How Reporting on Segments of Diversified Companies Impacts Equity-Based Pay

How does financial transparency affect how CEO’s themselves are paid?

Young Jun Cho and Hojun Seo investigate how the introduction of SFAS 131, requiring companies to report performance by business segments, impacts equity-based compensation. Their research reveals that more granular disclosure reduces the need for stock-based incentives, especially in firms with weak internal oversight, but strong external scrutiny. The findings show how reporting rules can act as powerful tools of corporate governance, reshaping executive behaviour and investor influence.

Read the original research: doi.org/10.1111/1911-3846.12928

Transcript:

Hello and welcome to ResearchPod, thank you for listening and joining us today. 

In today’s world of global multinational companies, where a company like Amazon has multiple types of diversified businesses all under one brand. That makes it challenging to understand how each part is performing, especially when financials are combined in a single report. 

To combat this, we must enforce more granular reporting, provide investors with better insights into how managers in each business segment are performing, and ensure that each business segment is aligned with shareholder needs to make more informed investment decisions. 

In 1997, the Financial Accounting Standards Board released the Statement of Financial Accounting Standards No. 131, also known as SFAS 131. This new U.S. accounting standard was released to govern how companies disclose financial information about different parts or ‘segments’ of their business. 

To understand how disaggregated segment reporting impacts executive equity-based pay in diversified firms like Amazon and other global multinationals, researchers Young Jun Cho from Singapore Management University and Hojun Seo from Purdue University used the adoption of SFAS 131 as a marker. They analysed how companies changed their approach to equity-based pay before and after implementation.

So why does SFAS 131 matter for executive pay? 

Before SFAS 131, many diversified companies reported their financials in a way that made it difficult to know which parts of the business were thriving and which were underperforming. To use the Amazon example further, whose diversified business segments include web services, online retail, groceries, and more, they might have lumped a profitable division, like their cloud services under AWS, and a struggling arm like their Fire Phone, which was a failure, into one single line item. Obscuring inefficiencies like this has allowed CEOs to quietly cross-subsidise bad segments and reduce pressure for reform. Investors and analysts often have to guess what is really happening within the different parts of the diversified company, which may lead to mispricing and misaligned compensation packages. It’s worth noting that SFAS 131 required firms to provide more detailed reporting, disclosing the performance of each business unit separately.

Equity-based compensation, such as stock options and restricted shares, has long been used to align executives’ interests with those of shareholders. The idea is simple: if a CEO stands to benefit financially when the company’s stock rises, they’re more likely to make decisions that drive long-term value. But this system only works well when investors can see how individual business units are performing. Without detailed segment-level reporting, it’s hard to know whether a stock’s performance is due to one high-performing segment masking poor performance in others. That’s where transparency, like that introduced by SFAS 131, becomes so critical.

To conduct this research, Cho and Seo used diversified firms, which are firms with multiple business parts, that were already using high-quality segmented disclosures as aligned with SAFS 131 as a control group. They compared this control group with diversified companies that started or enhanced segment reporting after the release of SAFS 131 in 1997 as a treatment group. 

The research team analysed 4,752 annual reports from diversified companies over a 10-year period surrounding the release of SFAS 131. They used a measure called "flow delta," which estimates the increase in the value of a CEO’s new stock-based pay if the company’s stock price rose by 1%, to assess the degree to which executive compensation is tied to stock performance. Here's a quick example to make that clearer: if an executive is granted new stock options this year and their flow delta is $30,000, it means that for every 1% increase in the company's stock price, the value of those new options increases by $30,000. So, if the stock rises 10%, the CEO’s new equity grant would be worth $300,000 more.

In other words, flow delta is a way to see how closely a CEO’s pay is linked to the company’s stock price  and how willing the CEO might be to do things to ensure strong stock performance.

One of the research team’s most important insights is the distinction between explicit incentives, such as stock options, and implicit incentives, like fear of poor performance being exposed. As soon as segment reporting was adopted, it made it easier to monitor CEO decisions. External stakeholders, including shareholders, analysts, and even potential investors in mergers or acquisitions, then had more power to hold managers accountable. This new layer of scrutiny effectively acted as a substitute for performance-based pay. In other words, CEOs were now implicitly motivated to perform because underperformance was more likely to be spotted and penalised.

The research found that the group of companies that began or enhanced segmented disclosures after the release of SFAS 131, namely the treatment group, experienced a significant reduction in equity-based pay, or flow delta. This was particularly true for companies with weak internal board oversight, but with stronger external scrutiny from asset managers, institutional investors, and shareholders. 

This means that the extra visibility of disaggregated reporting put additional scrutiny on the CEO, suggesting companies firms face less need to use equity-based pay to incentivise CEO to work properly. In other words, companies relied more on equity-based pay to ensure CEOs were making company stocks perform well before SFAS 131 was introduced, but after the extra layer of in-depth segmented disclosure, they were being pressured from external sources to align with investor interests.

The implication here is that segment disclosures in diversified companies act as a corporate governance mechanism. The extra oversight on corporations means that CEOs are influenced to align with shareholder interests without the need for expensive equity-based CEO pay.

Another fascinating implication is that more transparent segment reporting may increase a company’s vulnerability to takeover threats. When disaggregated data exposes poorly performing segments, activist investors or private equity firms can more easily target underperforming businesses for restructuring or acquisition. This raises the stakes for executives, who must therefore operate under greater market discipline. For shareholders, this can be a good thing; increased discipline for CEOs keeps management focused and responsive. For CEOs, it’s one more reason to stay sharp without relying solely on high-stakes compensation packages.

To build on this research, other studies might look at how increasingly segmented and granular disclosure impacts other types of executive compensation, and whether other disclosures of non-financial information impact compensation or bonuses. For example, do in-depth sustainability disclosures impact compensation tied to some performance on diversity or climate? Or, how are investors impacted by these segmented disclosures, and does it make them more likely to invest, and by how much? 

This research also adds to a broader conversation about how disclosure rules influence corporate behaviour. As investors demand more transparency, not just in finances, but also in environmental, social, and governance metrics, it’s worth asking: could similar patterns emerge in other areas? For instance, could regulatory-required climate or diversity disclosures also reduce the need for certain types of incentive pay? Policymakers may take note that disclosure isn’t just about information: it shapes how companies govern, the behaviour of investors and executives, how executives are compensated, and how capital gets allocated.

This important research by Young Jun Cho and Hojun Seo demonstrates that new regulations, such as SFAS 131, can offer benefits beyond simply reducing red tape and increasing reporting requirements. The increased level of granularity in reporting and exposure to managerial actions on specific segments in diversified businesses allows shareholders sufficient insight to pressure CEOs to take actions aligned with shareholder goals. 

In summary, Young Jun Cho highlights how increased transparency through segment disaggregation, prompted by the SFAS 131 disclosure rule, can influence internal corporate governance, particularly executive compensation structures. By making managers' actions within diversified firms more transparent, the new reporting standards created a lower emphasis on equity-based incentives in CEO pay. 

These findings contribute to both the segment reporting and executive compensation literatures by showing that disclosure reforms can impact corporate decisions beyond capital markets, including how companies design incentive structures under varying disclosure and transparency conditions.

That’s all for this episode, thanks for listening. Links to the original research can be found in the show notes for this episode. And don’t forget to stay subscribed to ResearchPod for more of the latest science!

See you again soon. Also published on: https://researchpod.org/business/reporting-segments-diversified-companies-equity-based-pay

Podcast is also available on Spotify, Apple iTunes, Google Podcasts, and many more (please use search term “ResearchPod”).