Because I think it does confuse a lot of people.

Shane Dikolli:

I looked at short horizon CEOs and in particular, how we could use forward-looking performance measures to incent them to think about the long-term. So, as an example of a forward-looking performance measure, Herb Kelleher, when he was at Southwest Airlines. He wasn't a short horizon CEO, but he was very famous for being passionate about keeping employees happy. And if employees happy, customers were happy, and happy customers led to long-term financial success for the firm. And so employee engagements are a really good example of forward-looking measures. So, that's one example.

                Another example is really interested in the idea of the long tenure of a CEO and how that plays a role in whether or not the CEO gets fired for poor performance. And what we find is that the longer a CEO is in place, the less likely that performance is actually going to be used as the basis for the CEO getting fired or leaving the firm. This is because there's not a lot of uncertainty about whether or not the CEO has high ability by the time that they've been there for at least five years. So think of someone like Tim Cook or Jamie Diamond, those sorts of CEOs who've been around a long time, people know their abilities. So they're not going to get fired for poor performance. They're going to move on because they're ready to retire or take on other types of opportunities.

Sean Carr:

Another stream of work that you've looked at, higher integrity versus low integrity CEOs. I think it's an intriguing concept. Tell us more about that.

Shane Dikolli:

We examined the shareholder letters that CEO's wrote. What we're able to do is measure the number of words related to causation, words like therefore or because. What we find is that CEOs who overuse those sorts of words tend to over-explain and the over-explainers tend to lack credibility. They feel like they have to over-explain because the market doesn't believe them. So this ultimately leads to us classifying CEOs as being low integrity and the low integrity CEOs tend to generate higher costs like higher audit fees, for example.

                It's a real challenge to try to measure integrity. We know it's important. We would try to brainstorm ways that we could somehow measure it. The nice thing about a shareholder letter is that it's fairly standardized. Every firm has a shareholder letter standardized in the sense that it's roughly the same size, but it does vary. And they tend to talk about similar sorts of things like what's happened with the firm during the year, what sort of events outside of the firms affected the performance. And so the ones that have to explain more were the ones that tended to have the lower integrity, is what we found. And on the flip side, the high integrity CEOs who didn't need to explain very much because they had high credibility were associated with high levels of future performance.

Sean Carr:

If I am following companies as an investor or an employee or prospective employee, should I be paying attention to kind of things you surface in your index to guide my actions?

Shane Dikolli:

I think there's investors and certainly proxy advisors that are interested in understanding better what the CEO is like. Now, a natural conclusion that someone could draw from our study is that firms shouldn't be hiring any low-integrity CEOs because they're associated with lower future performance. But the reality is there are certainly low-integrity CEOs who seem to do quite well because they've got other traits that offset the low integrity. So for example, a CEO might be thought of as being really harsh and difficult to deal with and may have low integrity potentially as well. But on the other side, they could be absolutely brilliant. Like a creative genius could be breaking rules all the time because that's what geniuses do, right? They want to break the boundaries. You could think of some examples where there's some really creative types that might have questionable integrity as you might define it, which is honoring your word. And so we think that there's offsetting traits that allow low-integrity CEOs to survive as well.

Sean Carr:

On the subject of CEO compensation, there are cynics who would definitely say that they're overcompensated, maybe even wildly so. Yet others would argue that well, CEOs are paid what the market will bear. I know a lot of your research has squirreled around these waters. Tell us where you've come out on that question or related questions.

Shane Dikolli:

I agree with you that there are two theoretical views on CEO compensation. One, if you believe that the market decides how CEOs should get paid so the compensation is fair, reflects what the labor market is willing to pay for the CEO. And the opposite to that is if you believe that CEO's abused their position of power and privilege and extract benefits, and they extract a pay that is higher than what they deserve.

                So based on my research, I tend to land more on the side that the CEO's compensation is what the market will bear, but there are pockets of counter-examples. And so we have a paper on co-opted CFOs, which is an interesting one where we showed that CEOs who hire a CFO receive a 10% compensation premium over what we'd expect. We believe that these co-opted CFOs feel some sort of pressure to manage earnings in a way that benefits their CEOs. But after the CFO has been on the job for three years, that premium disappears.

                We literally looked at when a CFO was hired relative to the CEO. So even with such a simple measure, we're able to show this result that there's a 10% increase for CEOs in terms of their pay if the CFO has been there three years or less. It's something that probably investors might not have known. So going back to what we were talking about earlier, what sort of practical implications does this have? I think that investors might not have potentially looked at something like that. And this is a paper that alerts investors, proxy advisors, to the idea that you should look at when the CFO is appointed and how long the CFO and the CEO have been together in terms of whether or not the CEO might be extracting a high level of pay than what the market bear.

Sean Carr:

The reason I'm so intrigued about this research is that you teach accounting and you come at this from someone who is leading in the field of scholarship in that area. This strikes me as perhaps a little unusual. What's it got to do with accounting?

Shane Dikolli:

Oh, accounting is communication, right? So we're just using numbers to communicate. I think accounting is becoming more and more related to not only numbers but disclosures about how the firm's doing. What are the measures that go into a CEO's contract, incentive contract, and why those measures have been chosen? Does it demonstrate to investors and capital market participants what the goals of the firm are and will the firm hold the CEO accountable to those goals? I'm really interested in this idea that firms disclose measures that signal to capital market participants what the goals of the firm are, and also what the benchmarks are for evaluating how well the CEO's performed. So these disclosures are in proxy statements that firms release each year that talk about how firms design their compensation contracts for executives. I just think there's just a wealth of information in there that we're only scratching the surface of so far.

Sean Carr:

So Shane, for managers who aren't necessarily making decisions about their CEO, actually, why should they care about accounting measures? What makes this research relevant for them?

Shane Dikolli:

I would say that the same principles should apply even at any manager level. It's just that we don't have accessible data to demonstrate that those same principles do apply at the lower levels. So similar characteristics of the manager, like a short horizon, the length of their tenure, their integrity, that should all drive managerial choices and similarly designed incentives such as those based on forward-looking performance measures. That should drive managerial choices. So I think that it's very relevant to managers.

                As an anecdote. I teach a case actually on Nordstrom in my second year elective, that's based on an article in the New York Times in 1985. Such an old article, and it discusses this sales per hour metrics. Back to this idea of performance measures and how it drives managers' choices. And so it turns out that the sales per hour metric was inducing all this poor behavior like working off the clock and coercing managers into making decisions that they would not have normally have made and incentivizing all sorts of bad behavior. Now, they've since tidied up all that behavior with certain controls in place, but they still use sales per hour metric because it induces creativity in a way that other metrics don't do. It's a very simple measure and it's very powerful.

                So I really liked this idea of simple measures along with the right controls around it, that can induce behavior that's consistent with the firm's objectives. And what's interesting about that, even though it's based in the 1980s, is that we see Amazon in the headlines today with the media and employees questioning the performance measures that are used to evaluate performance. And managers inside Amazon, or want to learn from Amazon could examine the metrics that they're using, and in particular, how those metrics are changing the way that they make decisions within the firm. And so I think that the lessons from Nordstrom are actually applicable to the way we think about companies like Amazon today.

Sean Carr:

Shane, this is great. Thank you so much for joining us on Darden Ideas to Action.

Shane Dikolli:

My pleasure. Thank you so much for the opportunity, Sean.

Sean Carr:

I'm Sean Carr, and that's it for today's episode of Darden Ideas to Action. Shane Dikolli is a professor at the University of Virginia Darden School of Business. His research interests focus on the performance evaluation of CEOs using both analytical modeling and empirical analysis. He currently serves as an editor at the Accounting Review. Join us next time for more research analysis and commentary from the University of Virginia Darden School of Business. You can subscribe to Ideas to Action on Apple Podcasts, Spotify, or Podbean. To read more expert insights on this topic and more, visit ideas.darden.virginia.edu.