What is the impact of segment disclosure on equity-based compensation?

By Jovina Ang

SMU Office of Research – Segment disclosure and reporting is intended to provide transparency and reveal information regarding the financial results and operations of the different segments within a firm.

It was for this reason that SFAS 131 (Statement of Financial Accounting Standards No. 131) was issued in June 1997, and became effective for all US publicly listed firms with fiscal years commencing 15 December 1997.

The reporting mandate requires firms to report financial results at the segment level, such as segment revenue, segment profit or loss, and segment assets, as well as reconciliations of total segment amounts corresponding to figures in the firm's general-purpose financial statements.

The disclosed information also includes the firm’s operating business units, products and services, the geographical areas in which the firm operates, and details of its major customers.

The SFAS 131 requires that firms define the segments based on how a firm would internally view and organise its business operations. For example, the reporting could be by product segments, geographical areas, customer types and so on.

Just as the SFAS 131 applies to US listed firms, SFRS(I) 8 (Singapore Financial Reporting Standards International 8) similarly applies to firms listed on the Singapore Stock Exchange for segment reporting.

In his previous research, Associate Professor Cho Young Jun found that the adoption of SFAS 131 can improve the efficiency of internal capital allocation.

Given the external monitoring by shareholders, investors, fund managers, investment managers, asset managers and other interested parties, the SFAS 131 has been shown to motivate managers to act in shareholders’ interests by optimising the allocation of capital to the different business units.

To understand the impact of SFAS 131 further, especially on “how it can affect the equity compensation of managers such as stocks, stock options, restricted stocks”, Professor Cho decided to embark on a research project. He explained his research in detail when the Office of Research caught up with him.

For the research, the questions that were at his top of mind included:

“Does disclosure transparency affect equity compensation policy?” and;

“Is there a relationship between disclosure transparency and compensation policy?”

The research

To answer the questions, Professor Cho collaborated with Assistant Professor of Accounting Hojun Seo from Purdue University.

Given that the SFAS 131 came into effect on 15 December 1997, the research team selected a 12-year window between 1993 and 2004, which covers the pre- and post-period of the introduction of the reporting mandate.

The sample consisted of 4,752 US firms with multiple business segments and with easily accessible financial, stock price, and compensation data found in Compustat, CRSP and ExecuComp. 

The sample included firms that had previously practised disclosure reporting (control group) versus those firms that only implemented the disclosure policy (treatment group) following the introduction of SFAS 131.

The sample was carefully chosen so that the causality between disclosure and equity compensation could be conclusively established.

Financial and regulated entities were excluded from the research because these firms typically have different pay practices compared to firms from the other industries.

The research team performed regression analysis using a ‘difference-in-differences’ approach comparing how the SFAS 131 had affected the treatment group versus the control group in the selected timeframe.

Insights from the research

The research showed that segment disclosure and reporting can increase the implicit motivation for managers to act in the interest of shareholders.

The increased transparency of the firms’ operations meant that managerial actions could be easily monitored by external parties such as shareholders and investors.

The research also showed that equity-based compensation incentives decreased following the introduction of SFAS 131.

The decrease on equity-based compensation incentives was more pronounced for firms operating in a volatile market environment, as well as for firms with weak operations monitoring by their boards prior to the introduction of the reporting mandate.

Contributions of research

As a shareholder or investor, you would want to have access to detailed information on the operations of a firm to make informed decisions, and also to ensure that the managers of the firm are acting in shareholders’ best interests.

Professor Cho commented: “It is clear from the research that there is a relationship between disclosure transparency and compensation policy, or more specifically, equity-based compensation policy.

“As an investor or shareholder of a firm, you take comfort when you know that the firm’s managers are acting in your best interest without the need of excessive compensation incentives. The data tells us a disclosure policy such as the SFAS 131 can do just that,” he continued.

“The data also tells us that the SFAS 131 can reduce agency costs, which in this case refers to the costs of any inefficiencies that may arise from employing managers to run the firm operations. In other words, the SFAS 131 can have the effect of optimising equity-based compensation without the need of over-paying managers to run the business,” he added.

To read about Professor Cho’s research, please go to this link.

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